Rules on liquidity levels set by the Basel III framework for bank capital could curtail banks’ appetite for underwriting lines of credit for companies. So says a recent panel of bankers and risk managers brought together by research firm CreditSights and regulators in the United States and Europe.
In a report Thursday, CreditSights said executives from the International Association of Credit Portfolio Managers, Mizuho Securities, and Barclays Capital stated the liquidity coverage ratio (LCR), a part of Basel III, “changes the way banks think about uncommitted credit lines,” including undrawn term loans, working capital facilities, and commercial-paper backstops.
According to the panelists, the focus for banks will go “from one of managing credit costs to managing significantly increased liquidity costs” for lines of credit. Banks will either have to eat the costs or charge borrowers more, CreditSights analysts wrote. “[They] are also likely to be more selective about making such commitments, focusing on relationships that can make up the increased costs by cross-selling other products.”
Controversy has been brewing over the LCR. Some banking groups are sounding off on its potential to restrict lending, and regulators in the United States and Europe are suggesting it needs modification.
The LCR is designed to force banks to maintain an adequate level of “high-quality, unencumbered assets” to meet net cash outflows for a 30-day “stressed” period, essentially a run on the bank. The ratio of liquid assets to net cash outflows has to be greater or equal to 100%, says the Basel Committee.
The model assumes a company will draw down 10% or 100% of its untapped lines of credit during the stress period, depending on whether the loan is classified as a credit facility or a liquidity facility and whether the company is a financial-services firm or a nonfinancial firm.
The Basel Committee says working capital loans to nonfinancial companies would be classified as credit facilities, so only the 10% assumption would be used. But for financial-institution borrowers and in cases in which the revolver is used as a backstop to commercial-paper borrowing, the loan would be defined as a liquidity facility and thus a 100% draw-down would be used. That increases the amount of liquid assets that has to be held against those loans substantially.
As a result, the LCR could affect that kind borrowing the most, experts say. Further, “if the LCR gives rise to a significant price differential between backstop and other types of corporate credit facilities, sources of finance which need to be backstopped, [like] commercial paper programs, may become less attractive,” attorneys from U.K. law firm Slaughter and May wrote in a client memo earlier this year.
Banks are worried that another Basel III item that restricts their funding, the net stable funding ratio, would exacerbate the impact of the LCR. The NSFR is designed to move banks away from short-term funding mechanisms to such long-term sources as customer deposits.
The LCR is set to go into effect on January 1, 2015. A quantitative impact study of the LCR, conducted by the Basel Committee on Banking Supervision last spring, found that the 212 largest global banks would collectively be short about $2.3 trillion under current LCR rules. That assumes they have made no changes to their liquidity profile or their funding structure since June 2011.
Group 1 banks in the study — those with more than $3.9 billion of Tier 1 capital and judged “internationally active” — would have had a weighted average LCR of 90%, and Group 2 banks (all others) an LCR of 83%. The combined shortfall represents 3% of the total assets of the 212 banks, the Basel Committee said.
The liquid assets that would be deemed high-quality include cash, securities issued by the U.S. government or other highly rated sovereigns, agency mortgage-backed securities, and corporate bonds rated AA- or higher. Bankers say that having to hold such paper — some of which earns meager returns — could hurt their net interest margins and force them to raise pricing.
More specific details about how the LCR will be computed have yet to be released. Amid criticism, the Basel Committee is reexamining the LCR with the intent to modify it. It’s scheduled to publish its recommendations by the end of 2012, but it has stated it would not “materially change” the rule’s underlying approach.
Federal Reserve governors have expressed some doubts about the liquidity rules, and the Fed could revise them even after the Basel Committee releases the modified version. The Fed says changes to the LCR may come as late as mid-2013.
In Europe, criticism of the LCR is building. Mario Draghi, president of the European Central Bank, recently warned of possible damage to lending and bank funding. He has also said the LCR could make it harder for the bank to implement policy. And the European Commission issued a proposal in mid-September that would reduce European banks’ reporting requirements under the LCR.
Still, bankers have not said — at least yet — that the LCR would put lines of credit and revolvers under heavy pressure: the kind experienced during the financial crisis. After the failure of Lehman Brothers, banks cut the size of revolvers, upped interest rates, and shortened maturities, regardless of firms’ creditworthiness.