Why is maintaining adequate capital ratios critical for banks?

Maintaining adequate capital ratios is vital for banks primarily because it ensures that they can absorb losses and protect depositors. Capital ratios are a measure of a bank’s financial strength and stability. When banks have sufficient capital, they are better equipped to withstand economic downturns or financial shocks without collapsing. This protection is crucial not just for the bank's viability but also for safeguarding the interests of depositors who rely on the financial institution to hold their money securely.

Furthermore, strong capital ratios enhance public confidence in the banking system, which is essential for maintaining stability within the financial system. If a bank experiences significant losses, adequate capital acts as a buffer, allowing it to continue operating and fulfilling its obligations to customers and investors. This protective function is particularly important in ensuring that taxpayer funds do not have to be utilized to bail out failing banks during financial crises.