Module: | MODULE B: RISK MANAGEMENT
Q264: Consider the following statements regarding Capital Adequacy and its role as an ultimate insolvency protection buffer:
1. A bank with zero regulatory capital can still remain solvent indefinitely provided it consistently generates high expected returns from a portfolio of highly volatile assets.
2. The primary regulatory function of maintaining a strict Capital Adequacy Ratio (CAR) is to ensure the bank possesses sufficient own funds to absorb catastrophic, unexpected portfolio losses.
3. Regulatory capital must always be structurally segregated from customer deposits, because customer deposits represent liabilities and cannot be written down to absorb a bank's internal credit losses.
Which of the statements given above is/are correct?
2. The primary regulatory function of maintaining a strict Capital Adequacy Ratio (CAR) is to ensure the bank possesses sufficient own funds to absorb catastrophic, unexpected portfolio losses.
3. Regulatory capital must always be structurally segregated from customer deposits, because customer deposits represent liabilities and cannot be written down to absorb a bank's internal credit losses.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is incorrect: A bank with zero regulatory capital cannot remain solvent.
Highly volatile assets generate large swings in value.
The moment the first Unexpected Loss (UL) occurs, a zero-capital bank would immediately become insolvent because its liabilities would exceed its assets.
Capital is the mandatory prerequisite for operating a bank.
Statement 2 is correct: The fundamental purpose of the Capital Adequacy Ratio (CAR) under Basel norms is to enforce a mathematical minimum of "own funds" (equity, reserves) specifically required to act as a shock absorber against catastrophic Unexpected Losses.
Statement 3 is correct: Customer deposits are strictly classified as liabilities.
They belong to the public, not the bank.
A bank cannot legally or structurally use public deposits to absorb its own credit or market losses.
Regulatory capital is the explicitly segregated equity layer that must take the hit to protect those very deposits.
Highly volatile assets generate large swings in value.
The moment the first Unexpected Loss (UL) occurs, a zero-capital bank would immediately become insolvent because its liabilities would exceed its assets.
Capital is the mandatory prerequisite for operating a bank.
Statement 2 is correct: The fundamental purpose of the Capital Adequacy Ratio (CAR) under Basel norms is to enforce a mathematical minimum of "own funds" (equity, reserves) specifically required to act as a shock absorber against catastrophic Unexpected Losses.
Statement 3 is correct: Customer deposits are strictly classified as liabilities.
They belong to the public, not the bank.
A bank cannot legally or structurally use public deposits to absorb its own credit or market losses.
Regulatory capital is the explicitly segregated equity layer that must take the hit to protect those very deposits.