Myths about Flexible Funding, Basel III and Supply Chain Finance

As Basel III moves into sharper focus for banks, plenty of misconceptions about its impact — and the disruption it will create — have arisen. In fact, some commentators have stated that Basel III will represent a sea change for banks when it goes live. The reality is more nuanced.

Myths about Basel III
Let’s take a look at three common myths about Basel III.

Myth 1: Banks are going to put pressure on treasurers for more ancillary business because Basel III makes it harder to get returns on traditional lending.

This myth is often tied to the idea that Basel III changes the way banks look at revolvers. The theory here is that revolvers were once a standalone product that met bank risk-adjusted return on capital (RAROC) goals on their own, but Basel III changes that calculus for banks. While it is true that banks face new capital rules, the reality is that revolvers have been a “gateway” product for more than 20 years.

Although a revolving credit facility (RCF) term sheet will rarely mandate ancillary business, ask any treasurer about that expectation and you will hear that there’s an expectation for additional business. In fact, many developed countries have regulations specifically precluding banks from demanding ancillary business as a quid pro quo for extending credit.

However, banks can make business decisions on extending credit based on their holistic relationship with a client, and whether they meet the bank’s established economic return targets. That is specifically permitted. It is that exception that drives banks to cross sell using their greatest asset – money – to drive the returns to all their stakeholders, including shareholders, employees, depositors and investors. Few banks are interested in doing a revolver by itself, and that was true a decade ago as well. Basel III has not changed this.

Myth 2: The go-live of Basel III will introduce significant changes.

The reality is that banks have known about Basel III for some time and have faced many challenges in becoming adequately prepared. Most banks have been working with Basel III capital treatment for the last two years, and are already making credit decisions based on the new risk-weighted assets.

In practice, regulatory adoption of Basel III is already mostly implemented. However, the challenges lie with implementing on time across various jurisdictions and standards as well as with certainty of the cost of impact. With that, many banks are also looking ahead to a potential Basel IV on the horizon.

Myth 3: Basel III decreases credit appetite for supply chain finance.

Banks have a significant concern that Basel III will choke off the supply chain finance (SCF) market. That risk is probably overstated. While there are reasons to worry for the future — more on this in a moment —supply chain finance will be fine. In particular, there are two positive things about SCF with regards to capital treatment.

First, SCF is uncommitted, which by nature, reduces the overall cost of capital. For example, if a funder offers a 5-year $500M committed RCF, the lender is charged capital on $500M regardless of the drawdown amount. Non-utilization fees help reduce this cost. In contrast, if a bank or group of banks are willing to write $500M of SCF, then the bank only pays a material capital charge on the outstanding amount, because it is uncommitted. All things being equal, SCF facility of equal size and return compared to a revolver, should yield a better return on capital.

Second, SCF is appealing under Basel III because it is a short-term risk. As a result, both the probability of default and the loss given default are low for less than 12 months risk on a typical client (e.g. mid to global corporate). This, in turn, brings down the hurdle on capital returns. The banks PrimeRevenue works with like SCF because of its short-term credit profile coupled with the creation of what is typically a long-term predictable revenue stream, as once suppliers start trading their invoices, they tend to continue.

Basel III has forced return on capital to the forefront of credit decisions, so what we are actually seeing in the market is an increased demand for SCF as an asset class amongst banks.

What does the future hold for supply chain funding?

None of this is to say that Basel III is not a big deal — it is. But the major impacts were telegraphed long ago, and smart firms are already moving to position themselves effectively. Far from restricting access to funding for SCF programs, Basel III can actually make it more viable for the right type of borrowers.

The caveat with the SCF side is that the benefits from uncommitted capital may change over time. Just as banks understand the benefits of uncommitted capital over committed capital and the associated return boost, regulators do as well.

As a result, a number of regulators and internal compliance groups are now requiring capital (far less than a committed line) to be held even against uncommitted lines. This trend started with Australian banks, and it’s been trickling through U.S. banks as well. However, there are arguments that Basel III requirements may actually encourage banks to offer more uncommitted lines in the U.S. and give banks a better process for maintaining high-quality liquid assets. As a result, the appetite for SCF and other uncommitted lines is likely to increase in correlation. This is a trend to keep an eye on going forward.

For interested firms that need access to supply chain finance, PrimeRevenue can provide an option for a company to use its own cash or third-party cash — sourced from 55+ funders — to fund a supply chain finance program.