5.4.4 Usability of Basel approach for the risk profile of investment firms?

218. As discussed earlier in this Chapter, the Basel approach to risk measurement is intended for internationally active banks. One aspect of the Basel Accords is that banks should be capitalized for their unexpected losses in their loan books and trading portfolios. This capitalization of unexpected losses is to prevent banks from failing if one of these unexpected losses does occur. Given the important role of banks in the financial system, but also given the differences in asset segregation requirements between banks and investment firms (as discussed in Chapter 4), the Basel approach is calibrated on a going-concern basis. Even after the occurrence of unexpected losses, the bank has to remain solvent and be able to service its clients. This going-concern assumption is something that can be questioned for investment firms, as the risks they pose, to both clients and the financial system, are significantly different to the risks posed by banks. Chapter 8 will go into further detail on this going-concern versus gone concern principle.

219. The credit and market risk approaches of the Basel Accords are thus directed at the loan portfolios and trading books of banks and the unexpected losses that can occur in these exposures. Chapter 3 discussed the differences between banks and investment firms and the consequences these differences have for the respective balance sheets. As discussed, investment firms usually do not have large portfolios of loans they originated. Some investment firms might have a portfolio of loans granted as investment credit. However, this is not the core activity of an investment firm, whereas granting credit is a core activity of a bank. The Basel credit risk approach therefore does not appear to be the most appropriate means of dealing with credit risk in an investment firm context.

220. Both banks and investment firms can have active trading books and are thus subject to market risks. From that perspective, the Basel approach to market risk would appear to be an appropriate approach for investment firms. This can be questioned, however, if we factor in a gone-concern prudential approach for investment firms. The Basel approach to market risk is based on going- concern capitalisation of risks. If we deem that investment firms can and should be able to fail, a market risk regime that is calibrated on capitalizing unexpected losses and thus preventing the failure of an institution is exceeding the primary objectives of prudential regulation for investment firms. The prudential regime for an investment firm that is allowed to fail can be less granular and detailed than the Basel market risk approach if that prudential regime mitigates the risks to the financial system of that failure in an acceptable manner.

221. As discussed in Chapter 2, the main risk for an investment firm is operational risk. The underlying concept of operational risk in the Basel approach is therefore very useful for investment firms. However, the specific calibration of the Basel operational risk approach is very much banking-oriented, as is made clear by the different business lines identified in the standardized approach. Applying the Basel operational risk approach to investment firms without a specific calibration might result in an over- or underestimation of the actual operational risk of investment firms.