Today, the Basel Committee finalized its revised risk-based capital framework for a bank’s equity investments in funds, which was proposed in July 2013. The revised framework includes three approaches for calculating risk-based capital requirements for equity investments in funds (hierarchy of approaches), which are in decreasing order of risk-sensitivity.
Scope of Application: The revised framework is applicable to banks’ equity investments in all types of funds that are held in their banking book, including off-balance sheet exposures (e.g., unfunded commitments to subscribe to a fund’s future capital calls). The Basel Committee stated that it is mindful of the need to avoid a disparate treatment between the banking book and trading book and will ensure, as part of its fundamental review of the trading book capital rules, that a consistent approach is applied. The revised framework applies to all banks, irrespective of whether they use the standardized approach or the internal ratings-based (IRB) approaches for calculating capital requirements for credit risk.
Exclusion for Investments Deducted from Capital: The Basel III capital framework requires banks to deduct certain direct and indirect investments in the capital of unconsolidated financial institutions from their regulatory capital. Exposures, including underlying exposures held by funds, that are required to be deducted from regulatory capital under the Basel III capital framework should not be risk weighted and therefore should be excluded from the revised framework.
Hierarchy of Approaches in the Revised Framework
1. The “look-through approach,” which is broadly similar to the full look-through approach in U.S. Basel III. The look-through approach is the most granular and risk-sensitive approach. It must be used when: (a) there is sufficient and frequent information provided to the bank regarding the underlying exposures of the fund; and (b) such information is verified by an independent third party.
2. The “mandate-based approach,” which is broadly similar to the alternative modified look-through approach in U.S. Basel III. Under the mandate-based approach banks may use the information contained in a fund’s mandate or in the national regulations governing such investment funds.
3. The “fallback approach,” which applies a 1,250% risk weight to a bank’s equity investment in a fund.
Leverage Adjustment: Significantly, the revised framework requires a bank to adjust the average risk weight of an investment fund (defined as total risk-weighted assets of the fund divided by the total assets of the fund) by the amount of financial leverage (defined as the fund’s total assets divided by its total equity), subject to a cap of 1,250%.
Formula: RWAinvestment = average risk weight of fund x leverage x equity investment
Potential U.S. Implementation Issues: It remains to be seen whether the U.S. banking regulators will implement the revised framework. If they do implement the framework, they may need to revise the current definition of “investment fund” in U.S. Basel III, which excludes leveraged funds (“Investment fund means a company: (1) Where all or substantially all of the assets of the company are financial assets; and (2) That has no material liabilities.”). Revising this definition could have other implications. For example, in the U.S. Basel III capital deduction regime for investments in the capital of unconsolidated financial institutions or in own capital instruments, an “indirect exposure” is currently defined as “an exposure that arises from the [BANK]’s investment in an investment fund which holds an investment in the [BANK]’s own capital instrument or an investment in the capital of an unconsolidated financial institution.”
Basel Committee, Capital Requirements for Banks’ Equity Investments in Funds (Dec. 13, 2013) available here: http://www.bis.org/publ/bcbs266.pdf