24. Equity Investments in Funds

When a bank has an investment in a fund (e.g. Fund A) that itself has an investment in another fund (e.g. Fund B), which the bank identified by using either the LTA or the MBA, the risk weight applied to the investment of the first fund (i.e. Fund A’s investment in Fund B) can be determined by using one of the three approaches set out above. For all subsequent layers (e.g. Fund B’s investments in Fund C and so forth), the risk weights applied to an investment in another fund (Fund C) can be determined by using the LTA under the condition that the LTA was also used for determining the risk weight for the investment in the fund at the previous layer (Fund B). Otherwise, the FBA must be applied. Partial Use of an Approach 24.10 A bank may use a combination of the three approaches when determining the capital requirements for an equity investment in an individual fund, provided that the conditions set out in paragraphs 24.1 to 24.12 are met. Leverage Adjustment 24.11 Leverage is defined as the ratio of total assets to total equity. Leverage is taken into account in the MBA by using the maximum financial leverage permitted in the fund’s mandate or in the national regulation governing the fund. 24.12 When determining the capital requirement related to its equity investment in a fund, a bank must apply a leverage adjustment to the average risk weight of the fund, as set out in 24.13, subject to a cap of 1250%. 24.13 After calculating the total risk-weighted assets of the fund according to the LTA or the MBA, banks will calculate the average risk weight of the fund (Avg RWfund) by dividing the total risk-weighted assets by the total assets of the fund. Using Avg RWfund and taking into account the leverage of a fund (Lvg), the risk- weighted assets for a bank’s equity investment in a fund can be represented as follows: RWAinvestment = Avg RWfund * Lvg * equity investment 24.14 The effect of the leverage adjustments depends on the underlying riskiness of the portfolio (i.e. the average risk weight) as obtained by applying the standardized approach or the IRB approaches for credit risk. The formula can therefore be re- written as: RWAinvestment = RWAfund * percentage of shares Application of the LTA and MBA to Banks Using the IRB Approach 24.15 Equity investments in funds that are held in the banking book must be treated in a consistent manner based on 24.1 to 24.14 , as adjusted by 24.16 to 24.17. 24.16 Under the LTA: (1) Banks using an IRB approach must calculate the IRB risk components (i.e. PD of the underlying exposures and, where applicable, LGD and EAD) associated with the fund’s underlying exposures (except where the underlying exposures are equity exposures, in respect of which the standardized approach must be used as required by 10.34 ). (2) Banks using an IRB approach may use the standardized approach for credit risk ( chapter 7 ) when applying risk weights to the underlying components of funds if they are permitted to do so under the provisions relating to the adoption of the IRB approach set out in chapter 10 in the case of directly held investments. In addition, when an IRB calculation is not feasible(e.g. the bank cannot assign the necessary risk components to the underlying exposures in a manner consistent with its own underwriting criteria), the methods set out in 24.17 below must be used. (3) Banks may rely on third-party calculations for determining the risk weights associated with their equity investments in funds (i.e. the underlying risk weights of the exposures of the fund) if they do not have adequate data or information to perform the calculations themselves. In this case, the third party must use the methods set out in 24.17 below, with the applicable risk weight set 1.2 times higher than the one that would be applicable if the exposure were held directly by the bank.