10.1 Framework for assessing prudential risks of investment firms

487. The prudential framework in the EU for investment firms that applies until June 2021, assesses the risk profile of an investment firm using methods designed for banks, based on the credit, market and operational risk of an investment firm. As discussed in Section 5.4, this approach, based on the Basel Capital Accord, for measuring the risk profile of an investment firm does not do justice to the actual risks an investment firm is exposed to. This Basel approach is intended for large and internationally active banks1 and thus aims to capture the risks of the business models of those banks. It, therefore, addresses the risks inherent in the loan portfolio, the market risks of the trading book and the operational risk of the various business lines/models of a bank.

488. Moloney proposed in her books on the financial regulation in the EU,2 as discussed in Section 2.1.2, to assess the risks of investment firms on the basis of “agency costs” and “systemic risk”. Agency costs, according to Moloney, 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 Moloney, however, links the regulatory response for these agency costs to “conduct regulation and operational regulation”,4 and therefore only to the requirements of MiFID II. This overlooks the fact that the risks included in Moloney’s agency risk framework can also have a prudential or financial impact.

489. Systemic risks, as applied in the framework by Moloney, are “associated with the liquidity and solvency risks which can arise from large-scale dealing activities and related market-making activities”.5 In Moloney’s view, these risks require a prudential regulatory response. The problem with this, however, is that Moloney equates a financial or prudential risk with having a systemic relevance or a systemic risk. Not all risks that should require a prudential regulatory response are also systemic risks and nor does having large-scale dealing activities inherently mean a systemic risk, as discussed in Section 2.1.4.

490. Moloney’s framework, therefore, has its limitations for assessing the actual (prudential) risk profile of an investment firm, and is therefore not fully adequate as a means of assessing the appropriateness of the current prudential regulatory response in the EU. This study proposes a different framework which measures the risk profile of an investment firm through ‘operational risks’ and ‘financial risks’, which in turn could lead to a ‘systemic risk.’