Introduction
Large investment firms, often headquartered in London and authorized under ISD and later under MiFID, typically held substantial financial assets, with extensive portfolios of receivables from margin lending, trading books of exchange-traded and OTC instruments (some held to maturity), and strategic investments in both equity and fixed income. They were active participants in repo, securities financing, and derivatives markets, often assuming end-risk in hedging chains. Funded primarily by equity rather than retail deposits, their balance sheets also included short- and medium-term liabilities associated with derivatives margining and securities financing transactions. Maturity transformation was central to their business models and risk profiles. Additionally, these investment firms played pivotal roles as underwriters in both equity and fixed income offerings, including sovereign debt, and facilitated initial public offerings—particularly assisting European issuers in raising equity on US exchanges.
Regulatory Framework
Due to the significant market risk undertaken by these ISD/MiFID investment firms in the early 1990s—since positions in the trading portfolio held with trading intent did not necessarily revert to the market intraday or overnight—they were subject to a capital requirements regime equivalent to that of banks. This regime was introduced in Europe in 1993 with the first Capital Adequacy Directive. The 1993 Basel 1.5 and EU market risk rules within the Capital Adequacy Directive applied to any financial business—credit institutions and investment firms alike—holding a trading portfolio, regardless of the holding period’s maturity. Thus, firms holding financial instruments intraday or overnight were treated similarly to those holding instruments for longer periods, such as commercial paper or medium-term notes, which may be held to maturity. This allowed for arbitrage between banking books and trading portfolios.
Purpose of the changes in regulation
In defining the activities of Class 1 investment firms, the European Banking Authority (EBA), in its response to the first part of the Call for Advice on 19 October 2016, introduced the term ‘bank-like’—a novel expression in this context. Previously, terms like ‘near banking’ or ‘merchant banking’ were used. In retrospect, EBA might have more accurately used ‘investment bank-like’ to describe the Class 1 firms, which play essential roles in EU capital markets. The term ‘bank-like’ has since evolved to encompass credit institutions as now defined in Article 4(1)(b) CRR.
Impact for the industry
By merely referencing MiFID Annex I A (3) and (6) and then labelling this as ‘bank-like’, the background to the introduction of the market risk rules in 1993 for a very limited subset of investment firms is overlooked; these firms effectively carried out virtually all banking activities as if they were banks, with the exception of being funded by (retail) deposits. It creates an imbalance in the applicable legal frameworks for firms that do not engage in any bank-like activities at all, but which, as a result of the legislator’s choices, are nevertheless subject to a regime that is not at all tailored to their activities
