The Middle East: The Effect of Bank Capital Structure and Financial Indicators

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Banks and Bank Systems, Volume 6, Issue 3, 2011

Wael Mostafa (Egypt), Tarek Eldomiaty (Egypt), Hussein Abdou (UK)

The effect of bank capital structure and financial indicators on CI’s financial strength ratings: the case of the Middle East
This paper aims to integrate the theory of bank financial performance with the practice of bank ratings. The paper studies the effect of bank capital structure and financial indicators in Middle Eastern commercial banks associated with high and low ratings issued by Capital Intelligence (CI). The authors also investigate how bank capital structure and financial indicators can be differentiated between banks with high and low ratings, using the multinomial logit technique. A sample of 65 rated commercial banks from eleven countries is used. The article focuses on commercial banks in order to avoid comparison problems between various types of banks. The data is taken from the Bankscope database and covers the period of 19942007. The results reveal that the financial indicators of the highly-rated banks are associated with decreases in the ratio of impaired loans to gross loans, the ratio of loan loss reserve to gross loans, the ratio of non-interest expenses to total assets, the ratio of net loans to deposits and short-term funding and the ratio of net loans to total assets. In contrast, these financial indicators are allied to an increase in the ratio of non-operating income to net income, the gap ratio, the interbank ratio and the equity ratio. The robustness of the results is quite obvious since the financial indicators associated with highly-rated banks are the opposite of those associated with low-rated banks. In view of the findings, some policy implications can be drawn that may be useful for bank management and policymakers in the Middle East region. Keywords: Financial Strength Rating, bank capital structure, multinomial logit, Middle East banks, Capital Intelligence. JEL Classification: G21, G24.

The interrelationships between bank credit ratings,
capital structures, ratings and financial indicators
have created an ongoing and interesting area of research for many years. The rating of banks is always conducted by external rating agencies, which follow
a usually unpublished methodology to assign a rating based on a bank’s financial indicators. Therefore, the concern for the public and for investors is that the banks’ financial indicators that determine

their ratings are not accurate. The banking business
depends to a large extent on gaining the public confidence that helps the banks to attract financial resources (i.e., deposits) and invest those resources in profitable opportunities. In this case, public confidence could be increased if the financial indicators associated with high ratings were disclosed.

The relevant literature on bank ratings has included
intermediary factors, such as a bank’s capital structure and credit ratings. The reason for the importance of capital structure is that it affects a bank’s Financial Strength Rating (FSR), given that the

adjustment of capital structure is largely controlled
by universal bank supervisory regulations such as
Basel I and II. Therefore, since the sources of bank
capital are regulated, FSR is also implicitly regulated. This requires bank managers to design financial strategies that do not deviate from the regulations and which help the bank to achieve a high rating. For this main reason, among others, this

paper treats bank capital structure as one of the
© Wael Mostafa, Tarek Eldomiaty, Hussein Abdou, 2011.

determinants of FSR assigned by Capital Intelligence (CI)1. The role of credit ratings is covered separately in the literature (Horrigan, 1966; Ederington, 1985; Ederington and Goh, 1998; Gray, Mirkovic et al., 2006). The connection between

credit ratings and FSRs is obvious. Banks that do
not base their lending decisions on sound credit
ratings end up with a cumulative bad...
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