On July 5 the Basel Committee on Banking Supervision published a series of proposals to revise banks’ equity investments in funds. The revised standards are meant to “more appropriately reflect the risk of a fund’s underlying investments and its leverage” and “help address risks associated with banks’ interactions with shadow banking entities.” The proposals are “based on the general principle that banks should apply a look-through approach to identify the underlying assets whenever investing in schemes with underlying exposures such as investment funds.”
Currently, the Basel II framework treats banks’ equity investments in funds under the “standardized approach” and the “internal ratings-based approaches” (IRB). Some commentators have observed that the problem with both these approaches is “that they do not require banks to reflect a fund’s leverage when determining capital requirements associated with their investments in a fun,” nor do they clarify “how banks should implement the various approaches.”
The three proposals suggested by the Basel Committee are the “look-through approach” (LTA), the “mandate-based approach” (MBA), and the “fall-back approach” (FBA). The “degree of conservatism increases with each successive approach (as risk sensitivity decreases)” to incentivize banks to increase the risk management of their exposures.
The “look-through approach” (LTA) “requires banks to risk weight the underlying exposures of a fund as if the exposures were directly held.” This is the most sensitive of the look-through proposals. The LTA must be used when “there is sufficient and frequent information provided to banks regarding the underlying exposures of the fund” and when “such information is verified by an independent third party.”
The “mandate-based approach” (MBA) “allows banks to use the investment mandate of the fund for calculating risk weights.” The MBA thus “provides a method for calculating regulatory capital that can be used when the conditions for applying the LTA are not met.”
The “fall-back approach” (FBA) applies a 1250% risk weight to the bank’s investment in the fund. This approach must be used when neither the LTA nor the MBA applies.
This risk weighting framework “therefore enables the application of a consistent risk-sensitive capital framework which provides incentives for improved risk management practices.”
Click here to read the Basel Committee’s Consultative Document regarding the proposals.