7. Banking Book Equity
7.1. Definition of Equity Exposures
[235] In general, equity exposures are distinguished from other types of exposures based on the economic substance of the exposure. Equity exposures would include both direct and indirect ownership interests, whether voting or nonvoting, in the assets or income of a commercial enterprise or financial institution that are not consolidated or deducted for regulatory capital purposes. An instrument generally would be considered to be an equity exposure if it (1) qualifies as Tier 1 capital; (2) is irredeemable in the sense that the return of invested funds can be achieved only by the sale of the investment or sale of the rights to the investment or in the event of the liquidation of the issuer; (3) conveys a residual claim on the assets or income of the issuer; and (4) does not embody an obligation on the part of the issuer.
[236] An instrument that embodies an obligation of the issuer is considered an equity exposure if the instrument meets any of the following conditions: (1) the issuer may defer indefinitely the settlement of the obligation; (2) the obligations requires, or permits at the issuer’s discretion, settlement by issuance of a fixed number of the issuer’s equity interests; (3) the obligation requires, or permits at the issuer’s discretion, settlement by the issuance of a variable number of the issuer’s equity interests, and all things being equal, any change in the value of the obligation is attributable to, and in the same direction as, the change in the value of a fixed number of the issuer’s equity shares; or (4) the holder has the option to require that the obligation be settled by issuance of the issuer’s equity interests.
[237] Debt obligations and other securities, derivatives, or other instruments structured with the intent of conveying the economic substance of equity ownership would be considered equity exposures. Equity instruments that are structured with the intent of conveying the economic substance of debt holdings would not be considered an equity exposure.
7.2. Market-based Approach (MBA) and PD/LGD Approach
[341] Supervisors may choose any of the two Approaches - MBA or a PD/LGD Approach - would be used by a Banks to calculate risk-weighted assets for equity exposures not held in the trading book. The PD/LGD Approach is designed to capture risks from credit-related losses only; this approach is more suited for use in cases where credit-related issues are seen as the main focus. The MBA is designed to capture a wide range of risks (e.g., interest rates, general market movements, etc), in addition to credit-related losses.
SAMA proposes that the MBA should be used for determining capital requirements for equity exposures in the banking book.
7.2.1 MBA Based Approach
Under the market-based approach, institutions are permitted to calculate the minimum capital requirements for their banking book equity holdings using one or both of two separate and distinct methods: a simple risk weight method or an internal models method.
The method used should be consistent with the amount and complexity of the institution’s equity holdings and commensurate with the overall size and sophistication of the institution.
Supervisors may require the use of either method based on the individual circumstances of an institution.
(Refer para 343, International Convergence of Capital Measurement and Capital Standards – June 2006)
• Under the simple risk weight method, a 300% risk weight to be applied to publicly traded, and 400% for all others.
• If an internal model is used, minimum quantitative and qualitative requirements would have to be met on an ongoing basis, including a minimum capital charge be no less than the capital charge that would be calculated under the simple approach at a risk weight of 200% for publicly traded, and 300% for other equities.
7.2.2 PD/LGD Approach
The minimum requirements and methodology for the PD/LGD approach for equity exposures are the same as those for the IRB foundation approach for corporate exposures subject to some constraints. These include the bank’s estimate of the PD of a corporate entity in which it holds an equity position must satisfy the same requirements as the bank estimate of the PD of a corporate entity where the bank holds debt. In practice, if there is both an equity exposure and an IRB credit exposure to the same counterparty, a default on the credit exposure would thus trigger a simultaneous default for regulatory purposes on the equity exposure. If a bank does not hold debt of the company in whose equity it has invested and does not have sufficient information on the position of that company to be able to use the applicable definition of default in practice but meets the other standards, a 1.5 scaling factor will be applied to the risk weights derived from the corporate risk weight function, given the PD set by the bank. If, however, the bank’s equity holding are material and it is permitted to use a PD/LGD approach for regulatory purposes, but the bank has not yet met the relevant standards, the simple risk weight method under the market-based approach apply.
7.3. Exclusions to the MBA
Nationally legislated programmes
[357] Supervisors may exclude from the IRB capital charge certain equity exposures made under legislated programs. These equity holdings can only be excluded from the IRB Approach up to an aggregate of 10 percent of Tier 1 plus Tier 2 capital.
In KSA, such investments made would not qualify for this exclusion.
Materiality
[358] Supervisors may exclude equity exposures of a banks from IRB treatment based on materiality. SAMA proposes that a Banks would not be required to use the IRB Approach if the aggregate carrying value, including holdings subject to exclusions and transitional provisions (see transitional arrangement), is less than or equal to 10 percent of Tier 1 and Tier 2 capital. A bank would risk weight at 100 percent equity exposures that qualify for this exclusion.
SAMA require that a bank qualifying for this exemption would not be eligible.