Examining the Bank-Specific and Macro-Economic Factors that Influence Capital Adequacy in Pakistan

Abstract

The capital adequacy ratio is a dominant factor in the banking system because it identifies its strength against riskiness. This study empirically investigates the relationship of bank-specific and macro-economic factors on CAR using 26 Pakistani banks for the 2006 to 2018 period. This study applies a fixed-effect model to examine the bank-specific and macro-economic factors that influence capital adequacy. We find that a bank’s size, loan loss reserves, and leverage significantly influence capital adequacy. At the same time, interest rate appears to be a significant macro-economic variable that affects the banks' capital adequacy. When we include bank-specific and macro-economic factors, liquidity risk significantly impacts CAR. Based on the classification of bank ownership, we find that NPLs of public banks negatively affect CAR; however, foreign and local banks' net interest margin is a significant factor in increasing the banks' capital base and positively affecting CAR. Furthermore, the leverage of local banks is a significant determinant that illustrates that investment in risky assets reduces the CAR. This study also reports that a financial crisis impacts capital to risk-weighted assets of the local banks. Large banks are more diversified than small banks, and ROA, NPL, leverage, loan loss reserve, and crisis are essential factors that cause large banks' CAR. To test the robustness of the results, the equity to assets ratio (ETA) is used as a dependent variable and finds that ROE and market capitalization are the robust predictors.