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CM-5.10.1

Where a bank acquires a holding of the capital instruments of another entity, the concerned bank acquires risk in that entity. The risk exposure to a bank through the acquisition of capital is arguably greater than that acquired by providing a loan or other credit facilities in four ways:

(a) The rights of a shareholder are subordinated to those of ordinary creditors in the event of liquidation of the concerned entity.
(b) Loans and other shorter-term credit facilities have an explicit obligation on the borrower to repay the sum advanced or committed. Share capital has no such commitment (with the exception of some subordinated debt). Investments in the capital of an entity can only be realized by the sale of the concerned capital instruments to a third party, or by winding up the concerned entity.
(c) A capital investment in a third party entity (particularly where the investment is significant in size) is a pledge of capital to the concerned entity to fund its longer-term activities. The funds concerned are no longer available to be used by the investor bank to fund its activities.
(d) There may be reputational and legal risk to the investing bank, particularly if the bank has a “control relationship” with the concerned entity.
Added: January 2011