Regulators Preparing to Finalize Basel IV
I. INTRODUCTION & BASEL IV BRIEFING
The US federal banking regulators are preparing to finalize the Basel IV regulatory framework, the effects of which will impact US financial institutions and the domestic commercial lending market.1 Lenders and borrowers in the private investment fund finance sphere are no exception, and should expect that Basel IV will impact loan amounts, pricing, loan documentation, and available lending products. This Legal Update briefly discusses some key expected developments from the existing Basel III regime as applied to US fund finance, then considers certain issues in the context of committed versus uncommitted lines of credit.
“Basel IV”, or “Basel Endgame,” is the Basel Committee on Banking Supervision’s latest regulatory capital standard for internationally active banks and builds on the Basel III framework that was published by the Committee in 2011 and implemented in the US in 2013. The aim of Basel IV is to take a more nuanced view of the risk exposure that a bank has via its different lending products, operations, and activities — with views to greater cross-border consistency and an overall more conservative approach to capital to stop bank failures. Despite the Basel IV framework’s publication in 2017, it has yet to be codified and implemented in the United States. The public comment period concluded in January 2024 for the proposed rules set forth by the US banking regulators, with comment periods on ancillary rules and documentation still ongoing.
Speculation remains that the regulators might significantly revise the proposed rules further. This is partly due to the fact that the data-collection period is ongoing after the publication of the proposed rules, which reverses the usual order of the standard regulatory rule-making and comment procedure,2 and is partly due to the mixed signals coming from the different regulatory bodies.3 Nevertheless, some developments are all but certain, including tighter capital requirements and therefore an imperative to have less aggregate risk exposure, more granular classification of assets for risk-weighting purposes, and the introduction of changeable risk weight of a loan over its lifetime if various parameters change.4
II. MARKET IMPACT
Basel IV is widely expected to require a significant increase in a bank’s capital. Increased capital requirements force a bank to raise more equity or lend less, translating into higher costs for banks and borrowers. Any existing or proposed lending relationship will be closely scrutinized for profitability.
Larger US institutions will be subject to dual-stack framework for assigning credit risk weights, with the more conservative calculation prevailing. These larger institutions will also need to establish reserves for operational risk, which will be determined by a standard formulaic approach, as opposed to internal models.
As with its other commercial lending products, a bank will categorize the loans in its fund finance portfolio and apply the appropriate risk weighting to establish the corresponding capital retention requirements. Basel IV will require a more holistic view of a borrower’s situation when determining the appropriate risk framework. For instance, if a borrower grows from a small business to a large business during the life of a loan, the corresponding risk weight will change. If a fund with multiple different lines of credit outstanding defaults on one, the proposed US rule applies a universal cross-default across all of its loans, thereby subjecting each of its loans to a higher risk weight. Funds that engage in hedging derivatives will have hedges subject to a different, higher risk weighting metric. Some risk weight percentages themselves are changing: For example, a bank’s exposure to unused lines will continue to be calculated by applying a conversion factor to the maximum contractual commitment of a loan, but those factors may change (in some cases, due to a given type of loan being recategorized and/or subject to a newly created category).
In the face of greater costs across the board, banks may consider various ways to mitigate any loss of profit. Some are blunt, such as passing higher costs along to borrowers via pricing and fees, particularly if lending agreements include increased cost triggers. Others are more sophisticated, such as engaging in credit risk transfer trades or other risk-shifting transactions.
III. COMMITTED VS. UNCOMMITTED FUND FINANCE FACILITIES
Many fund financings take the form of committed lines of credit, in which a bank commits (if specified conditions are met) to lend up to a pre-agreed amount over the life of a loan, most commonly on a revolving basis. For regulatory purposes, this effectively involves the bank holding capital for the drawn and unused portions of the line until repayment in full of all principal and interest thereon by the fund or termination of the bank’s commitment per the terms of the credit agreement. Committed facilities thereby limit the amount of capital available to a bank to satisfy capital adequacy requirements even though the bank has not disbursed any loan proceeds to the borrower. Tightening those requirements limits a bank’s capital even further.
However, borrower demand for credit exists independently of banks’ willingness and ability to fund. Uncommitted facilities have developed as an alternative, attractive both to lenders (less onerous regulatory treatment and therefore cheaper) and to borrowers (cost savings usually passed along in the form of reduced commitment fees). The adoption of more stringent capital requirements under Basel III over a decade ago correlates with an increase in the prevalence of uncommitted facilities to fund borrowers. We have noted previously that capital requirements applied to most fund financings and anticipated that uncommitted lines of credit would continue to increase in popularity.5
The cost savings under an uncommitted line of credit, however, must be balanced with the borrower’s need for certainty. The key commonality across all uncommitted lines of credit is the lender’s ability to refuse to fund any advance even if the borrower remains in compliance with the terms of its credit agreement. The other terms of the facility can vary, though. For instance, availability periods, tenor and final maturity can be fixed or open-ended, or can be predicated on triggering events. Additionally, a lender might be able to demand repayment of all or any portion of the outstanding loan at any time, subject to a negotiated notice period.
To those familiar with committed lines of credit, certain provisions (representations, covenants, reporting obligations, etc.) of an uncommitted line will look familiar. Others, such as borrowing mechanics, the effect of a borrower default or the inclusion of Events of Default, may look somewhat different. In some cases, these depend on the lender’s other rights under the documentation. For instance, in fully discretionary demand lines, Events of Default might be superfluous (and therefore limited), given the lender can call the loan at any time. Conversely, uncommitted lines that are not fully demandable at the lender’s option may retain more robust Events of Default as triggers for acceleration and termination. Furthermore, uncommitted lines present structural constraints due to the highly discretionary nature of funding decisions. For instance, club or syndicated deals are less common, due to each lender’s right to determine independently whether it wishes to fund or not, and the potential for lenders’ different risk appetites and other preferences could result in less predictability for a borrower.
Credit facilities can combine both committed and uncommitted aspects. For instance, committed credit facilities often provide for elective (i.e., uncommitted) accordions/upsize capacity, whose implementation is subject to any one or more lenders’ discretion to increase their respective hold amounts (and/or subject to successful syndication to new lenders, if there is insufficient appetite amongst existing lenders to meet the requested upsize amount). Uncommitted accordions, however, typically have the effect of increasing a facility’s maximum commitment amount (whether permanently or for a specified limited time), which means it ceases to be uncommitted at such time and therefore would increase a lender’s capital requirements once implemented and for the duration of such increase.
Less commonly, an uncommitted facility may allow for an additional term loan tranche or a committed revolving tranche, either with or without an outside end date, in addition to the uncommitted line of credit. Depending on the use terms, this may create a new or expanded line of credit or a drawn credit exposure. In all cases, once the facility or tranche is drawn, it would become subject to the generally applicable risk-weight (i.e., an effective credit conversion factor of 100%).
Going forward, uncommitted lines of credit will not be categorized differently for purposes of risk weighting. This is because the proposed rules do not appear to change the definition of a “commitment:” any legally binding arrangement that obligates a bank to extend credit or to purchase assets. Uncommitted lines of credit will continue to benefit from a lower credit conversion factor than committed lines of credit—which is relevant for purposes of determining the bank’s exposure at risk, and therefore its risk-weighted assets (a component of the minimum risk-based capital ratios).
The relationship-driven nature of private investment fund finance is instructive in considering whether, and what kind of, uncommitted facilities could meet the needs of a particular borrower. Due to the serial nature of private investment funds, fund organizations tend to be repeat customers of the same banks over time, building up longer-term banking relationships.
The value inherent in these lending relationships tends to mitigate the risk of uncertainty on a practical level—an important consideration for a lending product where a bank can decide not to lend for any reason.
IV. CONCLUSION
Fund finance is nothing if not innovative. As the prior decades have illustrated, funds and banks are remarkably canny in finding new and novel ways to backstop different extensions of credit. The rise in popularity of uncommitted facilities, partially attributable to the implementation of Basel III over a decade ago, is evidence of this innovative spirit.
Basel IV might sound alarm bells for some. However, we expect that banks and private investment funds will continue to look to uncommitted facilities as one method to address these changes. We anticipate that any constraints posed by this upcoming regime will be met head-on with new and creative funding solutions in the fund finance market.
1 The US federal banking regulators consist of the Board of Governors of the Federal Reserve System (“Federal Reserve”), Office of the Comptroller of the Currency (“OCC”), and Federal Deposit Insurance Corporation (“FDIC”).
2 https://www.mayerbrown.com/en/insights/publications/2023/10/cart-before-horse-banking-regulators-extend-comment-period-and-launch-data-collection-for-basel-endgame
3 https://www.mayerbrown.com/en/insights/publications/2023/07/overhaul-of-regulatory-capital-requirements-proposed-by-us-banking-regulators
4 For a brief lay summary of the existing Basel III regime as relates to fund finance, please see https://www.mayerbrown.com/-/media/files/news/2017/03/basel-iii-and-the-move-toward-uncommitted-lines-of/files/baseliiiandthemovetowarduncommittedlinesofcredit/fileattachment/baseliiiandthemovetowarduncommittedlinesofcredit.pdf
5 https://www.mayerbrown.com/-/media/files/news/2017/03/basel-iii-and-the-move-toward-uncommitted-lines-of/files/baseliiiandthemovetowarduncommittedlinesofcredit/fileattachment/baseliiiandthemovetowarduncommittedlinesofcredit.pdf
