Capital Adequacy-Bangladesh Scenario

BUS 485 : Business Research
SECTION 04 – SPRING 2015
Capital Adequacy, Cost Income Ratio and the Performance of
Commercial Banks:
The Bangladeshi Scenario
Contributor
Shurid Zaman ID: 1221160
ABSTRACT
Banks have always played an important role in the economic development of every nation in
recent past. Especially in the emerging economies, the Banking industry is tasked in mobilizing
savings for capital formation for financing industries. Not only do they facilitate transactions
home and abroad, they aid consumer purchases as well via retail financing, in turn generating

employment. Hence banks are integral to a properly functioning economy, more than a tool in
serving a nation's monetary policy. Bangladesh's banking industry still has a significant flaw in
loan recovery procedures as the ratio of non-performing loans is much higher than the
international average. Its default culture has been long documented (1999, 41.1% Non-
Performing Loan Ratio then). Hence the pervasive nature of NPL ratios across banking industry
is concerning as it hints at fragile and bankruptcy prone firms. In light of the recent banking and
financial scandals, and that the private commercial banks are a larger portion of the banking
sector in Bangladesh, a study is needed to measure the efficacy of BASEL II Policing by
Bangladesh Bank. This policy intends to prevent Bank bankruptcies. Selected private sector
banks (3), listed on both the Dhaka Stock Exchange and Chittagong Stock Exchange, in
Bangladesh were examined through extensive use of financial ratios that mainly indicate the
adequacy of the risk based capital, return on assets (ROA), return on equity (ROE), cost income
ratio (CIR), etc.. Annual time series data from 2008-2012 of the selected banks from their
respective audited annual reports (secondary data) were employed in multiple regression
analysis to apprehend the impact of bank size, asset growth rate, core capital ratio, equity
capital to asset ratio, cost income ratio, etc. on profitability of banks. Statistically, the hypothesis
is claiming that most of the independent variables have significant impact on financial
performance of Bangladeshi commercial banks.
Key words: Capital Adequacy, Financial Performance, Return on Assets, Cost Income Ratio
OBJETIVES OF THE STUDY
The major objective of this study is to analyze the financial performance of the selected
private sector banks in light of the capital levels they employ. The following are the specific
objectives of the study.
1. To determine whether total capital/ asset(TCA),risk weighted asset (RWA) core capital/
asset (CCA), equity capital asset (ECA) and total have statistically significant impact on

internal based performance (ROA) of Bangladeshi Private Sector commercial banks
NBL,NCC and Primer.
2. To determine whether total capital/ asset(TCA), RWA, core capital/ asset (CCA), equity
capital asset (ECA) and total have statistically significant impact on internal based
performance Return on Equity (ROE) .
3. To determine whether CIR have negative impact on the performance of these commercial
bank
INTRODUCTION
The financial environment of any economy consists of typically five components namely:
money, financial instruments, financial institutions, rules and regulations and financial markets.
Among the various financial institutions, banks are a fundamental component and the most
active players in the financial system (Dhanabhakyam & Kavitha, 2012). Bank is a financial
intermediary that channels funds from surplus units, the depositors, to the deficit units, the
borrowers, in the process gaining from the spread of the different interest charged. By the scope
of its functions, banks are the key to economic growth of any economy (Rashid, 2010). Further,
banks are a fundamental component of the financial system, and are also active players in
financial markets (Guisse, 2012). The essential role of a bank is to connect those who have
capital (such as investors or depositors), with those who seek capital (such as individuals
wanting a loan, or businesses wanting to grow). Banks have control over a large part of the
supply of money in circulation. Through their influence over the volume of bank money, they
can influence in nature and character of production in any country (Brigham & Houston, 2011).
The banking system of the developing and emerging economies such as Bangladesh plays a
pivotal role in promoting and enhancing the economic growth. However, there remains concerns
among citizens the perceived lack of transparency and trust between banks and their clients. This
is especially more in light of the wave of financial scandals that had hit the Bangaldeshi Press in
recent times. The often cited reason for the lack of trust and perhaps the reason behind not being
able to play even a greater role in promoting growth is that the capital market of the developing
economies lacks transparency and accountability. Additionally “information asymmetry”

problem is seen fierce in developing economies and this information asymmetry problem reduces
the depth of the capital market (Hossain, 2009).
A single bank is highly connected with other banks for payment system and other
functions of bank such that the failure of a single bank not only affects its shareholders and
depositors rather it affects rest other banks and even all rest other business. The failure of a
single bank creates an economic turmoil situation and is regarded as a disaster for the economy.
The recent global recession is also an example of economic disaster that occurred for the failure
of banking business. So, the government of any country must have a high concern about the
performance of all banks (Searle, 2008). The supervisory authority creates smooth and efficient
atmosphere for fund flow and payment system. Supervisory authority measures the performance
and assess the strength and weakness of banks and takes necessary actions (Iqbal, 2012). The
banking sector of Bangladesh compared to its economic size is moderately bigger than many
other economies of equal level of development and per capita income (Nguyen, Islam & Ali,
2011). There are more than fifty commercial banks operating in this small economy. Although
over the last thirty years, the country achieved noticeable success regarding the access to banking
services, in 1972 population per branch was 57,700 and in the year of 2010, it was 20,162 per
branch. The statistics indicates that getting banking services is not a significant problem for the
country (Nguyen, Islam & Ali, 2011).
In the banking system, the private commercial banks (PCBs) hold more than 61% of the total
deposits and 59% of industry assets followed by the four nationalized commercial banks (SCBs)
that hold 27.5% of the total deposits and 28.8% of industry assets (Annual Report, Bangladesh
Bank 2010-11). Bank financing was around 94% of total financing while equity financing
accounted for the remaining 6% in 2007. This represents that the financial system of Bangladesh
is predominately bank centric and the country’s economic growth primarily rests on the
development of its credible and stable banking system. To establish this, Bangladesh Bank has
introduced Risk Based Capital Adequacy guideline relating to the Basel 2 Accord. In compliance
to international standards Bangladesh Bank has made the guidelines statutory for all scheduled
banks in Bangladesh from January 01, 2010. The required Capital Adequacy Ratio required to
maintain is above 10%. Bangladesh's banking industry still has a significant flaw in loan
recovery procedures as the ratio of non-performing loans is much higher than the international
average, a study has found. The ongoing political unrest will augment the amount of classified
loans in future. On an average, non-performing loans (NPL) were 12.79 percent of total loans as
of September (2013), while the internationally accepted tolerable limit is 2-3 percent, according

to the study conducted by Bangladesh Institute of Bank Management. The default loans at non-
bank financial institutions are also quite high, but better than the Banking institutions. The
capital ceiling of the financial institutions has gradually been raised to Tk 100 crore initially,
which was Tk 2 crore to Tk 2.5 crore.
Having passed on many years from the implementation of BASEL II, the natural query today can
be whether performance and profitability of banks had been enhanced or affected by the
minimum capital adequacy ratios being enforced by the central bank. Hence the objective of this
study is to investigate the relationship between two determinants (capital adequacy and cost
income ratio) and the profitability of commercial banks in Bangladesh.
PROBLEM STATEMENT
HIGH NUMBER OF NON PERFORMING LOANS REGARDLESS OF BASEL-I AND
BASEL-II IMPLEMENTATION IN BANGLADESH
GENERAL QUESTION
DO POLICING OF BANKS BY BASEL REQUIREMENTS LOWER BANKRUPTCY
CHANCES AND MAKE THEM EFFICIENT IN BANGLADESH?
LITERATURE REVIEW
Capital represents a source of funds to the bank along with deposits and borrowings. Capital
adequacy has been the focus of many studies and regulators as it is considered to be one of the
key indicators for banking profitability. The level of capital has some implication on the
performance and bankruptcy of a bank. (Muthuva, 2009)

The level of capital of a bank does affect lending. It has implications for the performance of
banks as financial intermediaries. Hence for the allocation of real resources within the economy,
the need of capital by the bank is paramount. Undercapitalized bank will find itself subjected to
high levels of short term borrowing at potentially high excess costs during periods of tight
money. Hence Capital Adequacy does affect profitability. This will be further investigated in
Bangladeshi banking sphere to hold true or false. Market determined capital positions for banks
seems preferable than by design due to dynamic feedback capability given by market demand
and supply. (Muthuva, 2009)
Regulators concerned with systematic risk of a bank runs do not like to rely on exclusively
reserve requirement, deposit insurance because of the potential moral hazard. As a result
regulators aiming at minimizing the moral hazard requiring equity capital as a fraction of bank
risk weighted asset. (Mamun, 2013) Applying minimum capital adequacy ratios serves to protect
depositors and promote the stability and efficiency of the financial system (Reserve Bank of New
Zealand, 2007).
The Cost Income Ratio is another emerging measure of bank’s efficiency and profitability. CIR
measures a bank’s operating costs as a proportion of its total (net interest and non interest)
income (Welch, 2006). The cost-to-income ratio is a key financial measure, particularly
important in valuing banks. It shows a company’s costs in relation to its income. To get the ratio,
divide the operating costs (administrative and fixed costs, such as salaries and property expenses,
but not bad debts that have been written off) by operating income. The ratio gives investors a
clear view of how efficiently the firm is being run – the lower it is, the more profitable the bank
will be. Changes in the ratio can also highlight potential problems: if the ratio rises from one
period to the next, it means that costs are rising at a higher rate than income. (MoneyWeek,
2013)
In measuring the profitability of a bank, bank regulators and analysts have used Return on Assets
(ROA) and Return on Equity (ROE) to assess industry performance and forecast trends in market
structure as inputs in statistical models to predict bank failures and mergers and for a a variety of
other purposes where a measure of profitability is desired
Returns on Equity (ROE) is one way of measuring the relative performance of a bank to other
financial institutions (Navapan and Tripe 2003). This perspective allows a comparison of

investment in a bank’s shares with other investment opportunities, while it can also measure
bank’s riskiness.
CONCEPTUALFRAMEWORK
METHODOLOGY
Data:
For this study, data has been taken from secondary sources such as the Annual reports of Private
sector banks were used to collect the data regarding of bank size, capital management,

operational management, etc. for the time span 2008-2012. 3 of the many commercial banks that
operate in Bangladesh were chosen. This represents a small proportion of the all registered
commercial banks in Bangladesh, thus telling us of the severe limitation of this work.
Sample Size:
The sample of the study consists of three Bangladeshi Private Commercial banks listed on both
the Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE). Annual Time
Series data for both independent and dependent variables were extracted from the respective
banks’ annual audited financial statements from the period 2008-2012. Therefore, the total
sample year-observations of this study is 15.
Further Comments
The collected data was analyzed and interpreted with the help of different financial ratios and
statistical tools including percentages, averages, trend analysis, regression, correlation and the
significance test using SPSS 17.0. The five hypotheses were tested statistically to arrive at the
conclusions and policy implications. The approached used in this studies is used by Lazaridis
and Tryfonidis (2006) to analyze the different variables.
RESEARCH QUESTIONS
IS CAPITAL ADEQUACY CORRELATED WITH BANK PROFITABILITY?
IS COST INCOME RATIO CORRELATED WITH BANK PROFITABILITY?
HYPOTHESIS
H1: Capital Adequacy is positively related to bank profitability.
H2: Cost-income ratio is negatively related to bank profitability.
SUB HYPOTHESIS

H1A: The core capital (leverage) ratio is positively related to bank profitability.
H1B: The equity capital to asset ratio is positively related to bank profitability.
H1C: Tier 1 risk based capital ratio is positively related to bank profitability.
H1D: The ratio of total capital to assets is positively related to bank profitability.
Table 1 Variable Definition
Variable Formula
Return on Assets (ROA) Net income after taxes/total assets
Return on Equity (ROE) Net income/total equity
Core Capital/assets (CCA) Tier 1 (core) capital/total assets
Equity capital/assets (ECA) Total equity capital/total assets
Core Capital/Risk Weighted Assets (TRC) Tier 1 (core) capital/ RWA
Total Capital/Assets (TCA) Total Risk Based Capital/ RWA
Cost income Ratio (CIR) Operating Expenses/Operating Income
Bank Size Natural Logarithm of total Assets
Asset Liabilities (AL) Assets/liabilities
Debt to Equity Total Debt/ Total Equity
Table 2 shows the summary statistics of collected variables. The total observations are n = 15.
The banks included in the sample had an average (median) of 1.95% (1.90%) on ROA and an
average (median) of 18.2 % (17.4%) on ROE.
Table 2: Summary Statistics
Variables Year Observations Mean Median Standard
Deviation
Return on Assets 15 0.019447 0.018980 0.0128130
Return on Equity 15 0.181549 0.173920 0.0983758

Core Capital/
Assets
15 0.0991 0.979 0.0142948
Equity
Capital/Assets
15 0.103179 0.098 0.0152593
Total Capital/
RWA
15 0.098598 0.1021 0.0154996
Cost Income
Ratio
15 0.471233 0.401200 0.1984322
Asset Liabilities 15 1.115365 1.108606 0.0194078
Debt to Equity 15 8.866910 9.207586 1.2823366
Table 3 shows the Person product moment coefficient of correlation (also called the correlation
coefficient or correlation) for the pairs of variables. The correlation coefficient is a measure of
the degree of linear relationship between two or more variables. The dependent variables for the
study are bank profitability as measure by the Return on Assets (ROA) and the Return on Equity
(ROE). The independent variables are: the core capital (leverage) (CCR) ratio, tier 1 risk based
capital ratio (TRC), the ratio of total risk-based capital to assets (TCA), the cost income ratio
(CIR), Bank Size, Asset Liabilities (AL).
In order to assess the relationship between profitability and capital adequacy ratios, the
profitability is modeled as a function of the core capital ratio, the equity capital ratio, the total
risk based capital and the total capital ratio.
Table 3 Correlations involving dependent variable ROA
ROA CCA ECA TRC TCA CIR
ROA Pearson Correlation 1 .332 .726** -.196 .085 -.703**

Sig. (2-tailed) .227 .002 .483 .763 .003
N 15 15 15 15 15 15
CCA Pearson Correlation .332 1 .535* .316 .549* -.289
Sig. (2-tailed) .227 .040 .252 .034 .297
N 15 15 15 15 15 15
ECA Pearson Correlation .726** .535* 1 -.050 .186 -.522*
Sig. (2-tailed) .002 .040 .859 .508 .046
N 15 15 15 15 15 15
TRC Pearson Correlation -.196 .316 -.050 1 .909** -.002
Sig. (2-tailed) .483 .252 .859 .000 .993
N 15 15 15 15 15 15
TCA Pearson Correlation .085 .549* .186 .909** 1 -.080
Sig. (2-tailed) .763 .034 .508 .000 .776
N 15 15 15 15 15 15
CIR Pearson Correlation -.703** -.289 -.522* -.002 -.080 1
Sig. (2-tailed) .003 .297 .046 .993 .776
N 15 15 15 15 15 15
BS Pearson Correlation -.079 .437 .499 .411 .482 .078
Sig. (2-tailed) .780 .104 .058 .129 .069 .782
N 15 15 15 15 15 15
AL Pearson Correlation .732** .528* 1.000** -.051 .187 -.517*
Sig. (2-tailed) .002 .043 .000 .856 .506 .049
N 15 15 15 15 15 15

DE Pearson Correlation -.674** -.582* -.989** .043 -.181 .553*
Sig. (2-tailed) .006 .023 .000 .879 .518 .033
N 15 15 15 15 15 15
**. Correlation is significant at the 0.01 level (2-tailed).
*. Correlation is significant at the 0.05 level (2-tailed).
Pearson Correlation - These numbers measure the strength and direction of the linear
relationship between the two variables. The correlation coefficient can range from -1 to +1, with
-1 indicating a perfect negative correlation, +1 indicating a perfect positive correlation, and 0
indicating no correlation at all. (A variable correlated with itself will always have a correlation
coefficient of 1.)
We can see that ECA CIR AL DE are correlated with the dependent variable ROA.
All of them are significantly correlated, at the level of 1% (2 tailed).
ECA and AL are positively correlated.
CIR and DE are negatively correlated.
Table 3(continued) Correlations involving dependent variable ROE
ROE CCA ECA TRC TCA CIR
ROE Pearson Correlation 1 .241 .511 -.215 .043 -.733**

Sig. (2-tailed) .386 .052 .442 .879 .002
N 15 15 15 15 15 15
CCA Pearson Correlation .241 1 .535* .316 .549* -.289
Sig. (2-tailed) .386 .040 .252 .034 .297
N 15 15 15 15 15 15
ECA Pearson Correlation .511 .535* 1 -.050 .186 -.522*
Sig. (2-tailed) .052 .040 .859 .508 .046
N 15 15 15 15 15 15
TRC Pearson Correlation -.215 .316 -.050 1 .909** -.002
Sig. (2-tailed) .442 .252 .859 .000 .993
N 15 15 15 15 15 15
TCA Pearson Correlation .043 .549* .186 .909** 1 -.080
Sig. (2-tailed) .879 .034 .508 .000 .776
N 15 15 15 15 15 15
CIR Pearson Correlation -.733** -.289 -.522* -.002 -.080 1
Sig. (2-tailed) .002 .297 .046 .993 .776
N 15 15 15 15 15 15
BS Pearson Correlation -.281 .437 .499 .411 .482 .078
Sig. (2-tailed) .310 .104 .058 .129 .069 .782
N 15 15 15 15 15 15
AL Pearson Correlation .516* .528* 1.000** -.051 .187 -.517*
Sig. (2-tailed) .049 .043 .000 .856 .506 .049
N 15 15 15 15 15 15

DE Pearson Correlation -.469 -.582* -.989** .043 -.181 .553*
Sig. (2-tailed) .078 .023 .000 .879 .518 .033
N 15 15 15 15 15 15
**. Correlation is significant at the 0.01 level (2-tailed).
*. Correlation is significant at the 0.05 level (2-tailed).
Only AL and CIR are significantly related to ROE at the level of 1% (2 tailed).
CIR is negatively correlated to ROE
AL positively correlated to ROE
REGRESSION MODELS
RECALLING

HYPOTHESIS
H1: Capital Adequacy is positively
related to bank profitability.
H2: Cost-income ratio is negatively
related to bank profitability.
SUBHYPOTHESIS
H1A: The core capital (leverage) ratio is
positively related to bank profitability.
H1B: The equity capital to asset ratio is
H1C: Tier 1 risk based capital ratio is
H1D: The ratio of total capital to assets is
Hypothesis
H1A: The core capital (leverage) ratio is positively related to bank profitability.

ROA, = ao + a1CCR, + a2BS, + a3AL,+a4DE,+D+ e,
Variables Entered/Removed
Model
Variables
Entered
Variables
Removed Method
1 DE, BS, CCA,
ALa
. Enter
a. All requested variables entered.
Model Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .906a
.820 .748 .0064329
a. Predictors:(Constant),DE, BS, CCA, AL
Coefficientsa
Model
Unstandardized Coefficients
Standardized
Coefficients
B Std. Error Beta t Sig.
1 (Constant) -1.113 .737 -1.511 .162
CCA .132 .158 .147 .835 .423
BS -.016 .005 -.552 -3.363 .007
AL 1.284 .558 1.945 2.301 .044
DE .010 .009 1.033 1.152 .276
Comments
Referring to the table above, it was found that that the adjusted R-square value is 75% and

from this it is concluded that 75% of the variation in the dependent variable (ROA) is
explained by the independent variables. This indicates a strong explanatory power of the
regression
ROA, = -1.113 + .132CCR, + -.016BS, + 1.284AL,+ .010DE,+ e,
So core capital leverage is positively correlated to bank profitability (ROA)
Hypothesis
H1B: The equity capital to asset ratio is positively related to bank profitability.
ROA, = ao + a1ECA, + a2BS, + a3AL,+a4DE,+D+ e,
Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .898a
.807 .755 .0063475
a. Predictors:(Constant), ECA, BS, DE
Coefficientsa
Model
Standardized
Coefficients
1 (Constant) .155 .222 .700 .498
BS -.015 .005 -.536 -3.334 .007
DE .010 .009 .977 1.059 .312
ECA 1.646 .756 1.960 2.176 .052
a. DependentVariable:ROA
Comments

regression
ROA, = -1.55 + 1.646ECA, + -.015BS, +.010DE,+ e,
So, The equity capital to asset ratio is positively related to bank profitability
Hypothesis
H1C: Tier 1 risk based capital ratio is positively related to bank profitability.
ROA, = ao + a1TRC, + a2BS, + a3AL,+a4DE,+D+ e,
Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .903a
.816 .743 .0065003
a. Predictors:(Constant),TRC, DE, BS, AL
Coefficientsa
Model
Standardized
Coefficients
1 (Constant) -.852 .721 -1.182 .264
BS -.017 .006 -.603 -3.143 .010
AL 1.117 .540 1.692 2.070 .065
DE .007 .008 .666 .786 .450
TRC .090 .131 .109 .690 .506
Comments:

regression
ROA, = -.852 + .090TRC, + -.017BS, +1.117AL,+ .007DE + e,
So, Tier 1 risk based capital ratio is positively related to bank profitability.
Hypothesis
H1D: The ratio of total capital to assets is positively related to bank profitability.
ROA, = ao + a1TCA, + a2BS, + a3AG,+a4DE,+D+ e,
Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .917a
.840 .776 .0060601
a. Predictors: (Constant),TCA, DE, BS, AL
Coefficientsa
Model
Standardized
Coefficients
1 (Constant) -.696 .683 -1.019 .332
BS -.019 .005 -.658 -3.745 .004
AL 1.017 .509 1.541 1.997 .074
DE .005 .008 .531 .667 .520
TCA .136 .095 .211 1.433 .182
Comments:

regression
ROA, = -.696+ .136TCA, + -.019BS, + 1.017AL,+ .005DE + e,
So, The ratio of total capital to assets is positively related to bank profitability.
Hypothesis
H2: Cost-income ratio is negatively related to bank profitability
ROA, = ao + a1CIR, + a2BS, + a3AL,+a4DE,+D+ e,
Variables Entered/Removed
Model
Variables
Entered
Variables
Removed Method
1 CIR, BS, AL, DEa
. Enter
a. All requested variables entered.
Model Summary
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate
1 .939a
.882 .835 .0052075
a. Predictors:(Constant),CIR, BS, AL, DE
Coefficientsa

Model
Standardized
Coefficients
1 (Constant) -1.687 .644 -2.619 .026
BS -.008 .005 -.287 -1.742 .112
AL 1.589 .466 2.406 3.411 .007
DE .018 .008 1.774 2.258 .048
CIR -.027 .011 -.417 -2.515 .031
Comments:
regression
ROA, = -1.687 + -.027CIR, + -.008BS, + . 1.589AL,+ .018DE+ e,
So, Cost-income ratio is negatively related to bank profitability
CONCLUSION

The core capital (leverage) ratio is positively related to bank profitability.
The equity capital to asset ratio is positively related to bank profitability.
Tier 1 risk based capital ratio is positively related to bank profitability.
The ratio of total capital to assets is positively related to bank profitability.
HENCE, Capital Adequacy is positively related to Bank Profitability.
ALSO, Cost-income ratio is negatively related to bank profitability.
RECALLING PURPOSEOFTHE
STUDY
ANSWERING
DO POLICING OFBANKS
BY BASELREQUIREMENTS
LOWERBANKRUPTCY CHANCES
AND MAKETHEM EFFICIENT
IN BANGLADESH?
COMMENT: As we can see, BASEL Policing does indeed result in increased bank profitability.
Hence we can conclude that Bangladesh Bank policies so far do indeed make banks more
profitable and hence less are the chances for bankruptcy.

Limitations of the Study:
The research had a few limitations which were stated bellow:
Due to time constraints, interview of personnel from Private sector banks could not be
taken which might have led to a better understanding of the internal performance of the
bank.
The sample size includes data of three private banks for five years. Increasing the sample
size could improve the validity of the research.
Since the research is based on Secondary sources only, the accuracy of the research
depends completely on the accuracy of the secondary data used.
In addition to time and fund constraints, poor data availability rendered the research to a
limited sample size and only three models. With proper facilities the research could be
conducted more rigorously.
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