8.2 Volcker rule for investment firms?

308. In December 2013, the legislators in the United States of America introduced rules for banking entities that prohibit these entities from “from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account”.1 The European Commission commissioned a report, The Liikanen report2, published in October 2012,3 which included the proposal to separate the proprietary trading desk of credit institutions from their ‘other’ activities. Through this separation of trading activities and other activities of a bank, “deposits, and the explicit and implicit guarantee they carry, would no longer directly support risky trading activities”.4 The Liikanen report argued that: “The central objectives of the separation are to make banking groups, especially their socially most vital parts (mainly deposit-taking and providing financial services to the non-financial sectors in the economy) safer and less connected to trading activities; and, to limit the implicit or explicit stake taxpayer has in the trading parts of banking groups. The Group’s recommendations regarding separation concern businesses which are considered to represent the riskiest parts of investment banking activities and where risk positions can change most rapidly.”5

309. Both the Volcker rule and the proposals in the Liikanen report would result in a change in the risk profile of a bank. The activities for own risk and account of the bank would be separated from other activities for clients.6 By having these activities in a separate legal entity (the Liikanen report calls this entity a ‘trading entity’), it would make it easier for supervisory authorities to let this trading entity fail without jeopardizing the financial stability of the rest of this banking group and thus retain the critical economic functions these banks perform within the financial system.7

310. This also touches upon the going- versus gone-concern approach discussed above. Certain functions of a bank, like deposit-taking and the provision of certain financial services to the non-financial sectors as mentioned in the Liikanen report, would merit a going-concern prudential approach, as the repercussions of a disruption in those functions would cause serious problems within the financial system. The importance of the banking sector to society is highlighted in the Liikanen reports as follows: “Banks have a pivotal role in providing finance to households and firms. […] It is of utmost importance that the regulatory reform as a whole supports and strengthens the European banking sector’s ability to continue to provide its financial services efficiently, given how essential they are to society more broadly”.8

311. The separation of trading activities as proposed by the Liikanen report, was intended to achieve the following objectives: “1) limit a banking group’s incentives and ability to take excessive risks with insured deposits; 2) prevent the coverage of losses incurred in the trading entity by the funds of the deposit bank, and hence limit the liability of taxpayer and the deposit insurance system; 3) avoid the excessive allocation of lending from the deposit bank to other financial activities, thereby to the detriment of the non-financial sectors of the economy; 4) reduce the interconnectedness between banks and the shadow banking system, which has been a source of contagion in a system- wide banking crisis; and 5) level the playing field in investment banking activities between banking groups and stand-alone investment banks, as it would improve the risk-sensitivity of the funding cost of trading operations by limiting the market expectations of public protection of such activities”.9

312. Investment firms can also combine these trading activities for own risk and account with other, client-oriented, financial services such as investment advice, brokerage and asset management.10 As these trading activities for own account can become a substantial part of the business of an investment firm, the risks flowing from these activities can jeopardize the financial soundness and stability of the investment firm, which could then put at risk the provision of the investment services to its clients. As such, the separation of the trading activities and the provision of financial services might be a means of further protecting the interest of the clients of an investment firm and the stability of financial markets. The question, however, is whether the reasons for this separation identified for banks in the Liikanen report are also present for investment firms and whether this separation will provide the additional security desired.

313. The investment services provided by investment firms for their clients do not constitute a vital or pivotal role in the financial system in the same way as the deposit-taking and financing function of a bank.11 Clients faced with an insolvent bank might lose the deposits they have at that bank, or they might not be able to get loans they need, for instance, the loans needed by an SME to finance its daily operations. The insolvency of that bank will, therefore, have serious repercussions in the economy. When an investment firm becomes insolvent, its clients might lose their ability to get investment advice, have their orders executed or lose their asset manager. For an individual client, these consequences can be dire, but the implications for the financial system as a whole will not be that great. In a competitive market, an insolvent broker will readily be replaced by another broker. Clients of the insolvent broker should thus be able to select another broker without too many disruptions to their ability to operate in the financial markets as long as their proprietary rights to monies and securities are properly safeguarded.12 This is similar for the other investment activities such as investment advice and asset management. With the failure of an asset manager, the disruption for a client can be greater, as all the assets and funds of a client, and the accompanying administration, need to be transferred to a new asset manager. This transfer will be helped by the asset segregation requirements, as discussed in Chapter 4, which require the investment firm to have its client’s assets legally separated from its own assets, but the investment firm is also required to have a suitable administrative segregation. Both aspects of asset segregation will help a new asset manager to, in theory, assume its asset management role without severe disruptions for the client.

314. Because of the required asset segregation for investment firms, it should not be possible for losses in the own account trading portfolio of the investment firm to affect the assets of that investment firm’s clients. The investment firm is, therefore, unable to ‘use’ the assets of its clients to fund its own trading activities. The first and second objective identified in the Liikanen report13 are, therefore, not applicable to investment firms. An investment firm trading on own account should have the financial capabilities for this own account trading within its own balance sheet, i.e. with its own proprietary capital. If the investment firm is not able to raise enough capital or loans to fund these trading activities, it will not be able to trade. Banks, however, can use the deposits they have raised to fund these trading activities.

315. Although the separation of trading activities and other activities provided by investment firms seems, at first glance, a good measure to reduce the risk profile of investment firms, the actual benefits of this separation do not appear to be convincing. Through other requirements for investment firms, such as asset segregation, the possibility of contagion of clients’ assets by losses in own-account trading activities of investment firms is negligible. Furthermore, these asset segregation requirements would make it easier for other investment firms to assume the engagement with clients of an insolvent investment firm and thus retain the possibilities for clients to be active in financial markets, albeit through a different intermediary.

316. If the focus of prudential regulation for investment firms is on gone-concern regulation, as discussed in Section 8.1, the actual capital requirement for that investment firm should be sufficient for an orderly wind down. This would mean that for a large asset manager, whose function could not easily be replaced by another investment firm, the gone-concern prudential requirement would require that investment firm to hold enough capital so that in the event of a wind down another investment firm can be found that could manage all the client assets. A separation of trading activities and other activities to prevent losses for clients is therefore not needed, as the gone-concern regulation should provide enough of a capital base to keep servicing the clients of the failing investment firm until another investment firm can start servicing those clients. This, however, encounters a problem with the transferability of client relationships. Notwithstanding the recovery and resolution regime of the BRRD for certain investment firms, all other investment firms are subject to normal insolvency procedures which could affect the way these client relationships of the insolvent investment firm are transferred to another investment firm. This raises the question of whether a “business transfer tool” or “orderly wind-down tool” should be introduced within the prudential regime for investment firms. This can then also address possible concerns regarding national insolvency laws in respect to an orderly resolution of an investment firm.14