1.4 Stand-by credit facilities
As part of their liquidity policy, many organisations hold stand-by credit facilities. These are effectively unused loan facilities that organisations draw on when they are short of funds.
When these loans are drawn, the bank normally charges interest at a margin over the prevailing money market rate charged by banks to other financial institutions borrowing money – like LIBOR (London Interbank Offered Rate) or EURIBOR (Euro Interbank Offered Rate). So the overall rate is expressed, for example, as three-month LIBOR + x%.
When they are undrawn, that is, not used, the bank will still normally charge the organisation a small amount (for example, 0.25% p.a. or 0.50% p.a.) for providing the commitment to having the facility available on stand-by. Indeed, banks providing such commitments may have to put aside part of their capital in respect of the commitments made.
Activity 2
Attempt to answer the following questions.
What determines the size of the margin charged over LIBOR by the bank for a credit facility?
Discussion
The size of the margin over LIBOR is the credit spread sought by the bank. The tighter the general credit conditions and/or the weaker the creditworthiness of the borrower, the higher the spread charged. Note, though, that the process of establishing facilities involves negotiations between the bank and the organisation. Consequently, the organisation does not just automatically have to take the terms offered by the bank – particularly if they have a good credit standing and a strong financial position. Clearly, the greater the degree of competition between banks the better placed the borrower will be to negotiate the margin downwards.
Banks usually like to have the scope to renegotiate facilities each year.
Why do you think this is the case?
Discussion
Banks like to have the capacity to renegotiate a loan facility each year to give them scope to change terms – including the interest rate charged. In any case, it is common for facilities to have a term of 364 days (i.e. less than one year). This is particularly the case under the old international banking rules known as Basel 1, where the provision of facilities of up to 364 days did not require the bank to hold capital to support the loan, whereas capital is required for facilities of a term greater than 364 days (i.e. one year or more). Changes to the terms of a loan facility would be sought if the credit standing of the organisation requiring the facility had altered. Indeed, if it had changed for the worse the facility may not be renewed at all.