2.1.4.1 Critique on the framework used by Moloney

105. As discussed in section 2.1.2, the framework proposed by Moloney, dividing investment firms’ risks into agency costs and systemic risks, does not fully reflect the actual risks the provision of investment services or activities present. Furthermore, the theorem by Moloney that a large trading book will, by default, lead to systemic risks fails to consider the specific business models and subsequent business risks of investment firms. This theorem seems therefore to be incomplete and not appropriately addressing the true risk profile of such firms.

106. When assessing the risk profile of an investment firm and looking at the analysis of the inherent risks of the individual investment services and activities in Section 2.1.2, one can differentiate between operational risks and financial risks. The operational risks of an investment firm relate to the errors, either intentional or unintentional, made by the investment firm when performing its activities. What Moloney defines as agency costs are strongly linked to operational risks. Operational risk for an investment firm encompasses the errors made in the execution of the investment services or in the organisational structure of the investment firm. As discussed, these operational risks might lead to a liability risk which in turn drives the need for capital requirements as a means to manage the tail or residual risks of these operational errors insofar as conduct requirements of MiFID II do not fully address these risks. Furthermore, operational risks can have financial consequences as the operational errors need to be mitigated and possible reimbursements to clients need to be made. These ‘financial consequences’ are, however, distinct from ‘financial risks’.

107. The financial risks for an investment firm relate to market and credit risk and will primarily be located in the on- and off-balance sheet exposures an investment firm might incur in providing its investment services. For instance, a market maker or an investment firm dealing on own account will inherently have (exposures to) financial instruments on or off its balance sheet. The risk the investment firm faces on these financial instruments requires a prudential response. Similarly, an investment firm providing underwriting services might also retain the financial instruments it has failed to place on its balance sheet. Besides these market risks, investment firms can also be subject to credit risks, especially if they perform the ancillary service of granting investment credit.

108. What Moloney’s framework failed to include was an assessment of whether these financial risks will always lead to a systemic risk. As Moloney’s framework only differentiates between agency and systemic risks, that framework will inevitably simplify the actual heterogeneous investment firm sector and the various services and activities that can be provided as discussed in Section 2.1.2. Not all risks in trading books are automatically relevant to financial stability or financial markets, which means that systemic risk does not equate to financial risk. It is in fact the other way around: if an investment firm were to incur significant financial risks, it might pose a risk to the financial system; but merely incurring financial risks will not mean it is also a systemic risk. It is precisely this lack of granularity in Moloney’s framework that makes the systemic risk dimension in that framework problematic. It either means that every financial risk would lead to a systemic risk and as such even very small investment firms whose failure will not impact financial stability whatsoever will be deemed systemic. Or it would mean that only financial risks of significant impact will classify as systemic risks, and thereby thus ‘ignoring’ those financial risks and investment firms that are not significant. See also the discussion on the possible systemic risk of an investment firm dealing on own account or operating an MTF or OTF. To truly assess the risk profile of investment firms, more detail should be included in the framework to overcome these shortcomings.

109. Another factor to consider when assessing the risk profile of investment firms is that these risks will not always be linear. Operational risk in particular will most likely not show a linear increase directly related to the size of the investment firm’s business. One may question whether an investment firm that manages a small portfolio will be subject to a similar operational risk as an investment firm that manages a large portfolio. The simple fact of managing a large portfolio, having a large number of clients or processing a large number of transactions should not affect the probability of operational errors. One could even argue that an investment firm that manages a large portfolio would, by virtue of having more operational experience than its smaller competitor, be subject to a lesser probability of operational errors.1 The operational risk of an investment firm might therefore show a more logarithmic regression, where the operational risk will increase significantly for smaller businesses or start-ups, but where the relative increase will decline steadily as the business becomes larger.