Capital Adequacy as a Driver of Profitability: Panel Evidence from Nepalese Wholesale and Retail Microfinance Institutions

Background Capital adequacy is essential for the sustainable operation of microfinance institutions (MFIs). MFIs can expand their outreach to low-income and marginalized people if the institutions are sustainable. Methods This study is based on secondary data collected from the annual reports of the selected microfinance institutions. A descriptive and causal comparative research design was used. The study sampled 10 microfinance institutions from 57 MFIs, including wholesale and retail. The independent variables were capital adequacy ratio, leverage ratio, size, growth, inflation, and type. The dependent variables were return on assets (ROA) and return on equity (ROE). The purposive sampling method was used. Results The panel regression model observed that the regression coefficients for SIZE and GDP growth in the fixed-effect panel regression model, and CAR, LR, SIZE, GDP growth, and TYPE are statistically significant for ROA. This study did not find a statistically significant effect on ROE. Profitability of microfinance institutions is not only determined by the sum of capital and investments but also through the strategic balance between financial stability and operational efficiency. High levels of capital adequacy necessitate restrained management to avoid diminishing returns. The regression coefficient for TYPE is statistically significant; the profitability of Retail MFIs and Wholesale MFIs is different. Conclusion Capital structure, asset size, and leverage are determinants of the profitability of microfinance institutions. One remarkable result is that the type of microfinance institutions is statistically significant; the profitability of retail MFIs and wholesale MFIs is different. Wholesale MFIs are more capitalized but less profitable than retail MFIs. This implies that capital position does not necessarily translate into higher profitability. Retail business models in terms of financial performance may not necessarily work in wholesale business models. Capital adequacy is a significant determinant of the type of MFI profitability in Nepal. Policymakers should not apply a one-size-fits-all regulation but develop diverse supervisory and capital adequacy frameworks for wholesale and retail MFIs. This study is particularly useful for regulators and microfinance institutions for policy formulation.