“Relationship between financial risks and firm value: A moderating role of capital adequacy”

The study of firm value and financial risks became more important after the global financial crisis of 2007–2008, as the required risk was mismanaged, resulting in a deterioration in firm value. It is important to study the relationship between financial risks and firm value. This study aims to examine the moderating effect of capital adequacy on the relationship between financial risks and the firm value of listed banks in Pakistan. This study is based on half-yearly secondary data of 560 sample observations from 2009 to 2021. Multiple regression and panel data estimation techniques were employed for the analysis. The study used firm value as a dependent variable, proxied by Tobin’s Q, along with five independent variables and one moderating variable. The results of this study indicate that a higher capital adequacy ratio (CAR) increases firm value and has a moderating effect on financial risks and firm value. Nonperforming loans, net interest margin, and cost income ratio are found to have a significant negative relationship with firm value. The study concludes that the stock prices of listed banks in Pakistan are declining persistently, which causes the stock’s worth to shift from being inflated to being undervalued.


INTRODUCTION
The market price of equity shares increases market capitalization, which could enhance firm value.In other words, firm value is derived from market capitalization (Kirkpatrick & Radicic, 2020).Considering firm value is crucial because it is one of the essential components of well-governed firms (Esan et al., 2022).After the global financial crisis 2007-2008, the firm value became more important because the share price of various shares was severely affected and exposed to deterioration of market capitalization (Liu et al., 2012;Parida & Wang, 2018).
The global financial crisis 2007-2008 exposed banks to risk because most banks around the world faced financial distress due to an unhealthy risk environment.Hence, the incidents of bank failure due to mismanagement of risk appetite affected firm value (Acharya & Richardson, 2009).Market risk is a phenomenon where losses occur due to changes in market factors like interest rates and foreign exchange rates.The critical market risk measures are value at risk (VAR) and beta (Bouheni et al., 2016).Credit risk represents loan quality problems and exposes nonperforming loans (Kakanda & Salim, 2017).A lack of adequate internal control or system reveals operational risk.Interest rate risk arises when there is a persistent fluctuation in interest rates.Banks face liquidity risk when they have insufficient funds to meet their financial obligations (Bouheni et al., 2016).
The role of the capital adequacy ratio (CAR) is also important because it protects banks against any financial risk by holding a cushion of capital against expected losses.The State Bank of Pakistan recommends that banks comply with the risk-weighted capital adequacy framework proposed under Basel I and II (Rafique et al., 2020).As recommended by the central bank, all banks in Pakistan are required to maintain a minimum CAR of 10 percent (Ayub & Javeed, 2016).
The progress of the overall banking sector in Pakistan was recorded at 6 percent in 2016 with 3.3 percent of gross domestic product (GDP), which indicates a significant contribution to the economy's overall growth.However, the financial system in Pakistan is extensive as it consists of both bank and nonbank financial institutions, but the banking sector is dominant within the country (Akram & Rahman, 2018).The State Bank of Pakistan, the central bank of the country, issued comprehensive risk management guidelines for banks in 2003.The main objective of giving these guidelines was to strengthen the control over financial risks and to support the uniformity (homogeneity) assumption by which all banks were required to implement a system for risk management (Ishtiaq, 2015;Saeed & Tahir, 2015).
Investors use firm value as a yardstick when making investment decisions and trading in securities or equity shares (Shah et al., 2018).Therefore, the maximization of firm value is a core objective of all listed firms around the globe (Chen & Chen, 2011).The firm value of listed banks in Pakistan is decreasing compared to nonfinancial firms.It has been proven after analyzing the figures of the market capitalization of listed banks in Pakistan, which have declined from 2015 to 2020 (KPMG, 2020).Therefore, it is important to examine the relationship between financial risks and firm value in listed banks of Pakistan.Sheikh and Khan (2016) examined the association between board characteristics, corporate governance, and firm value without taking financial risks into account.Thus, these studies were inconclusive.Therefore, the Pakistani banking industry, which is dominant in economic growth is overlooked.Further, the financial risks and firm value are the major challenges for the banking sector of Pakistan, and they have been ignored in previous studies.Furthermore, past studies have also not examined the moderating role of CAR.The objective of this study is to measure the relationship of financial risks with firm value in listed banks of Pakistan with the moderating effect of CAR.
This study is unique in several ways compared to previous studies.This study examines the moderating effect of capital adequacy on the relationship between financial risks and the firm value of listed banks in Pakistan.However, most of the earlier studies were limited, only addressed nonfinancial firms, and were inconclusive.The earlier studies were also limited to board characteristics without focusing on financial risks.This study includes the capital adequacy ratio (CAR) as a new moderating variable to examine the moderating effects of financial risks and firm value.This study also includes the latest dataset, from 2009 to 2021.Hence, this study is conducted to fill the gap in the literature, as very few studies with inconclusive findings have previously examined.To the best of the authors' knowledge, this study is the first to investigate this relationship.

LITERATURE REVIEW AND HYPOTHESES
Agency theory supports financial risks by considering risk-taking practices and decisions made by the manager that could create agency problems be-tween the manager and shareholders.Agency theory also explains the notion that managers would be able to take appropriate decisions for the firm when favorable policies against risk management are prepared (Jensen, 1976).Therefore, risk-taking decisions may create conflict and an agency prob- H 6A .The impact of market risk is lower when CAR is higher.
H 6B .The impact of credit risk is lower when CAR is higher.
H 6C .The impact of liquidity risk is lower when CAR is higher.
H 6D .The impact of operational risk is lower when CAR is higher.
H 6E .The impact of interest rate risk is lower when CAR is higher.

METHODOLOGY
The study used quantitative data extracted from the financial statements of listed banks in Pakistan and the Pakistan Stock Exchange (PSX).
The sample for this study consists of listed banks in Pakistan.This study has taken half year data with 560 observations from 2009 to 2021 (details are provided in Table 1).This study uses secondary data to examine the relationship between the variables in the research framework.The research framework is presented in Figure 1 reflecting the logical relationship among variables.
This study used Multiple Regression Model to examine the hypotheses and the effect of financial risks on firm value.Next, the model will examine the moderating impact of capital adequacy ratio on financial risks and firm value.This study uses panel data for analysis.Panel data contains longitudinal and cross-sectional properties that allow it to track changes in firm values across time.Eight of the ten hypotheses are supported by Table 8, which shows that financial risks affect firm value.Hypothesis Supported H 6B : The impact of credit risk is lower when CAR is higher.

Descriptive statistics in
Hypothesis Supported H 6C : The impact of liquidity risk is lower when CAR is higher.
Hypothesis Supported H 6D : The impact of operational risk is lower when CAR is higher.Supported H 6E : The impact of interest rate risk is lower when CAR is higher.
Hypothesis Supported

CONCLUSION
This study aims to investigate the moderating effect of capital adequacy on the relationship between financial risks and the firm value of listed banks in Pakistan.To obtain a more robust empirical model, this study incorporates the moderator.The results of this study reveal that the capital adequacy ratio of listed banks in Pakistan is higher.This implies that banks in Pakistan meet the minimum capital requirements as set by the regulators.Other empirical findings reveal that there are increasing credit, operational, and interest rate risks that influence firm value.However, there are no market or liquidity risks affecting the firm value of listed banks in Pakistan.This implies that an increase in the proportion of risks could further deteriorate the firm value of listed banks in Pakistan.
Based on the empirical findings of this study, it is concluded that banks in Pakistan are encountering apparent risk, which could affect firm value.Therefore, the stock prices of listed banks in Pakistan are declining persistently, which causes the stock's worth to shift from being inflated to being undervalued.Thus, this study develops a framework to present the interactions between financial risks and firm value, in which capital adequacy acts as a moderator in the relationship between financial risk and firm value.
In this context, this study has considered the moderator as a proactive risk mitigation tool.The findings of this study help policymakers, regulators, and banks how capital adequacy acts as a moderator in the mitigation of financial risks and enhances firm value.
There are numerous opportunities for future research.First, this study only considered listed banks in Pakistan.The same investigation could be conducted by employing the listed banks of other South Asian developing countries to explore the cross-country findings.Second, the role of the corporate board is also very important.Therefore, the variables of this study and the characteristics of the board may be combined into a single model to explore the novel findings.
Isidro and Sobral (2015), Agyemang-Mintah and Schadewitz (2018), Vo and Bui (2017), Fallatah and Dickins (2012), Bhuiyan et al. (2020), Vintila et al. (2015), and Mishra and Kapil (2018) were among the earlier studies that examined the relationship between board characteristics and firm value without focusing on financial risk or the banking sector.However, research conducted in Pakistan by Javeed et al. (2017) and to the global financial crisis 2007-2008.These crises also affected equity stocks in the US and other countries, which affected firm value.Thereafter, credit risk has become a challenge for the banking sector around the world (Perera & Morawakage, 2017).The average outstanding loan generates less interest revenue when new loans are issued at a comparably lower rate, suggesting that real interest income is anticipated to drop.Consequently, it lowers the value of a firm.Commercial banks increase loan amounts to increase profits, but doing so may result in larger loan losses, which may have an impact on firm value(Olalere et al. (Ebenezer et al., 2019)Brien & Szerszen, 2017).The adverse price movement within the market could affect unfavorable variations in interest and currency exchange rates, which may bring about changes in equity stock and affect firm value.Therefore, an increase in market risk has an inverse relationship with firm value (Abdel-Azim & Abdelmoniem, 2015).During the financial crisis 2007-2008, over excessive risk-taking was a major cause of firm value deterioration.Thereafter, more emphasis on risk management was drafted in BASEL III to overcome the expected and unexpected risks(McShane et al., 2011).Although Pakistan's banking industry has grown significantly in recent years, it has been unable to fully regulate market risk.Therefore, market risk has significantly affected the banking sector in Pakistan(Hanif et al., 2019).Due to the borrowers' poor credit records, these loans are riskier.Hence, credit risk affects firm value(Inoguchi, 2016).Practices for credit risk management emerged due , 2020).Banks are renowned for offering a variety of financial services with the goal of maximizing profit and shareholder value.Banks give their attention to increasing their lending portfolio to achieve a major chunk of profit, but lending activity may also expose banks to credit risk, which could affect firm value(Dauda & Nyor, 2018).When liquidity risk is not effectively managed, it negatively impacts firm value.Excessive withdrawals from banks create liquidity risk.Therefore, it makes difficult for banks to meet their short-term obligations and unanticipated cash flow.Liquidity risk was also one of the main reasons for the global financial crisis in 2007-2008.Since the banks relied on the short-term money market to finance their assets, they experienced liquidity issues during the financial crisis(Chen et al., 2018).Liquidity risk is a threat to the banks and could affect firm value(Olalere et al., 2020).Earlier empirical studies investigated that besides market and credit risks, liquidity risk also affects firm value(Du et al., 2016).The net interest margin of the banking sector may be sensitive to changes in interest rates if the banks choose to take on comparable exposures.Bank customers continue to borrow money despite interest rate increases, which drives up borrowers' interest payments.Therefore, interest rate risk has an inverse relationship with firm value(Ebenezer et al., 2019).

Table 1 .
Half-yearly observations of listed banks of PakistanSource: State Bank of Pakistan, www.sbp.org.pk.

Table 2 .
Table 2 presents the measurement of variables.Summary of variables and measurements where Firm Value jt = Firm Value of jth bank at time t; jt = jth bank at time t; NPLR jt = Ratio Non-Performing Loans of jth bank at time t; RLATA jt = Ratio of Long-term Assets to Total Assets of jth bank at time t; Mβeta jt = Market Risk Beta of jth bank at time t; CR jt = Cost Income Ratio of jth bank at time t; RNIM jt = Ratio of Net Interest Margin of jth bank at time t; ε jt = error term of jth bank at time t.where RNPL = Non-Performing Loans; RLATA = Long term Assets to Total Assets; MBeta = Market Risk; CR = Cost Income Ratio; RNIM = Net Interest Margin; Interaction Terms -RNPL•CAR; RLATA•CAR; MBETA•CAR; CR•CAR; RNIM•CAR.RNIM Net interest income/Average.interest earning assets Ebenezer et al (2019); Olalere et al. (2020) http://dx.doi.org/10.21511/imfi.20(1).2023.25

Table 4
presents the test of goodness of fit, which is commonly known as model fitness.The regression model explained 67 percent of the variability observed in the targeted variable, resulting in an R-squared of 0.674.Further, 67 percent of the results of R-squared indicate that the data is fit for the regression model.

Table 5 .
Regression results of financial risks and firm value Note: a -Dependent Variable: Tobin's Q. p < 0.05.

Table 8 .
Hypotheses testing results

Table 7 .
Moderating effects of CAR on financial risks and Tobin's Q on increasing firm value.The findings of this study present factual evidence that an increase in capital adequacy enhances firm value in banks.Further, credit, operational, and interest rate risks affect firm value.Based on the empirical evidence of this study, banks need to improve their risk management framework to support firm value.