Problem
Capital requirements are key tool in ensuring the stability of financial markets in several ways:
I. Absorbing Losses - Capital requirements ensure that financial institutions have an adequate source of capital to absorb losses from unexpected events such as loan defaults, market downturns and just recently the pandemic that struck the whole world. This helps protect the financial institution from insolvency and prevents transmission of losses in in the whole financial system.
II. Responsible Lending Practices - Higher capital requirements contributes to financial stability and discourage financial institutions from taking on extreme risk, such as lending to borrowers with low credit standing or investing in speculative assets. The result is that financial institutions re required to make responsible lending and investment decisions, and the likelihood of them engaging in risky activities that could destabilized the financial system is reduced.
III. Promotes and encourage prudent financial management - It is through capital requirements that financial institutions are encourage to maintain prudent financial management practices, such as avoiding excess leverage and maintaining adequate reserves. The financial sector can benefit from a culture of financial responsibility and accountability, which promotes long-term stability and resilience.
IV. Enhances market confidence - It is essential that capital requirements be met in order to build market confidence by demonstrating to investors and other market participants that financial institutions are will - capitalized and financially sound. As a result, financial systems can be trusted more readily and the risk of panic or runs on banks can be reduced during stressful market conditions.