Final answer:
The market value of equity is a better indicator of a bank's ability to absorb losses than book value because it reflects real-time market perceptions and includes expectations about the bank's future risks and performance, which can be particularly important during times of economic fluctuation and loan defaults.
Step-by-step explanation:
The market value of equity is considered a better measure of a bank's ability to absorb losses than the book value of equity because it reflects the current market perception of the bank’s value, including all the information and expectations about the bank's future performance and risk. The book value might not be up-to-date, hence potentially being less accurate in representing the bank's financial health, especially in times of financial uncertainty or economic changes. The market value of equity fluctuates with the market conditions and investor sentiments, providing a more sensitive and real-time representation of the bank’s financial strength.
For instance, if loans on the bank's balance sheet suddenly decline in value due to an increased number of defaults, this risk is quickly factored into the market value but may not be immediately reflected in the book value. This timeliness makes the market value a more reliable gauge of the equity available to cushion losses as it occurs. A bank that has a strong market value of equity is likely assessed by the market to have superior risk management and a solid loan portfolio, which might not be clearly indicated by its book value.