4.3 The effects of asset segregation on the differences between banks and investment firms

185. It should be noted that asset segregation itself is a key difference between a bank and an investment firm. This relates, however, only to the segregation of client monies. For the segregation of client securities, the requirements for a bank and an investment firm are the same.1 A bank has the deposits it receives from its clients on its own balance sheet and can use those deposits to fund its activities. An investment firm, however, should only be allowed to use its clients’ funds when executing the investment services or activities provided for that client. This means that a bank can use its clients’ deposits to fund a loan to a third party. An investment firm, however, is only allowed to use its clients’ funds to buy financial instruments in accordance with the client’s instructions or the mandate provided by the client. A bankruptcy of a bank will therefore result in the holders of deposits having a claim on the assets of the bank in liquidation. To prevent depositors facing significant losses when a bank fails, European legislators have established Deposit Guarantee Schemes. “The key task of a DGS is to protect depositors against the consequences of the insolvency of a credit institution”.2 This means that a depositor will receive a reimbursement of its deposits, up to a certain level, without having to claim such reimbursement as part of the liquidation of the bank. Section 6.1.2 discusses the deposit guarantee schemes and investor compensation schemes further.

186. As discussed in Chapter 3, a bank faces credit and market risk on its loan portfolio and its trading book respectively. To protect a bank’s depositors, the bank, therefore, needs a system of prudential requirements that addresses the credit and market risks of the bank’s activities of. As banks have their clients’ assets (the deposits) on their balance sheet and the deposits are part of the bankruptcy estate of a failed bank, the depositors of a bank are subject to the risks of the business of the bank. There is thus a strong link between the prudential regulation for a bank, and the need for the protection of a depositor.

187. For investment firms, the need for prudential regulation to safeguard clients is less profound. Through the required asset segregation, the failure of an investment firm should not have a direct effect on the assets of the client. The client will be affected by the loss of service of that (failed) investment firm, but this service should, in a competitive market, easily be replaced by other investment firms providing similar services. As discussed, the main risk for an investment firm is operational risk, which could have effects for the investment firm’s clients, as the assets of a client can be at risk due to errors in the administrative segregation of the assets. So, although prudential regulation of an investment firm is not directly necessary to protect the client from the business activities of the investment firm, it is necessary to give the clients some form of protection for the operational risk of that investment firm’s operations.

188. To summarize, the failure of a bank can have a profound impact on the deposits of its clients, whereas the failure of an investment firm should, because of asset segregation, not have an impact on the financial instruments and funds belonging to the clients. This difference also has an impact on the prudential risks to which an investment firm is exposed, as discussed in Chapter 2.