The determinants of the capital structure of commercial banks in Taiwan | Asia > East Asi...

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The determinants of the capital structure

of commercial banks in Taiwan
HEADNOTE

On the basis of an empirical analysis of determinants of capital structure in commercial banks in

Taiwan, from a perspective of variables in the banks 'financial statements, and a comparative
analysis between domestic commercial banks and local branches of foreign banks (Kuo and Lee,
1998; Kuo, 2000). However, under impacts from internationalization of finance and opening of
markets, there have been structural changes in the financial market. Therefore, this study extends an
analysis of the above researches in order to further explore these impacts on the capital structure of
commercial banks in Taiwan. Investigating the financial performance of domestic banks and local
branches of foreign banks between 1991 and 2000, we find the following: In terms of liquid reserve
ratios, although domestic banks may have lower ratios than local branches of foreign banks, they are
still maintained above the legal ratio of 7%. In terms of capital ratios, for domestic banks, both debt
from deposit and debt from non-deposit decreased progressively, while for local branches of foreign
banks increased progressively, in terms of profitability ratios, both domestic banks and local branches
of foreign banks suffer a decline in probability ratios, while local branches of foreign banks still
maintained better operating and non-operating income over domestic banks. These changes reveal
that traditional activities of banks for deposits and loans are increasingly less important as
determinants of capital structure in banking in the changing financial markets of Taiwan.

1. Introduction

Management of financial institutes is unlike that of any other business firms because banks act as
both suppliers and demanders of funds, and they have high financial leverage. Lately, the global
economic system has broken the boundaries of financial regulation and stimulating competition. The
resulting increase in competition removed the profit advantages from banks in Taiwan, and posed
greater challenges for bankers to manage assets and debts. Early commercial banks in Taiwan were
founded in a highly regulated environment and tend to be government owned. However, in 1991, the
Taiwan Ministry of Finance deregulated the establishment of new commercial banks in order to
increase the competition between banks and also to increase financial efficiency. Since then, the
banking industry has been transformed from an oligopoly into a new era of high competition. Since
the critical difference between the banking industry and other businesses lies in the presence of
governmental supervision and regulation, earlier researches into capital structure of bank tend to put
their emphasis on the relationship between regulation and capital, thus neglecting the exploration of
the correlation between a bank's financial statement and its practical operation from the perspective
of capital structure.

Previous studies on determinants of capital structures attempted to define the optimal capital
structure for firms from various perspectives, such as bankruptcy costs (Berger et al., 1995), agency
theory (Jensen and Meckling, 1976; Smith and Warner, 1979), and asymmetric information (Myers
and Majluf, 1984). Because of the factors affecting capital structures, we cannot truly affirm an
optimal capital structure in practice. A broad range of issues have also been discussed in empirical
studies that focus on determinants of capital structures, such as financial statements, company
strategy, or managing decision. This study focuses only on the correlation between financial
statements and decisions on capital structure. A review of previous studies reveals that the following
factors from financial statement affect capital structure: firm size (Myers and Majluf, 1984), profitability
(Myers and Majluf, 1984), non -debt tax shields (Modigliani and Miller, 1958; DeAngelo and Masulis,
1980), collateral value of assets (Myers, 1977), operating risks (Myers, 1977), dividend policy (Smith
and Warner, 1979), and inflation (Homaifar et al., 1994). Among these factors, firm size, collateral

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value of assets, and inflation are positively correlated to capital structure, whereas profitability is
negatively correlated to non-debt tax shields, and operating risk and dividend policy may have either
positive or negative correlation.

The financial industry has been mostly omitted from previous studies of determinants in capital
structures. Then, Kuo and Lee (1998) conducted an empirical analysis of determinants of capital
structure in commercial banks in Taiwan from a perspective of variables in banks' financial
statements, and employed a comparative analysis between domestic commercial banks and local
branches of foreign banks. However, under impacts from internationalization of finance and opening
of the market, resulting in structural changes in the financial market. Meanwhile, with the permission
to participate in WTO from November 2001, the opening of markets has forced all kinds of industry in
Taiwan to face international competitions, especially in the financial industry. Therefore, this study
extends an analysis of Kuo and Lee (1998), in order to further explore these impacts on capital
structure for commercial banks in Taiwan.

2. Overview of the Banking Industry in Taiwan

Since the liberalization of establishment of new banks in 1991, the number of financial institutes in
Taiwan rapidly increased to overloading, so the competition between financial institutes became
heavy, and resulted into loss of credit standings. Then, after the Asian financial crisis in 1997, some
impacts resulting from over-competition emerged and were reflected on the market structure. At that
time, quality of assets generally worsened, while interest spread and profitability gradually decreases.
According to financial statistics up to November 1999, there is one financial institute for every six
square kilometer in Taiwan, which is the highest density in the world. Accordingly, the Taiwan
government drafted the "Merger Law for Financial Institutes" in October 1999 in order to improve the
domestic quality of assets, and to avoid financial crisis. In June 2001, "Regulations Governing the
Bond Investment for Finance Companies" was legislated, in order to create an environment for re-
organization and diversification of Taiwan's financial institutes, and also to increase their international
competitiveness and ability to participate in the global market.

Financial institutes in Taiwan can be grouped into banks (including domestic banks, trust companies,
and local branches of foreign banks), credit cooperatives, credit departments of agricultural
associations, credit departments of fisheries associations, bill finance companies, bond finance
companies, and insurance firms (including insurance cooperatives). By the end of the year 2000,
there were 5016 units of financial institutes in Taiwan, 13 units in off islands, 68 units of offshore
banking units, 79 units of foreign branches, with a total of 5172 units. In term of loan services,
domestic banks provided 83.0% of the total loans, while local branches of foreign banks provided
3.3%. In term of deposit services, domestic banks held 84.9% of the total deposit in Taiwan, while
foreign banks held 3.8%. In term of net income before tax, domestic banks had 74.2% of the total net
income before tax for banks in Taiwan, while foreign banks had 15.4%.

3. Financial Change for Capital Structure in Banking

Kuo and Lee (1998) studied 15 domestic public banks, 15 domestic private banks, and 21 local
branches of foreign banks in Taiwan, from 1989 to 1994. They suggested five determinants in
financial statements that might affect capital structure of banks, including firm size (logarithm of total
assets), profitability (return of total assets and return of equity), collateral value of assets (fixed assets
to total assets ratio and fixed assets to deposit ratio), operating risks (variance coefficient of operating
income), and inflation (yearly increasing rate of consumer price index). Kuo (2000) summarized
regression analysis and one-way ANOVA to explicitly adopt an analysis for the differences between
the groups of banks. One-way ANOVA revealed that there are significant differences between
domestic public, private banks and local branches of foreign banks in terms of capital structure, which
implies that different application of financial leverage in banks of different characteristic will make a
difference. Domestic public banks and domestic private banks are different in their capital structures.
Domestic banks and local branches of foreign banks, because of their differences in management,
business, and regulations, do not have same level of application of financial leverage. Moreover,
multiple regression analysis of each variance found that, in domestic public banks, firm size, return of
equity and financial leverage are positively correlated, while return of assets, fix assets to deposit
ratio, fixed assets and variance coefficient of operating incomes are negatively correlated. In

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domestic private banks, firm size and financial leverage are positively correlated, while fixed assets to
deposit ratio and inflation are negatively correlated. In terms of local branches of foreign banks in
Taiwan, firm size, variance coefficient of operating income, and financial leverage are positively
correlated, while return of assets, fixed asset to deposit ratio and fixed assets to total assets ratio are
negatively correlated.

In sum, capital structure for banks in Taiwan is related to the size of the bank, and from a dynamic
perspective, the growth opportunity of a corporation (evaluated by Tobin's Q), might also affect the
capital policy of the bank during its expansion.

McConnell and Servaes (1995) confirmed that leverage quality (total debt over total assets) is
negatively correlated to the firm value of a high growth firm, while it is positively correlated to that of a
low growth firm. The last two years have seen the rapid expansion of financial institutes in Taiwan, so
it is an opportunity to observe the relationship between growth and leverage quality. Shrieves and
Dahl (1992) pointed out that capital ratio and total asset risk are positively correlated, and vice versa.
In terms of nonperforming loans risk, bad debts are significantly positively related to capital ratios,
whereas capital ratios are positively but insignificantly related to bad debts. They further group banks
into banks with more than 7% capital ratio and those with less than 7% capital ratio and derived into
the same results. The only difference was that in banks with more than 7% capital ratio, the capital
ratio was negatively correlated to nonperforming loans risk, although insignificantly.

On November 2000, Economics indicated that because of the huge amount of bad debts in Taiwan, a
financial crisis might develop, starting a series of debates. A year later, in December 2001, the total
overdue loan ratio in the financial institute in Taiwan was still 7.48%. This high overdue loan ratio has
severely damaged the creditability and liquidity of the financial institutes in Taiwan. Because of limited
timeframe, many overdue loans must be either collected or listed as bad debts, and the enormous
bad debts further damaged the profitability of domestic banks.

An overview of financial performance in domestic banks and local branches of foreign banks between
1991 and 2000 indicating the following conditions, as shown in Table 1. In terms of liquid reserve
ratios, although domestic banks may have lower ratio than local branches of foreign banks, they are
still maintained above the legal ratio of 7%. In terms of capital ratios, for domestic banks, both debt
from deposit and debt from nondeposit decreased progressively, while for local branches of foreign
banks increased progressively. In terms of profitability ratios, both domestic banks and local branches
of foreign banks have suffered a decline in profitability ratios, while local branches of foreign banks
still maintain better operating or non-operating income than domestic banks. These changes reveal
that the traditional activities of banks for deposits and loans are becoming less and less important in
the Taiwan's changing financial market.

Financial changes in Taiwan might balance the operating disparity between domestic banks and local
branches of foreign banks. Meanwhile, financial performance indices, such as fixed assets to
collateral value of deposit ratio, variance of interest income in operating income, and various return
ratios, that were highly related to traditional deposit and loan services, might become less important
as determinants of capital structure for banks. With intemationalization of finance and the opening of
markets, deregulation leads to a turning point in banks' performances-it might get worse or get better.

IMAGE TABLE1

Table 1. Analysis of financial performance for domestic banks and local branches of foreign banks

Banks in Norway successfully increased performance and productivity because of deregulation of

transaction volume and interest rate (Berg et al., 1992), and so have banks in Turkey (Zaim, 1995).
Korean banks also successfully increased performance and productivity after privatization (Gilbert
and Wilson, 1998). Kumbhakar et al. (2001), demonstrated the effect deregulations have on banking
performance, as evaluated through variance return ratio of productivity. From the standpoint of
application, governments can exert control over capital structure for banks through deregulation and
performance, while "deregulation" itself may directly affect performance and policy formulation.
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With the increased use of derivatives by financial institutes, the degree of implicit leverage has also
increased, thus, changing traditional risk management. Considering the leverage implied in off -
balance-sheet, the evaluation of capital ratio differs greatly from traditional evaluation (Breuer, 2002).
In addition, research into small and medium -sized enterprise debts, Dietsch (2002) indicted that after
calculating future loss of probability density function, and combining it with value at risk (VaR), we
may find that capital requirements are lower than those calculated by standard capital ratios. Thus, a
bank may utilize the concept of risk value P(X^sub t^ > -VaR)=(1-±)%, combined with stress test and
scenario analysis to evaluate risks in each of the investments. Thus it can adopt and evaluate the
quality of risk assets as a basis for readjustment of determinants of capital structure.

4. Conclusion

Traditionally, banks in Taiwan play an intermediate role in financial services, and they are also
charged with the special mission to stabilize the economy and help the development of other
industries. Therefore, earlier commercial banks were highly regulated and tended to be government-
owned. With financial internationalization and the opening of markets, Taiwan is beginning to
deregulate the financial industry. Thus, the advantages for the domestic financial industry are no
longer present, and uncertainties in management have begun to increase. The financial industry is
greatly challenged by these changes, and the Taiwan government has been preparing for various
financial revolutions, which may have great impacts on Taiwan's financial markets.

Between 1991 to 2000, with the gradual deregulation of financial market in Taiwan, domestic banks
had lower liquid reserve ratios than local branches of foreign banks, although they still managed to
maintain the ratio above the legalized ratio of 7%. In terms of capital ratios, for domestic banks, both
debt from deposit and debt from nondeposit decreased progressively, while for local branches of
foreign banks increased progressively. In addition, local branches of foreign banks maintained better
operating and non-operating incomes compared to domestic banks. Meanwhile, the financial
revolution might make financial performance indices, such as fixed assets to collateral value of
deposit ratio, variance of interest income in operating income, and various return ratios, all of which
were highly related to traditional deposit and loan services, less important as determinants of capital
structure for banks.

FOOTNOTE

Footnote

We greatly appreciate the full support for this study from the National Science Council, Taiwan
(Contract No. NSC -87 -2416-H-260-002).

REFERENCE

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AUTHOR_AFFILIATION

Hsien -Chang Kuo

National Chi-Nan University, Taiwan

Chi -Haw Lee

National Chi-Nan University, Taiwan

AUTHOR_AFFILIATION

Contact email address: hckuo@ncnu.edu.tw

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