VII. Equity Investments in Funds
I. Introduction
1.This Standard articulates specific capital requirements for equity investments in funds held in the banking book by UAE Banks. It is based closely on requirements of the framework for capital adequacy developed by the Basel Committee on Banking Supervision (BCBS), specifically as articulated in Capital requirements for banks’ equity investments in funds, (BCBS 266, published December 2013).
2.This Standard formulates capital adequacy requirements that needs to be applied to all banks in UAE on a consolidated basis.
The requirements apply to all equity investments by banks in all types of funds that are held in the banking book (in-scope equity positions), including off-balance sheet exposures such as unfunded commitments to subscribe to a fund’s future capital calls. The requirements do not apply to exposures, including underlying exposures held by the fund, that would be deducted from capital under the Central Bank’s Guidance re Capital Supply.
3.This Standard requires banks to calculate risk-weighted assets (RWA) for any fund in which the bank has an in-scope equity position, with RWA calculated as if the bank held the fund’s exposures directly rather than indirectly through investment in the fund. Banks are required to use a hierarchy of three successive approaches with varying degrees of risk sensitivity and conservatism, as described below in these Standards. This Standard also incorporates a leverage adjustment to RWA to reflect a fund’s leverage appropriately. These requirements are discussed below in these Standards.
4.The Standards follow the calibration developed by the Basel Committee, which includes a maximum risk weight of 1250%, calibrated on a total capital adequacy requirement of 8%. The UAE instituted a higher minimum capital requirement of 10.5% (excluding capital buffers), applicable to all licensed banks. Consequently, the maximum capital charge for a single exposure will be the lesser of the value of the exposure after applying valid credit risk mitigation, netting and haircuts, and the capital resulting from applying a risk weight of 952% (reciprocal of 10.5%) to this exposure.
II. Definitions
In general, terms used in this Standard have the meanings defined in other Regulations and Standards issued by the Central Bank. In particular, for this Standard, the following terms have the meanings defined in this section.
- a.Credit Valuation Adjustment (CVA) reflects the adjustment of default risk-free prices of derivatives due to a potential default of the counterparty. Regulatory CVA may differ from CVA used for accounting purposes. Unless explicitly specified otherwise, the term CVA in this document means regulatory CVA.
- b.CVA Risk is defined as the risk of losses arising from changing CVA values in response to changes in counterparty credit spreads and market risk factors that drive prices of derivative transactions.
- c.Fund is a financial vehicle, whether established inside or outside the UAE, engaged in the activity of receiving investors' money for the purpose of investment against the issue of fund units of equal value and rights. This includes, but is not limited to, mutual funds, private equity funds and hedge funds, open-end funds, closed-end funds, debt funds and hedge funds.
- d.Mandate means instruction to manage a pool of capital, or a particular pile of funds, using a specific strategy and within certain risk parameters.
- e.Potential Future Exposure (PFE) is an estimate of the potential increase in exposure to counterparty credit risk against which a bank must hold regulatory capital.
III. Requirements
A. Approaches
5.Banks must treat in-scope equity positions in a manner consistent with one or more of the following three approaches: the “look-through approach”, the “mandate-based approach” and the “fall-back approach”.
1.Look-through approach (LTA)
6.The look-through approach (LTA) requires a bank to risk weight the underlying exposures of a fund as if the bank held the exposures directly. LTA must be used by a bank when:
- (iii)there is sufficient and frequent information provided to the bank regarding the underlying exposures of the fund to determine the applicable risk weights and exposure amounts; and
- (iv)such information is subject to verification by an independent third party.
7.To satisfy condition (i) above, the frequency of financial reporting of the fund must be the same as, or more frequent than, the financial reporting obligation of the bank, and the granularity of the financial information must be sufficient to calculate the corresponding risk weights and exposure amounts without requiring an external audit. To satisfy condition (ii) above, there must be verification of the underlying exposures by an independent third party, such as a depository or custodian bank or, where applicable, a fund management company.
8.Under the LTA, a bank must risk weight all underlying exposures of a fund as if the bank held those exposures directly. This includes, for example, any underlying exposure arising from the fund’s derivatives activities and the counterparty credit risk (CCR) exposure associated with those derivatives. However, instead of determining the applicable credit valuation adjustment (CVA) capital associated with the fund’s derivatives exposures, a bank should instead increase the CCR exposure by 50 percent (that is, multiply the CCR exposure by a factor of 1.5) before applying the risk weight associated with the counterparty. Banks are not required to apply the 1.5 factor to transactions for which the CVA capital charge would not otherwise be applicable, such as those conducted directly with central counterparties.
9.Banks may rely on third-party calculations to determine the risk weights associated with equity investments in funds (that is, the underlying risk weights of the exposures of the fund) if they cannot obtain adequate data or information themselves to perform the calculations. In such cases, however, the bank must increase the resulting risk weight by 20 percent (that is, multiplied by a factor of 1.2) relative to the risk weight that would be applicable if the bank held the exposure directly.
10.Banks should use the risk weights from the LTA to compute RWA for the fund. After calculating the RWA for a fund according to the LTA, banks must calculate the average risk weight for that fund (Avg RWfund) by dividing the total RWA of the fund by the total (unweighted) assets of the fund.
2.Mandate-based approach (MBA)
11.Banks should use the second approach, the mandate-based approach (MBA), only when the conditions for applying the LTA are not met. Banks should use the information contained in a fund’s mandate or in the relevant regulations governing such investment funds to perform a conservative calculation of the applicable risk weights for the assets of the fund.
12.Under the MBA, on-balance-sheet exposures (that is, the fund’s assets) are risk weighted assuming that the underlying portfolios are invested to the maximum extent allowed under the fund’s mandate in assets that would attract the highest risk weights, and then progressively in other assets that attract lower risk weights. If more than one risk weight could be applied to a given exposure, the bank should use the highest applicable risk weight.
13.The notional amount of derivative exposures and off-balance-sheet items should be risk-weighted according to the requirements of the risk-based capital standards.
14.Banks should calculate the CCR exposure associated with a fund’s derivative positions in accordance with the Central Bank’s Standard for Counterparty Credit Risk Capital. If replacement cost cannot be determined, the bank should use the notional amount of the derivative as the replacement cost. If the Potential Future Exposure (PFE) cannot be determined, the bank should use an amount equal to 15 percent of the notional value as the PFE.
15.As with the LTA, banks should account for CVA Risk on derivatives by increasing the CCR exposure by 50 percent (that is, multiply the CCR exposure by a factor of 1.5) before applying the risk weight associated with the counterparty. Banks are not required to apply the 1.5 factor for transactions to which the CVA capital charge would not otherwise be applicable, such as those conducted directly with central counterparties.
16.As with the LTA, after calculating the RWA for a fund according to the MBA, banks must calculate the average risk weight for that fund (Avg RWfund) by dividing the RWA of the fund by the total (unweighted) assets of the fund.
3.Fall-back approach (FBA)
17.When the conditions for applying either the LTA or the MBA are not met, banks are required to apply the FBA, under which Avg RWfund for a bank’s investment in the fund is set equal to 1250 percent.
B. Partial use of the Approaches
18.A bank may use a combination of the three approaches when determining the capital requirements for an equity investment in an individual fund, with one approach applied to a portion of the fund’s exposures and one or more other approaches applied to the fund’s other exposures. The requirements for each approach as articulated under this Standard must be met for any portions of the fund to which the LTA or MBA are applied. RWA calculations from each applied approach should be added together with the sum then divided by the total fund assets to compute Avg RWfund.
C. Treatment of Funds That Invest in Other Funds
19.When a bank has an investment in one fund (e.g., Fund A) that itself has an investment in another fund (e.g., Fund B), the risk weight applied to the investment holding of the first fund (that is, Fund A’s investment in Fund B) should be determined by using the same three approaches set out above (LTA, MBA, and FBA). If fund investments are further layered (for example, if Fund B has investments in a Fund C), the risk weights applied to the additional layers of investment (that is, Fund B’s investment in Fund C) can be determined using the LTA, but only if the LTA was also used for determining the risk weight for the investment in the fund at the previous layer (Fund A’s investment in Fund B). Otherwise, the bank must apply the FBA to the additional investment layers.
D. Exclusions to the LTA, MBA and FBA
20.Equity holdings in entities whose debt obligations qualify for a zero risk weight can be excluded from the LTA, MBA and FBA approaches (including government sponsored entities where a zero risk weight can be applied), at the discretion of the UAE Central Bank. If the UAE Central Bank makes such exclusion, this will be available to all banks.
21.The UAE Central Bank may, in its absolute discretion, change the risk weighting of debt obligations from time to time as it finds necessary.
E. Leverage Adjustment
22.When determining the risk weight for a bank’s equity investment in a fund, a bank must apply a leverage adjustment to the average risk weight of the fund as calculated above.
23.Leverage for a fund is calculated as the ratio of total fund assets (not risk weighted) to total fund equity. Under the LTA, this ratio should be calculated from the information obtained on the fund’s asset holdings and financing. Under the MBA, banks should assume the maximum financial leverage permitted in the fund’s mandate, or the maximum permitted under the regulations governing the fund.
F. RWA for Equity Investments in Funds
24.Banks must calculate the risk weight to be applied to their equity investments in any fund as the product of the fund’s average risk weight and the fund’s leverage:
Risk Weight = Avg RWfund × Leverage
where Avg RWfund = the average risk-weight for the fund’s assets as calculated under this Standard, and
Leverage = the fund’s leverage as measured by the fund’s ratio of assets to equity as calculated under this Standard.
25.The risk weight for a bank’s equity investment in any fund is subject to a cap of 1250 percent. If the calculation described in the paragraph above produces a result in excess of 1250 percent, the bank should use the maximum risk weight of 1250 percent instead.
26.Banks should compute the RWA for their investments in funds by multiplying the amount of the equity investment in a given fund by the risk weight calculated as described in this Standard, based on Avg RWfund and the leverage of the fund determined according to this Standard.
IV. Review Requirements
27.Bank calculations of risk-weighted assets for equity investments in funds under this Standard must be subject to appropriate levels of independent review by third parties and challenge. Reviews must cover associated bank processes including the identification of in-scope equity positions, determination of the appropriate approach under the hierarchy of approaches, and the processes for collection of information about the funds’ exposures or mandates, as well as material aspects of the calculations under this Standard, including but not limited to the risk weights applied to the underlying exposures (including on-balance-sheet, off-balance-sheet and derivative exposures as well as PFE), the average risk weights for funds and the calculation of fund leverage.
V. Shari’ah Implementation
28.Banks offering Islamic financial services that use Shari’ah-Compliant Equity Investment in Funds held in the banking book which is approved by their internal Shari’ah control committees should calculate the relevant risk weighted asset (RWA) in line with this standard and guidelines, to accordingly maintain the appropriate amount of capital, in accordance with the provisions set out in this standard and guidance in a manner acceptable by Shari’ah. This is applicable until relevant standards and/or guidelines in respect of these transactions are issued specifically for banks offering Islamic financial services.