The effect of Basel III on the costs of lending

[nonmember]Richard Skipper, senior associate, Norton Rose LLP examines how Basel III will affect business jet finance. ::join::[/nonmember][ismember]On 12th September, 2010, the Basel Committee on Banking Supervision agreed on detailed measures to strengthen the regulation, supervision and risk management of the banking sector. As is widely known, Basel III is a response by regulators to perceived weaknesses in the existing Basel II framework. The package of measures known as Basel III supplements the existing International Convergence of Capital Measurement Document (Basel II) which came into effect across the European Union, and many other jurisdictions, in 2008.

It is expected that Basel III will be implemented progressively across the European Union (and elsewhere) between 2013 and 2019. The implementation will require legislation to be introduced at both Community and national level.

One of the main outcomes of Basel III will be a significant rise in the banking industry’s capital requirements (and therefore, potentially, borrowing costs). By way of example, some estimates put the additional capital required by the European banking industry to comply with Basel III at around 700 billion euros, reducing return on equity by up to 30 per cent (McKinsey 2010).

This shortfall will not affect trading, corporate and retail banking equally and institutions will presumably reorganise to mitigate the cost. However, some of the costs will be shared with bank clients.

The combination of (a) increased capital requirements, particularly in the common equity element of Tier 1 capital and capital buffers and (b) minimum liquidity requirements is likely to reduce the return on equity for banks. It is unclear how different banks will address the situation, but the options include reduction of rates on retail deposits; reduced staff compensation; and increased margins on products.

In the corporate lending sector, new facilities will factor the capital costs into margin where the market will bear it. However, for existing facilities, if banks are not able to recover their consequential increased costs from their borrowers, their internal rates of return will be reduced.

Capital charges

In summary, the Basel frameworks impose capital adequacy requirements which limit the amount of assets (including loans) that a bank may have by reference to its capital, so helping to ensure that losses (including from non-performing loans) may be absorbed without prejudicing the rights of creditors and depositors.

There are two sides to the equation.

• On the capital side, banks must have a certain amount and type of capital which is categorised based on its ability to absorb losses.

• On the asset side, a bank must calculate the value of all of the exposures that it faces and then apply a risk weighting depending on the type of asset.

In simple terms, the Basel frameworks require that a certain amount of the bank’s regulatory capital must be allocated (at least notionally) to every loan advanced, or commitment made, by that bank. That allocation therefore restricts the amount of business that a bank may enter into, or forces it to raise fresh capital. Therefore, the capital adequacy requirements of any loan carry an implicit cost to the bank advancing it. The capital adequacy cost of a loan depends on the amount of capital by which it has to be backed. This amount is often referred to as the capital charge.

The question in each case is, if the capital charge for a loan changes, who should bear the cost of the increase or take the benefit of a reduction?

Increased costs clause

As with Basel II, a key issue when negotiating loan agreements is the so-called increased costs clause. Market practice when negotiating loan agreements has historically been based on the principle that borrowers should indemnify lenders for the amount of any increased costs (including any regulatory costs) incurred by them as a result of (a) the introduction of or any change in law or regulation or (b) compliance with any law or regulation made after the date of the relevant loan agreement.

That market practice, if continued, would result in borrowers becoming liable to indemnify lenders for the increased regulatory costs under existing facilities on the implementation of Basel III as law, but not to be so liable under loan agreements signed after the relevant legislation is passed. Because of the uncertainties as to the consequences of Basel III, banks are likely to insist that borrowers should be responsible for all related costs, whenever the documents are signed.

One of the major differences is that the capital charge for a facility may vary during its lifetime. This started under Basel II (e.g. with the calculation of risk-weighted assets being based on credit ratings that can change over time) but there will be a significant shift in Basel III as it is progressively introduced and as countercyclical buffers and liquidity requirements are set and re-set over the life of a loan. The complexity of the way in which the risk-weighting formulae operate makes the increased costs clause that much more difficult and important.

There are many complicated and far-reaching issues arising from Basel III. However, parties will need to revisit the increased costs clause in standard loan documentation to make sure both lender and borrowers know how it will work in the new regime.
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