INTRODUCTION

Main purpose of financial decision making is to “increase the value of shareholder’s of firm” 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. Use of more proportion of Debt in capital structure can be effective as it is less costly then equity but it also has some limitations and in the case of bank it has some regulatory restrictions. 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 have higher 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 less 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 government/ regulatory body imposed on these banks. Banks have to adjust theirs source of financing according to the regulations. 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) [1] . Capital in the dictionary of financial institution like banks is the Capital Funds, which are the total Owned Funds available to the Institution for a reasonably long time. ICCMCS [i] (2004) divided this capital into Core capital (basic equity) and Supplementary capital [2] and classified in Tier I, Tier II and Tier III Capital.

Tier 1 capital is the core measure of a bank’s financial strength composed of equity capital, mainly common stock and disclosed reserves like retained earnings. [3]

Tier II capital is used to measure the financial strength of a bank and is the second most reliable form of financial capital [4] . It includes Revaluation of assets (a reserve created when a company has increase in the value of asset and that increase is brought into the accounts), Undisclosed reserves (Reserves that are not burdened to any liabilities), General Provision (shelter against those losses whose actual impact is not known), Hybrid instruments which are the capital instruments having the debt & equity characters and Subordinated debts. [5]

Tier III capital is used to support market risk, commodities risk and foreign currency risk. Tier III capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier II capital [6] .

Banks play a leading role in mobilizing savings, allocating capital, overseeing investment decisions of corporate managers, and providing risk management vehicles as mentioned by Asli Demirgiu-Kunt, Harry HuizIi (2000). [7]

Capital structure is the combination of a firm’s debt (long-term debt and short-term debt) and equity (common equity and preferred equity). So the Capital structure is the firm’s various sources of funds used to finance its overall operations and growth. Debt is in the form of bond issues or long-term notes payable, while equity consists of common stock, preferred stock, or retained earnings. Joshua Kennon [8] stated advantages and disadvantages of each financing option and management always tries to find out the best combination to finance their capital.

According to Eugene F. Brigham [9] 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 minimum and value of the firm is maximum. J.Abor (2005) believed that there is no universal theory of debt-equity choice, different choices are used in different situations.

The concept of 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 whether or not a firm survives in a recession or depression (Joshua Kennon).

Equity financing is one of the financing options, and is composed of funds that are raised by the business itself. This financing can be raised by the ow