13.3 The European Union and nancial regulation

would have been given a competitive advantage over banks engaged in securities

business, which were required to meet capital adequacy rules. However, it was widely

argued that the same rules should not apply to both forms of business. This ultimately

led to the Capital Adequacy Directive (CAD) of 1993 – implemented in January 1996

– which applied both to investment rms and to the securities activities of banks.

One problem with this solution is that the argument for ofcial protection of

investment rms is less clear than for banks. A major difference is that the assets

of securities houses consist largely of marketable securities, making them much less

vulnerable than banks to contagious liquidity and solvency crises. Thus, there is

much less chance than in the case of banks that they will cause systemic problems

with their associated social costs.

Systemic risks:Risks for the whole of the nancial system, probably arising through

contagion from problems in individual banks, sectors of the market or countries.

Systemic problems may, of course, arise for banks within a nancial market

regime characterised by increasing integration of banking and securities business to

the extent that banks engage in securities business directly or through a subsidiary,

or lend to investment rms. This, however, does not provide a justication for the

regulation of separate investment rms. It has been argued that, if both banks and

securities houses are to be regulated, different techniques should be applied with the

emphasis being on solvency for banks but on liquidity for securities houses.

The Capital Adequacy Directive solution made the securities activities of banks

subject to a capital adequacy regime separate from that of their banking business.

This approach is known as the trading book modelsince the bank is being required,

for the purposes of capital adequacy, to keep its trading business separate from its

banking business. The distinction between the trading bookand the banking bookof

banks is that the trading book covers trading for short-term gain, while the banking

book relates to longer-term investment or hedging. Only certain types of instrument

can be held in the trading book, but some types of instrument can be held in either

the trading book or the banking book depending on the purpose for which it is

being held. A single instrument cannot be held simultaneously in both books.

Items held in the banking book are subject to the risk-weighting scheme described

in section 13.4. Items in the trading book are subject to capital charges. The size

of these capital charges varies with the nature of the risk. The capital charges for

all trading book items are added together and a measure known as Notional Risk

Weighted Assets is produced. This allows the capital adequacy requirement for both

the banking and trading books to be expressed as a single unit.

Trading book:The securities and investment activities of banks, until recently not

regarded as a normal part of banking business in the UK.

The approach of the Capital Adequacy Directive ensures competitive equality

between the securities arms of universal banks and separate investment rms, but in

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Chapter 13 • The regulation of nancial markets

so doing it assumes that banks engaged in securities business can genuinely prevent

problems in one part of its activities from spreading to the other. It has been sug-

gested that this approach puts competitive equality before that of the soundness and

stability of the system.