Question

Alluding to Basel Accords and domestic regulations, explain why bank regulations are designed to ensure the capital adequacy and solvency of banks.

Answer 1

The level of capital adequacy is relevant from the point of view of banks' solvency and their security from adverse events arising from liquidity risk, as well as the credit risk to which banks are exposed in their normal course of operation.

Bank solvency is not a problem which can be left to the banking industry alone. That is because banks hold all of the economy's profits in their deposits. Therefore, if the banking industry were to go bankrupt the entire economy would crash in no time. Also, if ordinary people's savings are lost, the government would need to step in to pay the premiums on deposit.

As the government has a vested interest in the issue, hence, regulatory bodies are interested in the development and compliance of capital ratios. In addition to this, foreign financial institutions also control the capital ratios.

The reserve requirements are meant to limit the amount of money that the banking institutions can create. However, there is certainly no reserve provision in certain nations, such as the United Kingdom and Canada. But here too the banks can not continue to generate infinite liquidity. It is because the equity adequacy ratio often influences the amount of credit the banks will build.

Capital adequacy requirements mandate that anytime a loan is made, a certain amount of deposits be placed aside. This investments are retained as insurance to compensate the damages in the event that the loan goes wrong.

Accordingly, these laws restrict the amount of deposits that may be loaned and thereby restrict credit formation. Consequently shifts in the capital adequacy ratio will have a huge effect on the economy's inflation.