6.1.2 Reasons for prudential supervision

227. Although the CRD 2013 and the CRR are also applicable to investment firms, the provisions of and the rationale behind the CRD 2013 and the CRR are primarily focused on credit institutions. This focus on credit institutions is also reflected in two guiding principles1 of the CRD 2013 and the CRR, which state that the CRD is intended to “(1) ensure the financial stability of [the institutions]”, and (2) “ensure a high level of protection of investors and depositors”.2 This focus on credit institutions has become increasingly apparent when looking at the recitals of the various versions of the CAD since 1993. Recital 7 of the CRR shows the current focus on banking supervision when it states: “this regulation should, inter alia, contain the prudential requirements for institutions that relate strictly to the functioning of banking and financial markets …”,3 even though this regulation is also applicable to investment firms, whereas the recitals of the CAD 1993 only mention credit institutions when arguing that they should be subject to the market risk requirements as set forth in that directive.4 The European legislators also state in the recitals of the CAD 1993 that this directive should be seen as “part of the wider international effort to bring about approximation of the rules in force regarding the supervision of investment firms and credit institutions”5 and that “it is therefore desirable to achieve equality in the treatment of credit institutions and investment firms”.6 The European Commission thereby highlighted that the supervisory regimes for credit institutions and investment firms are linked but indeed separate. In Recital 11 of the CAD 2006, which indicates the start of the merging of the super .visory regimes for investment firms and credit institutions, the European legislator stated that investment firms, for their trading portfolios, are exposed to risks similar to those of credit institutions. During the negotiations, while drafting the CAD 2006, negotiators stated that investment firms are active in the same business as banks, and therefore have the same risks and should be subject to the same capital requirements.7 The European legislator felt at that time, the early years of the 21st century, that the inherent risks of an investment firm’s business model for investors were similar to those of credit institutions for depositors. Prudential supervision is therefore required to “strengthen the Community financial system”8 and ensure the “continuity of institutions and to protect investors”9 The prudential supervision of banks and investment firms should thus be similar.

228. This position of the European legislator raises the question of whether the risks posed by investment firms are indeed similar to the risks posed by credit institutions. Dale10 (1994) and Allen and Herring11 (2001) discuss the differences in risks between investment firms and credit institutions. Dale (1994) states that “[…] banks are uniquely vulnerable to contagious collapse. This inherent fragility arises out of the liquid nature of banks’ liabilities (deposits) and the illiquid nature of their assets”. Any loss a credit institution suffers on its trading portfolio directly affects its ability to repay its liabilities and therefore its ability to repay its deposits. In ensuring a high level of protection for depositors, it is therefore logical that the European legislators intended to mitigate the risks posed by the trading portfolios of credit institutions.

229. According to Dale (1994) an investment firm “can be (and often is) required to segregate investors’ cash and securities in special accounts so that in the event of the firm’s insolvency client’s assets are protected from the claims of general creditors.” The risks identified by the European legislator in the trading portfolios managed by the investment firm for the risk and account of its customers may have two distinct consequences from the perspective of the investor.

230. Firstly, the trading portfolios are managed by the investment firm for an investor, whereby the investment firm then usually has an asset management relationship with these investors. Any losses in the trading portfolio directly affect the investor but have no effect on the solvency of the investment firm. This asset management relationship is regulated under the market conduct requirements of the MiFID II. The investment firm might be liable for the losses on its investor’s trading portfolio and for misconduct under the market conduct provisions governing the asset management relationship between the investment firm and the investor.12 The losses in the portfolio are first and foremost for the risk and account of the client.

231. In this asset management relationship, as described above, the investor has both the upside and downside potential of his investment portfolio. The investment firm only manages this portfolio for its client. The investment firm is also obliged to segregate the securities and funds belonging to its clients from its own balance sheet. The segregation of funds and securities is discussed in Chapter 4. Therefore, the risk that losses on the investment firm’s balance sheet will directly affect the investor’s segregated accounts is significantly reduced. When comparing an investment firm to a credit institution, the risks of the trading portfolio managed by the investment firm for investors and the risks to the financial stability of the investment firm are not similar to the corresponding risks for a credit institution. For a credit institution the funds of its depositor do not have to be segregated from the funds of the credit institution itself.13 Therefore, the customer’s funds are directly at risk when the credit institution suffers losses on its trading portfolio maintained for its own risk and account. Credit institutions use the funds provided by their depositors as funding for their activities, which means that the losses suffered by a credit institution will directly impact the credit institution’s ability to repay its funding and thus its depositors.

232. To protect credit institutions from the risk that depositors will remove their deposits if they suspect that the credit institution is in financial difficulties, depositors are guaranteed to receive a minimum amount of their deposits under deposit guarantee schemes.14 This reinforces the idea that the losses a credit institution suffers directly affect the depositor if that guarantee is not in place.

233. Clients of investment firms in the European Union are protected by an “investor compensation scheme”.15 This investor compensation scheme (ICS) has several characteristics that limit its effectiveness. The ICS only covers those “claims arising out of an investment firm’s inability to: (1) repay money owed to or belonging to investors and held on their behalf in connection with investment business, or (2) return to investors any instruments belonging to them and held, administered or managed on their behalf in connection with investment business”.16 This means that the investor can only submit a claim to the ICS if the investment firm fails to meet its obligations.17 As long as the investment firm complies with its obligations, an investor will have difficulties in getting compensation out of the ICS. There is also no coverage for investment losses under the ICS as the ICS only reimburses the investor with the financial instrument, he or she had with the investment firm. Errors by the investment firm or fraudulent behaviour by the investment firm are not covered by the ICS as long as the investment firm is still able to meet its financial obligations. Additional measures, such as asset segregation, have therefore been put in place which have changed the risk profile of investment firms as compared to the risk profile of credit institutions. In practice, the ICS will only provide coverage if the investment firm, either through fraud or incompetence, is not able to reimburse the investor for its monies or securities and the investment firm is simultaneously in bankruptcy or liquidation. As long as the investment firm is not going through a bankruptcy or liquidation procedure and is willing to repay its investors for the monies or securities it has misplaced, the ICS will not become active. Only when the willingness (or ability) of the investment firm to repay its investors stops, will the ICS become active.

234. Secondly, an investment firm can have a trading portfolio to deal for its own risk and account. If the investment firm suffers any losses in its own-account trading portfolio, this will result in capital losses, and therefore a reduced solvency ratio. Since the investment firm is required to segregate the investor’s funds and securities from its own funds and securities, however, these losses do not affect the assets belonging to investors.18 The main risk for investors is not a loss in the investment portfolio owned by the investor, but the risk of losing the service provided by the investment firm. The investor faces a risk in the substitutability of the service provided by the investment firm. Although the loss of the service provided by the investment firm can have a big impact on the investors, this impact is less than when the assets of the investors are directly affected by the failure of an investment firm.

235. The risks to the financial system of losses occurring in the trading portfolio held by an investment firm for its own risk and account are similar to those risks of a bank. However, given the relative size of most investment firms as opposed to banks,19 the risks to the financial system from a failure of an investment firm are less than those of a bank. Furthermore, an investment firm that solely deals on own account, as follows from the regulatory regime applicable to these firms in Europe,20 has no external clients and its failure can therefore only affect the owners of the investment firm. A credit institution has, by definition, multiple depositors as clients. A failure of the credit institution as a result of its losses in the own-account trading portfolio would, therefore, result in losses for the depositors on their deposits. The risks to investors or financial stability posed by a failure of an investment firm that deals on own account are not, therefore, in principle, similar to the risks posed by the failure of a credit institution.

236. According to Dale (1994) “one of the main purposes of bank regulation is to prevent bank failures and to sustain banks as going concerns. […] By way of contrast, an investment firm [should be able to wind down its operations in an orderly fashion]”. This difference in regulatory objectives illustrates the difference between supervision of credit institutions and supervision of investment firms. Although in theory investment firms and credit institutions face similar risks when performing similar investment services and activities, these risks materialize in different forms for investment firms and credit institutions. The inherent risks of an investment firm and the need to regulate these types of institutions differ from those of a credit institution. An investment firm should be able to wind down its operations in such a manner that the service provided for its clients faces minimal disruption, as is also stated by IOSCO in its 1998 principles.21 Regulation of a credit institution is based, among other things, on the protection of its depositors and the ability of the credit institution to repay its depositors and thus the continuity of its service to its clients. The focus of regulation for credit institutions is therefore to “protect a credit institutions solvency as to sustain it as a going concern”.22