3.2.3 Comparison of banks and investment firms

154. The balance sheets of a bank and of investment firms presented above highlight the key differences between banks and investment firms. Banks provide loans and other forms of credit for their customers. Banks do not have the funds themselves, however, to provide those loans and thus have to attract funding from third parties, most notably depositors and interbank lenders. These two activities, granting loans and raising deposits, have a significant impact on the risk profile of a bank and are thus the core drivers of the prudential regulation developed for banks. As investment firms do not grant loans on a comparable scale1 and are not allowed to hold funds belonging to their clients, the risks incurred by banks when performing these activities should not similarly affect investment firms. Although one can argue that any type of firm is exposed to some form of credit risk,2 for an investment firm this will not be the predominant risk factor.

155. One similarity between banks and investment firms is their exposure to market risk.3 Both banks and investment firms can trade in financial instruments either for their own account or using their own balance sheet when performing client orders. As such, both banks and investment firms are exposed to the risk that the price of the financial instrument may change and thus result in a loss for the firm. However, as not all investment firms perform these activities, not all investment firms are exposed to market risk. Similarly, not all banks have large trading portfolios and as such could also have limited exposure to market risk.

156. These differences confirm the fact that banks and investment firms have different business models and that, although some balance sheet items accrue and are relevant for both types of institutions, a prudential requirement designed to mitigate a specific risk of a bank might not address a specific risk of an investment firm or vice versa. For instance, a credit risk requirement, which is designed for an active loan portfolio of a bank, does not directly lead to results for investment firms that show the true prudential risk of an investment firm. As the investment firm is not actively granting loans, a requirement intended to address the risk a firm is exposed to when grating these loans does not give supervisors any insight into the risk profile of an investment firm, a prudential framework should provide. An elaborate analysis of the credit, market and operational risk frameworks will be provided in Chapter 5.