Introduction to Financial Law

Introduction:

This note will discuss the nature and functions of financial law.

Nature and Functions of Financial Law

In “Financial Law”, Joanna Benjamin presents financial law as “a system of risk transfer.” The learned author identifies the following two functions of financial law, an understanding of which is necessary to grasp its nature:

1. Financial law permits risks (and the rewards associated with taking them) to be transferred from protection buyers to risk takers, and to circulate amongst risk takers in the financial markets.
2. Financial law serves to translate risks of many kinds into the form of credit risk.

These functions are now discussed.

Function One: Financial law permits risks (and the rewards associated with taking them) to be transferred from protection buyers to risk takers, and to circulate amongst risk takers in the financial markets:

To understand this function, it is essential to understand the terms "protection buyers," "risk takers," and "financial markets".

1. Protection Buyers: These are the persons or entities that seek protection against a particular risk by paying another person or entity to assume that risk. In simple terms, they are the persons or entities that buy protection from someone else.
2. Risk Takers or Protection Providers: These are the persons or entities that agree to assume the risk transferred by the protection buyer. In return for bearing the risk, they receive a reward, usually in the form of periodic payments or premiums. For example, an insurance company is a risk taker because it agrees to compensate a customer for covered losses in exchange for premium payments.
3. Financial Markets: These are marketplaces where financial instruments, such as shares, bonds, and other securities, are bought and sold. They also enable financial institutions and investors to transfer and redistribute financial risks among themselves. According to Joanna Benjamin, financial institutions take risks in exchange for rewards, and they do this by entering into financial positions. For instance, a lending bank will assume the risk that a borrower will not repay the loan in exchange for interest. She asserts that the function of the financial market is to allow positions, with their attendant risks and returns, to move from one person to another.

In light of these explanations, financial law provides the legal framework that permits the transfer of risks, together with the rewards associated with assuming those risks, from protection buyers (for example, a customer of an insurance company) to risk takers (for example, an insurance company). In some cases, the risk taker may subsequently transfer some or all of the risk to other participants in the financial markets. In this way, financial risks can circulate among those who are willing and able to bear them.

Function Two: Financial law serves to translate risks of many kinds into the form of credit risk:

To understand this function, it is essential to understand the terms "risk" and "credit risk."

1. Risk: This is the possibility that an adverse event or outcome may occur and cause loss, harm, or damage. An example of a risk is the possibility that a business will incur losses. On page 13, Joanna Benjamin characterises risk as “ a measure of exposure to danger, of the likelihood and the extent of loss.” It arises from an uncertain future.
2. Credit Risk: Joanna Benjamin, on page 3, characterises a credit risk as “the risk of a debt not being paid or another obligation not being performed.” It is the potential for financial loss that arises when a borrower or counterparty fails to meet its contractual obligations, such as repaying a loan. This kind of risk is also considered measurable, manageable, and transferable.

Per Joanna Benjamin, financial law translates many kinds of risk into credit risk.

The learned identified two main ways by which financial law serves to translate risks of many kinds into credit risk:

1. Through limited liability companies.
2. Through financial positions, of which there are four.

These are briefly discussed.

1. Translating Risks of Many Kinds Into Credit Risks with Limited Liability Companies:

Financial law recognises limited liability companies. Where a company is described as a limited liability company, the liability of its members is limited. The essential question is, limited to what?

Liability may be limited to the amount the shareholders undertake to contribute in the event of winding up (making it a company limited by guarantee) or to the unpaid amount on the shares held by the members (making it a company limited by shares). Essentially, there is a risk that the company will fail, which is a business risk (not a credit risk). If the company fails, there is also the risk that it will be unable to repay its debts to creditors. This latter risk is a credit risk. It arises in this context because the recognition of limited liability means that creditors generally cannot look to the shareholders or members for payment if the company is unable to satisfy its debts. Put differently, financial law translates the risk of a company failing (which is a business risk) into the risk of the company failing to repay its debts to creditors (which is a credit risk) by recognising limited liability companies, thereby limiting the liability of their shareholders or members.

2. Translating Risks of Many Kinds Into Credit Risks with Financial Positions:

According to Joanna Benjamin, on page 19, “under a financial position, the risk taker agrees to take risk from the protection buyer.” The learned author identified four types of financial positions: simple financial positions, such as guarantees, insurance, and performance bonds; funded positions, such as bank loans; net positions; and asset-backed positions.

The essential question is how financial positions (as defined above) translate risks into credit risk. According to Joanna Benjamin, on page 19, financial positions “expose the protection buyer to the credit risk of the risk taker.” To illustrate, if a risk-taker, such as an insurance company, agrees to assume the risk of loss from fire damage for a protection buyer, the protection buyer now faces the risk that the insurance company itself defaults on its contractual obligation to pay for the loss. Here, the risk of fire damage, one of many forms of risk, is now translated into the risk that the insurance company will not fulfil its contractual obligations.

In a subsequent note, we will begin the discussion on financial positions.

Conclusion:

This note briefly discussed the meaning and nature of financial law, focusing on its functions. In a subsequent note, we will discuss how various financial positions can be used to translate risks of many kinds into credit risk.