UK: Basel II And Increased Cost Clauses

Last Updated: 14 March 2006
Article by Gwendoline Griffiths

The implementation of Basel II (the new capital adequacy framework) may seem to be a rather remote matter. However, banks and borrowers should be considering its effects on increased costs clauses now to ensure that appropriate action is taken with regard to loan and other finance documentation.

Background

In June 2004, the Basel Committee on Banking Supervision published the International Convergence of Capital Measurements and Capital Standards: a Revised Framework ("Basel II"). This is due to be implemented by bank regulators from 2006-2007 and it will replace the existing 1988 Basel Capital Accord (the "1988 Accord").

Both the 1988 Accord and Basel II deal with the way in which bank regulators set regulatory capital requirements. As such they are relevant to loan facilities because the provision and maintenance of those facilities results in capital costs for the banks providing them.

Many types of loan and finance documentation include "increased costs clauses". Generally they provide that borrowers will indemnify lenders against costs or losses attributable to the relevant facilities which arise from changes in existing laws or regulations (or their application or interpretation) or the introduction of new laws or regulations.

Whilst the precise way in which Basel II will be implemented has yet to be finalised, it will inevitably lead to some changes which will fall within increased cost clauses (as currently drafted). These could result in indemnity payments becoming due from borrowers.

Differences between the 1988 Accord and Basel II

Under the 1988 Accord, banks are required to hold minimum capital of 8 per cent of risk weighted assets. The risk weighting applied to each asset depends on its category. For example, a loan to a corporate borrower is 100 per cent weighted, regardless of that borrower’s credit rating, so that £8 of capital is required for every £100 lent, unless it is secured by recognised collateral. The capital cost of a loan is constant over its life and is the same for all banks.

Basel II will result in a more sophisticated approach, and various options will replace the existing risk-weighted regime. Generally banks will use external credit assessments (the "Standardised Approach") but larger banks with more sophisticated risk management capabilities will be able to use internal ratings (the "IRB Approach"). The capital costs to a bank of lending to a particular borrower will vary depending upon which approach is used and they will change over the life of a loan if there are changes in the borrower’s credit worthiness or the bank’s assessment techniques.

Basel II and traditional increased costs clauses

If existing increased costs clauses are not amended, or new agreements are entered into with such clauses in their traditional forms, borrowers may have to indemnify their lenders against increased costs not only when Basel II is implemented but also when their own credit ratings change or their lenders change their approach. Conversely, such clauses do not deal with reductions in costs, so borrowers will not be able to claw-back any benefits if the changes result in reduced costs for their lenders.

Potential changes to increased costs clauses

Borrowers and their advisers expressed concerns about the potential effect of the 1988 Accord under such clauses. This resulted in express exclusions of the costs attributable to the 1988 Accord in loan agreements signed prior to its implementation. Similar concerns have arisen in relation to Basel II, although the position is more complicated, since changes can arise not only on its implementation, but also at any time during the life of a loan.

As a result, in the August 2005 edition of the Loan Market Association’s recommended forms of primary facility agreements, there is a footnote to the increased costs clause. It suggests that lenders consider the effect of Basel II on their transaction and sets out optional wording to exclude the costs of Basel II from the increased costs indemnity. The footnote also mentions alternative ways to address Basel II costs such as a margin ratchet (so that the pricing of the loan will move in the same direction as the capital cost if there is a change in credit rating) or an agreement to re-negotiate the pricing if the borrower’s risk-weighting changes.

Steps to be taken

It is advisable for banks and borrowers or issuers to review increased costs clauses in their existing loan and other finance documentation if the relevant facilities are likely to extend beyond the implementation of Basel II to determine their position. Where new facilities are being negotiated, consideration should be given to the exclusion of Basel II costs from increased costs indemnities and the insertion of other potential provisions. For example, a claw-back provision in favour of a borrower (if costs reduce) could be included, although it is perhaps unlikely that lenders will agree to this.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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