EXECUTIVE SUMMARY
Because banks receive favorable capital treatment when a credit facility's tenor is shorter than one year, lenders increasingly offer financing with 364-day tenors and uncommitted extension option terms of up to 364 days. In this Legal Update, we explain the potential impact associated with extending a 364-day credit facility tenor prior to the stated maturity date then in effect for an additional 364 days, discuss potential Basel III Endgame implications, and offer solutions to mitigate these implications.
BACKGROUND
Banks have traditionally received favorable capital treatment when a credit facility's tenor is shorter than one year. Accordingly, lenders increasingly offer 364-day facilities, with uncommitted extension options of terms up to 364 days. In practice, lenders often would like to effectuate these uncommitted extension options prior to the current stated maturity dates without realizing the impact. This practice has certain implications, however, and new federal banking regulations may negate this impact all together.
WHAT LENDERS SHOULD CONSIDER BEFORE EXTENDING 364-DAY CREDIT FACILITIES
IMPLICATIONS OF EARLY EXTENSIONS
If the term of a facility is extended for an additional 364 days, and the extension takes effect prior to the original stated maturity date, this could be viewed as a committed tenor in excess of a year. Because borrowers typically request extensions 30 days or more in advance of a credit facility's maturity date, lenders and borrowers often would like to effectuate the extension before the facility's original maturity date to mitigate refinancing risk or operational risks; however, the lender may be subject to additional capital requirements because the tenor is longer than one year.
RISK MITIGATION STEPS FOR LENDERS AND CREDIT FACILITY PARTICIPANTS
First, credit facility participants could wait until the current stated maturity date before making an extension effective. While this option has its own risks, such as a delayed closing of the extension when it's already at maturity, it would allow lenders to continue receiving the favorable capital treatment for these facilities because the financing commitment would be under the year mark.
Additionally, lenders should consider allowing extensions to occur in advance but reducing the number of days the facility is extended so that the facility would mature 364 days from the effectiveness of the extension rather than from the original stated maturity date. Borrowers could then request another uncommitted extension for the number of days lost to act as a "top up," in which case, borrowers would still receive the same facility length they preferred but would be receiving it in two extensions opposed to one. A downside to this option is that, given the extension is uncommitted, borrowers would need to request the increase and the extension would be subject to bank's credit approval.
POTENTIAL IMPACT OF BASEL III ENDGAME
In July 2023, US federal banking regulators issued proposed rule changes, commonly referred to as Basel III Endgame, that would significantly change the risk-based regulatory capital requirements for certain midsize and larger US banking organizations. Although the proposed rules don't directly increase capital requirements, they do increase the amount of capital a lender must hold by changing the calculation for certain risks, asset amounts, and exposures.
Among various impacts of Basel III Endgame, it would eliminate favorable capital relief treatment for short-term facilities. The proposed rules provide that the same capital charge applies regardless of the tenor, thereby eliminating the regulatory benefit of short-term credit facilities.
The period for public comment on the Basel III Endgame proposal closed January 16, 2024, and the proposal anticipates a three-year transition period; however, banks likely will begin implementing the Basel III Endgame rules internally prior to the effective date.
KEY TAKEAWAYS
Although 364-day credit facilities with early extension options have become commonplace in the fund finance market, the attractiveness of the short-term facilities may decrease given the Basel III Endgame proposal. For now, banks should consider the implications of extending 364-day facilities in advance of their current maturities and consider the options to mitigate the capital treatment impacts.
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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.