Capital Strength and Bank Profitability

Abstract

The objective of this study is to examine the relation between capital strength and profitability of Korean banks. Employing a panel regression analysis for Korean banks during 2000-2008, this study finds that higher capital-ratio banks tend to manage the better factors of determining bank profitability. That is, the association between major explanatory variables and bank profitability is more significant and consistent with the general predictions of finance literature in the higher capital-ratio banks: Higher capital-ratio banks tend to relate larger asset size, higher capital ratio, and higher operating leverage to higher profits more significantly than lower capital-ratio banks. We find a similar result with respect to loan ratio, too. This indicates that higher capital-ratio banks may transform their advantageous position in capital strength more effectively and successfully into generating higher profits than lower capital-ratio banks. This result may be attributed to the various advantages higher capital-ratio banks have such as lower cost of capital, lower bankruptcy and financial distress costs, and less regulatory interference from bank regulator, etc. The policy implication that we can derive from the empirical results of this study may be the following. To improve bank profitability for banking sector’s soundness and safety, bank regulator needs to implement a discriminative regulatory policy between higher and lower capital ratio banks. That is, ignoring the degree of bank capital strength and imposing uniformed regulatory policy may not be effective in improving bank profitability.