2.1.1 How to assess the risks of investment firms?

27. Before discussing the (financial) risks associated with the different investment services and activities themselves, it is useful to firstly discuss the risks of these services and activities in a broader perspective. According to Moloney,1 the regulation of investment services has “traditionally been concerned with the correction of market failures related to asymmetric information and to externalities, notably systemic risk”.2 Moloney then groups these market failure risks into two categories: agency costs and the stability of financial markets.

28. Agency costs arise “between the client and the intermediating firm where the interest of the principal client and agent firm diverge, and where monitoring is difficult because of information asymmetries”.3 According to Moloney, agency costs in the investment services sector “can take the form of simple incompetence or fraud and loss of assets”.4 These agency costs, as identified by Moloney, are primarily a means of assessing the risks for which the market conduct requirements of MiFID are established. They do provide a useful tool and starting point for assessing the risk profile of an investment firm. Agency costs can lead to operational risk for the investment firm. Errors made in the operations of the investment firm, unknowingly (through negligence or incompetence) or knowingly (through fraudulent actions), that result in a loss for the clients of the investment firm are operational risks, and are also, with regard to agency costs, a consequence of the information asymmetry between the investment firm (with extensive knowledge of the financial markets and the positions of its clients) and the client (with limited knowledge). According to Moloney, the “regulatory response to client-facing agency costs has typically been some combination of authorization, conduct regulation and operational regulation”.5 The regulatory response mentioned by Moloney is limited, however, to market conduct aspects. From a prudential supervision perspective, agency costs can also lead to financial consequences for the investment firm, and therefore should lead to a prudential regulatory response in the form of capital requirements for investment firms. Operational errors might lead to a liability6 on the part of the investment firm towards its clients. This liability risk might cause a bankruptcy of the investment firm if the clients’ liability claim exceeds the available funds of the investment firm. To prevent a situation where a single operational error results in the bankruptcy of the firm, and thus prevent other clients that might have suffered operational errors claiming their losses, operational risks which occur within this agency costs dimension should lead to prudential supervision of investment firms.

29. The second category of market failures, as identified by Moloney, are externalities that effect the stability of financial markets. These are “associated with the liquidity and solvency risks which can arise from large-scale dealing activities and related market-making activities”.7 The regulatory response to these risks has, according to Moloney, taken the form of prudential regulation. The systemic risk, or risk to the stability of financial markets, is influenced by those firms that have a larger market footprint. Investment firms that have large market-making or own-account portfolios and that do not properly assess the risks of these portfolios run a larger risk of facing financial difficulties, which in turn could lead to problems for financial markets, as all counterparties of that investment firm might suffer losses. Prudential regulation, in the framework proposed by Moloney, is therefore needed to mitigate the risks one individual firm might pose to the financial market as a whole.

30. Although Moloney identifies these two categories of market failures, this author does not fully explore the consequences of these failures. The framework proposed by Moloney divides the regulatory response into market conduct requirements for smaller investment firms and those firms providing investment advice or asset management services, whereas larger broker-dealers should be subject to prudential supervision. Which services or activities then would lead to these market failures? This is not explored further by Moloney and this author does not apply these two categories of market failures when discussing the current prudential regulatory framework for investment firms. Although prudential supervision to protect the financial markets from the failure of investment firms having large trading portfolios is indeed necessary, this is not the only reason for having prudential supervision. This is something Moloney also alludes to, but this author fails to explore further, stating that “while mainly concerned with the financial stability, [prudential requirements] also serve a client-facing function by bolstering the soundness and solvency of firms and, thereby, protecting client assets”.8 Even for investment firms with smaller trading portfolios, or investment firms providing investment advice or asset management services, whose failure will not impact (the functioning of) financial markets, prudential supervision serves a purpose. Furthermore, it could also be considered that investment firms not dealing on own account, but operating market infrastructures (i.e. trading venues), may be prone to cause financial stability risks.

31. Although this framework used by Moloney is a useful starting point for assessing prudential risks of investment firms, the framework itself does not fully incorporate all aspects of operational, financial or prudential risks to which an investment firm can be exposed and which should require a prudential regulatory response. It seems, therefore, that Moloney’s framework is incomplete and lacks the necessary details to fully understand the risks an investment firm is exposed to and what the consequences thereof should be for a prudential regulatory response.

32. When discussing the prudential risks of the individual investment services or activities, this study will reflect on the appropriateness of the framework proposed by Moloney. However, this study will propose a different and more tailored framework for assessing the prudential risks to which investment firms are exposed, although the underlying principles of Moloney’s framework will be used. The framework proposed in this study will be discussed further in in Section 2.1.4 of this Chapter. This framework will be based on the analysis of the prudential risks of the individual investment services or activities and will identify two broad categories of risks to which an investment firm can be exposed. The first category is ‘operational risk’, which encompasses a set of risks similar to those discussed above in the ‘agency costs’ section of Moloney’s framework. The second category comprises ‘financial risks’, most notably market and credit risks. This category of financial risks aligns partly with Moloney’s ‘systemic risk’ category but will also consider the financial risks to which smaller firms are exposed and will also discuss when a financial risk might, as a result of additional factors, result in a systemic risk. As the following sections will highlight, it is not only large investment firms, whose failure might have an impact on financial markets, that are exposed to these financial risks. Although operational risk might lead to a financial consequence, as described above in paragraph 28, these financial consequences of operational risk are part of the operational risk dimension. Financial risks concerns credit and market type risks an investment firm can be exposed to and are therefore distinct from the financial consequences of an operational risk.