Question

Give an example to show how bank capital can prevent bank failure.

Answer 1

The bank failure occurs when bank fails to fulfil its financial obligations to the depositors and creditors. To prevent the risk of the bank failure it is important to maintain the bank follow the strict rules in regard to the equity, capital, risks and liquidity management. The requirements on the bank capital improve the safeness of the banking system. For example: the increasing capital requirements will enhance the defaulting loans fraction that the bank may be able to absorb without undergoing failure with the effect of capital buffer. Higher capital requirements will be decreasing the leverage of the banks and, for given asset risk will decrease the probability of the failure of banks.