ABSTRACT
The study seeks to analyse the effect of leverage on bank financial performance and provide a comprehensive comparative analysis of foreign and domestic banks in Ghana with regards to the debt component of their capital structure over a ten year period. Secondary data was collected from the annual reports and financial statements of twenty-four (24) banks between 2006 and 2015. Parameter sensitivity analysis is carried out to test the difference between the performance of foreign and domestic banks in relation to their capital structure. The analysis revealed a statistically significant difference between the performance of foreign and domestic banks in relation to their capital structure. Random effects panel data estimation technique is used to evaluate the relationship between bank-specific variables (leverage, size, asset tangibility and sales growth) and financial performance using an unbalanced panel data. Evidence indicates that capital structure (leverage) has a negative significant effect on bank financial performance. However, it had a greater bearing on the financial performance of foreign banks because of their higher debt ratios. Evidence also suggests a positive significant relationship between financial performance and bank size. On the other hand, the results revealed a negative significant relationship between bank asset tangibility and financial performance. The result reveal that on average, the foreign banks are more profitable as compared to their domestic competitors. This can be attributed to the high risk accommodating characteristics (coefficient of variation) of the foreign banks. The study suggests that banks in Ghana heavily rely on debt as major source of financing which adversely affects their financial performance. Therefore, it is important for banks to consider debt as an indispensable component of their capital structure decisions.
Keywords: Capital structure, domestic banks, debt, equity, financial performance, foreign banks, Ghana, panel data regression.
CHAPTER ONE INTRODUCTION
Research background
The right proportion of debt in relation to equity that financial managers of firms must use to maximize shareholders wealth has remained a contentious debate since the seminary of Modigliani and Miller (M & M) in 1958. This talk prompted the recommendation of the capital structure concept by Modigliani and Miller. The total assets of a firm short its liabilities is its capital and may also be referred to as net wealth. “The capital structure of a firm concerns the mix of debt and equity the firm uses in its operation” (Abor, 2005).
One of the key choices a firm must make towards accomplishing its target of significant wealth creation relates to its capital structure (Margaritis & Psillaki, 2010; Modigliani & Miller, 1958). The management of firms face various difficulties with respect to capital structure decisions and how it influences profitability. The employment of various levels of debt financing by management of a firm is one approach utilized by firms to enhance profitability (Gleason, Mathur, & Mathur, 2000). According to Antwi, Atta and Zhao (2012), in developing economies such as Ghana, shareholders’ equity as a constituent of capital structure is related to the estimation of firm value and long-term debt.
The issue of funds has been recognized as an immediate motivation behind why organizations in emerging nations fail to advance (Abor, 2008). The choice of capital structure and its consequential optimal risk exposure is very vital in the financial performance of every business (Sulaiman, 2011).
This is on the grounds that the decision of leverage ought to at least materialize in the development of the estimation of speculations made through the different classifications of investors especially equity holders (Watson and Head, 2007). In the banking industry, capital structure decisions are predominantly important for continual growth and sustainability. Firms operate in open systems and this makes debt financing decisions important (Pearce & Robinson, 2009). This implies that, every firm depends on other institutions which provide essential resources and services for their set-ups and operations.
Financial performance denotes the yield on funds invested by the owners and creditors achieved by the efforts of management. According to Gleason, Mathur and Mathur (2000), capital structure influences performance and this holds for financial performance measurements as well. Titman and Wessels (1988) recognized non-obligation tax shield, development, uniqueness, mechanical order, size, instability and productivity as the contributing factor of the capital structure of firms. Various philosophies have been proposed to expatriate the capital structure of firms. Nonetheless, there is absence of unanimity among researchers of modern finance theory as to the ideal capital structure (Abor, 2005). The varieties in the various theories being progressed to advise such exceptionally essential choice further makes capital structure vital. Therefore capital structure choice is extremely basic, especially in connection to financial performance and estimation of debt (Awunyo-Vitor & Badu, 2012). The concept of an ideal leverage ratio is communicated on the notion of asymmetric information (Myers, 1984; Myers & Majluf, 1984). When firms modify their capital structures, they have a tendency to incline towards a focused leverage level that is consistent with theories in view of tradeoffs between the costs and advantages of debt (Hovakimian, Opler, & Titman, 2001).
Equity capital is the approach that empowers shareholders to sway as well as observe managerial judgements consistently from the side of the board of directors (Kisgen, 2006). Thus, they can make unexpected remedial move when they recognize an underlying indications of inefficient utilization. “Debt capital is the capital which a business raises by taking out loans” (Watson & Wilson, 2002). Debt capital differs from equity or share capital because subscribers to debt capital do not become part owners of the business. They are mere creditors and the suppliers of debt capital usually receive a contractually fixed annual percentage return on their loan which is known as the coupon rate.
Problem statement
In the last two decades, many countries have deregulated their financial sectors and have opened them up to foreign players. Opening up to foreign players has broadened the scope of products and services available to users of financial services and has led to significant financial innovations. This opening up to foreign entities has significantly led a growth in the size and number of transnational banks worldwide. In Ghana, these have included ECOBANK, Bank of Africa, Republic Bank, Zenith Bank, GN Bank, Barclays Bank and Standard Chartered (Haas & Lelyveld, 2011). These banking groups have subsidiaries across Africa and Europe.
Transnational banking groups finance their local subsidiaries through a range of financing types including debt and equity. Either type of financing has its advantages in terms of tax benefits, repatriation of profit, exchange rate hedging, etc. The financing of transnational subsidiaries by parent debt has the favorable position that while premium installments on the debt are tax deductible, there are no offsetting bankruptcy costs (Chowdhry & Nanda, 1994). On the account
of the tax differentials, parent firms are given incentives to charge high interest as possible on intra-firm loans. However, once the remote corporate tax rate is higher than the local rate, the parent corporation may have the motivation to overstate the fee on the loan and tax experts put restrictions on these rates to deter such an act (Chowdhry & Nanda, 1994). Multinational firms are by and large financed by a blend of internal debt and equity from the parent firms. Subsidiaries of such multinational firms depend intensely on the assets of parent companies for their financing need (Chowdhry & Coval, 1998). As indicated by Stonehill and Stitzel (1969) the upside of an intra-firm parent credit over external debt is that, there are no insolvency costs related with internal debt. Domestic firms unlike these multinational subsidiaries have no parent corporations to rely on for their funding needs.
Logically, it is expected that domestic banks should be able to have a comparative advantage over their foreign rivals. However, existing literature suggests that local banks face fierce competition from foreign banks and sometimes lose the race in specific areas such as technological and service portfolio innovation (Sturm and Williams, 2004; Figueira, Nellis and Parker, 2006). As clearly indicated by Sturm and Williams (2004), domestic banks are not good at putting their physical factors of production to prudent use. More so, these domestic banks are also less efficient at generating revenue as compared to their foreign rivals.
Existing empirical studies on bank capital structure has as yet not been successful in establishing the relative advantage of either financing options (Rajan & Zingales, 1995). Meanwhile financial theory such as Modigliani and Miller (1958) proposition II suggested that more debt should be
preferred. Some studies however have argued that there is an optimal level of debt that should be maintained in order to avoid bankruptcy costs. In practice however, the tax benefit of debt and control of free cash flow problems pushes firms to use more debt financing while bankruptcy costs and other agency problems provide firms with incentives to use less (Maina & Ishmail, 2014). Modigliani and Miller (1958) as well as Miller (1977) indicated the significance of the difference in increment tax duties for optimal leverage arrangement of firms in their studies.
Loans from parent corporations are often seen as equivalent to equity capital by both receiving firm and the financing parent corporation. A subsidiary firm maybe subject to all classes of debt but has no danger of insolvency from an external debt. A defining highlight of the banking systems in a number of emerging economies like Ghana is the large scale presence of foreign banks. This gives proof to the presence of internal capital markets through which foreign banks deal with the credit development of their foreign affiliates (Haas & Lelyveld, 2008). There are various financial frameworks that have opened up to coordinate foreign investment through local financial institutions, frequently as an immediate outcome and as an apparent answer to financial crises in developing countries (Dages, Goldbergn & Kinney, 2000). Whichever way the role of the capital structure of firm is looked at, the overarching concern of stakeholders is in how it affects the performance and long term survival of the firm.
