The Most Important Concepts in Finance
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The Most Important Concepts in Finance

Edited by Benton E. Gup

Anyone trying to understand finance has to contend with the evolving and dynamic nature of the topic. Changes in economic conditions, regulations, technology, competition, globalization, and other factors regularly impact the development of the field, but certain essential concepts remain key to a good understanding. This book provides insights about the most important concepts in finance.
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Chapter 10: Risk and the probability of insolvency: a regulatory perspective

Betsy Brown Faulk, Walter H. Faulk and Thomas Lutton


Few concepts in finance and regulation have received more attention than risk: how to define it, estimate it, monitor it, and ultimately manage it. Risk assessment and monitoring requires estimation of the probability of incurring future losses, the magnitude of such losses, and who bears the losses. Regulators charged with monitoring risks taken by banks have increasingly replaced compliance-based banking regulations with risk-based supervision (RBS) since the mid-1990s. In its more sophisticated forms, RBS recognizes the importance of monitoring risks as a forward-looking process that exists in every phase of regulation from licensing through to bank resolution. Estimating likelihood of incurring losses and the size of the losses become essential components of risk monitoring. As commonly practiced, however, RBS has failed to keep up with advances in risk analytics that appear in the financial and economics literature. A gap has developed between risk assessments made by banks and those made by regulators. Banks actually estimate and quantify risk to themselves. Risk-based supervision does not require regulators to actually estimate and quantify risks to banks, their counterparties, and society at large. Many RBS regulators make no attempt to estimate probability of future losses or incorporate probability into risk assessments. The “risk” in RBS takes on a different and more qualitative meaning than probability defined in a statistical sense.

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