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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank's treasurer is explaining to the board why a bank needs equity capital even though depositors are protected by deposit insurance and the bank is profitable. Which statement best describes the primary role of bank capital?

The primary role of bank capital is to absorb unexpected losses so the bank stays solvent, protecting depositors and creditors and supporting confidence. Capital is a small part of funding, and it does not guarantee liquidity or replace liquid asset holdings.

  1. AIt provides funds for lending because capital is the largest source of a bank's financing
  2. BIt absorbs unexpected losses so the bank can remain solvent and protect depositors and creditorsCorrect
  3. CIt guarantees that the bank will never experience a liquidity shortage
  4. DIt eliminates the need for the bank to hold liquid assets

Explanation

Capital is a loss-absorbing buffer that supports solvency and confidence, and it limits moral hazard from limited liability. Capital is typically a small share of bank funding, so it is not the main source of lending funds. It also does not remove liquidity risk, which is managed by liquid assets and funding policies.

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