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FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management

Which of the following best explains why financial institutions are subject to prudential capital requirements, rather than relying only on market discipline?

Capital requirements exist because bank failures create systemic costs borne by others, while deposit insurance and implicit guarantees reduce creditors' incentive to monitor. This moral hazard means market discipline alone is insufficient, so regulators require loss-absorbing capital.

  1. ABecause capital eliminates all credit losses
  2. BBecause failures impose systemic externalities on others, and deposit insurance and implicit guarantees weaken creditors' incentive to monitor the institutionCorrect
  3. CBecause capital increases a bank's return on equity
  4. DBecause shareholders always prefer lower leverage than regulators

Explanation

Bank failures spread costs to the wider economy, and safety nets such as deposit insurance reduce creditor monitoring and encourage risk-taking (moral hazard). Capital cannot eliminate losses, and higher capital typically lowers ROE, not raises it.

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