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

A risk manager at a mid-sized bank explains to the board why a bank holds equity capital even though deposits are insured. Which statement best describes the primary role of bank capital from a risk management perspective?

The primary role of bank capital is to absorb unexpected losses so that the bank remains solvent and depositors and other creditors are protected. Expected losses are handled by pricing and provisions, and capital is neither a liquidity pool nor a guarantee of stable returns.

  1. AIt absorbs unexpected losses and protects depositors and creditors from insolvencyCorrect
  2. BIt funds the bank's day-to-day liquidity needs for payment settlement
  3. CIt eliminates expected losses by being set aside as a reserve for each loan
  4. DIt guarantees that the bank's return on assets remains stable across the cycle

Explanation

Capital is the loss-absorbing buffer against unexpected losses, so the bank stays solvent and creditors are protected. Expected losses are covered by pricing and provisions, not capital. Capital is not a liquidity source and does not guarantee stable returns.

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