Capital Structure and Firm Performance in the Financial Sector

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Asian Journal of Finance & Accounting ISSN 1946-052X 2012, Vol. 4, No. 1

Capital Structure and Firm Performance in the Financial Sector: Evidence from Australia Vedran Skopljak School of Economics and Finance, La Trobe University Kingsbury Drive, Bundoora, Vic 3086, Australia Tel: 61-3-9479-1111 E-mail: vedran.skopljak@latrobe.edu.au

Robin H. Luo (Corresponding author) Department of Finance, Wuhan University Luojia Hill, Wuhan 430072, China Tel: 86-27-6875-2740 E-mail: robin.h.luo@gmail.com

Received: January 29, 2012 doi:10.5296/ajfa.v4i1.1319

Accepted: March 1, 2012

Published: June 1, 2012

URL: http://dx.doi.org/10.5296/ajfa.v4i1.1319

Abstract How does capital structure affect firm performance of Authorised Deposit-taking Institutions (ADIs) using explicitly Australian data? This paper investigates the relationship between capital structure and firm performance of Australian ADIs. Our findings show a significant and robust quadratic relationship between capital structure and firm performance of Australian ADIs. At relatively low levels of leverage an increase in debt leads to increased profit efficiency hence superior bank performance, at relatively high levels of leverage increased debt leads to decreased profit efficiency as well as bank performance. This can most likely be attributed to financial distress outweighing any gains made from managerial performance improving. Keywords: Profit efficiency; Capital structure; Agency cost theory, Financial sector

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Asian Journal of Finance & Accounting ISSN 1946-052X 2012, Vol. 4, No. 1

1. Introduction Capital structure and its effect on firm performance has long been a topic of discussion, with no shortage of papers on the issue (e.g. Modigliani and Miller, 1958; Myers, 1977; Jensen and Meckling, 1976; Harris and Raviv, 1991 and Margiratis and Pslilaki, 2007). However, these papers are very general in their conclusions and their reach to the financial sector is relatively limited. The reason being that the financial sector has its own unique set of regulations, and is generally highly leveraged; nevertheless, the underlying imperatives still apply to the financial sector just as they do for firms across other disciplines. This paper mainly investigates the relationship between capital structure and firm performance of Australian Authorised Deposit-taking Institutions (ADIs). Based on agency cost theory (Jensen and Meckling, 1976), it suggests that debt is used as a motivating factor for managerial staff. Agency theory states that separation of top end management and ownership has a negative effect on firm performance; there is no incentive for management to perform at maximum capacity. Debt is enrolled as an instrument to heighten work ethic and performance of management; however an increase in the proportion of debt causes the firm to experience higher financial distress (Harris and Raviv, 1991). The main hypothesis to be explored in this paper contributes to academic research in this field in two major ways. First, research papers in the field of capital structure have not often concentrated on the effect of capital structure on profit efficiency, especially linking the two in the financial sector. The general method has been to try linking capital structure with firm performance using common financial ratios. One notable research paper by Berger and Bonaccorsi di Patti (2006) stands out as offering a significant and comprehensive empirical contribution to the link of capital structure and profit efficiency in the financial sector. The financial sector is fundamentally different from any other sector of the market in terms of its high leverage and regulation, therefore the results obtained from papers using data across multiple sectors in the market cannot be directly carried over to the financial sector with a high degree of confidence. Second, papers on the relationship of capital structure and Australian Financial...
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