The Basel Committee on Banking Supervision's capital adequacy requirements look set to take a toll on hedge fund-linked investments by applying a similar risk-weighting to the funds as to equity. This has dealers scrambling to prevent client banks from turning away from the structures--at a time when a perceived drawdown in hedge fund returns is already putting pressure on the sector.
Part of the difficulty is that the U.S. and Japan are among a few jurisdictions still to finalize Basel II details and it is still unclear how hedge funds will be treated there. Elsewhere, the deadline for implementation is 2008, but several firms reported auditors from domestic regulators will be looking this year to see systems in place for complying with Basel II.
"This is probably the hottest issue from an investment bank view right now," said one structurer. Top-tier firms hedging capital protection sold on hedge funds and funds of funds will likely be able to qualify this as a trading book exposure, which should lessen the capital requirement. But smaller banks invested in hedge funds, or which are also structuring fund-linked notes, could be hit hard by the capital adequacy accord.
Michel Prouteau, financial engineer in charge of regulatory and accounting issues at SG Corporate & Investment Banking in Paris, thinks Basel II will accelerate the trend toward transparency and visibility in the hedge fund industry. Investors can use the so-called look-through approach to calculate the risk weighting of the underlying assets in a fund and this will be easier for funds with fully transparent investments such as SG's managed accounts run through Lyxor Asset Management. SG is investigating providing services for investors who want a complete look-through approach. "We are quite confident that we have a competitive advantage," said Prouteau.
Firms which do not have access to managed accounts are also looking at ways of reducing capital requirements for fund-linked investments, within the Basel rules. While every structuring desk on the street said it was looking at this, none wanted to give away any structures they had come up with.
