BASEL III - WHAT A TOWN WITHOUT PITY CAN DO

Variable rate debt has been a staple of public finance since the 1980s. While each decade has seen permutations, the standard variable rate demand bond backed by a bank letter of credit or standby bond purchase agreement has endured. Prices for liquidity support came down in the mid 2000s with the bubble bursting at the Lehman bankruptcy.

Just as the costs of bank support are receding from the post Lehman highs comes the new Basel III standards for bank capitalization and liquidity. The Bank for International Settlements, based in Basel, Switzerland, released its second set of revisions to bank standards.

The new standards are a response to the worldwide financial crisis in which banks were overleveraged and undercapitalized. Bank failures were based in part on their inability to absorb lending and investing losses. In the United States, the Fed's stress tests demonstrated some weakness in the banking system. The new standards are aimed to correct those areas of weakness.

If Basel has any pity, it isn't for bank credit customers. The Basel III standards are aimed at overall bank financial health, but are not aimed at the interests of bank credit customers. Under the new standards, banks need to accumulate more Tier I capital, actual honest to goodness equity. Banks are no longer allowed to depend as heavily on leverage. This results in a safer, but a bit more "expensive" banking system.

For banks that provide credit support in the public finance markets, reserves (cash and security equivalents) need to be equal to 100% of the amount that can be reasonable estimated to be payable in the next 30 days. While this is still subject to a level of interpretation, what is crystal clear is that banks will be required to maintain significantly higher reserves to support letters of credit and SBPAs.

The new rules are imposed by each national banking regulator, but are expected to be in force by January 1, 2015. Basel III's impact on the costs to banks is clear. What remains unclear is how all of this comes out in the wash. For example, we don't know if there will be any impact on pricing for credit that expires by January 1, 2015. However, banks are expected to be on a trajectory to enforcement before that date. Moreover, investment bankers, in response to the collapse of the auction rate market, have been developing non bank variable rate products, like SIFMA floating rate notes and extendable commercial paper. At present, these remain mostly "boutique" products with application limited to a few large issuers and a handful of purchasers.

Which force is stronger on variable rate debt, the upward price pressure from Basel III or the downward pressure from the non bank alternatives. Stay tuned, it's going to get interesting.