3.2 Types of exposures and balance sheet items of investment firms

140. In the previous Chapter an analysis was included of the various activities an investment firm can perform and which prudential risks can be associated with performing these activities. In order to gain a better understanding of the effect these prudential risks can have on the financial solidity of an investment firm, it is essential to understand the components of an investment firm’s balance sheet and how the prudential risks can affect the balance sheet items or the profit and loss account of the investment firm. This insight into an investment firm’s balance sheet is also relevant for determining what the actual effect or impact of a prudential risk can be, but it is also essential to understand the fundamental differences between a bank, or credit institution, and an investment firm. These differences between banks and investment firms also affect the way the current prudential framework can actually address the risks associated with the activities of banks and investment firms. The introduction to this Chapter briefly described the differences in activities between banks and securities or investment firms. However, this description does not truly reflect the financial impact these differences in activities have on the balance sheets of both types of firms and the financial risks to which these firms can be exposed. The following section will go into further detail on the financial differences between banks and investment firms. As banks’ balance sheet risks have been researched extensively,1 this study will start this analysis by describing a prototypical balance sheet of a bank before describing prototypical balance sheets of investment firms. After describing these prototypical balance sheets, the differences between banks and investment firms will be discussed, including the impact of these differences on the types of financial risks they are exposed to and the way certain financial risks can occur.