Capital Structure and Profitability of Deposit Money Banks: Empirical Evidence from Nigeria

Abstract

The banking sector consolidation exercise that took place in Nigeria in 2005 did not only reduce the number of Deposit Money Banks (DMBs) but diversified their capital structure and adjusted their regulatory capital requirements. Given these developments, it is imperative that the DMBs determine the most optimal financing mix which minimises the cost of financing as well as maximises returns. This study empirically examined the impact of capital structure (owners’ funds and borrowed funds) on bank profitability in Nigeria. Applying autoregressive distributed lag model on a sample of 13 DMBs from 2005 through 2014, the study found that about 83 per cent of total assets employed by the DMBs are not financed by owners, confirming the hypothesis that banks are highly levered institutions. Consistent with the agency and static trade-off theories of capital structure and earlier empirical findings in Nigeria, the results further found evidence of a positive and significant influence of both owners’ and borrowed funds on profitability. However, borrowed funds was found to be more prevalent in enhancing the performance of DMBs during the study period. Following these findings therefore, the study recommends that DMBs should study and understand the dynamics of capital structure to enable them make optimal capital mix decision. In addition, since debt is more critical in boosting profitability of banks in Nigeria, DMBs should employ more debt than equity in financing real investment with positive net present values. The management and board of directors of DMBs should incentivise lenders and depositors so as to enhance easy access to funds other than shareholders’. Additional incentives on depositors’ and creditors’ funds such as increase in their returns are capable of attracting more funds from the investing public to create assets.

Key Words: Capital Structure, Owners’ Funds, Borrowed Funds, Gross Earnings, Deposit Money Banks, Nigeria