According to Pecking Order Theory,

According to Pecking Order Theory, developed by Myers and Majluf (1984) and Myers
(1984), firms having high profits, tend to attain low debt profile because when firms are more
profitable their first priority is to generate financing through retained earnings because they can
maximize the value of the existing shareholders. If retained earnings are not sufficient, the firms
can then go for debt and if further financing is required they issue new equity. The retained
earning is preferred because it almost has no cost, but if the external resources are used for
financing like issuance of new shares it may take very high cost. The Pecking Order Theory is as a
result of information asymmetries existing between insiders of the firm and outsiders (Raheman,
Zulfiqar and Mustafa, 2007). The model leads managers to adopt their financing policy to minimize
these associated costs. It means that they will prefer internal financing to external financing and
very risky debt to equity.
An important issue to note at this juncture is that despite the large tax advantage enjoyed by
debt, why do firms still have low leverage ratios? This issue aggravated the early research on
agency theory (Jenson and Meckling, 1976 and Myers, 1997); work on information asymmetries
(Myers and Majluf, 1984; Miller, 1977; Myers, 1984; Leland, 1998 and Graham, 2000). The
conclusion is that bankruptcy costs alone is small to offset the value of the shields, and they also
conclude that agency costs must be included into the cost-benefit analysis to explain capital
structures of corporate entities.
In both theories, investment opportunities tend to make firms to use less debt than equity.
However, banks cannot do without higher debt acquisition in their capital mix by way of deposit
mobilization. As the capital structure has many dimensions such as leverage, size, growth, etc, it is
very difficult to state which portion is the best choice to adopt in order to maximize a firm’s value
to its shareholders as well as maximize its corporate profitability. There is no final decision that
profits have positive relations with debt or retained earnings. It is still a mutable point! However,
uniqueness of the firm’s product also influences its capital structure posture. In addition, the
industrial classifications also impact on the capital structure as the variety of intensity of the basic
factors may also influence the structure. In the case of the banking firm which largely depends on
debt or external sources of funds and their equity or capital funds to finance lending and other
investments, there is need to ascertain which effect this kind of capital structure would have on
bank profits (Uremadu, 2000). Furthermore, the duration of financial requirements also induces
firms to go for either debts or equity. The banking firm being a service industry has no other
option but to mobilize both short-term and long-term funds to run both its lending and investment
activities. This, of course, will be with an eye on attaining a compromise point between getting
adequate liquidity and getting adequate profitability for the particular banking firm in question
(Uremadu, 2000).
Therefore the central issue before a financial manager is to determine the appropriate mix
between equity and debt for his firm. The mix of debt and equity is known as the firm’s capital
structure. A financial manager must strive to achieve an optimum mix or the optimal capital
structure for his or her firm; that is, the capital structure which would maximize the market value
of the firm’s shares and assure adequate liquidity. The use of debt affects the return (profitability)
and risk to shareholder; it may increase the return to equity funds but (it) always increases its risk.
Thus, a proper balance has to be struck between the need for return and the danger of risk. When
the shareholders’ return is maximized and risk is minimized, the market value per share (eps) will
be considered optimum (Okafor and Harmon, 2005).
This study is an attempt to establish the relationship between corporate capital structure
and the profitability-cum-liquidity of the banking system in Nigeria, and to ascertain to what
direction the impact has been on the total banking system profits within the period under study.