Autumn 2015

Reducing investors’ regulatory capital burdensBanks and insurers will soon face prohibitive capital charges on investments in alternatives. But ‘look-through’ can help

Following the great !nancial

crisis, a rising tide of regulation

is promoting !nancial market

stability. "e Basel III international

regulatory framework for banks

is being gradually introduced up until 2019.

Meanwhile, within the EU, the Solvency II

directive’s risk-based solvency framework

goes live on 1 January 2016.

"e result is that regulations now restrict

two important types of fund investor.

Although some studies have pointed out

inconsistencies between the capital stand-

ards for banks and insurers, there is a certain

amount of equivalence in that, through new

and revised capital charges, both these regu-

lations signi!cantly in#uence the asset allo-

cations of the relevant regulated institutions.

In terms of investing in alternative invest-

ment funds, there is a signi!cant amount

of overlap between the capital and liquidity

rules for banks and the new capital require-

ments for insurance companies (Solvency II).

"ese regulations are forcing both banks and

insurance companies to change the way they

allocate capital.

Basel III restricts bank investments

As is already well documented, Basel III

changes the landscape for alternative invest-

ment managers. Not only are some prime

brokers and banks reassessing their relation-

ships with managers in order to optimise

their balance sheets, but also banks face

signi!cant restrictions when investing into

alternative investment funds.

"e Basel Committee’s !nal policy frame-

work has three options for calculating the

capital requirements for banks’ equity invest-

ments in funds, with signi!cantly di$erent

risk weightings. When a bank is restricted

to using the Fall Back Approach (FBA), a risk

weighting of 1,250% is applied to its equity

investment in the fund , which e$ectively

raises the capital weighting from 8% to 100%.

But the FBA only has to be used when it’s not

possible to apply the Look "rough Approach

(LTA) or the Mandate Based Approach (MBA).

"e LTA is the most granular approach. A

bank employing it must apply the risk weight

of the fund’s underlying exposures, as if the

bank held them directly.

"e MBA provides an additional layer of

risk sensitivity that can be used when banks

cannot apply the LTA. Banks employing the

MBA assign risk weights on the basis of the

information contained in a fund’s mandate

or in the relevant national legislation. When

neither of the above approaches is feasible,

the FBA must be utilised.

In terms of timeline, Basel III’s !nal stand-

ards will be implemented by 1 January 2017.

Solvency II requires risk classi!cation

For Europe’s insurers, Solvency II means that

their capital requirements no longer depend

on the volume of their premiums alone.

When Solvency II goes live in January 2016,

insurers’ investment portfolios will also

in#uence their capital requirements.

Insurance companies investing into

alternative investment funds will have to

hold capital worth 49% of their investment.

Although it is anticipated that higher returns

will often justify the extra charges, this

capital charge is a signi!cant hurdle.

To reduce these capital charges, insurers

will need to utilize Solvency II’s look-through

approach. "is involves categorizing under-

lying investments (including derivative posi-

tions) and their risk classi!cation.

How administrators can help

"ese regulations present alternative asset

managers with a dilemma. "ey need to

share portfolio data with bank and insurer

investors in an e&cient way that meets

needs in terms of look-through asset clas-

si!cation, yet at the same time not risk

disclosing information that could hamper the

fund’s trading activities.

Both bank and insurance company inves-

tors in hedge funds will need summary level

information about their fund investments in

order to reduce capital charges. Top-tier fund

administrators should have the capability to

provide the necessary data in a consistent and

robust fashion, helping to reduce the burden

on both these important investor types.

by Kieran Dolan, Managing Director, Citco Alternative Investor Services kdolan@citco.com

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