Navigating Risk-Based Capital Requirements for Equity

The globalization of financial institutions and the resulting changes in their risk profiles have driven the need for regulatory requirements, mandating firms to maintain adequate capital levels proportional to the risks inherent in their business activities. The Basel Committee on Banking Supervision (BCBS), operating under the Bank for International Settlements, has spearheaded efforts to establish risk-based capital adequacy standards. The BCBS has continuously enhanced these standards to address the increasing complexity of banking activities and regulatory gaps highlighted by the 2007/2008 financial crisis. Basel II followed in 2004, and Basel III was introduced in 2010. The Basel III Accord is structured around three key pillars:

?

Pillar 1: Specifies the minimum capital requirements for banks and provides guidelines for their calculation.

• Pillar 2: Focuses on the supervisory review process, ensuring banks have effective risk management processes and controls in place.
• Pillar 3: Emphasizes public disclosure of banks' risk exposures, risk management practices, and capital adequacy.

Understanding Risk-Based Capital Requirements

Risk Based Capital Requirements are particularly relevant for equity exposures, where volatility and potential losses can be significant. The implementation of RBC frameworks varies across jurisdictions, reflecting different regulatory philosophies and market conditions.

Globally, RBC frameworks surrounding equity are designed to ensure that Banks and Insurance Companies maintain adequate capital buffers to absorb potential losses, safeguarding policyholders and reducing systemic risk. Globally, the RBC requirements for equity impose higher capital charges for investments in stocks and funds compared to fixed-income securities, reflecting equities' higher market volatility and risk. While these measures enhance the sector's financial integrity, they can inadvertently disincentivize investment in the local stock exchange, where trading volumes may already be low.

Risk Weightings:

Subordinated debt, equity and other capital instruments:Subordinated debt, equity, and other regulatory capital instruments not deducted from regulatory capital or risk-weighted are assigned a 250% risk weight.

?

?Definition of Equity Exposures

• Equity exposures are determined by their economic substance, encompassing direct and indirect ownership in commercial or financial enterprises not consolidated or deducted.
• To qualify as equity, an instrument must: Be irredeemable, with returns realized only through sale or liquidation. Have no repayment obligation for the issuer. Convey a residual claim on the issuer’s assets or income.

Risk Weighting for Investments in Commercial Entities

Materiality thresholds apply:

• 15% of the bank’s capital for individual investments.
• 60% of the bank’s capital for aggregate investments.

Investments exceeding these thresholds are risk-weighted at 1250%.

Banks will assign a risk weight of 400% to speculative unlisted equity exposures.

Speculative unlisted equity exposures refer to short-term investments in unlisted companies, such as venture capital, aimed at significant future capital gains but subject to price volatility. National supervisors may permit a 100% risk weight for equity holdings made under government-supervised programs with significant subsidies and restrictions, up to 10% of the bank's total capital. Restrictions may include limitations on business types, ownership levels, and geographical location to mitigate risk.

Subordinated debt and non-equity capital instruments must be assigned a 150% risk weight by banks.

Source: https://www.bis.org/publ/bcbs128b.pdf

Traded Volume and Market Activity (Trinidad and Tobago Stock Exchange) pre and post the change in the Insurance Act, with the implantation of capital risk charges on the holding of equity investments:?

The Insurance (Capital Adequacy) Regulations, 2020 were introduced to update and refine the capital adequacy requirements for insurers, ensuring alignment with international best practices and the evolving financial landscape.

Global Comparisons

Internationally, RBC frameworks have been implemented with varying degrees of stringency. For instance:

• United States: Under the Standardized Approach, equity exposures are assigned risk weights based on their type:

1. Publicly traded equities typically receive a 300% risk weight, while non-publicly traded equities are assigned a 400% risk weight, with certain community development investments qualifying for lower risk weights of 0% to 100%.
2. The Internal Models Approach (IMA), used by larger banks, allows for customized loss estimation but imposes minimum risk weights of 200% for publicly traded equities and 300% for non-publicly traded equities. Additionally, the U.S. employs a dual capital framework, combining risk-based capital (RBC) measures with leverage requirements to ensure institutions maintain a minimum capital ratio relative to both risk-weighted assets and total assets.

• European Union: The European Union, under the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR), employs both standardized and internal model approaches for capital adequacy. The standardized approach assigns varying risk weights based on the type of equity investment, with lower weights for certain qualifying investments.

1. The EU’s Solvency II framework for insurance companies further exemplifies a sophisticated risk-based capital (RBC) regime, incorporating nuanced capital charges by accounting for risk correlations across asset classes. Additionally, larger institutions may use internal models to calculate capital requirements, provided these models are thoroughly validated and approved by regulators.

• Asia-Pacific: Countries like Japan and Australia adopt RBC models that incorporate dynamic elements, adjusting capital charges based on market conditions to avoid excessive pro-cyclicality.

Sources: https://www.pwc.com/us/en/industries/financial-services/library/our-take/basel-iii-endgame.html

Sources: https://www.fdic.gov/sites/default/files/2024-03/fil-107-2007a.pdf

?Sources: https://a2ii.org/en/blog/landscape-of-riskbased-capital-regimes-in-emerging-markets

?

Considerations for lower risk weights:

United States: Certain equity investments related to community development or public welfare may qualify for lower weights.

European Union: Equities tied to government initiatives or SMEs may attract lower weights (150%). Also, equities held as part of insurance portfolios or strategic investments may benefit from reduced capital requirements under Solvency II regulations.

United Kingdom: For Green Investments the Prudential Regulation Authority has proposed favorable treatment for ESG-compliant equity investments as part of its sustainable finance initiatives.

These systems demonstrate that while stringent capital requirements ensure financial stability, flexibility and transitional measures can help sustain investment activity and market growth.

Challenges for Trinidad and Tobago

The RBC requirements for equity in Trinidad and Tobago could exacerbate existing challenges in the local stock exchange. Low trading volumes, limited listings, and a lack of diverse investment options already stifle market activity. With higher capital charges making equity investments less attractive for insurers and other institutional investors, these challenges may deepen, reducing liquidity and deterring new entrants to the market.

?

Potential Solutions to revitalizing the Local Stock Exchange

To mitigate these challenges and reignite activity on the Trinidad and Tobago Stock Exchange (TTSE), a multifaceted approach is required:

1. Policy Adjustments: The Regulator could consider introducing transitional measures or differential capital charges for strategic equity investments, such as those in essential sectors or companies with strong ESG (Environmental, Social, and Governance) credentials.
2. Market Diversification: Efforts should be made to attract new listings, particularly from high-growth sectors like technology and renewable energy. Encouraging more SMEs to go public through incentives could also broaden market participation, at a lower capital charge.
3. Public Awareness Campaigns: Financial literacy programs in schools and the workplace, aimed at educating the public about the benefits of equity investments can help attract retail investors, increasing market depth and liquidity, resulting in less reliance on the Institutional market for market depth.
4. SME’s: To encourage growth of SME’s listing on the exchange, some consideration on the tax liability of dividends can be considered, to reduce the impact of the increased capital charges, specific to equity investments.

A Balanced Path Forward

Trinidad and Tobago's adoption of RBC requirements for equity represents progress toward a more robust and resilient financial system. However, to ensure that these regulations do not stifle market development, it is essential to adopt a balanced approach that promotes financial stability while fostering growth in the equity market.

By drawing on global best practices and tailoring solutions to local market conditions, policymakers and industry stakeholders can create an environment where institutional investors have sufficient motivation to allocate capital resources. Revitalizing the TTSE is not only critical for the institutional sector but also for the broader economy, as a vibrant stock exchange serves as a barometer of economic health and a catalyst for long-term growth.

Trinidad and Tobago has the opportunity to lead by example in the Caribbean, demonstrating how regulatory advancements can coexist with a dynamic and inclusive capital markets.

?