Capital Requirements for Unfunded Construction Loans Under Basel III

A medium-sized client of Austin Associates recently asked an interesting question regarding pricing for a large construction loan they were bidding on for a middle market customer in the northeast. As you might imagine, competition for this construction loan was intense as the borrower was an “above average” credit.  Several larger banks, as well as a specialty real estate finance company, were all involved in the competition.

Knowing that some of the competitors would be required to comply with Basel III capital and liquidity requirements, our client hoped to understand how these increased capital requirements might build a floor under the minimum level of pricing likely to be offered by the competition. We assisted our client in determining their pricing offer by using LoanPricingPRO to calculate the minimum price their competition could offer, given their need to cover the heightened capital requirements imposed by Basel III capital guidelines.

The basic terms of the deal were as follows:

  • Commitment Amount – $50,000,000
  • Construction Period – 18 Months
  • Target Pricing – LIBOR + 3%

Additional assumptions made by our client in analyzing the proposed transaction:

  • A 1% fee would apply to the entire commitment amount.
  • An additional unused line fee of 0.25% would be applied to the unused portion of the line.
  • The minimum capital allocation under Basel III is 8% on the actual loan balance, plus:
    • This loan would fit the Basel III definition of a “Highly Volatile” CRE; therefore it would be treated as a 150% Risk Weighted Asset, requiring 12% capital on the outstanding amount.
    • The unfunded portion of the loan still requires capital, but at 50% of the actual loan rate (50% of 150% at 8%) for an additional capital requirement of 6% on the unfunded portion.
  • The Targeted Risk Adjusted Return on Equity (RAROC) would most likely fall in the range of 12% to 15%.

Upon analyzing this lending opportunity from the perspective of the competitors’ pricing requirements, our client gained the following insights to assist them in pricing their offering:

  • The loan as specified with a 3.10% rate, including fees, would earn an 18.7% return.
  • If the competitor was to target a 15% return, they could price the loan at 2.25%.
  • If the competitor was to target a 12% return, they could price the loan at 1.625%.

Based on this information, our client was in a better position to present a loan package that was perceived favorably by this high quality borrower, and won the business. The information they had on competitive costs and capabilities played a significant role in winning the deal.