Basel III will introduce new liquidity and leverage ratios for banks, and recalibrate the capital requirements banks must meet. These measures will have far-reaching impacts including on the profile and administration of syndicated loans. In this article, Rosali Pretorius, Andrew Barber and Juan Jose Manchado look at some of the changes the syndicated lending market must prepare for.
Status of Basel III
Basel III does not have legal status. It must be implemented into the laws and regulations of member countries or blocs, such as the EU. The EU proposals have been the subject of significant debate, which has led to a delay to the originally planned implementation date of January 2013.
In early March 2013, the EU policy-makers reached agreement on policy issues. Final approvals and legislative text remain outstanding. January 2014 is the current target date for implementation in the EU, but further delays are possible. What we do know is the EU will implement the Basel III proposals through a package known as CRD IV, comprising a new Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR). This article refers to the Council text of 21 May 2012.
Key changes under Basel III
Key areas of change are the liquidity coverage ratio (LCR), net stable funding ratio (NSFR), leverage ratio and increased requirements on the quality and quantity of capital. While we still await the final text of EU measures implementing the new standards, banks should prepare for significant changes, including the ones discussed below.
Liquidity coverage ratio
The LCR requires banks to hold enough high-quality liquid assets (HQLA) to meet prescribed assumed net cash outflows during a 30-day stress scenario. The original version would have required banks to assume a 100 per cent drawdown rate on a wide range of undrawn committed credit and liquidity facilities. This would have led to banks having to hold increased levels of HQLA to meet the LCR requirements.
The Basel Committee on Banking Standards (BCBS) has recently reviewed several parts of the LCR, and decided to relax these assumptions:
- from 100 per cent down to 30 per cent for committed liquidity facilities to non-financial corporates; and
- from 100 per cent down to 40 per cent for credit and liquidity facilities where the borrower is a financial institution subject to prudential supervision.
There was no change to the prescribed drawdown rate on credit and liquidity facilities to SPVs (which remains 100 per cent).
Given the different assumptions that they must apply, lenders will need to categorise facilities and price them according to the bucket in which they fall. In some transactions, the purpose clause in loan documents is likely to become much more important, for example in showing that a revolving facility is not intended to be used as a liquidity facility.
BCBS has proposed a gradual phase-in for the LCR from 2015 to 2019.
Net stable funding ratio
The NSFR, which BCBS is still developing, seeks to ensure a sustainable maturity structure of assets and liabilities over a one-year period. Assets that cannot be liquidated in less than a year must be backed by stable funding. This will impact banks that provide long-term finance, and could lead to a decline in such finance.
The leverage ratio is the ratio of Tier 1 capital to gross assets, without risk weighting. Banks must meet a 3 per cent ratio, probably from 1 January 2018, although BCBS will review this in 2017. For this calculation, banks cannot set off assets against liabilities to reach a net position, and credit risk mitigation techniques, such as collateral and guarantees, cannot be taken into account. Banks must account for off-balance-sheet commitments in full (although under CRR there is a conversion factor for certain trade finance products, such as standby letters of credit, that was not included in Basel III itself). Before 2018, banks must disclose calculation of the leverage ratio to their supervisors and the market (known as Pillar 2 & 3 disclosures).
The leverage ratio may make low-risk products less attractive for banks.
Use of IRBA
The CRR will require firms that calculate their credit risk-weighted exposure under the Internal Ratings Based Approach (IRBA) to apply a new asset value correlation multiplier of 1.25 to exposures to large financial sector entities and to unregulated financial entities. The proposed definition of "unregulated financial entity" is broad enough to capture lending to a (non-financial) corporate group with a subsidiary for treasury operations, or to an SPV that on-lends money to a non-financial corporate client. If that definition remains, banks will need to devote more resources to classifying borrowers correctly for the purpose of applying the multiplier.
Basel III also changes the risk-weights or "loss given default" applicable to certain exposures so that banks will need to hold more capital against those exposures. Notwithstanding Basel III, there seems to be growing regulatory opposition to banks’ use of the IRBA. This is reflected in the FSA’s decision to withdraw the right of modelling for commercial property assets, and instead to force slotting, i.e. classifying loans into one of four categories, each category with a fixed risk-weight attached.