INTRODUCTION

Financial decision making moves around “increasing the wealth of shareholder’s” and these financial decisions can be very tricky sometimes. One basic question “proportion of debt to equity?” and there could be hundreds of options but to decide which option is best in firm’s particular circumstances. It is effective to use more portion of Debt for the purpose of financing as it is less costly then equity but there are also some limitations and in the case of bank it has restrictions imposed by regulatory authority and after the certain limit it will affect company’s leverage (traditional theory of Capital Structure). Financially troubled or risky companies could face severe consequences as they normally are charged more interest rates on debt. So there should be a balanced proportion of securities mix in firm’s capital structure. Capital structure affects leverage and consequently profitability of firm. Firms with low earnings and high leverage are more exposed to risk and less attractive for investors. Most of these statements are true for banks also but capital structure of banks is a bit different from firm’s perspective. So far there is no clear understanding about combination of financing options and this is because of regulations from government/ regulatory body, banks have to follow them and they have to adjust theirs source of financing accordingly. All the banks are regulated by the State Bank and rules of SBP are same for all the banks but still these banks have different levels of profitability. Research paper aims to observe Banking sector of Pakistan (population) during this research because this sector has a major impact on the economy of Pakistan. Objective of this research is to investigate the relationship between capital structure and profitability of Banks regulated by the State Bank of Pakistan because one of the main factors that effect profitability is capital structure decision. For this research paper sample of 20 banks is taken and their 5 years financial data i.e. 2004-2008.

Idea for this paper is taken from a research article written by Joshua Abor (2005). The variables used by Prof. J. Abor in that study are different from those used for this paper. These variables are taken after going through the literature. Gearing ratio and Equity Multiplier are taken as an independent variable and dependent variables are Return on Equity (ROE), Return on Assets (ROA), Net Interest Margin (NIM), Efficiency ratio, Burden ratio, Earning Base and Spread ratio. For better analytical results, Size (log of Total Assets) is used as control variable.

This study has certain limitations like full access to the data related to this research is a problem, sample selected can be constraint to the research, data is gathered through published financial reports and data shown in the reports might or might not represent the actual picture. This research is helpful for further studies in a way that now one doesn’t need to find the profitability of banks in Pakistan and one can focus on certain broad areas like profitability interrelationship of local and multinational banks, determinants of capital structure of the banks, liquidity position and so on.

LITERATURE REVIEW

Capital is the engine of the economy and the financial information is the oil that keeps the engine running smoothly (R.S Raghavan). For banks Capital is the total Owned Funds available to the Institution for a reasonably long time. ICCMCS (2004) divided this capital into Core capital (basic equity) and Supplementary capital and classified in Tier I, Tier II and Tier III Capital.

Tier 1 capital consists of common stock and disclosed reserves like retained earnings and is the core measure of a bank’s financial strength.

Tier II capital is also used to measure the financial strength of a bank and is the second most reliable form of financial capital which includes Revaluation of assets, Undisclosed reserves (Reserves that are not burdened to any liabilities), General Provision, Hybrid instruments which are the capital instruments having the debt & equity characters and Subordinated debts.

Tier III capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier II capital and is used to support market risk, commodities risk and foreign currency risk.

According to Asli Demirgiu-Kunt and Harry HuizIi (2000) banks play a major role in capital allocation, to mobilize savings, to manage investment decisions of corporate managers and provide risk management guidance.

Capital structure is the combination of a firm’s debt (long-term debt and short-term debt) and equity (common equity and preferred equity). Firm uses its various sources of funds to finance its overall operations and growth. Debt can be in the form of issuance of bonds or long-term notes payable, while equity consists of issuing common stock, preferred stock, or having retained earnings. Joshua Kennon stated advantages and disadvantages of each financing option and management always tries to find out the best combination to finance their capital and lower the cost of financing. As Eugene F. Brigham stated, there is an optimal capital structure which is the best combination of equity and debt financing. On this level of optimization, cost of the capital is lowest and value of the firm is highest. J.Abor (2005) believed that there is no universal theory for debt-equity choices, different combination are used in different situations to achieve the desired outcome.

Capital structure is very important for any firm. It not only helps in determining the return a company earns for its shareholders and also shows how a firm will behave in recession or depression (Joshua Kennon).

One of the financing options is Equity financing which is composed of funds that are raised by the business itself. This financing can be raised by the owners of the firm or by adding more peoples in the ownership i.e. issuing the shares of the company. There is certain amount paid against these share and the shareholders get dividend against those shares or against that money they have invested in the company. It depends on the company’s policy that how much capital they need and how much of that capital should be raised through shares. Mostly companies with high growth rate use equity financing because they can give high return to the investors. Equity capital is considered to be the expensive type of capital because its “cost” is the return the firm must earn to attract investment (Joshua Kennon)

Debt financing, second choice of financing means borrowing money to run the business. The amount of debt that a firm uses to finance its assets is also called leverage. Debt financing constitutes of long term debt and short term Debt based on the type of money one borrows. Interest rates for long term debt and short term are different and vary from situation to situation and firm to firm.

Long term debt refers to the money one borrows for financing the assets which can be used by the firm for longer periods. E.g. Purchase of Assets, machinery, land etc. The scheduled payment of long term loan is usually extended for more then 1 year. In the case of Banks their sub-ordinate loans and fixed deposits are long term in nature because they are held for more then one year depending on their nature.

Short term debt is the debt taken for meeting the daily basis business requirements like purchasing of inventory or paying the wages. Its scheduled payment ta