08 Nov 2010


Authored by: James Farn


In the second of two articles on yield protection clauses, James Farn looks at the practical effect of the Increased Cost clause in a committed loan agreement.
In brief:

  • The Increased Cost clause is a 'risk allocation' provision designed to protect lenders in the event regulatory changes result in the rise of the cost of a loan or the reduction in receivables under a loan after a borrower has signed his loan agreement.
  • The lender which invokes the clause has to decide how much of a cost (which arises from changes to the capital adequacy requirement) is attributable to a particular loan.
  • The clause can be subjective because it tends to look at the financial state of the lending bank as a whole and not just the loan in question which the lender is funding.

The main costs that a lender incurs in providing its loan are its funding costs – for example, EIBOR and the cost of complying with capital adequacy and liquidity requirements applicable to that loan.
In the UAE, the margin imposed by a lender is generally designed to cover that lender for the cost of complying with existing capital adequacy requirements. Unlike some other markets, the practice in the UAE is for the margin to absorb these existing capital adequacy as well as liquidity requirements. In other markets, these requirements are covered separately in the form of a Mandatory Cost requirement.  
Capital adequacy
The Basel Accords (Basel I and Basel II issued and Basel III currently under development), which are recommendations on banking laws and regulations, impose common definitions for qualifying components of a bank's capital. Amongst other things, they:

  • assign ‘risk weightings’ to certain bank assets; for example, secured and unsecured loans; and
  • apply a minimum ratio of a bank's capital to its ‘risk weighted assets.’

This is the ‘capital adequacy ratio.’ The capital adequacy ratio restricts the amount of assets (loans) which a bank can have, based on its own capital base.
These regulatory requirements attempt to standardise these risk–weightings and the categories of capital that count towards a bank's capital base in order to determine its capital adequacy ratio.
Basel II requires all banks to maintain a capital adequacy ratio of at least 8%. In broad terms, this means that for every AED100 on its book, a UAE bank must have a capital base of at least AED8 (resulting in a 'capital adequacy' ratio of 8%).
Basel II allows deviation from this minimum capital adequacy requirement based on the historical experience of banks based in different jurisdictions. The UAE Central Bank has imposed a higher capital adequacy ratio to which all banks in the UAE should have complied by June 2010.
Basel III requires higher capital adequacy ratios, on the basis that banks should have an adequate and liquid capital "buffer",  accumulated when the times are good, that could come into use in case of financial market shocks and minimise the public costs of a potential bailout. Capital reserve requirements (capital as a percentage of risk-weighted assets) are therefore central to current banking regulatory reforms.
To comply with these requirements, a bank can basically do one or a mix of three things:

  • reduce its loan book;
  • increase the size of its capital base;
  • impose any increased cost (arising by reason of compliance with these capital adequacy rules) on to its customers as borrowers.

Increased Costs
The Increased Costs clause should be nothing more than a 'risk allocation' provision.
It is concerned with changes in circumstances (not simply changes in law). It says that if something happens by way of change in regulatory requirements affecting a lending bank after the date on which a loan agreement is signed and which either;
(a)        raises the cost to that bank of making or maintaining its loan; or
(b)        reduces the amount receivable by that bank under the loan (including a reduction in the rate of return on the facility or a rate of return on the bank's overall capital)
which is attributable to that bank funding the loan (or its participation in the loan), that Increased Cost must be borne by the borrower. Note that the clause does not require a lender to make any adjustment if costs decrease.
This clause is intended to cover increased costs associated with a bank complying principally (but not exclusively) with such capital adequacy requirements.
The clause does not cover increases in the bank's general overheads or a reduction on its ordinary profits or other costs to the bank such as withholding tax (which should be dealt with separately in the loan agreement).
The theory is quite simple. If an unexpected cost arises during the term of the loan, it could easily swallow up the margin that each bank is charging on the loan (or its participation in the loan) and therefore would affect its anticipated profit.
Some banks attempt to exclude capital adequacy requirements from the ambit of the Increased Costs altogether and deal with them in different way – for example, through a 'margin ratchet' or the inclusion of a negotiation provision in the loan agreement to address what should happen if the borrower's risk weighting (as assigned to his particular loan) changes after the loan agreement has been signed.
Can the borrower object?
The big problem with this part of the Increased Cost clause is that it is subjective. The bank which invokes the clause has to decide how much of a cost (which arises from changes to the capital adequacy requirement) is attributable to a particular loan. The clause tends to look at the financial state of the lending bank as a whole, not just the loan in question.
A bank's capital can be viewed simply as a cost doing business and lending. The borrower then argues why, if a commercial bank decides to increase its capital base or is required to do so by some supervisory authority should he be asked to shoulder the cost of making that lender a stronger and more competitive bank?

  • The lender should be required to provide the borrower the details about how any claim is calculated, rather than rely on 'self-certification' by the bank.
  • The facility agreement should give the borrower the right to prepay the affected loan on notice and without any early payment/prepayment fee or penalty.
  • The facility agreement should include a provision obliging the affected bank to take reasonable steps to avoid or mitigate an Increased Cost. This may involve transferring its loan to an affiliate or changing lending offices for the credit.

When negotiating the facility agreement:

  • The borrower may request that the clause may be amended to expressly exclude requirements which are known at the time the agreement is made but which are not to implemented until a known later date (on the basis the banks can work out any cost arising from this requirement into the margin at the time that the agreement is made). This would be hard to rebut.
  • As an alternative, the borrower could try to restrict the clause to a regulatory change which affects all (or most) of the banks – in other words try to stop one bank from claiming an Increased Cost because its requirements have been increased by a regulator as a result of its own diminishing financial status.

Lenders are advised to check that their loan agreements contain a protoctive clause of this nature to ensure that they are adequately protected.