The Effect of Capital Adequacy Requirements on Profitability: An Empirical Study on Licensed Finance Companies in Sri Lanka

Abstract

Licensed Finance Companies (LFCs) in Sri Lanka are recognized as authorized and regulated financial institutions to accept public deposits. However, with the recent collapse of a few LFCs in Sri Lanka, a serious concern has been raised about whether the LFC sector in Sri Lanka does not expose its shareholders to excessive levels of risk. Accordingly, the primary objective of this study is to examine the relationship between capital adequacy and the profitability of LFCs in Sri Lanka. This study is classified into the quantitative research approach based on secondary data of 18 LFCs in Sri Lanka from 2011 to 2020. The Core Capital Adequacy Ratio (CCAR), Total Capital Adequacy Ratio (TCAR), and LFC size (SIZE) were used as independent variables and as measures of profitability of LFCs, Net Interest Margin (NIM), Return on Assets (ROA) and Returns on Equity (ROE) were considered as dependent variables. The empirical results indicated that NIM, ROA, and ROE are positively related to CCAR, but none was significant. Further, NIM and ROA show a positive relationship with TCAR; however, only a significant relationship between ROA and TCAR was observed. Accordingly, this study recommends that since ROA would be increased in the capital adequacy level of LFC, all LFCs need to develop their internal policies to ensure that they have a clear set of capital adequacy expectations in place.