The definition of legal risk and its management by central banks

Abstract

Currently, there are no international rules specific to central banks on what is to be understood by "legal risk" and how it should be managed. In the context of the discussion on Basel II (the International Convergence of Capital Measurement and Capital Standards), it was considered that assessing, monitoring and mitigating legal risk may positively affect the way in which financial institutions conduct business. Basel II was transposed into Community legislation by means of the Recast Banking Directive2 and the Recast Capital Adequacy Directive 3 which do not define the concept of legal risk but instead include it under the wider definition of operational risk. The concept of legal risk as applied by central banks may have some common ground with the concept as applied to credit institutions. However, when managing legal risk, the fundamental differences between central banks and credit institutions in terms of functions, risk profile, etc. and the roles of central banks as public entities and the risk of reputational loss related to their tasks need to be taken into account. Nonetheless, some elements of managing legal risk may be common to both central banks and credit institutions, depending on the special characteristics of the institution in question.