Bringing up Basel

In July, the Federal Reserve and Federal Deposit Insurance Corporation announced its final adoption of Basel III, a regulatory framework that will increase the minimum amount of equity capital held by banks globally.

The new framework stipulates that banks must now hold at least 4.5 percent of their risk-weighted capital as common equity tier one capital, with a common equity tier one capital conservation buffer of 2.5 percent. The minimum ratio of tier one capital has increased from 4 percent to 6 percent.

“This framework requires banking organisations to hold more and higher quality capital, which acts as a financial cushion to absorb losses, while reducing the incentive for firms to take excessive risks,” Federal Reserve chairman Ben Bernanke said in a 2 July statement. “With these revisions to our capital rules, banking organisations will be better able to withstand periods of financial stress, thus contributing to the overall health of the US economy.”

Although that may be true, some have argued the new rules set by the Fed and FDIC may mute the economic benefits of a more stable banking sector. Higher capital requirements translate into higher borrowing costs, which would curtail lending. As costs associated with borrowing from traditional lenders increase, companies may seek financing through the bond market rather than through loans. Another alternative – particularly for buyouts – would be for companies and sponsors to approach non-traditional lenders, which aren’t subject to Basel III requirements.

“This whole private debt world does have connections to … what financial institutions are doing generally, to what liquidity is on bank balance sheets and what their appetite for risk taking is,” says Michael Bailey, a senior investment officer at the Massachusetts Pension Reserves Investment Management Board. “I think that generally, private credit should do better when financial institutions are on the sidelines for whatever reason.

“If indeed there’s kind of a withdrawal of capital from some of the financing markets corporates tend to go to, then I think that ought to make things more favorable for private lenders,” he adds. 

The logic certainly holds up. Any regulatory action that causes banks to pull back on lending would create an opportunity for other entities that are not held to the same standards. As one party withdraws from the market, another steps in to fill the void. 

“If you look at capital requirements, those are one of the levers for liquidity in the market. So by increasing capital requirements, you’re going to have a negative impact on liquidity,” says Ross Hostetter of Duff & Phelps. “In a traditional sense, a decrease in the supply of capital from traditional lenders may entice alternative lenders to enter [the market].”

However, Hostetter is also careful to stipulate that US regulators’ final adoption of Basel III probably will not lead to the sort of market dislocation – such as that caused by the global financial crisis – that would allow for a new wave of entrants.

The changes implemented by Basel III will not raise borrowing costs enough to force major banks and underwriters out of the lending game (estimates on the cost increase tend to fall in the 30 to 50 basis point range). Such a measure would effectively shut down the credit markets. And even if hell froze over and that did happen, non-traditional lenders lack the bandwidth to handle the volume of deals currently worked on by the banks.  

“On the margins, it’s a favourable development because it’s going to – in all likelihood – decrease the available lending from traditional bank lenders. To the extent the alternative investors are there and can fill the void, that’s a tailwind for them,” he says. “But again, I don’t see it as a market shift or dislocation that’s going to create a whole new segment of entrants or opportunities.”

Banks are likely to take smaller bites of individual deals. For example, in the past, banks may have been willing to lend on a transaction with 3.5x leverage. The new capital requirements may force them to lower that to 3.25x. Filling the 0.25x difference is where mezzanine providers or other alternative lenders could step in.

Even though the above example reflects a relatively small portion of the deal, it’s large enough for existing non-traditional lenders to make a name for themselves. Stuart Boesky, a former chief executive at commercial real estate financial services firm CHC, founded Pembrook Capital Management in 2006 with these specific transactions in mind.

Pembrook, which has a strategic partnership with Mariner Investment Group, specialises in providing mezzanine and bridge loans to the commercial real estate sector.

“If you’re going to buy a property, you’re going to need to finance it. And if you have a choice between putting, [let’s] say, 20 percent more equity than you’re used to in the acquisition or, in the alternative, doing a loan with a bank for 65 [percent] and with Pembrook another 20 [percent] as mezz, you’re probably going to take that option,” Boesky says with a laugh. “Unless you’re very, very liquid and have no alternative use for the capital.”

Pembrook also benefits from how Basel III treats the weighting of commercial real estate loans, which effects how much capital banks must have on their balance sheet.

“Basel III increases the risk weighted capital charge for commercial real estate. It also obviously increases the regulatory capital that the banks require for everything,” Boesky says. “So it makes … from what I can discern, it makes commercial real estate loans less attractive and less profitable for banks.”

“[Basel II] ends up opening up – we think – a big structural change in how commercial real estate will get financed for some time,” he adds. “This is not a cyclical change. Alternative lenders, non-traditional lenders like ourselves, will have a lot better competitive edge in the marketplace and will have a much more important role in commercial real estate lending.”

Of course, the finalisation of Basel III’s effect won’t be immediate. The institutions most effected by the regulation have several years to bring themselves into compliance and, at that point, any number of factors contributing to the hypothetical opportunity presented by Basel III’s onset may shift.

“Is there an opportunity? The answer is yes for private equity firms. In the short term, financial institutions have to be more conservative on each type of lending activity, to ensure they make a proper rate of return on the deployed capital,” says Jonathan Jacobs, also of Duff & Phelps. “But as Ross said, there has to be equilibrium. The banks and the institutions have to make their return on the loans and on the capital requirements. If there’s a shortfall in the marketplace, someone’s going to fill the void.”