Capitalization decisions are important to the success of modern institutions. Banks are expected to follow rigorous international and national standards in this connection. The aim of bank capital requirements is to ensure the stability and solvency of banking system in any country. By implementing several Basel Accords, regulators change capital requirements according to economic situations and adjust capital requirements time to time . Capital adequacy defends against negative shocks and enhances the possibility of better earnings and profitability [3, 16, 35].
The capitalization-profitability nexus can be examined under the following hypotheses, namely the signalling hypothesis, the bankruptcy cost hypothesis, the Agency hypothesis, the pecking order hypothesis, and the Modigliani and Miller hypotheses and general theory of the cost of capital and capital structure (the Brusov-Filatova-Orekhova (BFO) theory) [9, 10, 11].
According to the signalling theory, increasing the capital of a bank conveys to the market favourable information about the bank’s prospects and profitability which eventually increases the bank’s business and leads to better profitability [13, 14, 15]. A well-capitalized bank, according to the bankruptcy cost hypothesis, is not relied on borrowing and has low credit and bankruptcy cost. This prevents the banks from bankruptcy while simultaneously increasing profitability. Some researchers, however, supported agency theory and claimed a negative association existed between capitalisation and profitability. They argued that equity is a costly source of funding due to high agency costs and higher returns required by shareholders which will affect profitability [6, 19]. According to agency theory, a greater capital ratio raises the agency cost, which limits managers’ capacity to put more effort in creating shareholder value, resulting in poorer bank profitability.
Some researchers endorse the pecking order theory, including Annor, Obeng, and Nti , Mili, Sahut, Trimeche, and Teulon , Abusharba, Triyuwono, Ismail, and Rahman , Konishi and Yasuda , Saunders and Wilson , Keeley . They argued that a profitable corporation could easily keep regulatory capital as needed. Internal funds, according to pecking order theory, are the least information-intensive source of funding,hence, a more prosperous corporation may maintain revenues to finance known investment prospects, resulting in better capital ratios.
Berger and Patti  and Williams  investigated hypotheses of reverse causation from profitability to capital and supported Modigliani miller model theory. According to their findings, profitable banks prefer lesser equity capital and prefer more leverage because increased efficiency reduces the cost of insolvency and financial turmoil (a substitution effect). Modigliani and miller’s model assumes that in presence of tax, a corporation can opt for higher debt financing because it will reduce the overall cost of capital due to tax advantages. But increased use of debt increases the risk of insolvency in the business. However, if a bank is constantly earning profit, it can opt for more debt and lower capital. Modigliani and Miller proposed that more prosperous corporations may opt to keep lower capital ratios, and a negative relationship exists [31, 32]. Modigliani and Miller’s preposition is supported by various research works undertaken in numerous industrialized and emerging nations [2, 8, 29].
The Brusov-Filatova-Orekhova (BFO) theory (the general theory of the cost of capital and capital structure) characterizes enterprises of any age. According to BFO theory, the assumption of corporate perpetuity in Modigliani and Miller’s proposition leads to an underestimating of weightage average cost of capital, cost of equity, and firm capitalization. The Modigliani–Miller theory was expanded by the BFO theory, which developed a quantitative theory for evaluating essential parts of a company’s financial activities over a short period of time. The application of BFO theory allows for the application of derived conclusions in actual economics, for firms with limited lifetimes, the introduction of a time component into theory, and the estimation of the conditions of companies with arbitrary lifetimes (or arbitrary age). We did not examine BFO theory in this study since banks are always focused on the long term and are not supposed to have an arbitrary life.
The interrelationship of capitalization and profitability is a contentious issue, and the available literature presents contradictory findings in many industries and situations, necessitating more research in this field. This study’s contribution and novelty may be seen in numerous areas. This study investigated five main capitalization and profitability hypotheses (signalling hypothesis, bankruptcy cost hypothesis, Agency hypothesis, pecking order hypothesis, Hypothesis of Modigliani and Miller) that yet not been empirically tested by existing literature, contributing to the study’s exclusiveness. This study investigated the interrelationship of capitalization and profitability across BRICS states where no earlier study has been conducted. The banking industry has aided the exceptional financial development of several emerging nations, notably the BRICS countries, which have seen significant economic upheavals in recent decades. To maintain a well-capitalized position, most countries, including the BRICS, require banks to hold the needed minimum capital. In terms of methodology, this study utilises two alternate capitalization and profitability measurements to provide precise finding on bank’s capitalization and profitability nexus. We looked at two capital indicators: bank capital to total assets (CR) and bank regulatory capital to risk-weighted assets (CAR). We also used two profitability indicators to assess a bank’s profitability: return on equity (ROE) and return on assets (ROA).
We are investigating the interrelationship between capitalization and profitability in BRICS nations from 2000 to 2020 utilizing yearly data for BRICS countries in the panel and individual settings. This study contributes to the existing range of evidence capitalization and profitability nexus by utilizing a variety of ideas, samples, procedures, time periods, and conditions. This study’s empirical findings are drawn on the basis of more acceptable approach of the VECM/VAR Granger causality test and ARDL estimation, which delivers consistent and robust results. We anticipate that the results of our research will assist policymakers in making capitalization and profitability choices. Long-term empirical findings of the study corroborate the signalling and the bankruptcy cost hypothesis for the BRICS, Brazil, Russia, and India, implying a favourable influence on capitalization from profitability. Capitalization appears to have a significant adverse influence on profitability in China and South Africa, lending credence to the agency hypothesis, which claims that capitalization has a detrimental effect on profit. Profitability appears to have a significant positive long-run influence on capitalization, agreeing with pecking order argument of Myers and Majluf’s  for BRICS and Brazil that increased profitability may support higher capital ratios since earnings are a source of capital. Profitability has a detrimental influence on capitalization in India and South Africa, supporting Modigliani and Miller’s  conclusions (1977). In Russia and China, profitability has no bearing on capitalisation. Although the significance is smaller in most situations, the short-term estimation results are comparable to the long-run ones.
We may also utilize our findings to make policy recommendations. Findings are relevant for BRICS bank regulators who are attempting to adjust capital requirements and help them in designing “macroprudential” regulations because our findings upheld that banks may enhance their profitability by increasing their capital ratios, and vice versa.
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