For years, financial services regulation allowed banks--actually encouraged them--to offer short-term credit facilities known as 364-day credit lines. Because banks were not required to maintain capital reserves against these less-than-one-year loans, they could offer them at extremely attractive price points. Even when drawn against, bankers say that the margins for this type of credit have been extremely thin. As a result, 364-day lines are massively popular: Banks use them as loss leaders to attract large corporate customers, and treasurers from companies of all sizes depend on them as economical, readily available standby credit.
But the glory days of the 364-day line are almost certainly over, according to banking experts, thanks to the adoption of the Basel II banking accord and its requirement that banks must start setting aside capital against these short-term loans in 2007. That may seem a distant prospect, but banks are already implementing the necessary systems changes. Experts warn that companies need to think about the consequences now, especially because banks may seek to pass on costs through the "increased cost" clauses that most loan agreements contain--a potential battleground that is already sparking debate between lenders and borrowers.
With the imminent demise of 364 goes short-term credit that was once as cheap as 50 to 75 basis points, and bankers claim that Basel II will push the cost of that type of facility closer to 200 basis points. "CFOs and treasurers need to care [about Basel II]," says Martin O'Donovan, technical officer with the Association of Corporate Treasurers (ACT) in the U.K.
Beyond the fate of the 364, there is increasing evidence that in some cases--particularly if you happen to be a small or midsize company or your credit rating is either nonexistent or has seen better days--the bottom line for Basel II could amount to tighter credit at higher rates. "If we get this right," says Mark Levonian, deputy comptroller for modeling and analysis at U.S. bank regulatory agency the Office of the Comptroller of the Currency (OCC) in Washington, "it means that a CFO is more likely to get credit on the right terms. Of course, if that CFO is currently getting credit on terms that are better than they should be, then [he or she] won't be very happy."
A MORE EXACTING SCIENCE
The reason is simple: Besides forcing banks to set aside capital against short-term lines, Basel II also calls upon larger banks to use a more precise calculation of the probability of default, called the Advanced Internal Ratings Based approach, or A-IRB, when pricing loans to companies--and then to hold capital reserves that match that risk. Like so many sets of new regulations these days that try to standardize a process, the new accord--relative to existing bank regulation--is astonishingly complex. While the rulebook of Basel II's predecessor took all of 30 pages to regulate how much capital has to be set aside as a cushion against large loan losses, the sequel agreement is more than eight times that length.
Basel I compelled banks to hold capital equivalent to 8% of the sums they lend--with crude weighting modifiers to reflect the relative risk of different classes of exposure such as loans to other banks, residential mortgage loans and loans to corporate customers. In contrast, Basel II offers three approaches to the calculation of credit risk capital--a standardized approach for smaller or less sophisticated banks that will rely on external credit ratings to work out how much capital should be set aside, and two more sophisticated approaches that allow the use of internal bank ratings models for determining risk and capital set-asides.
In the U.S., regulators have decided to adopt only the most advanced approach and apply it on a mandatory basis to the country's large, internationally active banks. There will also be a group of institutions that decide to opt in to Basel II because they fear being at a competitive disadvantage. In total, it's estimated that the 20 largest U.S. banks will switch to the new system. While this leaves many banks to use current capital requirements, the 20 making the switch control the bulk of the corporate credit market.
Borrowers with similar probabilities of default (PDs) will be grouped in the different grades of the bank's internal ratings system. These internal ratings will be more granular and differentiate more finely between risks than external credit rating agencies--especially further down the risk spectrum. As an example, where Standard & Poor's has nine ratings grades between BBB+ and B-, one large German bank has 15. The idea is to be able to measure risk more accurately and distinguish more precisely between different risk levels, so that the bank is holding the right amount of capital for its risk. It also means that, if a loan is under- or overpriced, a bank won't be able to ignore it--the capital requirements attach cost implications that must be adhered to. By contrast, under the existing system, a borrower's credit risk is connected to the lender's capital requirements in only the loosest way. The new accord will also make certain types of lending look more attractive, so banks may avoid riskier, and more costly, loans.
THE PRESSURE TO HIKE
Banks and bank regulators tend to see all of this as a good thing: In their eyes, the current system distorts bank funding costs. But CFOs and treasurers may be less pleased. "A bank which is using the A-IRB approach and is lending to a company with a high probability of default will see capital charges under the new accord going up by 300 or 400%," says Tolek Petch, a lawyer in the financial regulation department of law firm Slaughter and May in London. "The non-investment grade borrowers I've spoken to are very concerned."
Borrowers may not be able to do anything about the system, but understanding the way it works could help them use it to their advantage, says the ACT's O'Donovan. "If the borrower knows what performance measures the bank is using to calculate PDs, or where the thresholds are that separate one ratings grade from another, it may be able to present itself to the lender in a better light," he notes.
In anticipation of Basel II, some of the global banks have already been using stricter risk criteria and the largest, most creditworthy companies probably have little to worry about--and may even see borrowing costs fall. Unfortunately, the opposite is true for midsize and small companies, which don't often work with the bigger global banks. For them, bankers predict higher costs. "If a [bank] portfolio has primarily high-quality corporate customers, the capital requirements will be lower," notes Ashish Dev, head of enterprise risk management with KeyCorp in Cleveland. "For portfolios that are predominantly middle-market or unrated, the chances are that capital requirements will be higher. In both cases, this should have some impact on pricing."
Dev also notes that some lenders may seek to use the introduction of the accord as a justification for an across-the-board hike in wholesale loan margins either way. "If they try to do it for the lines, they will try to do it for other things too--anything which does not meet the hurdle rate," Dev says. The argument, he says, will go along these lines: Basel forces us, the banks, to measure risk differently. Now that we measure risk differently, we can see that we have to charge you, the borrower, more.
Quite apart from the impact on the cost for corporate products and borrowers, Basel II also alters the way that capital is calculated for almost every kind of risk a bank takes, including operational risks like rogue trading, fraud, and settlement or systems failures as well as consumer risks such as mortgage, credit card and personal lending. For some banks, this will cut into their ability to lend, which from a treasurer's standpoint means pressures on the credit market. "Basel II is something that companies need to go into with their eyes open," says ACT's O'Donovan. "There will be plenty of things to argue over and companies will only be able to do that if they are informed."