A case can be made that regulators should set minimum capital requirements for b

Question

A case can be made that regulators should set minimum capital requirements for banks because, if left to decide for themselves, banks would choose to hold less capital than would be socially optimal. Which of the following correctly makes that case?

A. Banks can increase ROE, given ROA, by holding less capital.

B. Banks cannot effectively solve the problems arising out of asymmetric information and make loans that are excessively risky.

C. Bank managers cannot be trusted to act in the best interest of bank owners because of the principal-agent problem.

D. Banks get all the benefit of taking on more risk, but some of the costs are externalized by shifting them to uninsured depositors, the FDIC, and other banks.

E. All of the above

Explanation / Answer

Ans. A

Capital requirement is amount of capital bank or financial institution has to hold as required by its finacial regulator.These requirements are to ensure that banks do not take excess leverage and be insolvent. Capital is required for banks to operate smoothly.Capital is that portion of baks liabilities which does not have to be repaid and is available as buffer in case value of bank's assets decline.

However banks would choose to hold less capital than would be socially optimum then case might be of banks can increase Return on Equity (ROE) , given Return on Assets(ROA).The common measure of bank's profitability is its return on equity.It is ratio of bank's profit divided by equity.Bankers can increase ROE either by increasing profits or by reducing equity.Reducing equity will increase ROE even if profits are flat.So banks would choose to operate to hold less capital by increasing ROE.

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