6.2 Financial systems in the European Union and their impact on the design of prudential securities regulation

237. The previous paragraphs discussed the rationale of European regulations concerning prudential regulation of investment firms and concluded that the risks posed by a credit institution are not similar to the risks posed by an investment firm. This conclusion, however, assumes that credit institutions and investment firms are two separate businesses. Credit institutions may also perform investment services and activities, and in some European countries investment firms focusing only on the provision of investment services are almost non-existent.1 The combination of these activities, banking and investment services in one entity, creates complications when drafting the prudential regulations, especially when these rules have to apply to banks with a less homogeneous business model, investment firms and “universal” banks. The next section will discuss the differences in financial systems in Europe and the effect these have had on the prudential supervision of investment firms.

238. One of the difficulties the European legislator had to overcome in the years when the prudential supervisory landscape was shaped2 was the difference in financial systems in existence in the various European member states. According to Forsyth and Verdier3 “financial systems can be distinguished in a system in which commercial and investment banking are carried out by separate types of firms and those in which universal banks carry out both kinds of operations”. The United Kingdom, France and the Netherlands4 are countries where commercial banking and investment banking are usually carried out by separate entities. In these countries a large sector of specialized (non-bank) investment firms is active. According to Verdier,5 Germany, Belgium, Austria and Italy are countries where universal banking developed. Because of these differences in European financial systems,6 the European legislator faced difficulties in establishing a set of harmonized rules which fitted both the non-bank investment firms and the universal banks performing investment services.7 Under the CAD 1993 and up until 31 December 2013, the CRD 2013 (and its legal predecessors) contained rules regarding, amongst others, the credit risk of universal banks and specialized banks; the CAD contained the provisions for the universal banks and the non-bank investment firms. Under the CRD 2013 and the CRR this distinction between the CAD and the CRD has been removed making the non-bank investment firms, in theory, subject to the full set of rules applicable to the universal banks.

239. According to Dale “the main driving force behind the […] CAD [has been] the need to ensure competitive equality between universal banks and non-bank investment firms. Since universal banks were to be subject to the capital adequacy rules of the banking directives in respect of their securities business, it was thought necessary to impose similar requirements on non-bank investment firms which would otherwise enjoy the competitive advantage of operating on a narrower capital base”.8 This is also reflected in the recitals of the CAD 1993 as mentioned earlier.

240. As discussed earlier, the focus of investment firm supervision, in theory, is to provide a minimum amount of capital with which the investment firm can be wound down in an orderly fashion. A bank needs a higher amount of capital, however, to ensure its capability to continue as a going concern. Because universal banks perform investment services but have to comply with the banking provisions on capital, a competitive disadvantage occurs in respect of the level of required capital for the universal bank, whereas the non-bank investment firms do not face similar capital requirements for those investment services. The provisions and recitals of the CRD 2006 are written for and applied to both universal banks and specialized banks. Although the European legislators do not explicitly choose either model, the provisions in the CRD 2006 are written in such a way that they accommodate the universal banking model, for instance through the activities which fall under mutual recognition9 in the European internal market and which include all investment services and activities referred to in MiFID II. This mutual recognition is limited, however, to those activities the credit institution is allowed to perform in its home member state. Any activities which the credit institution is not allowed to perform in its home member state can similarly not be performed in any other member state of the European Union. An institution which is authorized as a credit institution is allowed to perform all the activities mentioned in Annex I of the CRD 2013 under its European passport. The CRD provides the framework for credit institutions wishing to perform all activities normally associated with the universal banking model. The CRD contains the possibility of not performing all of these universal banking activities, but this is dependent on the strategic choices of the credit institution itself to limit its activities to a more specialized banking model.

241. By accommodating the universal banking model in the CRD 2006, the European legislator accepted the regulatory restraints on non-bank investment firms. The restraints on non-bank investment firms in the CAD were increased at the time of the merger of the CRD 2006 and the CAD 2006 into the CRD 2013 and the CRR. While the European legislator has tried to accommodate non-bank investment firms by changing the definition of investment firm in the CRR, this has resulted in a more fragmented and complicated set of rules for non-bank investment firms.