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FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure

A risk manager at a hedge fund sponsored by a large bank is asked why the bank's regulators care about the fund's leverage even though the fund is not a regulated deposit-taker. Which explanation best reflects the Basel framework's concern about exposures to highly leveraged institutions?

Regulators care because a bank lending to or trading with a leveraged fund bears counterparty credit exposure that can balloon in stress, with collateral falling short. The bank must measure and capitalise that exposure; the fund itself is not bound by the bank's capital ratios.

  1. ALeveraged funds create counterparty credit exposure for the bank, so the bank must manage and capitalise that exposure, including the risk of fast-moving collateral shortfallsCorrect
  2. BLeveraged funds are required to hold the bank's minimum Tier 1 capital ratio directly
  3. CLeverage at a hedge fund reduces the bank's risk-weighted assets because positions offset
  4. DHedge fund leverage only matters if the fund holds government securities

Explanation

Basel-based supervision focuses on the bank's counterparty credit exposure to leveraged funds, which can grow quickly in stress and be hard to collateralise. Funds themselves are not subject to the bank's capital ratio, and leverage does not reduce RWAs.

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