Understanding corporate finance: the legal and regulatory capital: regulation and risk
Regulation and risk
All businesses have to contend with risk of one sort or another. For example, there are the common risks of damage to or loss of stock or premises, bad debts, legal action by dissatisfied customers, computer systems failing, and so on. Most businesses take out insurance and have contingency plans for coping with disruption. Derivatives are commonly used to mitigate many financial risks, such as those from interest rates and exchange rates fluctuation.
In the case of businesses that are central to the stability of the financial system as a whole, the regulatory regime aims to ensure that risks are managed successfully. All financial sector businesses face similar risks. For example, in banking, the main types of risk are as follows.
- Credit risk: the risk that a borrower will not repay a loan. This can be broken down into Country risk or Sovereign risk where it relates to the credit risk of lending to a particular nation.
- Liquidity/funding risk: the risk that a bank will have insufficient cash to meet all demands in normal operations - so that customers cannot withdraw funds. It can arise from mismatches in the timing of cash flows.
- Interest rate risk: the risk of exposure to changes in interest rates where assets and liabilities do not have equal and opposite interest rates. A bank could only avoid this risk entirely if the interest terms and maturity of its lending exactly matched its borrowing.
- Foreign exchange risk: exchange risk arises on a bank’s foreign exchange positions on its own and its customers’ account. There will normally be a mismatch between currencies and maturity dates that has to be monitored and managed.
- Market risk/equity position risk: the risk that market prices or share prices will change, reducing the value of assets in general or equities specifically. Foreign exchange risk is also a type of market risk.
- Operational risk: the risk that the trade is disrupted, for example by terrorist attack or computer failure. Or simply that internal systems, people and procedures fail leading to a loss.
- Fiduciary risk: the risk that the bank may carry out customers’ instructions incorrectly or in a way that is negligent or unprofessional leading to claims for compensation.
The FSA Handbook sets out the ways in which firms in the various parts of the financial sector are required to meet such risks. A particular feature of these rules is the ‘prudential’ requirement to hold a certain amount of capital - CFM14110.