December 19th, 2014
from the Kansas City Fed
Banks finance their loans and other assets with a mix of deposits, debt, and equity capital. Maintaining adequate capital is important for banks because it absorbs losses and protects them from failure. Capital also protects the financial system and overall economy from the costs that can arise from bank failures. For example, one of the reasons policymakers were concerned about financial stability during the financial crisis was low capital ratios - the ratio of equity capital to total assets - at some of the largest banks, which led to government programs to provide capital to these banks.
While capital helps ensure the safety of banks and the economy, bank owners and managers have mixed incentives to hold capital. On one hand, banks have an incentive to hold low levels of capital because it costs more to fund assets with capital than with debt or deposits. On the other hand, banks that are relatively risky might have to hold higher levels of capital to satisfy uninsured creditors or address their regulators’ safety and soundness concerns.