This paper shows that banks play a crucial role (resource allocation) in the functioning of every economy, more so for developing economies where capital markets are not well developed and, in some cases, non-existent. Drawing from existing literature, we show that capital structure is an important determinant of bank performance and that political risk influences the choice of how much and what sort of debt banks employ. We show that heightened political risk increases the cost of debt, especially long-term debt thereby influencing the amount of employed debt versus equity, that is, capital structure. This paper shows that, relative to developed economies, developing economies experience more political risk. Another important finding is that, contrary to common belief, banks do rely on non-deposit debt to finance their activities, to an extent that, factors such as political risk, that affect the availability and cost of debt, directly impact banks’ decisions, performance and efficiency. We precisely explain how capital structure affects performance and demonstrate the exact channels through which political risk influences the debt-equity mix.
