Role Of Bank Capital

Introduction

The main aim of this report is to identify the key roles played by bank capital in the banking business. This report briefly outlines the main functions of bank capital and takes a brief look at the benefits of bank capital to the bank and the banking industry. It is hoped that from reading this paper a general understanding of the roles of bank capital in the banking business can be gained.

Bank Capital

A bank's capital also known as equity is the margin by which creditors are covered if the bank's assets were liquidated. A bank must hold enough capital to protect lenders and depositors from losses and also allow the bank to meet its customer requirements. Banks must maintain capital levels equal with the amount of risks assumed and hold enough to weather severe and considerably long financial storms.

Roles of Bank Capital

Banks are susceptible to many forms of systematic risk which at times can evolve into industrial crisis. The risks they face include credit risk, market risk, business risk and interest rate risk to name a few. And bank capital plays an essential role in the absorption of losses related to these risks.

Credit Risk

Credit risk is the risk that an obligator will not make future interest payments or principle repayments when due and is the main risk faced by banks, considering how large global financial markets are and the proportion of transactions that may be at risk. Credit risk tends to vary with the business cycle as initial rapid expansion results in falling spreads, and a decline in credit widening spreads with banks being hit by large loses as the spread widens.

Banks are taking on more diverse forms of lending including direct finance, margin lending, over the counter derivatives ...

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...ng safety to risk weary investors and liquidity to borrowers. The dramatic effects of weak banking systems can be seen in both developed and developing economies and the repercussions these have had on financial markets everywhere. Each occasion is a reminder of the need for strongly capitalized financial institutions.

References

• Viney C 2007, McGrath’s Financial Institutions, Instruments and Markets, McGraw- Hill

• Mehta D, Fung H 2004, International Bank Management, Blackwell Publishing, Oxford, UK

• Bacon F, Tai S, Shin, Suk H, Garg R 2004, Basics of Financial Management, Copley Publishing Company, Action, MA

• Berger A N, Herring R J, Szegö G P 1995, The role of capital in financial institutions, Journal of Banking and Finance 19, Nos. 3-4.

• Diamond, Douglas W, Rajan R G 2000, A Theory of Bank Capital, The Journal of Finance, Vol. LV, no. 6