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Setting risk-based capital requirements for banks is a fine balancing
act. The level of capital must adequately cover the risk posed by a
particular asset without being excessively conservative, which could
threaten the ability of banks to participate in that market. The
methodologies used for calculating capital must also be sophisticated
enough to accurately measure risk, but not so operationally complex and
impractical that banks can’t implement them.
The Fundamental Review of the Trading Book (FRTB) sets several methodologies for calculating capital for EIIFs under either an internal models-based or standardized approach, but these methodologies are extremely computationally intensive and not viable in several cases. Earlier this month, ISDA published a paper together with the Global Financial Markets Association (GFMA) and the Institute of International Finance (IIF) that explores the challenges and proposes alternative methods.
This is an important issue because funds provide significant economic and social benefits to investors. By enabling access to a diversified portfolio of managed assets at a lower cost than investing in individual stocks in isolation, funds remove the barriers to entry faced by many small investors. Global assets under management have grown significantly in recent years and had exceeded $100 trillion by the end of 2020, according to data from the Boston Consulting Group.
Banks play a key role in facilitating indirect investment in funds for their clients, offering hedging solutions for their customers and creating an effective, liquid market. If implemented without recalibration, the capital treatment of EIIFs under the FRTB could constrain their ability to participate in this market.
As they stand, the rules introduce an onerous methodology under the internal models approach, known as the look-through approach, which requires banks to have the capability to analyze the individual components of a fund on a regular basis. Given the reluctance of some asset managers to disclose this information and delays in the publication of data, it can be very difficult to apply in practice.
Under the standardized approach, other methodologies are available, including an index-based approach and a mandate-based approach, but these are also computationally complex and will be difficult for many banks to deploy. A fallback approach that allows banks to treat EIIFs as unrated equity exposure is less computationally intensive but imposes a punitive risk weight that doesn’t allow for any diversification benefit.
An industry survey conducted during the development of the paper found that most banks plan to calculate capital for EIIFs using the fallback approach, despite its conservatism. As a result, 70% of banks that will use the fallback approach expect their capital to increase by six times on average. This is not a good outcome, and risks constraining banks’ ability to support investment in funds. We believe the calculation methodologies should be modified to make them simpler and more accessible to market participants.
Now is the time to revisit the rules and make the necessary changes. In October 2021, the European Commission published legislative proposals to implement the final parts of Basel III, and other jurisdictions are expected to issue their own proposals in the months ahead. This will set the framework for risk-based capital requirements for decades to come, so it is critical that the standards are appropriately calibrated to preserve the accessibility of funds for retail investors.
Capitalization of Equity Investments in Funds Under the FRTB