Change in the standard risk weight for non-transparent funds

 

By the end of June 2021, the standard risk weight for non-transparent funds will increase from the current 100% to 1250%. Institutions will then have to cover the full amount of their fund investments with own capital if they do not choose another permissible approach. Fund investments would then be treated in the same way as re-securitisations, for example.

 

Institutions usually apply the look-through approach and ask their asset managers to provide them with the necessary data. Therefore, at first glance, this change is not relevant. However, this assessment is deceptive if the fund itself is significantly invested in other funds. In this case, the significantly higher risk weight must be applied to these other funds, i.e. the target funds, if no look-through approach is possible for them. But this look-through this requires that the holding information for the target funds is available. This can be problematic in practice and requires additional efforts and processes, especially if these target funds are not managed by the client of IDS itself but by a third party fund company.

 

 

Treatment of funds in the CRR until June 2021

The Capital Requirement Regulation (EU) 575/2013 defines, among other things, how institutions must calculate their credit risks, market price risks and operational risks and how they have to cover these risks with the bank’s own capital¹. Three approaches are available for the calculation of credit risks, the Credit Risk Standard Approach (CRSA), the Internal Ratings Based Approach (IRBA) and the internal models. The treatment of funds in the CRSA is regulated in Article 132 CRR "Exposures in the form of units or shares in UCIs". This includes funds of the UCITS Directive as well as certain funds of the AIFM Directive².

 

Art. 132 CRR lists four approaches that institutions can choose to calculate the credit risks from fund investments within the CRSA:

 

  • The credit risk assessment method referred to in paragraph (2) for which an external credit rating of the fund is required
  • The look-through approach under paragraph (4), where the fund is broken down into its individual investments and an average risk weight is calculated from the risk weights of these investments in the fund
  • The average risk weight approach under paragraph (5), where a risk weight of the fund is derived from the investment limits and the risk weights of the eligible asset classes
  • The treatment of the fund as a non-transparent fund under paragraph (1) for which a standard risk weight is applied

 

The method according to paragraph (2) is not used in practice, since credit ratings for funds are usually not available funds. The method according to paragraph (5) is conceivable; in practice, however, it turns out to be problematic in particular if funds can invest in varying proportions in different asset classes or the asset classes are defined in a way that it is not possible to assign a single risk weight cannot to all current investments in this asset class. Additional difficulties arise in the case of funds with a significant amount of derivatives.

In fact, for a large number of funds, the look-through approach under paragraph (4) is used, and it is precisely this approach that the IDS service provides. In certain cases, however, the approaches are also combined. If the funds for which the service is provided contain so-call “target funds”, these are often considered non-transparent and the standard risk weight of currently 100% is used.

Footnotes

¹ As the institutions generally account their funds in the so-called banking book, the calculation of market price risks for fund investments is largely irrelevant. The only exceptions are the foreign currency risk and the interest rate risk in the banking book. Special reports are prepared for this, namely the report on foreign currency positions, the cash flow report and the calculation of IRRBB-compliant stress tests. However, these reports are not affected by the changes discussed here and will not be in scope of this information.

 

² According to Art. 4 (7) CRR, "UCI" stands for funds according to the UCITS Directive and certain funds according to the AIFM Directive. However, this regulation does not cover "particularly high-risk positions" according to Art. 128 CRR, which include, for example, venture capital companies, private equity positions and participations in highly leveraged AIFs. Therefore, in practice, private equity funds and hedge funds are often excluded from the provisions of Art. 132. Also excluded are REITs, which are to be treated like equity.

 

Changes valid from July 2021

In May 2019, the Council and Commission of the European Union approved Regulation 2019/876, introducing some significant changes to the CRR that has been in force since 2014. Some of the regulation, commonly referred to as "CRR II", will come into force from the end of June 2021 and are to be taken into account for the first time in the re-ports that will be prepared in July with the end-June 2021 holdings.
One of these changes also affects the general approaches to the treatment of fund investments in the calculation of credit risks under the CRSA. These changes are summarised in the following figure. In detail:

 

  • The credit risk assessment method will no longer exist in the future, but this will be of little practical signifi-cance.
  • The look-through method will continue to exist. In future and will be specified in Art. 132a CRR. 
  • The approach of using an average risk weight will also continue to exist. The name will change to "man-date-based approach".
  • Funds can still be assessed as non-transparent funds in the future. But, the standard risk weight will change from 100% to 1250%.
  • In addition, if an institution does not calculate the average risk weight itself and instead relies on the calcu-lations of third parties, it must multiply the result by a factor of 1.2. This add-on can only be avoided if the third party (i.e. the asset manager) provides the institution with all the information it needs to make the calculations itself.

(image 1) Overview of the changes

 

 

 

Consequences for the CRR CRD IV Service of IDS

The good news: Through the CRR CRD IV reporting of IDS, the asset manager already provides its invested institution with a calculation that corresponds to the look-through approach. And with the new disclosure report, extensive information has already been made available at the level of the individual investments since October 2020. It enables the institution to recalculate the reported solvency ratio and thus avoid the factor of 1.2.


Material changes may arise if a fund contains other funds as investments to a significant extent. For these "target funds", the standard risk weight must be applied if no other information is available. This will lead to an increase in the solvency ratio of the entire fund. The extent of this increase depends on how much a fund invests in other target funds. Here is a brief example:


Let there be a fund that holds a liquidity ratio of 5% and is otherwise invested in equities, government bonds of de-veloped countries and corporate bonds in varying weights. Assume that the asset class corporate bonds is repre-sented by the investment in a target fund. If there is full transparency about the investments in the fund and in the target fund, the average solvency ratio is 67%.

(image 2) Example calculations

If there is no transparency for the target fund, the standard risk weighting is to be applied. Before June 2021, a value of 100% is to be applied instead of 50%, which increases the solvency ratio from 67% to 72% - a comparatively mod-erate change. From July 2021, on the other hand, a risk weight of 1250% is to be applied to the target fund. This in-creases the solvency ratio of the fund quite significantly to 187%.


Of course, this result cannot be generalised. It depends largely on the weight of the target funds in a fund. However, it is not the weight of the individual target fund but the aggregated weight of all target funds that is decisive, because all non-transparent target funds are assigned the same dramatic standard risk weight. Funds of funds in particular will face massive challenges with this change.

Solution Approach

IDS is also able to apply the look-through approach even to target funds in the clients' funds. However, this requires the data of the target funds.

 
If these target funds are managed by the client itself, the data provision is usually quite simple. The target funds are simply to be included in the agreed data deliveries, i.e. the portfolio, position and investment data are to be delivered in the same formats and via the same processes as the data of all other funds.


If the target funds are managed by third parties, this option is usually not possible. But even in this case, IDS sup-ports the application of the look-through approach for the target funds if the data is made available in the format of the currently valid version of the Solvency II TPT. The TPT is an established standard for the delivery of fund infor-mation that can be uploaded directly by IDS. In order to keep the operational effort for IDS and the costs for such a service as low as possible, we ask our customers to collect the TPTs and to deliver them to IDS.

 

Do you have any questions? Please talk to us, we look forward to developing customised solutions together with you!