Nasirulla Nasirli

Type of the article: Research Article

Abstract
The balance between stability and profitability in banking systems has gained renewed urgency as rising interest rates, persistent inflation, and credit risks reshape the global financial landscape. Regulators, such as the IMF, ECB, and OECD, emphasize that while robust capital buffers are indispensable for resilience, excessive capitalization may constrain lending. In contrast, weak asset quality undermines returns regardless of capital strength. Against this backdrop, this article aims to explore how capital adequacy and asset quality jointly influence bank profitability. The analysis uses IMF Financial Soundness Indicators for 133 countries over 2010–2024 and applies two-way fixed-effects panel regressions with Driscoll-Kraay robust inference. The results reveal a consistently concave relationship: Tier 1 capital to assets is positively related to return on assets (ROA) with diminishing returns, though the turning point lies at an implausible 161.7%. In contrast, Tier 1 capital to risk-weighted assets shows an economically plausible peak around 26.3%, with gains tapering beyond that level. Within typical ranges (15-20% RWA), a one percentage point increase in capital is associated with a 0.06-0.03-point rise in ROA, but additional accumulation yields little benefit. Asset quality exerts a strong negative influence, with a 1-point increase in non-performing loans lowering ROA by 0.04-0.05 points, while liquidity remains statistically insignificant. These findings highlight that capital deepening contributes to profitability only up to moderate levels, and that poor asset quality can offset the benefits of stronger capital buffers, underscoring the need for integrated regulatory approaches to stability and performance.