Financial Structure and Financial Stability of Commercial Banks
DOI:
https://doi.org/10.5281/zenodo.22978462Keywords:
Financial Structure, Financial Stability, Commercial Banks, Debt Financing, Equity FinancingAbstract
The financial stability of commercial banks underpins confidence in the financial system, the mobilisation of savings, the extension of credit and the wider growth of an economy. Banks nonetheless face a persistent challenge in choosing a financial structure that balances profitability, liquidity, solvency and risk, where financial structure refers to the combination of short-term debt, long-term debt, equity and retained earnings used to fund operations. This paper reviews the relationship between financial structure and the financial stability of commercial banks, with attention to how each financing source shapes a bank's capacity to absorb shocks. The review is motivated by mixed empirical evidence: some studies link debt financing to stronger performance, others link excessive leverage to financial distress, and equity and retained earnings are generally associated with firmer capital buffers, although their effect still depends on how the funds are used. The paper is anchored on the Modigliani-Miller theorem, Trade-Off Theory and Pecking Order Theory. The Modigliani-Miller theorem offers a benchmark for financing irrelevance under perfect market conditions; Trade-Off Theory explains how firms weigh the benefits of debt against distress and repayment costs; and Pecking Order Theory highlights a preference for internal funds ahead of debt and external equity. Drawing these perspectives together, the paper offers a theoretical account of how the components of financial structure may influence bank stability once market imperfections, regulatory requirements and risk conditions are taken into account. The review further points to a need for empirical work that measures financial stability more broadly, through capital adequacy, liquidity, asset quality and insolvency risk, rather than relying mainly on profitability.
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