Tougher rules for banks that invest in outside funds

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A global watchdog is cracking down on banks that invest in external funds, such as hedge funds and private equity funds, by forcing them to beef up their capital levels when dabbling with risky investments.

Come 2017, banks will be required to enhance their capital cushions whenever external funds in which they have invested use a lot of leverage, and they will be forced to dramatically boost their capital whenever these funds offer only opaque descriptions of their investment activities.

By implementing these rules, the Basel Committee on Banking Supervision believes banks will be more inclined to invest in transparent funds and to steer clear of funds that rely on leverage, which the Committee said is "one of the main drivers of risk related to equity investments in funds." The Committee sets guidelines that govern banking operations around the world, and individual countries can decide to implement even tougher standards if they so choose.

The rules come on the heels of U.S. regulatory approval of the Volcker Rule, which bans U.S. banks from investing in most external funds altogether. Anticipating that such rules were coming, U.S. banks spun off most of their private equity investments over the past few years. Morgan Stanley, for example, started to spin out most of its ownership in the $4.5-billion FrontPoint Partners hedge fund.

While the Basel Committee isn't going as far as the Volcker rule, its own guidelines are far-reaching, and apply to fund investments of all types – including off-balance sheet exposures, such as unfunded commitments to subscribe to a fund's future capital calls.

The new rules will be implemented in three tiers, with the capital rules becoming more stringent as banks move through the different levels.

For funds that constantly report their activities and whose operations can be verified by a third party, banks will be able to treat these investments as if they were part of their own operations. In other words, normal bank capital rules apply.

When a fund's investment activities are a little murkier, more scrutiny is required and additional risk weights will be applied based on the fund's disclosures. This tier, known as the mandate-based approach, takes a fund's leverage into account by applying a new risk weighting to the maximum leverage permitted in the fund's mandate.

Finally, when very little information can be obtained about a fund's activities, banks must slap an onerous 1,250-per-cent risk weighting to their equity investment in the fund. Such a stringent requirement will "help to address risks associated with banks' interactions with shadow banking entities," the Basel Committee said. Shadow banks are increasingly conducting traditional bank activities, but are subject to much less regulation and disclose very little about their operations.