A negative and statistically significant relationship exists between EFCROE and CAP (Tables 3, 4, and 5). Thisresult suggests that a higher capital ratio leads to or predicts lower profitability. The traditionally tested signallinghypothesis suggests that as the information between managers and investors has an asymmetrical distribution,itcan be less costly for managers of low risk banks to signal the bank’s quality through high capital ratios than formanagers of high risk banks. This hypothesis suggests a positive relationship between capital-asset ratio and thebank’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-capitalrelationship for the American banking industry. The efficiency-risk hypothesis suggests that more efficient bankstend to choose low capital ratios, as higher expected returns from the greater profit efficiency substitute for equitycapital to a certain extent by protecting the banks against distress, default risk, or liquidation (Athanasoglou et al.,2008).Insert Table 3 hereInsert Table 4 hereInsert Table 5 here

International Journal of Business and Social ScienceVol. 2 No. 22; December 2011261Besides the previous finding, the non-monotonic relationship between profitability and the capital ratio can beanalysed considering the quadratic form, as in the second columns in Tables 3, 4, and 5. The efficiency-riskhypothesis and the franchise-value hypothesis support this quadratic framework. The franchise-value hypothesisargue that more efficient firms tend to choose relatively high equity ratios to protect the future income derivedfrom high profit efficiency; while the efficiency-risk hypothesis suggests the opposite relationship. According toAthanasoglou et al. (2008) the impact of equity capital on bank profitability is ambiguous. This argument claimsthat lower capital ratios imply a relatively risky position, which leads to the indication of a negative relationshipbetween capital ratios and profitability (Athanasoglou et al., 2008). However, it could be the case that higherlevels 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 dosuggest a U-shaped relationship between EFCROE and CAP in the fixed effect (with-in) estimation, the GMMsystem estimator, and the OLS pooled estimation (tables 3, 4, and 5). Just considering the regression results fromthe GMM system estimator, which overcome the problems of endogeneity and constant heterogeneity, the returnon equity drops whenever the capital asset ratio increases up to a level of 41.35%.

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