Understanding Basel II : A Guide for Japanese Financial Institutions

"The freedom to fail is vital if you're going to succeed. Most successful people fail time and time again, and it is a measure of their strength that failure merely propels them into some new attempt at success."

Michael Korda (1933- ) novelist and former Editor-in-Chief at Simon & Shuster

The new reality of Japan's financial environment in the aftermath of Basel II has been hanging like the shadow of Father Time over the hedge fund and HFoF industry. Why? Beginning next fiscal year Japanese financial institutions will be constrained in their demand for product particularly when the investment strategy or asset exposure of a fund is tough to ascertain.

Basel II will force Japanese financial institutions (mainly money-center or city banks, regional banks and credit unions and other bank-like institutions) to set aside considerably higher levels of balance sheet capital as "risky" hedge fund assets fall under a new capital requirement regime. The new requirements will require capital set aside for certain hedge fund holdings to jump up dramatically from anywhere from 400% to 1,250%. Of course, this is going to put a big brake on demand for product.

How big will be the inevitable impact (of falling demand)? According to recent FSA figures recently outlined in a HSBC paper, investments by Japanese financial institutions in single managers and FoHFs rose from approx. US$51 billion to US$62 billion from 05 to 06 - figures far beyond those imagined by the many outside and domestic observers.

According to the FSA survey of 1,252 Japanese financial institutions. The breakdown was as follows:

Trust Banks: US$9.3 billion
Regional Banks: US$9.3 billion
Other: US$12.4 billion
City Banks: US$14.8 billion
Insurance Cos. : US$16.1 billion

Further, the numbers point to Japan's hedge fund industry being very concentrated with 17 domestic institutions accounting for 60% of the total (average investment of US$2.2 billion).

The crux though involves the Internal Ratings Based Approach to hedge fund investing by financial institutions. A solid understanding of what is at stake here can have a significant impact on the ability of the Japanese financial institution's future appetite for hedge fund product - whether single manager or FoHF.

If assets held in the fund are identifible then...
1/ Look through Method. This is simply the weighted average risk weight of assets contained in a fund.

If more than 50% of the assets in the fund are equities then...
2/ Adjusted Simple Majority Method. This treats the whole fund as if it is wholly invested in stocks and apply a risk weight of 300% (if listed stocks) and 400% (if non-listed stocks).

If the fund investment mandate is clear...
3/ Mandate Method. This involves a conservative estimate of individual assets in the fund based on the investment mandate and calculate a average risk weight.

If there is access to a daily/weekly mark to value the fund portfolio...
4/ Internal Method. This involves calculation of required capital based on NAV changes of fund estimates based on an FSA aqpproved internal VaR model.

And if it is impossible for the fund to hold high risk assets...
5/ Simple Method. Confirm whether the fund contains no mezzanine od subordinated traches of securitization deals, non-performing loans, or other "high risk assets" and apply a risk weight of 400%.

6/ Simple Method. Apply a risk weight of 1,250%.

Interesting to note that the methodological approach tries to bucket the risk but says nothing about use of leverage among other things...

Initial feedback among banks has been mixed from, "...we cannot invest in hedge fund product going forward" to "...lets find some innovative ways around this (e.g. swaps)"...to "If I am going to be penalized for investing in hedge funds I want even more high octane managers". Where the dust settles is still a big unknown.
Mahalo.