Capital requirements for banks' equity investments in funds

The Basel Committee on Banking Supervision has revised its policy framework for the prudential treatment of banks' investments in the equity of funds that are held in the banking book. The revised policy framework will take effect from 1 January 2017 and will apply to investments in all types of funds (eg hedge funds, managed funds, investment funds). The framework will be applicable to all banks, irrespective of whether they apply the Basel framework's Standardised Approach or an Internal Ratings-Based (IRB) approach for credit risk.

Basel II outlines the current policy framework for banks' equity investments in funds. The revised standard improves upon the framework by:

• taking account of a fund's leverage when determining risk-based capital requirements associated with banks' investments in a fund; 
• clarifying the application of the IRB approaches for credit risk; and
• more appropriately reflecting the risk of a fund's underlying investments, including the use of a 1,250% risk weight for situations in which there is not sufficient transparency regarding a fund's investment activities.

The revised framework is based on the general principle that banks should apply a look-through approach to identify the underlying assets whenever investing in funds. The Committee recognises that a full look-through approach may not always be feasible and that a staged approach based on different degrees of granularity of the look-through is warranted. The proposed risk-weighting framework therefore enables the application of a consistent risk-sensitive capital framework which provides incentives for improved risk management practices.

Following this principle, the framework includes three approaches for setting capital requirements for banks' equity investments in funds, which have varying degrees of risk sensitivity: the "look-through approach" (LTA), the "mandate-based approach" (MBA), and the "fall-back approach" (FBA). To ensure that banks have appropriate incentives to enhance their risk management of their investments, the degree of conservatism increases with each successive approach (as risk sensitivity decreases). This hierarchy of approaches was instituted to promote due diligence by banks and transparent reporting by the funds in which they invest.

The revised policy framework will also help to address risks associated with banks' interactions with shadow banking entities. The work of the Basel Committee therefore contributes to the broader effort by the Financial Stability Board to strengthen the oversight and regulation of shadow banking.