Capital adequacy refers to the sufficient amount of banks equity to absorb any shock that may occur. Basically, capital adequacy is calculated by using Equity to Assets ratio (EA). The equity-to-assets ratio (EA) is also included as a measure of the overall capital strength. The ratio is a measure of capital adequacy, and should capture the general average safety and soundness of the financial institutions. Therefore, a bank with higher EA has a strong ability to withstand with financial risk, and reduce the needs of external funding and thus result in higher profit. Besides, the well-capitalised banks is able to obtain more business opportunity is because it is able and flexible in handling the risk and lowers the risk of going insolvent which will reduce the need of borrowing and subsequently increased bank profitability.
According to Staikouras and Wood (2003), they investigate the internal and external factors that affecting the European bank’s profitability. In their research, Equity to Assets ratio is one of the internal factors and they found that a higher EA ratios is associated with lower profitability. A higher capital-to-assets ratio tends to reduce the risk of equity and therefore lowers the equilibrium expected return on equity required by investors.
In the Molyneux (1993) and Short (1979) studies stated that lower EA will result in higher risk but higher profit also. For example, Molyneux found that lower EA ratios suggest a relatively risky position, one would expect a negative coefficient on this variable, although it could be the case that high levels of equity suggest that the cost of capital is relatively cheap and therefore this variable may have a positive impact on profitability. Moreover, Short (1979) stated that if all banks have the relatively same rate of Return on Equity (ROE), and then the one who have the higher leverage will have highest rate of return.
However, based on the findings of Berger (1995), he stand an opposite opinion that Higher capital-to-assets ratio may also cause higher profitability if the higher capital reduces risk-related barriers to entry or expansion into some profitable product lines. Banks that increase capital and reduce their risks may be better able to avoid issuing off-balance-sheet guarantess, such as loan commitments and standby letters of credit. Safer banks may also be able to borrow uninsured funds more easily to pursue high revenue on-balance-sheet investment opportunities as they arise.