Sixth in a nine-part series

The Basel Committee on Banking Supervision's barely noticed, but very important consultative paper on how to measure the risk of banks' equity investments in funds signals its strong concern with how banks are interconnected to shadow financial institutions.

In order to bolster the Financial Stability Board's efforts to increase shadow banking oversight, the Basel committee initially set out to analyze what type of capital requirements banks should have if they invest in funds that act as shadow financial firms. The new paper illustrates, however, that the committee expanded its review to cover capital requirements that apply to banks' investments in the equity of all types of funds. Together with its recent guidelines on how to calculate banks' exposures to central clearing parties, the committee is flexing its muscles to another important part of the industry.

Banks should be looking at these proposed guidelines very carefully, because the Basel Committee is determined to have banks calculate higher risk weights for all equity investments in all types of funds regardless of whether banks book these investments in the banking or trading book. 

Unfortunately, up until now, Basel's standardized approach did not have specific guidance for bank exposures to equity investments in funds. Instead, those exposures are classified as "other assets" and are risk-weighted at 100%, which in many cases is not heavy enough. Under the advanced approach, which is what most globally systemically important banks use, banks have had too much flexibility in deciding how to calculate risk-weighted assets for their equity exposures in funds. Since most banks do not disclose their RWA inputs, the market is left guessing what level of risk banks are taking in this area.

In order to make up for the shortcomings in existing capital requirements for equity exposures to funds, the committee is recommending three approaches, all with varying degrees of risk sensitivity: the look-through approach, the mandate-based approach and the fall-back approach. The committee has designed the guidelines so that the degree of conservatism increases with each successive approach. It is clearly trying to ensure that banks have incentive to enhance risk management of their equity exposures to funds in order to carefully minimize the impact on capital requirements.

The look-through approach would require banks to risk-weight the fund's assets as if the bank were holding them directly. From what I have seen in comparable frameworks, this is the most granular and risk-sensitive form of look-through.

In order for banks to use this approach, funds will have to provide frequent information to them about the funds' holdings. Importantly, fund managers will have to ensure that the information is verified by an external auditor. In some instances, the look-through approach could be very expensive for banks. For example, if banks invest in a fund of funds, they will be required to apply a risk weight of 1,250%. Clearly, the Basel Committee is concerned about the lack of transparency in these layered funds.

Banks failing to qualify for the look-through approach would be required to calculate exposures using the mandate-based approach. This approach permits banks to use the information contained in the fund's mandate or in the national regulations governing investment funds. This could pose a problem because fund managers have a bias to make their investments look less risky. Fortunately, the Basel committee has added parameters in the mandate-based approach to ensure that all of the fund's underlying risks, such as credit risk, are taken into account. There are also parameters prohibiting banks from using mandate-based approach calculations as a way to have lighter capital requirements.

Undoubtedly, banks will strive to meet the look-through or mandate-based approaches, because under the third option, the fall-back approach, they would have to risk-weight all equity exposures in funds at 1,250%. Banks may find this charge punitive, but it is important that it be high. Unlike stocks, these exposures to funds can be illiquid and much more challenging to value. I found the annexes in the proposed guidelines to be very good in providing clear, useful examples of how to do the calculations and how each approach affects the bank's capital requirements.

The proposed guidelines also reinforce that leverage is very much on the mind of the Basel Committee as they would increase the risk weight derived from the proposed calculations by including a measure of leverage. This is a very good idea, because one of the key risks in equity investments in funds is their underlying leverage.

I am also very pleased to see that the Basel Committee wants to use a simple and transparent accounting-based financial leverage measure, which would be defined as the ratio of total assets over total equity. Banks should pay close attention to this leverage requirement as national supervisors have the discretion to choose a stricter leverage metric if they felt it necessary.

Given banks' interconnectedness to funds, CCPs and other types of nonbanks, the Basel Committee is likely to have more proposals for those types of exposures in the coming months. This could be a very effective way for the committee to increase capital requirements for banks and to exert influence over the rest of the global financial sector.

Let's not forget the incredibly painful damage inflicted by nonbanks such as Long-Term Capital Management, AIG, Bear Stearns and Lehman Brothers. If we really are concerned about improving the state of the global financial sector and economy, all financial institutions, whether in the shadows or not, need to increase their capital and improve their risk management.

Next: Basel's updated methodology to designating GSIBs.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at the New York Institute of Finance.