Management & Engineering Commercial Banks on Profitability

Management & Engineering 22 (2016) 1838-5745
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Management & Engineering
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A Study on the Impact of Capital Structure of China’s Listed
Commercial Banks on Profitability
Ziwei HUANG ∗, Haiying PAN
Business School, Hohai University, Nanjing 211100, Jiangsu, P.R.China
KEYWORDS
ABSTRACT
Capital structure,
Liner relationship,
Listed commercial banks,
Profitability
Based on the annual report data of 13 listed commercial banks from 2009 to 2011, this paper
studies the impact of capital structure of China’s listed commercial banks on profitability.
The result indicates that return on equity (ROE) has a significant negative linear relationship
with the proportion of the largest shareholder, capital adequacy ratio, non-performing loan
ratio and loan-to-deposit ratio, and has a significant positive linear relationship with the
proportion of the top five shareholders and the proportion of supplementary capital to core
capital, and has no significant linear relationship with the nature of the largest shareholder
and asset scale. At the end, we propose our solutions to the banks based on the results and
their current situation.
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1 Introduction
Since China's accession to the WTO, with the rapid and steady development of the domestic economy, banks have made great
progress in scales, profitability and risk resistance ability. Meanwhile the competition in banking has become increasingly fierce.
Specifically, at the end of the year of 2006, with the full opening of China’s financial markets and the entrance of a large number of
foreign banks into the domestic market, China's banking have to face the competition from all around the world. How to win in the
competition is one of the practical problems faced by each bank. As for commercial banks, profitability directly reflects the ability of
management, risk control and sustainable development. Therefore, China's commercial banks should continue to enhance their
profitability in order to remain an invincible position in the competition. According to the modern theory of capital structure such as
MM theory, Trade-off theory, Agency theory, Pecking order theory and so force, capital structure can affect the cost of capital and
governance structure, thereby affecting operating performance. Specific to the banking, the impact of capital structure of commercial
banks on profitability are mainly reflected in two aspects: on one hand, there is a direct impact on the profitability by affecting the
cost of capital; on the other hand, there is an indirect impact on the profitability by affecting governance structure. From the capital
adequacy ratio requirements that agreed in Basel II, we know that capital adequacy ratio is required to be higher than 8%, the ratio
that equity capital accounts for the total capital of commercial banks is quite small, in addition to the fact that commercial bank is a
high-debt industry, the financial leverage is quite high. As a matter of fact, the effect of capital structure is mainly showed on the
indirect aspect — the governance structure. Meanwhile, as special enterprises, banks get earnings through operating risks, the level of
∗
Corresponding author.
E-mail address: [email protected]
English edition copyright © ST. PLUM-BLOSSOM PRESS PTY LTD
DOI:10.5503/J.ME.2016.22.013
65
development is directly related to the benefits of people's livelihood, so the capital structure of banks are far more complex than that
general companies. The study of the influences of capital structure on the profitability can urge the operators to optimize capital
structure, to improve operating performance, thus to improve the profitability of banks.
In recent years, the domestic scholars launched a number of studies about the relationships between commercial banks' capital
structure and profitability. Based on the theory of factor analysis, Zhang et al (2012) chose 14 indexes to study China’s 16 listed
banks through the use of factor analysis, and made the evaluation which gave the ranking of the banks in accordance with the
weighted Eigenvalue [1]. The results show that the scale factor and efficiency factor determine the bank performance in great extent.
Zheng (2011) used multiple linear regression method to analyze the relationship between the net profit of commercial banks in China
and the capital structure [2]. Li (2012) used the principal component analysis method to account the comprehensive performance of
the commercial banks based on the three principles, including liquidity, profitability and safety [3]. Meanwhile, the author also studied
the effect of capital structure to comprehensive performance. Shan et al (2010) used the factor analysis method to evaluate the
comprehensive score of listed commercial banks’ profitability [4], and analyzed the main indicators that affect capital structure with
regression analysis. They found that there is a positive correlation between capital structure and profitability of listed commercial
banks in China.
There are plenty of foreign literatures about the relationship between capital structure and bank performance. As the time of the
completion of the joint-stork reform of China’s commercial banks is inconsistent, together with the fact that the domestic financial
market has just opened and the reform of economic system and so forth, the development of the financial market is not perfect when
compared with foreign countries. So the researches on the impact of capital structure of commercial banks on operating performance
are still relatively few. Additionally, as the research methods and the focus are different, so the conclusions are always inconsistent.
On the basis of previous studies, this paper uses multiple regression analysis to check the influence of capital structure of listed
commercial banks on profitability.
2 Research Design
2.1 Samples selection
This paper chooses 4 state-owned banks and 9 joint-stock commercial banks, a total of 13 banks as samples. They are all listed in the
A share market, including Agricultural Bank of China, China Construction Bank, Bank of China, Industrial and Commercial Bank of
China, Bank of Communication, Pudong Development Bank, Merchants Bank, Industrial Bank, CITIC Bank, Everbright Bank,
Shenzhen Development Bank, Beijing Bank and Ningbo Bank. The data is from the annual report of the 13 listed banks, and the
period is from 2009 to 2011.
2.2 Model specification and variable description
We choose 8 indexes to analyze the impact of capital structure of commercial banks on profitability, and build the regression model
of the relationship between capital structure and profitability of the commercial banks. The model is as follows:
ROE= β + β ⋅ SH + β ⋅ SH + β ⋅ SH + β ⋅ SC+ β ⋅ CA+ β ⋅ SE+ β ⋅ NL+ β ⋅ LD+ ε
5 4
5
7
0 1 1 2
3
6
8
(1)
In formula (1), ROE indicates return on equity; SH1 indicates the proportion of the largest shareholder; SH indicates the nature of the
largest shareholder; SH5 indicates the proportion of the top five shareholders; SC indicates the proportion of supplementary capital to
core capital; CA indicates capital adequacy ratio; SE indicates asset scale; NL indicates non-performing loan ratio; LD indicates
loan-to-deposit ratio; ε indicates random interference term. The further explanation of variables in model (1) is as follows.
2.2.1 Dependent variable
We choose return on net assets as the dependent variable. It is the ratio of net profit and shareholder's equity, so it is also called return
on equity. It is used to measure the utilization efficiency of shareholders’ investment funds to the company. The reason why we
choose ROE as the index on behalf of profitability is that once a bank appears on the market, as an enterprise, it has the obligation to
realize the financial management objectives of maximizing shareholders’ wealth. It is recognized in modern financial management
theory that shareholders are the owners of an enterprise, and the goal of starting a business is to increase the wealth of shareholders.
If an enterprise can’t generate wealth for shareholders, they won’t invest the enterprise. Without equity funds, the enterprise also
cannot exist. Generally speaking, the higher the return on net assets can get, the more profits of the investment can make, thus the
equity of shareholders can be better guaranteed. Correspondingly, the shareholders should get much more in return.
2.2.2 Independent variables
According to the Base I approved in July 1988, the capital of banks are divided into two parts, including core capital and
supplementary capital, and The Basel I sets strict requirements on both of them. Therefore, there are three parts in explanatory
variables, including core capital, supplementary capital and capital adequacy ratio.
At first, Core Capital is also called tier one capital or equity capital, including equity capital and open reserve. This part shall not be
less than 50% of the total capital. The core capital is the most stable and best qualified part in a commercial bank, which can be a
permanent possession of the bank and can be used as a tool of absorption losses. According to the definition of core capital in Basel I,
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core capital means equity capital or own capital, so the measurement of ownership structure of listed commercial banks consists of
three parts, including the proportion of the largest shareholder (SH1), the nature of the largest shareholder (SH) and the proportion of
the top five shareholders (SH5). We define SH as a dummy variable, when SH=1, it means the largest shareholder is state-owned;
when SH=0, it means the largest shareholder is non state-owned.
Secondly, Supplementary capital is also called tier II capital. It consists of non-public reserve, asset revaluation reserve, general
reserve, hybrid capital instruments (claims/equity) and long-term subordinated bonds. According to requirements, the supplementary
of commercial banks shall not exceed 100% of the core capital, the proportion of supplementary capital to total capital shall not be
more than 50%, the long-term subordinated debt included in the supplementary capital shall not exceed 50% of the core capital. It
can be seen that capital of a commercial bank is quite different from that in the general enterprise. It not only includes core capital
(equity capital), but also includes a small part of the debt (long-term subordinated debt). Due to the special structure of subsidiary
capital, it is stably financed and has long duration. Therefore, the supplementary capital can perform the core capital’s function under
certain conditions, such as raising operating funds, making up the funding chain gap, enhancing the security of capital, absorbing the
losses of loans and reducing financial risks. To measure the condition of supplementary capital, this paper uses the proportion of
supplementary capital to core capital.
At last, according to the Basel II requirements, the capital adequacy ratio shall not be less than 8%. This means an increasing
supervision on capital adequacy ratio to commercial banks. If the capital adequacy ratio is not up to the standard requirements, on
one hand, the managers will be punished by the authority; on the other hand, the increasing of capital adequacy ratio means the
agency problems between managers and shareholders will be more obvious. Consequently, the capital adequacy ratio can show the
operation conditions of a commercial bank.
2.2.3 Control variables
Loan-to-deposit ratio. Bank is an enterprise which has high operating liabilities and high financial leverage, the debts mainly come
from customers deposits, and the use of funds is mainly for business loans, while the deposits and lending spreads are the major part
of the bank’s profits. That is why we select loan-to-deposit ratio to measure the special debt structure of banks.
Non-performing loan ratio. Among the influencing factors of the banks' capital structure, we must highlight the risk factors. In
accordance with the risk-based standard, loans include normal loans, special-mentioned loans, sub-prime loans, doubtful loans and
loss loans, the latter three are collectively referred to as non-performing loans. The increase of non-performing loans certainly will
add to bank’s operation risks. For weighing risk factors, we choose non-performing loan ratio, which can reflect the security of
assets.
Asset scale. It is generally recognized that bank has scale economies effect. Due to the large-scale operation, commercial banks can
seek profits. In addition, the larger the bank keeps, the more profits the bank can generate. Based on this, we select the natural
logarithm of total assets as the index which can measure scale.
Specific variables and the definitions are showed in Table 1.
Table 1 The definition of Variables
The nature of variable
Dependent Variable
Independent
Variables
Core Capital
Supplementary
Capital
Capital
Adequacy
Control Variables
Variable
The definition of variable
Return on equity (ROE)
Net profit/Shareholders' equity
The proportion of the largest
shareholder (SH1)
The nature of the largest
shareholder (SH)
The proportion of the top five
shareholders (SH5)
The proportion of supplementary
capital to core capital (SC)
Stake of the largest shareholder / Total shares
SH=1 State-owned;
SH=0 Non state-owned
∑ (The proportion of the ith largest shareholder)
(i=1,2,3,4,5)
Supplementary / Core capital
Capital adequacy ratio (CA)
(Capital-Deductions) / (Risk-weighted assets+12.5 ×
Operational risk capital+12.5 × Market risk capital)
Asset scale (SE)
Ln (Total assets)
Non-performing loan ratio (NL)
Non-performing loans / Total loans
Loan-to-deposit ratio (LD)
(Total loans +Total advances) / Total deposits
3 Empirical Results and Analysis
The paper uses SPSS17.0 to conduct a regression analysis of the sample data. From the regression results, we know that the
proportion of the largest shareholder (SH) and asset scale haven’t passed the test of significance 10%. It indicates that both of the two
variables have no significant linear relationships with ROE, therefore, we re-conduct the regression analysis after excluding these
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two variables. After arrangement, Table 2 shows the impact of capital structure of listed banks on profitability.
Table 2 The results of parameter estimation
Variable
Unstandardized coefficients (B)
t
Sig.
β0
34.242
7.462
0.000
SH1
-0.126
-4.058
0.000
SH5
0.095
3.484
0.002
SC
0.080
2.795
0.009
CA
-0.749
-2.848
0.008
NL
-2.681
-2.961
0.006
LD
R (R square)
-0.086
-2.072
0.047
0.771 (0.594)
Adjusted R Square
0.512
Durbin-Watson
2.171
F
7.305
p
0.000
The regression results show that the coefficient of determination R2 is 0.594, and the adjusted R2 is 0.512. According to coefficient of
determination, 6 independent variables could explain 59.4% of the total variance of the dependent variable. Autocorrelation of
Durbin-Watson is 2.171. It indicates residuals does not go against the assumption of no self-related. The F-value of the overall
regression equation is 7.305, p-value is 0.000. That means there is a significant correlation between independent variables and
dependent variable. From Table 2, we can get the final regression equation:
ROE = 34.242− 0.126⋅ SH1 + 0.095⋅ SH5 + 0.080⋅ SC − 0.749⋅ CA− 2.681⋅ NL − 0.086⋅ LD + ε
(2)
According to the regression results, we can draw the following conclusions.
3.1 There is a significant negative linear relationship between the proportion of the largest shareholder and
profitability
Under 1% significance level, the proportion of the first shareholder and ROE are negatively related. That means the higher the
proportion of the largest shareholder is, the lower the profits bank can generate. High concentration of equity is likely to cause
dominance. Under the circumstance of lacking external supervisions, it is likely to cause major shareholders’ encroachment upon the
interests of other shareholders in order to pursue their own, along with the opportunistic behaviors that result from ignoring the
banks’ profitability and development. This may cause hollow position of the subject and the phenomenon of internal control, which
can seriously damage the interests of other shareholders and lower the capacity of sustainable development, finally reduce the
profitability of banks. As a result, dominance should be avoided in reality.
3.2 There is a significant positive linear relationship between the proportion of the top five shareholders
and profitability
Under 1% significance level, the proportion of the top five shareholders and ROE are positively related. If the bank's equities are
concentrated in a few independent shareholders' hands rather than individual shareholders, then the disadvantage of dominance can
be effectively avoided. Accordingly, supervision and regulations will be formed between shareholders, and it can put an end to the
malpractice that a shareholder's interests are so big that damage the interests of other shareholders’. Then decisions will be made
from the overall point, which can improve the profitability of the bank. Together with the introduction of strategic investors, banks
always have different types of juridical person. In the pursuit of maximum profits, they will pay more attention to bank’s profitability,
and will implement strict supervision and restrictions to operators, which can prevent operators from damaging shareholders’
interests.
3.3 There is a significant positive linear relationship between the proportion of supplementary capital to
core capital and profitability
Under 1% significance level, the proportion of supplementary capital to core capital and ROE are positively related. From the annual
report data published by commercial banks recently, we know that the proportion of supplementary capital to net capital haven’t
reached 50%, at the same time, the proportion of supplementary capital to corn capital are far away from the requirement of 100%,
which means there is much room for that. Although supplementary capital is tier two capital, it is stably financed and the duration is
long, and it can perform some functions of core capital under certain conditions. When the proportion of supplementary capital
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appropriately increased, then the undercapitalized situation may be relieved and the pressure of the 8% supervision requirement is
likely to be alleviated effectively. As a result, supplementary capital plays a role in improving profitability, enhancing liquidity and
flexibility while adjusting capital structure and reducing capital cost.
3.4 There is a significant negative linear relationship between capital adequacy ratio and profitability
Under 1% significance level, capital adequacy ratio and ROE are negatively related. Except meeting the demands for long-term funds
of normal operating, bank capital is also the primary source of funds of absorbing losses and bearing risks. Meanwhile, bank capital
also carries out the functions such as maintaining market trust and preventing large-scale expansion of banking business. According
to the requirement of capital adequacy ratio in Basel II (Table 1), higher capital adequacy ratio means higher capital stocks or less
deductions, or lower risk capital at the same time. Deductions consist of business reputation, capital investment for non-consolidated
financial institutions, non-self-use real estates and enterprises, while they precisely to be one of the main forces of profit growth.
According to risk-reward trade-off theory, lower risk often associated with lower remuneration. Under such circumstances, with the
lack of liquidity of bank funds, shareholders cannot be able to achieve higher capital gains. Thus, raising venture capital in an
appropriate range helps to improve bank’s profitability. Consequently, capital adequacy ratio and ROE are negatively related.
3.5 There is a significant negative linear relationship between non-performing loan ratio and profitability,
as well as loan-to-deposit ratio
Under 1% significance level, non-performing loan ratio and ROE are negatively related. It is not difficult to understand the
conclusion. In spite of the continuous development of intermediate business in commercial banks, the spreads is still the main way
for profits. In case non-performing loans increase, banks would use profits to compensate for losses caused by loans. As a matter of
fact, the increase of non-performing loans could have a negative effect on profitability.
Under 5% significance level, loan-to-deposit ratio and ROE are negatively related. On one hand, with the increase of loan-to-deposit
ratio, the bank is provided with more funds to invest, therefore profits can be generated. On the other hand, from the perspective of
the bank’s risk resistant ability, due to the reason that there should be sufficient cash preserved in bank for the demands of
withdrawing cash by customers and settling accounts daily, loan-to-deposit ratio shall not be too much high. High loan-to- deposit
ratio may trigger credit crisis and payments crisis, on the condition crisis spreads, it may lead to financial crisis. The sample banks
we choose are in the early stage of financial reform, under the drive of pursuing profits, each bank manages to grant loans as much as
possible under the cordon of loan-to-deposit ratio, in order to generate more profits. Especially after the sub-prime mortgage crisis in
2008, pushed by the policy made by the government to stimulate economy recovery, there is a sharp increase in the scale of loans
among commercial banks, which happened in 2009. Banks loosen the control of loan quality, so the improvement of loan-to-deposit
ratio is also companied by the increase of risk-weighted assets, which caused the decline of profitability. Consequently, the negative
linear relationship between loan-to-deposit ratio and ROE has been showed.
3.6 There is no significant linear relationship between the nature of the largest shareholder and profitability,
as well as asset scale
Previous literatures tend to show that state-controlled may bring about the absence of benefits. Thereby, this is not conducive to the
play of shareholders' oversight functions, which may lower the capability of generating profits. The reason why the nature of the
largest shareholder and profitability are uncorrelated is duo to that under the circumstances of further deepen of joint-stock reform of
state-owned banks, further improvement and diversification of ownership allocation and further standardization of corporate
governance structure, no matter nation, state-owned legal person or foreign legal person holds the largest share, the objective is to
maximize shareholders' equity. In order to achieve profitability, they must be in accordance with the modern corporate governance
approach of bank management.
Asset scale and profitability are uncorrelated indicates that banks are not the bigger the better. The reason is probably because the
existence of the government’s implicit guarantee. On one hand, it may exacerbate moral hazards of banks — when operating
condition has been deteriorated, the bank may expand without any restrictions, which is likely to cause greater losses; on the other
hand, the implicit guarantee may give rise to the policy that banks are too big to close down. Due to the fact that banking is of vital
influence on the overall national economy, the authorities surely are not willing to let bankrupt and cause too much volatility to
national economy, which directly lead to the speculative motives in high risk business of large banks, thus enhancing bankrupt risk.
4 Conclusion and Suggestions
The paper verifies the impact of capital structure of China’s listed commercial banks on profitability from different aspects, including
the proportion of the largest shareholder, the nature of the largest shareholder, the proportion of the top five shareholders, the
proportion of supplementary capital to core capital, the capital adequacy ratio, asset scale, non-performing loan ratio and
loan-to-deposit ratio. The result shows that return on equity (ROE) has a significant negative linear relationship with the proportion
of the largest shareholder, capital adequacy ratio, non-performing loan ratio and loan-to- deposit ratio, and has a significant positive
linear relationship with the proportion of the top five shareholders and the proportion of supplementary capital to core capital, and
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has no significant linear relationship with the nature of the largest shareholder and asset scale. Capital structure of commercial banks
has a significant impact on their profitability, therefore it is necessary to improve governance structure and profitability by means of
optimizing the capital structure of commercial banks. Based on the results and commercial banks’ current situations, we propose our
solutions as follows.
4.1 Establish a relatively centralized ownership structure
The empirical results show that the proportion of the first shareholder should not be too high, and the proportion of the top five
shareholders could be increased appropriately. This can prevent the consequences of dominance [5], suppression the voting rights of
large shareholders in general meeting, preventing major shareholders acting merely in accordance with their own interests which
could damage the legitimate interests of minority shareholders, guaranteeing high-level strategic decision made from the interests of
the bank as a whole.
4.2 Treat state-owned shares from a correct point of view
In spite of the fact there is no significant linear relationship between the nature of the largest shareholder and profitability, the higher
the proportion of state-owed shares is the more stable and steady the bank will be. Consequently, we shall not cast a negated view
upon the role of state-owned shares in bank governance. We know that high ownership concentration is not conducive to improving
the profitability of banks, therefore we can take it into consideration that a moderate reduction of the proportion of state-owned
shares in a certain range [6]. At present, state-owned shares of China's listed commercial banks are basically in a holding position,
lower the proportion of state-owned shares helps to optimize the equity structure and establish a real modern corporate system, as
well as enhance the liquidity of capital market.
4.3 Optimize supplementary capital structure
There is still quite a distance for the proportion of supplementary capital in China's commercial banks when compared to the
specified limit. Hence, there exists certain room for growth. There are two main ways to replenish supplementary capital. One way is
to issue subordinated debts. Subordinated debts have the ability to maintain the original shares of shareholder’s, so that shareholder’s
equity can be safeguarded. At the same time, subordinated debts allow bank to make full use of financial leverage, and shareholders
can also benefit from the gains. The other way is to issue hybrid capital bonds. Hybrid capital bonds are capital instruments that
equipped with both equity and some debt characteristics, and are equipped with unsecured, slave and full features. Specially, hybrid
capital bonds can make the interests payment deferred when the capital adequacy ratio is lower than 4%. Consequently, hybrid
capital bonds equipped a higher capital property when compared with subordinated debts. Under the circumstance of bankrupt
liquidation, they can be paid off after subordinated bonds but prior to equity capital.
4.4 Improve the core capital as much as possible
Core capital consists of actual receipt capital, additional paid-in capital, features surplus, undistributed profits and minority stake.
Emphasize the importance of core capital owing to the reason that these are the most stable and reliable parts, which bank has the
right to occupy permanently. They are the tools for absorption losses as well as reducing risks during management. However, there is
no need to pursue high capital ratio blindly, it is showed from the empirical results that too much high capital adequacy ratio have a
negative impact on the profitability of banks. This can be solved by strengthening risk management — choose a moderate increase in
the stocks of these capital within the range of risk controllable, which can improve the profitability finally.
4.5 Improve the quality of loans
On the basis of the full use of collection, litigation and write-offs, reduce non-performing loan ratio; within the allowance permitted
by law, follow the principle of market competition, try to make use of the methods such as debt restructuring, asset securitization and
so force to deal with non-performing assets; upgrade the loan audit standards and transparency. With the methods listed above, the
goal to achieve the purpose of optimizing asset quality and improve its financial position can be realized.
Fund:
This paper was supported by “Humanities and Social Sciences Research Planning Foundation Project of Ministry of Education”
(12YJA790102).
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