Impact of Bank-Specific Determinants on Capital Adequacy Evidence from Licensed Banks in Sri Lanka

Abstract

Introduction: Capital adequacy assesses a bank’s ability to absorb losses and meet its obligations. Capital adequacy can be expressed as banks’ capital to its risk-weighted assets. Basel Committee on Banks Supervision has imposed the minimum capital adequacy ratio to ensure that banks operate safely. Also, a higher capital adequacy ratio implies that a bank has adequate capital to meet its obligations and unexpected losses. Therefore, increasing the customers' and investors’ confidence. The capital adequacy ratio indicates the financial health of a bank.

Methodology: Bank-specific variables such as return on asset ratio (ROA), return on equity ratio (ROE), non-performing loan ratio (NPL), deposit to asset ratio (DR), loan to deposit ratio (LTD), total equity to total liability (EQL), and net interest margin ratio (NIM) on capital adequacy ratio of licensed banks (licensed commercial banks and licensed specialized banks) in Sri Lanka considered independent variables. And capital adequacy ratio is considered a dependent variable. A quantitative research approach was used to conduct this research. As a sample, this research used 6 licensed specialized banks and 10 licensed commercial banks. This study used 13 years (2011–2023) of secondary data to investigate the relationship between capital adequacy ratio and bank-specific variables. A linear regression model was used to analyze the relationship between the capital adequacy ratio and bank-specific variables of licensed banks in Sri Lanka. Further panel data analysis with a random effect model.

Findings: The findings show that the return on asset ratio and non-performing loan ratio have a positive and significant impact on the capital adequacy ratio of licensed banks in Sri Lanka. And return on equity ratio has a negative and significant impact on the capital adequacy ratio of licensed banks in Sri Lanka. However, net interest margin, total equity to total liability, deposit-to-asset ratio, and loan-to-deposit ratio haven’t significant impact on the capital adequacy ratio of licensed banks in Sri Lanka. ROA, ROE, and NPL ratios are important determinants of the capital adequacy ratio. So banks need to give much attention to these variables.

Conclusion: In conclusion, this study aimed to investigate the relationship between the capital adequacy ratio (CAR) and key bank-specific variables for licensed commercial and specialized banks in Sri Lanka. According to the findings, the return on asset ratio, return on equity ratio, and non-performing loan ratio have a significant impact on the capital adequacy ratio. Therefore, must prioritize improving asset returns (ROA) and effectively managing non-performing loans. Additionally, attention to the return on equity (ROE) is necessary to avoid reducing capital buffers. And findings contribute to the bank managers of both licensed commercial and specialized banks, policymakers, regulators, investors, and customers.