10.4.4 Methods for assessing systemic risks of investment firms

522. Despite the analysis above, certain investment firms might still pose a systemic risk and thus should be subject to other requirements addressing this systemic risk, as discussed in Section 8.4. The systemic relevance of an investment firm should be assessed based on 1) the systemic importance of the investment firm and 2) the complexity of the investment firm. This should be an explicit part of the review by the EC in accordance with Point G of Article 66 of the IFD.1 The systemic importance of an investment firm is influenced by its importance for the economy in a specific country. Furthermore, the substitutability of the investment firm is relevant when assessing systemic relevance. The complexity of an investment firm is influenced by its organisational structure, by the types of financial instruments it invests in (either for itself of for its clients), but can also be influenced by the funding profile of that investment firm.

523. Some investment firms are for all intents and purposes banks, by virtue of the activities they perform and the size of those activities. The only difference between these so-called “investment banks” and a regular bank is that these investment banks do not take deposits. The EC’s approach has always been to label certain investment services and activities, such as dealing on own account and underwriting, as bank-like, and to apply banking regulations to all investment firms that provide those activities, regardless of the size and actual systemic relevance of those activities. This study has argued that simply providing these activities does not equate to systemic risk, nor do these activities make an investment firm bank-like. This study analysed the bank- like nature of an investment firm through the criteria used by the FSB to analyse the shadow banking system. See also Sections 3.1, 8.4 and 9.2.1.

524. The FSB identified five economic functions which help to identify if an entity is a shadow banking entity.2 The five economic functions are: “1) Management of collective investment vehicles with features that make them susceptible to runs, 2) Loan provision that is dependent on short term funding, 3) Intermediation of market activities that is dependent on short term funding or on secured funding of assets, 4) Facilitation of credit creation, 5) Securitisation based credit intermediation and funding of financial entities”. Furthermore, Bank-like investment firms do not take deposits, which means that the funding of their business comes from both equity and from wholesale markets, whereas investment firms that are not bank-like typically do not rely on the wholesale market for the funding of their day-to-day business. Because these “bank-like” investment firms perform banking functions within the financial market, such as “(i) maturity transformation, (ii) liquidity transformation, (iii) credit risk transfer, and/or (iv) leverage”,3 these “bank-like” investment firms can also be seen as shadow banking entities which therefore should be treated in a similar way to a normal bank.

525. As discussed in Section 3.1, investment firms will usually not perform any of these economic functions. However, certain bank-like investment firms (so called investment banks) might perform the economic functions two to five. Measuring systemic risk of an investment firm should, therefore, take into account this shadow banking activity of an investment firm. By including the amount of wholesale funding such a “bank-like” investment firm needs, either in an absolute amount or a relative position, into the complexity criteria, the systemic relevance of an investment firm can be assessed.

526. This new means of assessing systemic relevance will mean that the Class 1 investment firm category, including the sub-categories Class 1a and Class 1b, of the IFR, should be redrawn. The approach in the IFR is more qualitative by simply looking at the activities performed by an investment firm, and adds a simple quantitative measure that looks only at balance sheet size, to determine if an investment firm is ‘bank-like’ and would therefore require regulations to address financial stability risks. A true assessment of systemic relevance should be conducted along the dimensions discussed above and should encompass a more quantitative set of criteria that measure, for instance, wholesale funding. The qualitative criteria should also be amended to encompass the interconnectedness of an investment firm, its complexity, the performance of shadow banking functions, the substitutability and the relevance of an investment firm for the financial stability of a country or region. Only by applying this more granular and detailed assessment of systemic relevance, will those investment firms be identified that are truly systemically important or that pose an actual risk to the financial stability.