QIS 3 FAQ: O. Equities and Investments

1. In order to apply the PD/LGD approach to equity we need to determine a credit rating for the counterparty concerned. Could you indicate how we should assign credit ratings if we do not have a line of credit to this counterparty?

Answer: In assigning 'credit ratings' for equity positions banks generally should proceed as if they were rating for the purpose of making a loan. If a bank does not hold debt of the company, however, 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 curve, given the PD set by the bank. If, however, the bank's equity holdings 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 will apply.

2. Many companies have multiple credit ratings depending on the type and seniority of the debt. Which rating should we use for equity positions?

Answer: The IRB requirements prescribe that each obligor should have one, unique rating,6 this rating should also be used for the PD/LGD approach. Factors like seniority should be reflected in the facility dimension rather than the obligor dimension of a banks rating structure, i.e. seniority should only affect LGDs, not PDs. In case of equity the 90% LGD reflect the (inherent) supersubordinated nature of equity holdings.

3. How should we treat preferred equities in the PD/LGD approach?

Answer: In the PD/LGD approach preferred equity should be treated like any other kind of equity. The preferred status of such equities could only be reflected in a better LGD than that of other equities, the PD/LGD approach, however, does not allow this kind of fine-tuning.

4. How should mutual funds be treated (e.g. equity funds, bond funds, money market funds, mixtures) under the PD/LGD approach?

Answer: Preferably banks should look at the underlying assets of such a pool in order to determine capital requirements. Alternatively they could assign a PD to the pool as if it were a single equity. Where assigning such a PD is not possible, they should apply the simple approach.

5. What is the definition of private equity?

Answer: Everything that satisfies the definition of equity positions in paragraph 197-200 of the Technical Guidance and that is not publicly traded.

6. How should non-significant investments in financial corporations be treated?

Answer: When such investments are not deducted according to scope of application rules the bank should treat them as ordinary equity positions.

7. Where should undrawn commitments to private equity funds be recorded?

Answer: Please convert them to a credit equivalent amount and risk weight this amount.

8. Could you confirm that the internal risk measurement models that may be used to calculated risk-based capital requirements for equity (paragraph 306 of the Technical Guidance) should use book values? How does excess over book value factor in?

Answer: Paragraph 316 of the Technical Guidance instructs banks to use the 'value presented in the financial statements', i.e. the book value. Excess over book value does not factor in; whether book values are based on fair values or the lower of cost or market depends on the financial accounting rules the bank uses.

9. To what exposure class should I assign investments in a fund containing both equity investments and other non-equity types of investments?

Answer: Preferably you should apply a look-through approach and assign the individual assets to the appropriate exposure class. If this is not possible such an investment can be treated as a single investment based on the majority of the fund's holdings (following paragraph 317 of the Technical Guidance).

10. Is there a special treatment for hedges under the PD/LGD approach to equity?

Answer: Generally speaking, hedging-including netting requirements-for PD/LGD equity exposures is the same as for corporate exposures, although for equities of course the relevant IRB-parameters have to be applied. In other words, the hedge provider gets an LGD of 90% and the equity position is treated as having a five-year maturity. Moreover the relevant floors (100% for not for capital gain positions, 200% for publicly traded equities and 300% for private equities) have to be applied. When the bank does not have sufficient information on the position to be able to use the applicable definition of default a 1.5 scaling factor must be applied to the risk weights.

6 As indicated in paragraph 343 of the technical instructions there are two exceptions two this rule. Firstly, in the case of country transfer risk, where a bank may assign different borrower grades depending on whether the facility is denominated in local or foreign currency. Secondly, when the treatment of associated guarantees to a facility may be reflected in an adjusted borrower grade. In either case, separate exposures may result in multiple grades for the same borrower.

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