Capital Adequacy and Profitability Relationship in Nepalese Commercial Banks: An Empirical Investigation

Abstract

Capital adequacy requirements are important in ensuring the stability of the banking sector and may impact profitability due to regulatory limits and risk management behaviours. The relationship between capital adequacy and profitability amongst Nepalese commercial banks is important in developing regulatory policy and strategic planning of banks. This research paper will empirically examine the connection between capital adequacy and profitability in Nepalese commercial banks, exploring how the capital adequacy ratios impact on the various profitability measures and which factors moderated this relationship. The analysis of panel data was completed on 15 commercial banks during the period 2017-2023, and a total of 105 bank-years were analysed. Multiple regression models were used to test the relationship between capital adequacy ratio (CAR), Tier 1 capital ratio and profitability ratios such as ROA, ROE and NIM. Bank size, liquidity, asset quality and macroeconomic factors were control variables. The researcher discovered that capital adequacy is significantly and positively correlated with ROA (b = 0.328, p < 0.01), negatively correlated with ROE (b = -0.267, p < 0.05). The maximum CAR that maximised ROA was considered to be 14.06 percent and the returns were declining with higher CAR. The capital- profitability relationship was simply moderated by asset quality (NPL ratio) (b = -0.156, p < 0.05). Effects of size revealed that bigger banks were able to sustain their profitability on less capital levels than smaller ones. Capital adequacy has a non-linear and intricate association with the profitability of Nepalese banks. Although sufficient capital increases ROA by helping to manage risks better and meet the requirements of the regulation, surplus capital can make ROE less efficient. The banks are advised to maximise the capital levels based on their size and the risk profile, besides the positioning in the market.