3.1 Differences between banks and investment firms

130. Both banks and investment firms in the European Union are, until the 26^th of June 2021 when the new regime for investment firms will come into force, subject to the CRD 2013 and the CRR with regard to their prudential requirements. Whereas the similarities between banks and investment firms have resulted in a similar prudential regime,1 the differences between business models and conduct of affairs by these two types of enterprises might indeed be more profound and could lead to a divergence in the prudential regimes for banks and investment firms.2

131. Although the expression “bank” is commonly used, European legislation uses the expression “credit institution”.3 Both expressions encompass those types of firms that take deposits from the public and which grant credit. These activities are also the main identifying factors included in the European definition of credit institution4 in the CRR. Any firm whose business is “taking deposits or other repayable funds from the public and granting credits for its own account” is a credit institution within the European Union and is subject to the prudential requirements of the CRR. The activities included in this definition immediately highlight the main differences between banks and investment firms. If we look at the activities which an investment firm may perform according to Annex 1 of MiFID II (see also Section 2.1), an investment firm is not allowed to take deposits. The granting of credit for own account, which is a primary part of a bank’s business, is usually limited for an investment firm to only “granting credits or loans to an investor to allow him to carry out a transaction in one or more financial instruments”.5MiFID II requires a permission for the ancillary service of granting “investment credit” but does not regulate any other forms of credit an investment firm can grant. An investment firm can grant credit on a broader scale then as defined in the ancillary services of MiFID (and possibly requiring other permissions or authorisations for that broader scope of granting credit by supervisory authorities). In practice, however, most investment firms will not pursue an active business in granting credit,6 other than granting investment credit to a customer if that customer needs the credit to conclude a transaction in a financial instrument. Banks grant credit for a wide variety of reasons, and it is fair to say that this activity is a core element of their business model.

132. Broos et al (2012)7 elaborate on the activities performed by a bank: “banks fulfil an important social function by bringing together supply and demand of capital, provide liquidity and maturity transformation and facilitate transfer of payments”. A bank provides transformation of maturity, credit and liquidity8 and as such matches those firms seeking funding with those firms having excess funding or cash. As discussed above, these activities are part of the core elements of bank business models. There are, however, entities that are not banks that do perform these activities. These non-bank entities are sometimes referred to as shadow banking entities. The Financial Stability Board identified five economic functions which help to identify if an entity is a shadow banking entity.9 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.

133. It is necessary to further discus the first of these five economic functions; the management of funds with features that make those funds susceptible to accelerated repayment or payment obligations. This “susceptibility to runs” is a consequence of a liquidity mismatch between an open-ended fund (with the possibility for investors to redeem their investment fund units on a daily basis) with longer term investments10 in that investment fund. This mismatch between obligations towards investors and the (possible) inability to sell investments to meet the redemptions can create financial risks within these funds, which in turn lead to a “repricing of assets, liquidity strains in certain markets and the potential for contagion across asset classes”.11 The FSB, however, acknowledges that this liquidity mismatch risk has “not generally created global financial stability concerns”.12 As such, managing an investment fund which has a liquidity mismatch might lead to risks, in itself it is not a good indicator of systemic risks of asset managers.

134. A further note should be made regarding this liquidity mismatch risk for the scope of this study. The managing of investment funds is not an activity which a MiFID II authorised investment firm is allowed to perform without also holding a license to provide collective portfolio management regulated under the AIFMD or UCITS. This possible systemic risk associated with this first economic function should therefore not apply per se to investment firms authorised under MiFID II and therefore falls outside of the scope of this study.

135. Although it is possible that investment firms are also performing economic functions two to four identified by the FSB as shadow banking functions13 in the assets of clients they manage, the firms themselves will most likely not perform the shadow banking functions in points 2 to 5. An investment firm is in principle not allowed to use the “funds of its clients for own account”.14 Using the funds of a client for own account would effectively mean that such investment firm would function as a credit institution. Furthermore, the definition of a credit institution in Article 4(1)(1) of the CRR highlights that an undertaking “the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account”15 qualifies as a bank.

136. One of the key drivers of the risk profile of a bank is that they use the deposits taken from their clients to fund their credit granting business. This usage of client monies to fund a part of the credit granting business, is not possible for investment firms due to the asset segregation requirements. So even though an investment firm can hold a significant amount of client monies and that same investment firm can have a sizeable (investment) credit portfolio, the asset segregation requirements applicable for investment firms, and as discussed in Chapter 4, will ensure that the monies belonging to clients can never be used for any activities for the own risk and account of the investment firm.

137. It should be noted that the Financial Stability Board16 includes broker-dealers as firms that might qualify under one of the economic functions attributed to the shadow banking17 sector insofar as these broker-dealers are “dependent on short-term funding or on secured funding of client assets”. All other types of investment firms will most likely not perform functions 2 to 5 of the economic functions associated with shadow banking and will thus have activities which are not comparable with those of banks.

138. While the activities described above, taking deposits and granting credit, will lead to a firm qualifying as a bank (i.e. credit institution) within European legislation, these are not the only activities a bank is allowed to perform. Under its licence as a credit institution in the European Union, a bank is (often) allowed to perform a myriad of other activities,18 including the provision of investment services and activities.19 So, while an investment firm is not allowed20 to take deposits and needs permission to grant investment credit, a bank is allowed to perform investment services and activities and can therefore compete directly with investment firms for the same types of business.21 That being said, the balance sheet of a bank will differ significantly from that of an investment firm because of the deposits taken by the bank and the credit granted. As such, the prudential risk of a bank will be fundamentally different from that of an investment firm.

139. Another difference between banks and investment firms is the way in which both types of firms are entitled to “hold client funds or securities”.22 Chapter 4 will explore this subject in more detail. Generally speaking, investment firms are not allowed to hold any funds or securities belonging to their clients without having specific arrangements in place to safeguard the clients’ funds or securities. Banks, however, since their main activity is taking deposits, are allowed to hold funds belonging to their clients. If a bank providing investment services for a client holds securities belonging to that client, it is subject to the same asset segregation requirements for those securities as an investment firm will be.23 The main difference between a bank and an investment firm therefore concerns the applicable requirements, and the consequences thereof, with regard to the holding and safeguarding of client monies. And, finally, it is fair to say that, at least for European investment firms, because of the asset segregation rules, firms that wish to provide the ancillary service of granting credit to their clients, will only be capable to do so if the firm has a sufficiently robust equity funding in place. Any credit granted by such firms must by nature be funded with equity.