Final Rule, USA
Risk-Based Capital Standards
Advanced Capital Adequacy Framework
Basel II
Equity exposures
Introduction and exposure measurement
This section describes the final rule’s
risk-based capital treatment for equity exposures.
Consistent with the proposal, under the final rule, a bank
has the option to use either a
simple risk-weight approach (SRWA)
or an
internal models approach (IMA)
for equity exposures that are not exposures to
an investment fund.
A bank must use a look through approach for equity exposures to an
investment fund.
Although the New Accord provides national
supervisors the option to provide a grandfathering period for equity exposures
– whereby for a maximum of ten years, supervisors could permit banks to exempt
from the IRB treatment equity investments held at the time of the publication of the
New Accord – the proposed rule did not include such a grandfathering provision.
A number
of commenters asserted that the proposal was inconsistent with the New Accord and would
subject banks using the agencies’ advanced approaches to significant competitive
inequity.
The agencies continue to believe that it
is not appropriate or necessary to incorporate the New Accord’s optional
ten-year grandfathering period for equity exposures.
The grandfathering concept
would reduce the risk sensitivity of the SRWA and IMA. Moreover, the IRB approach does
not provide grandfathering for other types of exposures, and the agencies see no
compelling reason to do so for equity exposures.
Further, the agencies believe that the
overall final rule approach to equity exposures sufficiently mitigates potential
competitive issues. Accordingly, the final rule does not provide a grandfathering period for equity
exposures.
Under the proposed SRWA,
a bank generally would assign a 300 percent risk weight to
publicly traded equity exposures and a 400 percent risk
weight to non-publicly traded equity exposures.
Certain
equity exposures to sovereigns, multilateral institutions,
and public sector enterprises would have a risk weight of
0 percent, 20 percent, or 100 percent; and certain
community development equity exposures, hedged equity
exposures, and, up to certain limits, non-significant
equity exposures would receive a 100 percent risk weight.
Alternatively, under the proposed rule, a
bank that met certain minimum quantitative and qualitative requirements
on an ongoing basis and obtained the prior written approval of its primary Federal
supervisor could use the IMA to determine its risk-based capital requirement for all
modeled equity exposures.
A bank
that qualified to use the IMA could apply the IMA to its
publicly traded and non-publicly traded equity exposures, or could apply the IMA only to
its publicly traded equity exposures.
However, if the bank applied the IMA to
its publicly traded equity exposures, it would be required to apply the IMA to all such
exposures. Similarly, if a bank applied the IMA to both publicly traded and non-publicly
traded equity exposures, it would be required to apply the IMA to all such exposures.
If a
bank did not qualify to use the IMA, or elected not to use the IMA, to compute its
risk-based capital requirements for equity exposures, the bank would apply the SRWA to assign
risk weights to its equity exposures.
Several commenters objected to the
proposed restrictions on the use of the IMA.
Commenters asserted that banks should be
able to apply the SRWA and the IMA for different portfolios or subsets of equity
exposures, provided that banks’ choices are consistent with internal risk management
practices.
The agencies have not relaxed the proposed
restrictions regarding use of the SRWA and IMA. The agencies remain
concerned that if banks are permitted to employ either the SRWA or IMA to different equity
portfolios, banks could choose one approach over the other to manipulate their
risk-based capital requirements and not for risk
management purposes.
In
addition, because of concerns about lack of transparency,
it is not prudent to allow a bank to apply the
IMA only to its non-publicly traded equity exposures and not its publicly traded
equity exposures.
The proposed rule defined publicly traded
to mean traded on
(i) any exchange registered with the SEC as a national
securities exchange under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f) or
(ii) any non-U.S.-based securities exchange that is registered with, or approved by, a
national securities regulatory authority and that provides a liquid, two-way market for the
exposure (that is, there are enough independent bona fide offers to buy and sell so that a
sales price reasonably related to the last sales
price or current bona fide competitive bid
and offer quotations can be determined promptly and a trade can be settled at
such a price within five business days).
Several commenters explicitly supported
the proposed definition of publicly traded, noting that it
is reasonable and consistent with industry practice.
Other commenters requested that the agencies
revise the proposed definition by eliminating the requirement that a non-U.S.-based
securities exchange provide a liquid, two-way market for the exposure. Commenters asserted that
this requirement goes beyond the definition in the New Accord, which defines a
publicly traded equity exposure as any equity security traded on a recognized security
exchange.
They asserted that registration with or approval by the national securities
regulatory authority should suffice, as registration or approval generally would be predicated on
the existence of a two-way market.
The
agencies have retained the definition of publicly traded
as proposed.
The agencies believe that
the liquid, two-way
market requirement is not in addition to the requirements
of the New Accord.
Rather,
this requirement clarifies the intent of “traded” in the New Accord and helps to ensure that
a sales price reasonably related to the last sales price or competitive bid and offer
quotations can be determined promptly and settled within five business days.
A bank using either the IMA or the SRWA
must determine the adjusted carrying value for each equity
exposure.
The
proposed rule defined the adjusted carrying value of an
equity exposure as:
(i) For the on-balance sheet component of
an equity exposure, the bank’s carrying value of the exposure reduced by any
unrealized gains on the exposure that are reflected in such carrying value but excluded from
the bank’s tier 1 and tier 2 capital;101
and
(ii) For the off-balance sheet component
of an equity exposure, the effective notional principal amount of the exposure,
the size of which is equivalent to ahypothetical on-balance sheet position in
the underlying equity instrument that would evidence the same change in fair value
(measured in dollars) for a given small change in the price of the underlying equity
instrument, minus the adjusted carrying value of the on-balance sheet component of the exposure
as calculated in (i).
Commenters generally supported the
proposed definition of adjusted carrying value and the agencies are adopting the
definition as proposed with one minor clarification regarding unfunded equity
commitments (discussed below).
The agencies created the definition of the
effective notional principal amount of the off-balance sheet portion of an equity
exposure to provide a uniform method for banks to measure
the on-balance sheet equivalent of an off-balance sheet
exposure.
For example, if the value of a derivative
contract referencing the common stock of company X changes the same amount as the value of
150 shares of common stock of company X, for a small (for example, 1 percent)
change in the value of the common stock of company X, the effective notional principal amount
of the derivative contract is the current value of 150 shares of common stock of company X
regardless of the number of shares the derivative contract
references.
The
adjusted carrying value of the off-balance sheet component of the derivative is the current
value of 150 shares of common stock of company X minus the adjusted carrying
value of any on-balance sheet amount associated with the derivative.
The final rule clarifies the determination
of the effective notional principal amount of unfunded equity commitments.
Under the final rule, for an unfunded equity commitment that is unconditional, a bank
must use the notional amount of the commitment.
If the
unfunded equity commitment is conditional, the bank must
use its best estimate of the amount that would be
funded during economic downturn conditions.
Hedge transactions
The agencies proposed specific rules for
recognizing hedged equity exposures;they received no substantive comment on
these rules and are adopting these rules as proposed.
For purposes of determining
risk-weighted assets under both the SRWA and the IMA,
a bank may identify hedge pairs,
which the final rule defines as two equity exposures that form an effective hedge
provided each equity exposure is publicly traded or has a
return that is primarily based on a publicly traded equity
exposure.
A bank
may risk weight only the effective and
ineffective portions of a hedge pair rather than the entire
adjusted carrying value of each exposure that makes up the
pair.
Two
equity exposures form an effective hedge if the
exposures either have the same remaining maturity
or each has a remaining maturity of at least three months;
the hedge relationship is documented formally before the
bank acquires at least one of the equity exposures; the
documentation specifies the measure of effectiveness (E)
(defined below) the bank will use for the hedge
relationship throughout the life of the transaction; and
the hedge relationship has an E greater than or equal to
0.8.
A bank
must measure E at least quarterly and must use one of
three alternative measures of E – the dollar-offset
method, the variability-reduction method, or the
regression method.
It is possible that only part of a bank’s
exposure to a particular equity instrument is part of a hedge pair.
For example,
assume a bank has an equity exposure A with a $300 adjusted carrying value and chooses
to hedge a portion of that exposure with an equity
exposure B with an adjusted carrying value of $100.
Also
assume that the combination of equity exposure B and $100
of the adjusted carrying value of equity exposure
A form an effective hedge with an E of 0.8.
In this
situation the bank would treat $100 of equity exposure A and $100
of equity exposure B as a hedge pair, and the remaining $200 of its equity exposure A as
a separate, stand-alone equity position.
The effective portion of a hedge pair is E
multiplied by the greater of the adjusted carrying values of the equity exposures
forming the hedge pair, and the ineffective portion is (1-E) multiplied by the greater
of the adjusted carrying values of the equityexposures
forming the hedge pair.
In the
above example, the effective portion of the hedge pair would be 0.8 x $100 = $80 and
the ineffective portion of the hedge pair would be (1 – 0.8) x $100 = $20.
Measures of hedge effectiveness
Under the dollar-offset method of
measuring effectiveness, the bank must determine the ratio of the cumulative sum
of the periodic changes in the value of one equity exposure to the cumulative sum of
the periodic changes in the value of the other equity exposure, termed the ratio of value
change (RVC).
If the
changes in the values of the two exposures perfectly offset each
other, the RVC will be -1. If RVC is positive, implying that the values of the two equity
exposures move in the same direction, the hedge is not effective and E = 0.
If RVC
is negative and greater than or equal to -1 (that is, between zero and -1), then E equals
the absolute value of RVC.
If RVC is negative and less than -1, then E equals 2 plus RVC.
The variability-reduction method of
measuring effectiveness compares changes in the value of the combined position of the
two equity exposures in the hedge pair (labeled X) to changes in the value of one exposure
as though that one exposure were not hedged (labeled A).
This
measure of E expresses the time-series variability in X as
a proportion of the variability of A. As the
variability described by the numerator becomes small relative to the variability described by
the denominator, the measure of effectiveness improves, but is bounded from above by a value of one.
E is computed as:
B
the value at time t of the
other exposure in the hedge pair.
The value of t will range from zero to T,
where T is the length of the observation period for the values of A and B, and is
comprised of shorter values each labeled t.
The regression method of measuring
effectiveness is based on a regression in which the change in value of one exposure
in a hedge pair is the dependent variable and the change
in value of the other exposure in the hedge pair is the
independent variable.
E equals the coefficient of determination of
this regression, which is the proportion of the variation in the dependent variable
explained by variation in the independent variable.
However, if the estimated regression
coefficient is positive, then the value of E is zero.
The closer the relationship between the
values of the two exposures, the higher E will be.
Simple risk-weight approach (SRWA)
Under the SRWA in section 52 of the
proposed rule, a bank would determine the risk-weighted asset amount for each equity
exposure, other than an equity exposure to an investment fund, by multiplying the
adjusted carrying value of the equity exposure, or the effective portion and ineffective portion
of a hedge pair as described above, by the lowest
applicable risk weight in Table J.
A bank
would determine the risk-weighted asset amount for an equity exposure to an
investment fund under section 54 of the proposed rule.
If a bank exclusively uses the SRWA for
its equity exposures, the bank’s aggregate risk-weighted asset amount for
its equity exposures (other than equity exposures to investment funds) would be
equal to the sum of the risk-weighted asset amounts for each of the bank’s individual
equity exposures.
Table J
Several commenters addressed the proposed
risk weights under the SRWA.
A few commenters asserted that the 100
percent risk weight for the effective portion of a hedge pair is too high.
These commenters
suggested that the risk weight for such exposures should be zero or no more than 7
percent because the effectively hedged portion of a hedge
pair involves negligible credit risk.
One
commenter remarked that it does not believe there is an economic
basis for the different risk weight for an equity exposure to a Federal Home Loan Bank
depending on whether the equity exposure is held as a condition of membership.
The agencies do not agree with commenters’
assertion that the effective portion of a hedge pair
entails negligible credit risk.
The
agencies believe the 100 percent risk weight under the proposal is an
appropriate and prudential safeguard; thus, it is
maintained in the final rule.
Banks
that seek to more accurately account for equity hedging in their risk-based capital
requirements should use the IMA.
The agencies agree that different risk
weights for an equity exposure to a Federal Home Loan Bank or Farmer Mac depending on
whether the equity exposure is held as a condition of membership do not have an
economic justification, given the similar risk profile of the exposures.
Accordingly,
under the final rule SRWA, all equity exposures to a Federal Home Loan Bank or to Farmer
Mac receive a 20 percent risk weight.
Non-significant equity exposures
Under the SRWA, a bank may apply a 100
percent risk weight to non-significant equity exposures.
The proposed rule
defined non-significant equity exposures as equity exposures to the extent that the aggregate
adjusted carrying value of the exposures did not exceed 10 percent of the bank’s tier 1
capital plus tier 2 capital.
Several commenters objected to the 10
percent materiality threshold for determining
significance.
They
asserted that this standard is more conservative than the 15 percent threshold under the OCC, FDIC,
and Board general risk-based capital rules for non financial equity investments.
The agencies note that the applicable
general risk-based capital rules address only nonfinancial equity investments; that the
15 percent threshold is a percentage only of tier determining non-significant equity
exposures is appropriate for the advanced approaches and, thus, are adopting it as proposed.
As discussed above in preamble section
V.A.3., the agencies have discretion under the final rule to exclude from the
definition of a traditional securitization those investment firms that exercise
substantially unfettered control over the size and
composition of their assets, liabilities, and off-balance
sheet exposures.
Equity
exposures to investment firms that would otherwise
be a traditional securitization were it not for the specific agency exclusion are leveraged
exposures to the underlying financial assets of the
investment firm.
The
agencies believe that equity exposure to such firms with
greater than immaterial leverage warrant a 600
percent risk weight under the SRWA, due to their
particularly high risk.
Moreover, the agencies believe that the 100 percent risk
weight assigned to non-significant equity
exposures is inappropriate for equity exposures to investment firms with greater than
immaterial leverage.
Under the final rule, to compute the
aggregate adjusted carrying value of a bank’s equity exposures for determining
non-significance, the bank may exclude
(i) equity exposures that receive less than a 300
percent risk weight under the SRWA (other than equity
exposures determined to be non-significant);
(ii) the
equity exposure in a hedge pair with the smaller adjusted
carrying value; and
(iii) a
proportion of each equity exposure to an investment fund equal to
the proportion of the assets of the investment fund that are not equity exposures or that
qualify as community development equity exposures.
If a
bank does not know the actual holdings of the investment
fund, the bank may calculate the proportion of the assets
of the fund that are not equity exposures based on the terms of the prospectus,
partnership agreement, or similar contract that defines
the fund’s permissible investments.
If the
sum of the investment limits for all exposure classes within the fund exceeds 100
percent, the bank must assume that the investment fund invests to the maximum extent
possible in equity exposures.
When determining which of a bank’s equity
exposures qualify for a 100 percent risk weight based on non-significance, a
bank first must include equity exposures to unconsolidated small business investment
companies or held through consolidated small business investment companies described in
section 302 of the Small Business Investment Act of 1958 (15 U.S.C. 682),
then must include publicly traded equity exposures (including those held indirectly
through investment funds), and then must include non-publicly traded equity
exposures (including those held indirectly through investment funds).
The SRWA is summarized in Table K:
Table K
Internal models approach (IMA)
The IMA is designed to provide banks with
a more sophisticated and risk sensitive mechanism for calculating risk-based
capital requirements for equity exposures.
To qualify to use the IMA, a bank must
receive prior written approval from its primary Federal supervisor.
To receive such
approval, the bank must demonstrate to its primary Federal supervisor’s satisfaction that the
bank meets the quantitative and qualitative criteria
discussed below.
As noted
earlier, a bank may model both publicly traded and non-publicly traded equity exposures or
model only publicly traded equity exposures.
In the final rule, the agencies clarify
that under the IMA, a bank may use more than one model, as appropriate for its
equity exposures, provided that it has received supervisory approval for use of the IMA,
and each model meets the qualitative and quantitative criteria specified below and
in section 53 of the rule.
IMA qualification
The bank must have one or more models that
(i) assess the potential decline in value of its modeled
equity exposures;
(ii) are
commensurate with the size, complexity, and composition of the bank’s modeled
equity exposures; and
(iii)
adequately capture both general market risk and
idiosyncratic risks.
The
bank’s models must produce an estimate of potential losses for its
modeled equity exposures that is no less than the estimate of potential losses produced by a
VaR methodology employing a 99.0 percent one-tailed confidence interval of the
distribution of quarterly returns for a benchmark portfolio of equity exposures comparable
to the bank’s modeled equity exposures using a long-term
sample period.
Banks
with equity portfolios containing equity exposures with values that are highly nonlinear in nature
(for example, equity derivatives or convertibles) must employ an internal model designed to
appropriately capture the risks associated with these instruments.
In addition, the number of risk factors
and exposures in the sample and the data period used for quantification in the
bank’s models and benchmarking exercise must be sufficient to provide confidence in the
accuracy and robustness of the bank’s estimates.
The bank’s model and benchmarking exercise
also must incorporate data that are relevant in representing the risk profile of the
bank’s modeled equity exposures, and must include data from at least one equity market cycle
containing adverse market movements relevant to the risk profile of the bank’s modeled
equity exposures.
In
addition, for the reasons described below, the final rule adds that
the bank’s benchmarking exercise must be based on daily
market prices for the benchmark portfolio.
If the
bank’s model uses a scenario methodology, the bank must demonstrate
that the model produces a conservative estimate of potential losses on the bank’s modeled
equity exposures over a relevant long-term
market
cycle.
If the
bank employs risk factor models, the bank must demonstrate
through empirical analysis the appropriateness of
the risk factors used.
Under the proposed rule, the agencies also
required that daily market prices be available for all modeled
equity exposures.
The
proposed requirement applied to either direct holdings or proxies.
Several commenters objected to the requirement of daily
market prices.
A few
asserted that proxies for private equity investments are
more relevant than public market proxies and
should be permitted even if they are only available on a monthly basis.
The agencies
agree with commenters on this issue.
Accordingly, under the final rule, banks
are not required to have daily market prices for all modeled
equity exposures, either direct holdings or proxies.
However,
to ensure sufficient rigor in the modeling process,
the final rule requires that a bank’s benchmarking exercise be based on daily
market prices for the benchmark portfolio, as noted above.
Finally, the bank must be able to
demonstrate, using theoretical arguments and empirical evidence, that any proxies used
in the modeling process are comparable to the bank’s modeled equity exposures, and that
the bank has made appropriate adjustments for differences.
The bank must derive any
proxies for its modeled equity exposures or benchmark portfolio using historical
market data that are relevant to the bank’s modeled equity exposures or benchmark portfolio
(or, where not, must use appropriately adjusted data), and such proxies must be robust
estimates of the risk of the bank’s modeled equity exposures.
In evaluating whether a bank has met the
criteria described above, the bank’s primary Federal supervisor may consider,
among other factors,
(i) the nature of the bank’s equity exposures, including the
number and types of equity exposures (for example,
publicly traded, non-publicly traded, long, short);
(ii) the
risk characteristics and makeup of the bank’s equity exposures,
including the extent to which publicly
available price information is obtainable on the
exposures; and
(iii)
the level and degree of concentration of, and correlations
among, the bank’s equity exposures.
The agencies do not intend to dictate the
form or operational details of a bank’s internal model for equity exposures.
Accordingly, the agencies are not prescribing any
particular type of model for determining risk-based
capital requirements.
Although
the final rule requires a bank that uses the
IMA to ensure that its internal model produces an estimate of potential losses for its
modeled equity exposures that is no less than the estimate of potential losses produced by a
VaR methodology employing a 99.0 percent
one-tailed confidence interval of the
distribution of quarterly returns for a benchmark portfolio of equity exposures, the rule
does not require a bank to use a VaR-based model.
The agencies recognize that the type and
sophistication of internal models will vary across banks due to differences in the
nature, scope, and complexity of business lines in general
and equity exposures in particular.
The
agencies also recognize that some banks employ models for internal risk management
and capital allocation purposes that can be more relevant to the bank’s equity
exposures than some VaR models.
For
example, some banks employ rigorous historical scenario
analysis and other techniques for assessing the risk of their equity portfolios.
Banks that choose to use a VaR-based
internal model under the IMA should use a historical observation period that
includes a sufficient amount of data points to ensure statistically reliable and robust loss
estimates relevant to the long-term risk profile of the
bank’s specific holdings.
The data
used to represent return distributions should reflect the longest sample period for which data
are available and should meaningfully represent the risk profile of the bank’s specific
equity holdings.
The data sample should be long term in nature and, at a minimum, should
encompass at least one complete equity market cycle containing adverse market movements
relevant to the risk profile of the bank’s modeled exposures. The data used should be
sufficient to provide conservative, statistically reliable, and robust loss
estimates that are not based purely on subjective or judgmental considerations.
The parameters and assumptions used in a
VaR model should be subject to a rigorous and comprehensive regime of
stress-testing. Banks utilizing VaR models should subject their internal model and
estimation procedures, including volatility computations, to either hypothetical or historical
scenarios that reflect worst-case losses given underlying
positions in both publicly traded and non-publicly traded
equities.
At a minimum, banks that use a VaR model should
employ stress tests to provide information about the effect of tail events beyond the
level of confidence assumed in the IMA.
Banks using
non-VaR internal models that
are based on stress tests or scenario analyses should estimate losses under
worst-case modeled scenarios.
These
scenarios should reflect the composition of the
bank’s equity portfolio and should produce risk based capital requirements at least as
large as those that would be required to be held against a representative market index or
other relevant benchmark portfolio under a VaR approach.
For
example, for a portfolio consisting primarily of publicly
held equity securities that are actively traded,
risk-based capital requirements produced using historical scenario analyses should be
greater than or equal to risk-based capital requirements produced by a baseline VaR
approach for a major index or sub-index that is representative of the bank’s holdings.
The loss estimate derived from the bank’s
internal model constitutes the risk based capital requirement for the modeled equity
exposures (subject to the supervisory floors described
below).
The
equity capital requirement is incorporated into a bank’s
risk-based capital ratio through the calculation of
risk-weighted equivalent assets.
To convert the equity capital requirement
into risk-weighted equivalent assets, a bank must
multiply the capital requirement by 12.5.
Risk-weighted assets under the IMA
Under the proposed and final rules, as
noted above, a bank may apply the IMA only to its publicly traded equity
exposures or may apply the IMA to its publicly traded and
non-publicly traded equity exposures.
In
either case, a bank is not allowed to apply the IMA to equity exposures that receive a
0 or 20 percent risk weight under the SRWA, community development equity exposures,
and equity exposures to investment funds (collectively, excluded equity exposures).
Unlike the SRWA, the IMA does not provide for a 10 percent materiality threshold for
non-significant equity exposures.
Several commenters objected to the fact
that the IMA does not provide a 100 percent risk weight for non-significant
equity exposures up to a 10 percent materiality threshold.
These commenters maintained
that the lack of a materiality threshold under the IMA will discourage use of this
methodology relative to the SRWA.
Commenters suggested that the agencies incorporate a
materiality threshold into the IMA.
The agencies do not believe that it is
necessary or appropriate to incorporate such a threshold under the IMA. The agencies
are concerned that a bank could manipulate significantly its risk-based capital
requirements based on the exposures it chooses to model and those which it would deem
immaterial (and to which it would apply a 100 percent risk
weight).
The
agencies also believe that a flat 100 percent risk weight
is inconsistent with the risk sensitivity of
the IMA.
Under the proposal, if a bank applied the
IMA to both publicly traded and non publicly traded equity exposures, the bank’s
aggregate risk-weighted asset amount for its equity exposures would be equal to the sum
of the risk-weighted asset amount of excluded equity exposures (calculated
outside of the IMA) and the risk-weighted asset amount of the non-excluded equity
exposures (calculated under the IMA).
The risk weighted asset amount of the non-excluded equity
exposures generally would be set equal to the estimate of potential losses
on the bank’s non-excluded equity exposures generated by
the bank’s internal model multiplied by 12.5.
To
ensure that a bank holds a minimum amount of risk-based capital
against its modeled equity exposures, however, the proposed rule contained a supervisory
floor on the risk-weighted asset amount of the
non-excluded equity exposures.
As a
result of this floor, the risk-weighted asset amount of the non-excluded equity exposures could
not fall below the sum of
(i) 200 percent multiplied by the aggregate adjusted
carrying value or ineffective portion of hedge pairs, as appropriate, of the bank’s non-excluded
publicly traded equity exposures; and
(ii) 300 percent multiplied by the
aggregate adjusted carrying value of the bank’s
nonexcluded non-publicly traded equity exposures.
Also under the proposal, if a bank applied
the IMA only to its publicly traded equity exposures, the bank’s aggregate
risk-weighted asset amount for its equity exposures would be equal to the sum of
(i)
the risk-weighted asset amount of excluded equity exposures (calculated outside of
the IMA);
(ii) 400
percent multiplied by the aggregate adjusted carrying value of the
bank’s non-excluded non-publicly traded equity exposures;
and
(iii)
the aggregate risk-weighted asset amount of its
non-excluded publicly traded equity exposures.
The
risk-weighted asset amount of the non-excluded publicly traded equity exposures would be
equal to the estimate of potential losses on the bank’s non-excluded publicly traded equity
exposures generated by the bank’s internal model
multiplied by 12.5.
Under
the proposed rule, the risk-weighted asset amount for the non-excluded publicly traded equity
exposures would be subject to a floor of 200 percent multiplied by the aggregate
adjusted carrying value or ineffective portion of hedge pairs, as appropriate, of the bank’s
non-excluded publicly traded equity exposures.
Several commenters did not support the
concept of floors in a risk-sensitive approach that requires a comparison to
estimates of potential losses produced by a VaR methodology.
If floors are required in the
final rule, however, these commenters noted that the calculation at the aggregate
level would not pose significant operational issues.
A few commenters, in contrast, objected to
the proposed aggregate floors, asserting that it would be operationally difficult to
determine compliance with such floors.
The agencies believe that it is prudent to
retain the floor requirements in the IMA and, thus, are
adopting the floor requirements as described above.
The
agencies note that the New Accord also imposes a 200 percent
and 300 percent floor for publicly traded and non-publicly
traded equity exposures, respectively.
Regarding the proposal to calculate the floors on an aggregate basis, the
agencies believe it is appropriate to maintain this approach, given that for most banks it
does not seem to pose significant operational
issues.
Equity exposures to investment funds
The proposed rule included a separate
treatment for equity exposures to investment funds.
As
proposed, a bank would determine the risk-weighted asset
amount for equity exposures to investment funds
using one of three approaches: the full look through approach, the simple modified look-through
approach, or the alternative modified look-through approach, unless the
equity exposure to an investment fund is a community
development equity exposure.
Such
equity exposures would be subject to a 100 percent risk
weight.
If an
equity exposure to an investment fund is part of a hedge pair, a bank could use the ineffective
portion of the hedge pair as the adjusted carrying value
for the equity exposure to the investment fund.
The
risk-weighted asset amount of the effective portion of the
hedge pair is equal to its adjusted carrying value.
A bank could choose to apply a different approach
among the three alternatives to different equity exposures to investment funds.
The agencies proposed a separate treatment
for equity exposures to an investment fund to prevent banks from arbitraging the
proposed rule’s risk-based capital requirements for certain high-risk
exposures and to ensure that banks do not receive a punitive risk-based capital requirement
for equity exposures to investment funds that hold only
low-risk assets.
Under
the proposal, the agencies defined an investment fund as a company
(i) all
or substantially all of the assets of which are financial
assets and
(ii)
thathas no material liabilities.
Generally, commenters supported the
separate treatment for equity exposures to investment funds.
However, several commenters objected to the exclusion of investment funds with material liabilities from this
separate treatment, observing that it would exclude equity exposures to hedge funds.
Several commenters suggested that investment
funds with material liabilities should be eligible for the
look-through approaches.
One commenter suggested that the agencies
should adopt the following definition of investment fund:
“A
company in which all or substantially all of the assets
are pooled financial assets that are collectively
managed in order to generate a financial return, including investment companies or funds
with material liabilities.”
A few commenters suggested that equity exposures to
investment funds with material liabilities should be treated under the SRWA or IMA as
non-publicly traded equity exposures rather than the separate treatment developed for equity
exposures to investment funds.
The agencies do not agree with commenters
that the look-through approaches for investment funds should apply to
investment vehicles with material liabilities.
The lookthrough treatment is designed to capture the risks
of an indirect holding of the underlying assets of the
investment fund.
Investment vehicles with material liabilities provide a leveraged exposure to the underlying
financial assets and have a risk profile that may not be appropriately captured by a
look-through approach.
Under the proposal, each of the approaches
to equity exposures to investment funds imposed a 7
percent minimum risk weight on such exposures.
This
proposed minimum risk weight was similar to the
minimum 7 percent risk weight under the RBA for securitization exposures and the
effective 56 basis point minimum risk-based capital requirement per dollar of securitization
exposure under the SFA.
Several commenters
objected to the proposed 7 percent risk weight floor.
A few commenters suggested that the floor should
be decreased or eliminated, particularly for low-risk investment funds that receive the
highest rating from an NRSRO.
Others recommended that the 7 percent risk weight
floor should be applied on an aggregate basis rather than on a fund-by-fund basis.
The agencies proposed the 7 percent risk
weight floor as a minimum risk-based capital requirement
for exposures not directly held by a bank.
However,
the agencies believe the comments on this issue have
merit and recognize that the floor would provide banks
with an incentive to invest in higher-risk investment
funds.
Consistent with the New Accord, the final rule does not impose
a 7 percent risk weight floor on equity exposures to investment funds, on either
an individual or aggregate basis.
Full look-through approach
A bank may use the full look-through
approach only if the bank is able to compute a risk-weighted asset amount for
each of the exposures held by the investment fund.
Under
the proposed rule, a bank would be required to calculate
the risk-weighted asset amount for each of the exposures
held by the investment fund as if the exposures were held
directly by the bank.
Depending on whether the exposures were wholesale, retail, securitization, or equity
exposures, a bank would apply the appropriate IRB
riskbased capital treatment.
Several commenters suggested that the
agencies should allow a bank with supervisory approval to use the IMA to
model the underlying assets of an investment fund by including the bank’s pro rata
share of the investment fund’s assets in its equities model.
The commenters believed there is no
basis for preventing a bank from using the IMA, a sophisticated and risk-sensitive
approach, when a bank has full position data for an investment fund.
The agencies agree with commenters’
views in this regard.
If a
bank has full position data for an investment fund and
has been approved by its primary Federal supervisor for use of the IMA, it may
include the underlying equity exposures held by an investment fund, after adjustment for
proportional ownership, in its equities model underthe IMA.
Therefore, in the final rule, under the full look-through
approach, a bank must either
(i) set the risk-weighted asset
amount of the bank’s equity exposure to the investment fund equal to product of (A)
the aggregate risk-weighted asset amounts of the exposures held by the fund as if they were
held directly by the bank and (B) the bank’s proportional
ownership share of the fund; or
(ii)
include the bank’s proportional ownership share of each exposure held by
the fund in the bank’s IMA.
If the
bank chooses (ii), the risk-weighted asset
amount for the equity exposure to the investment fund is determined together with the
risk-weighted asset amount for the bank’s other
non excluded equity exposures and is subject to the
aggregate floors under this approach.
Simple modified look-through approach
Under the proposed simple modified
look-through approach, a bank would set the risk-weighted asset amount for its equity
exposure to an investment fund equal to the adjusted carrying value of the equity
exposure multiplied by the highest risk weight in Table L that applies to any exposure the
fund is permitted to hold under its prospectus, partnership agreement, or similar contract
that defines the fund’s permissible
investments.
The bank
could exclude derivative contracts that are used for
hedging, not speculative purposes, and do not
constitute a material portion of the fund’s exposures.
Commenters generally supported the simple
modified look-through approach as a low-burden yet moderately risk-sensitive
way of treating equity exposures to an investment fund.
However, several commenters objected to the large jump in risk weights (from a 400 percent to a 1,250
percent risk weight) between investment funds permitted to hold non-publicly traded
equity exposures and investment funds permitted to hold OTC derivative contracts and/or
exposures that must be deducted from regulatory capital or receive a risk weight greater
than 400 percent under the IRB approach.
In addition, one commenter objected to the
proposed 20 percent risk weight for the most highly rated money market mutual funds
that are subject to SEC rule 2a-7 governing portfolio
maturity, quality, diversification and liquidity.
This
commenter asserted that a 7 percent risk weight for such exposures
would be appropriate.
The agencies agree that the proposed
risk-weighting for highly-rated money market mutual funds subject to SEC rule
2a-7 is conservative, given the generally low risk of such funds. Accordingly, the
agencies added a new investment fund approach— the Money Market Fund Approach—which
applies a 7 percent risk weight to a bank’s equity exposure to a money market fund
that is subject to SEC rule 2a-7 and that has an applicable external rating in the highest
investment-grade rating category.
The agencies have made no changes to
address commenters’ concerns about a lack of intermediate
risk weights between 400 percent and 1,250 percent.
The
agencies believe the range of risk weights is
sufficiently granular to accommodate most equity exposures to investment funds.
Alternative modified look-through approach Under this approach, a bank may assign the
adjusted carrying value of an equity exposure to an investment fund on a pro
rata basis to different risk-weight categories in Table L based on the investment limits in
the fund’s prospectus, partnership agreement, or similar
contract that defines the fund’s permissible investments.
If the
sum of the investment limits for all exposure classes
within the fund exceeds 100 percent, the bank
must assume that the fund invests to the
maximum extent permitted under its investment limits in the exposure class with the
highest risk weight under Table L, and continues to make investments in the order of the
exposure class with the next highest risk-weight under
Table L until the maximum total investment level is
reached.
If more
than one exposure class applies to an exposure, the
bank must use the highest applicable risk
weight.
A bank
may exclude derivative contracts held by the fund that are
used for hedging, not speculative, purposes and do
not constitute a material portion of the fund’s exposures.
Other
than comments addressing the risk weight table and the 7
percent floor (addressed above), the agencies did not
receive significant comment on this approach and have adopted it without significant change.
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