Equity capital deductions under the CRR and look-through on collective investment funds: an overview


Equity capital deductions under the CRR and look-through on collective investment funds: an overview

The financial crisis of 2008 showed very clearly that financial markets and financial institutions around the world are extremely interconnected. Therefore, the European Parliament and the Council introduced the Directive "2013/36/EU" (CRD IV) and the Regulation "575/213/EU" (CRR) of 26 June 2013 on prudential requirements for credit institutions and investment firms. The Directive oversees the activity and ensures the prudential supervision of credit institutions. Meanwhile, the Regulation states the prudential requirements for credit institutions, concerning capital requirements, leverage, and liquidity. In particular, to mitigate this contagion risk, the CRR introduced the obligation for credit institutions to deduct from their own funds the exposures they have to other financial institutions, directly or indirectly.

Following our overviews on the Solvability Ratio and the Solvency II Capital Requirement for Market Risk for investment funds, we would like to share with you aggregated analytics on the (indirect) equity capital deductions related to investments in collective investment funds. Equity capital deductions are a subtraction made up of the three components of a bank’s total capital, including Common Equity Tier 1 (CET-1), Additional Tier 1 (AT-1), and Tier 2 (T-2), as the banks have an exposure to other financial institutions. These interconnected exposures must be deducted from the capital base to ensure that banks are equipped with both sufficient capital that enables them to absorb losses, and high quality capital to allow them to address the inter-financial sector exposures. The methodology defined in the CRR aims to cover both quantitative and qualitative indicators, to mitigate the systemic risk, and to enhance the stability of the financial system.

Before a bank acquires a share in an investment fund, it needs to know the repercussions on its capital structure. In the case of equity capital deductions, the lower the deductions, the lower the additional cost for the bank in terms of regulatory capital requirements. The graph below displays the proportions of deductions per capital tier CET-1, AT-1, and T-2 and per fund category when applying the Capital Requirements Regulation, on a representative sample of 150 sub-funds.


Proportions of CET-1, AT-1 and T-2 deductions accross investment fund categories

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NB: These deductions are related solely to the investments of the different fund categories.

After applying the deductions above, the credit institution is then able to retrieve its final eligible regulatory capital— the higher the deductions, the lower the remaining capital. It is clear and safe to say that investing in Equity funds is the most costly for banks. This is because their regulatory capital bears higher equity deductions which means they need to bring additional capital to be in line with the rules below:

  • Common Equity Tier 1 Capital (CET-1): at least 4.5% of the Risk-Weighted Assets at all times
  • Tier 1 Capital (T-1): at least 6% of the Risk-Weighted Assets at all times
  • Total Regulatory Capital: at least 8% of the Risk-Weighted Assets at all times

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