A negative and statistically significant relationship

A negative and statistically significant relationship exists between EFCROE and CAP (Tables 3, 4, and 5). This
result suggests that a higher capital ratio leads to or predicts lower profitability. The traditionally tested signalling
hypothesis suggests that as the information between managers and investors has an asymmetrical distribution, it
can be less costly for managers of low risk banks to signal the bank’s quality through high capital ratios than for
managers of high risk banks. This hypothesis suggests a positive relationship between capital-asset ratio and the
bank’s profitability. Nevertheless, there is another theory which supports the contrary relationship: the efficiency -
risk hypothesis. The results, a priori , seem to support these alternative hypotheses about the profit-capital
relationship for the American banking industry. The efficiency-risk hypothesis suggests that more efficient banks
tend to choose low capital ratios, as higher expected returns from the greater profit efficiency substitute for equity
capital to a certain extent by protecting the banks against distress, default risk, or liquidation (Athanasoglou et al.,
2008).
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International Journal of Business and Social Science Vol. 2 No. 22; December 2011
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Besides the previous finding, the non-monotonic relationship between profitability and the capital ratio can be
analysed considering the quadratic form, as in the second columns in Tables 3, 4, and 5. The efficiency-risk
hypothesis and the franchise-value hypothesis support this quadratic framework. The franchise-value hypothesis
argue that more efficient firms tend to choose relatively high equity ratios to protect the future income derived
from high profit efficiency; while the efficiency-risk hypothesis suggests the opposite relationship. According to
Athanasoglou et al. (2008) the impact of equity capital on bank profitability is ambiguous. This argument claims
that lower capital ratios imply a relatively risky position, which leads to the indication of a negative relationship
between capital ratios and profitability (Athanasoglou et al., 2008). However, it could be the case that higher
levels of equity would decrease the cost of capital, leading to a positive impact on profitability (Berger, 1995a).
Consideration of these arguments led to a study of this quadratic – non-monotonic – relation. The results do
suggest a U-shaped relationship between EFCROE and CAP in the fixed effect (with-in) estimation, the GMM
system estimator, and the OLS pooled estimation (tables 3, 4, and 5). Just considering the regression results from
the GMM system estimator, which overcome the problems of endogeneity and constant heterogeneity, the return
on equity drops whenever the capital asset ratio increases up to a level of 41.35%.