TOKYO (HedgeWorld.com)--The Japanese regulator has been working with the nation's major banks for some time on implementing Basel II recommendations with many Japanese banks facing true internal ratings based (IRB) method implementation by March 31, 2008.
Speaking at a recent AIMA breakfast in Hong Kong, Christopher Wells, a Tokyo-based partner at international law firm White & Case gave an in-depth presentation on the implications of Basel II on fund raising in Japan; he explained that the Basel II clock started ticking on April 4, 2006, with first accounting to show up in bank financial reporting starting March 31, 2007.
The effect this has had on the funds market in Japan was visible as early as Spring 2005, with smaller regional banks redeeming their lesser-performing or smaller investments. In addition, there was notable standoffishness of regional bank investors to new products due to the uncertainty in Basel II implementation.
"It [Basel II] has only come to the attention of the product providers as a result of redemptions," said Mr. Wells in an interview with HedgeWorld. "All of a sudden everyone is in a panic."
Basel II concerns center on the banking book, the part of a bank's assets and liabilities that consist of positions falling outside the trading book, since assets held in the trading book will be included in the bank's market risk model and valued using the VaR model.
Under Basel II the analysis for hedge funds and funds of funds is determined by whether banks seek to treat these investments as equity investments, or if the standardized or look-through approach is adopted.
In accordance with the structure of FSA's Basel II implementing regulations, most hedge funds and funds of funds will not qualify for equity treatment under Article 167 of the FSA's regulations, even if organized in a corporate form, because they do meet all the criteria. One criterion for a financial instrument to be treated as an equity investment is that it is not redeemable. Because hedge funds and funds of funds are redeemable, most of them will have to be treated by the banks as non-equities.
Generally, under Basel II if an investment is not treated as an equity instrument, a bank can elect to calculate the risk weight under either the standardized approach set by national bank regulators or IRB method applying different rules from the equity method.
Under Japanese rules, "the current standardized approach would apply a risk weighting of 100% for hedge funds (the same rating currently applied to hedge fund investments) or, alternatively, the actual credit rating of the fund by an independent rating agency," explained Mr. Wells in his presentation.
However, this approach can only be applied to "non-significant businesses or asset classes" if specified in the implementation plans for the IRB method. The FSA also has made it clear that banks will have to justify the use of the standardized method of 100%, where the regulator believes 100% does not accurately reflect the level of risk or where the total exposure is greater than 10% of total assets.
Thus, in general, "the standardized approach will not be available for hedge funds or funds of funds investments by banks over time. Certainly within a 10-year horizon," said Mr. Wells.
With no alternative in the long run but to use the IRB approach, Japan's major city banks have already moved to the IRB method while certain super-regional banks also have migrated to this method. The super-regionals were the best credits in Japan for five or six years while the large national banks were restructuring.
"Smaller regional banks are likely to continue to use the standard approach, but it is not anticipated that they will increase their fund exposures. Some of these institutions will either exit these investments before (or after) their inspections while others will need assistance with IRB method compliance," said Mr. Wells.
What does this mean for hedge funds? "Hedge funds have to adapt to the reality that if they want regional bank money they have to become either transparent or provide some other solution to their investors.
"The funds that are transparent, which they could dress it up with lots of confidentiality, or answer the Basel II credit charge math problem for the Japanese bank will lead the pack," said Mr. Wells.
The market believes that the Japanese regulator expects bank staff to be able to explain the VaR calculation. If banks are not comfortable with this then they will redeem out of the hedge fund and buy something else. "Banks are wary of foreign products that are not constructed with Basel II in mind." And, "they are not receiving the needed level of understanding by foreign alternative investment firms regarding reporting needs," noted Mr. Wells.
He found that some banks are turning to credit enhancing products to simplify the Basel II explanation to regulators. Also, the leading hedge funds will have their funds rated which will simplify this task immensely.
Mr. Wells suggested the likely response of regional banks in the funds space will be to become increasingly selective in fund choices based on high transparency of the underlying investments. Greater flexibility in redemption arrangements also will possibly be sought to allow for exit where capital constraints become an issue. Greater knowledge by managers of bank Basel II needs and sensitivity to the bank's compliance requirements will be increasingly important as will a hedge fund manager's ability to assist banks with justifying Basel II risk calculations.
Contact Bob Keane with questions or comments at firstname.lastname@example.org.