Question

Banks do not want to hold too much capital because ?

a. excess capital will encourage borrowers to default.
b. they do not bear fully the costs of bank failures.
c. higher capital levels attract the scrutiny of regulators.
d. higher returns on equity are earned when bank capital is smaller, all else equal.

Answer 1

Banks aim to balance capital levels to maximize returns on equity while managing risk, as excess capital can lead to reduced financial leverage and hence lower ROE.

Step-by-step explanation:

Banks do not want to hold too much capital because higher returns on equity are earned when bank capital is smaller, all else equal. This is because the return on equity (ROE) is calculated by dividing the net income by shareholder's equity.

When a bank has less capital, it can leverage its investments and loans to earn higher returns relative to its equity, which becomes more attractive to investors. This concept is known as financial leverage.

However, banks need to manage this carefully as too much leverage can increase the risk of bank failure, especially in times of economic uncertainty when the risk of loan defaults is higher and banks may need excess reserves to meet their obligations.

Therefore answer is d. higher returns on equity are earned when bank capital is smaller, all else equal.