There is a growing interest among banking institutions to invest in capital-protected notes linked to hedge fund indices, hedge fund-of-funds and equity indices. Given this increased demand, the structured products community has sought advice on the regulatory capital treatment on these instruments for U.S. banking institutions that hold capital protected fund- or equity-linked notes.
The following analysis takes a hypothetical fund-linked structured product and applies the two primary regulatory capital tests to the structure:
1) the risk-weight analysis of the fund-linked note for capital purposes; and
2) whether the structured product qualifies as a type III security for bank regulatory purposes, which would mean it receives a more favorable regulatory treatment.
This Learning Curve concludes with the regulatory limitations of purchasing structure notes.
Terms Of The Hypothetical Structure
* 10-Year dollar LIBOR Indexed Notes
* 100% principal protection at maturity
* 150% constant leverage
* Linked to the HFR Investible Hedge Fund Index
* Semi-annual coupons
* 100% participation in the Fund's performance at maturity
* Medium term notes denominated in dollars
* Weekly liquidity
Legal Analysis
In the U.S. the Office of the Comptroller of the Currency, a bureau of the U.S. Treasury Department, is the federal governmental authority that is responsible for determining the capital treatment of financial instruments for national banks, and setting forth procedures and written guidance in the form of rules, bulletins and interpretive releases.
The OCC is the authority that will consider investments to be held by national banks for their proprietary accounts and determine what type of capital treatment they will receive.
Risk Weight Analysis: OCC's Risk-Based Capital Treatment
Aside from sovereign debt, the most favorable risk-based capital treatment for an investment is a risk-weighting of 20%; for less liquid alternative investments, the capital treatment can be 100% (or in certain cases more than 100%) of the value of the security.
According to 12 CFR Part 3 Appendix A, an obligation that is fully guaranteed by an Organisation for Economic Co-operation and Development-based financial institution carries a risk weighting of 20%, irrespective of the risk-weighting that would apply if the obligation were not so guaranteed.
Definitions Of Investment Securities Eligible For Bank Purchase
Is This A Type III Instrument?
The OCC's investment securities regulations at 12 CFR Part l classify securities as type I, II or III in relation to how and under what limits banks are permitted to invest in them. A type III security is one that a bank may purchase and sell for its own account, subject to a 10% capital limitation. The bank may not deal in or underwrite a type III security; the bank can only hold them in its own account.
A type III security must have the following two characteristics to be eligible for purchase by a banking institution in the U.S.:
(1) Investment grade (as defined in 12 C.F.R. § 1.2(d)) or the credit equivalent of a security rated investment grade and therefore is not predominantly speculative in nature (12 C.F.R. § 1.2(e)); and
(2) Registered under the Securities Act of 1933, is offered and sold pursuant to Securities and Exchange Commission Rule 144A, or can be sold with reasonable promptness at a price that corresponds reasonably to its fair value. (See 12 C.F.R. § 1.2(f).)
The hypothetical note complies with the type III requirements and therefore may be classified as a type III security because:
* The guarantor bank is an investment grade counterparty; and
* The structure meets the reasonable promptness test by providing a mechanism whereby the investors will have the opportunity, at least once during any given week, to sell notes to the issuer or its affiliates, as market maker, at a price corresponding reasonably to the fair value of the notes.
Type I Securities: The OCC's regulations define a type I security as one that a national bank may deal in, underwrite, purchase and sell for its own account without limitation, subject to prudent banking judgment. Generally, type I securities include obligations of the U.S., municipal general obligations of any state in the U.S., or any political subdivision of a state.
Type II Securities: A type II security is one that a national bank may deal in, underwrite, purchase, and sell for its own account, subject to a 10% capital limitation. Generally, type II securities include obligations of certain development banks listed in 12 U.S.C. 24 (Seventh), the Tennessee Valley Authority, and obligations issued by any agency of a state or a political subdivision for housing, university, or dormitory purposes.
Limitations On The Purchase Of The Note
Under existing OCC rulings, however, a national bank may invest in an investment company security that represents an undivided fractional interest in other obligations, only up to 5% of its capital and surplus, as contrasted to the usual 10% limitations for other type III securities. This 5% limit therefore would apply to a national bank's investment in the principal-protected note.
This week's Learning Curve was written by Keith Styrcula, an official in the structured solutions group at JPMorgan and chairman of the Structured Products Association in New York.
