2.1.4 Framework for assessing prudential risks of investment services and activities

102. The discussion on the different investment services and activities above concerns the (theoretical1) situation of an investment firm providing each single investment service or activity only. However, this is not the common practice and investment firms usually provide a combination of the nine investment services and activities and the seven ancillary services. The risk profile of an investment firm is therefore a combination of the risks discussed in Sections 2.1.2 and 2.1.3.

103. Taking a step back from the risks posed by the individual investment services and activities, the investment firms’ business models can also lead to other risks that would require some form of prudential regulation.2 Investment firms can be subject to concentration risk.3 This is particularly relevant to those investment firms that deal on own account. If the investment firm has a large concentration with a single counterparty or a single financial instrument on its trading book, it can face additional risk on this concentrated exposure if that counterparty defaults (or if the market for the financial instrument deteriorates) and the investment firm thus suffers losses on that exposure. Asset managers or investment advisers can also face concentration risks, but these will normally be smaller than those for firms with an active trading book. An asset manager can have a concentration in terms of clients, which will lead to an additional risk if those clients fail and therefore cannot pay their management fees. The practical consequences for the investment firm will be limited, however. Before a client fails, it will probably “use” the assets it has entrusted to the asset manager to fulfil its obligations. One aspect of concentration risk that can affect an asset manager is the concentration of clients. If one of the asset manager’s clients contributes a significant part of the asset manager’s assets under management, the asset manager may get into financial difficulties if that client decides to terminate its asset management relationship with that asset manager.

104. Credit and market risk may also be applicable but will only materialize for those firms that grant investment credit or have an active trading book respectively. Credit risk can also be incurred by those investment firms that have repo business4 or that perform securities lending within their trading book. Counterparty risk will also be relevant to parties with an active trading book and will be important for firms that perform OTC trading.