Question

Bank capital is said to serve a number of roles or functions. Discuss the functions of bank capital and the importance of capital adequacy.

Answer 1

Functions of bank capital

1. Buffer against unexpected losses: - capital is supposed to protect a bank from all sort of uninsured and unsecured risks apt to turn into losses. Bank with insufficient capital to absorb losses face insolvency risk.

2. confidence function:-depositors and creditors have to be convinced that their bank deposits and assets are safe. Adequate capital indicates that a bank has enough assets to back its liabilities, Thus adequate capital power building and sustaining credibility.

3. Sources of long term investment:- a new band requires funds to finance fixed assets such as building, Land and equipment. It is desirable to have permanent capital coverage for fixed assets. That means any additio-
nal investments in fixed assets should coincide with a ca-
pital rise.

4. Demonstrates shareholder's Commitment

Bank capital has important consideration since it is a measure of bank's ability to absorb losses. It is also a source of long term investment in technology and aquisition of other financial institutions. Thus adequacy of bank capital depends not only upon absolute volume of liabilities to be covered but also affected by quality of bank assets.

Hence, banks must maintain adequate capital if they want to survive. This is generally measured in the form of a “capital adequacy ratio” and banking regulatory authorities all over the world prescribe the level of capital that needs to be maintained.

importance of capital adequacy

1.Ensuring solvency of banks

2.Limits the amount of credit creation

3. reduce credit risk

4.reduce liquidity shocks