30. Equity Investments in Funds: Illustrative Examples of the Leverage Adjustment
No: 44047144
Date(g): 27/12/2022 | Date(h): 4/6/1444
Status: In-Force
30.1
Consider a fund with assets of USD 100 that invests in corporate debt. Assume that the fund is highly levered with equity of USD 5 and debt of USD 95. Such a fund would have financial leverage of 100/5=20. Consider the two cases below.
30.2
In Case 1 the fund specializes in low-rated corporate debt, it has the following balance sheet:
Assets
Cash
USD 10
A+ to A- bonds
USD 20
BBB+ to BBBbonds
USD 30
BB+ to BB- bonds
USD 40
Liabilities
Debt
Debt USD 95
Equity
Shares, retained earnings and other reserves
USD 5
30.3
The average risk weight of the fund is (USD10*0% + USD20*50% + USD30*75% + USD40*100%)/USD100 = 72.5%. The financial leverage of 20 would result in an effective risk weight of 1,450% for banks’ investments in this highly levered fund, however, this is capped at a conservative risk weight of 1,250%.
30.4
In Case 2 the fund specializes in high-rated corporate debt, it has the following balance sheet:
Assets
Cash
USD 5
AAA to AA- bonds
USD 75
A+ to A- bonds
USD 20
Liabilities
Debt
USD 95
Equity
Shares, retained earnings and other reserves
USD 5
30.5
The average risk weight of the fund is (USD5*0% + USD75*20% + USD20*50%)/USD100 = 25%. The financial leverage of 20 results in an effective risk weight of 500%.
30.6
The above examples illustrate that the rate at which the 1,250% cap is reached depends on the underlying riskiness of the portfolio (as judged by the average risk weight) as captured by SA risk weights or the IRB approach. For example, for a “risky” portfolio (72.5% average risk weight), the 1,250% limit is reached fairly quickly with a leverage of 17.2x, while for a “low risk” portfolio (25% average risk weight) this limit is reached at a leverage of 50x.
