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The LMA Mandatory Costs Schedule provides a mechanism for institutions to recover certain regulatory costs which are levied on their lending function. Though widely used in the market without negotiation, Borrowers will want to bear in mind that the FSA announced a sharp increase in supervisory fees for deposit-takers in May 2009, a change which may be repeated in future years.

Borrower Notes

The calculation of the amount payable by the Borrower

The Investment Grade Agreement requires the Agent to calculate the Mandatory Cost for each Loan, and notify the Borrower as soon as possible at the start of each Interest Period.

The Mandatory Cost is the average of the Lenders’ Additional Cost Rates, weighted in proportion to their participation in the relevant Loan. The Additional Cost Rate for any Lender whose Facility Office is in the UK is calculated by reference to different formulae, according to whether the Loan is in sterling or not. The Additional Cost Rate for any Lender whose Facility Office is in the euro-zone is the percentage notified by that Lender as its cost of complying with ECB requirements in respect of Loans made from that Facility Office.

UK mandatory costs: Lender with Facility Office in the UK

There are two categories of costs applicable to Lenders with a Facility Office in the UK: reserve asset costs and supervisory fees.

Reserve asset costs

UK reserve asset costs apply to all Eligible Institutions. A Lender will qualify as an Eligible Institution if, broadly speaking, it has permission under Part 4 of the Financial Services and Markets Act 2000 to accept deposits, or if it is an “EEA firm” with permission to accept deposits in the UK.

Eligible Institutions are required to make non-interest bearing cash ratio deposits with the Bank of England if their Eligible Liabilities exceed a threshold of £500 million. The amount of the deposits required is 0.11% of Eligible Liabilities in excess of the threshold. Eligible Liabilities are, broadly speaking, short term (ie less than 2 years) sterling liabilities, net of sterling loans made to other banks in the UK banking sector.

Supervisory fees

While the Bank of England remained banking supervisor, there was no specific charge for banking supervision. The transfer of banking supervision to the FSA in 1998 however triggered the introduction of supervisory fees. Although these fees decreased significantly in the decade which followed, after the financial crisis the FSA announced a sharp increase in supervisory fees for deposit-takers in May 2009. It had commented that it had been doing supervision “on the cheap” (FT, 17 October 2008).

Supervisory fees are calculated chiefly by reference to Modified Eligible Liabilities (“MELs”), which are (broadly speaking) the total of Eligible Liabilities (explained above) and 33.3% of foreign currency liabilities; foreign currency liabilities exceeding £1 billion are discounted to zero if offset by intra-group lending. There is a scale of rates applicable to different tranches of MELs: each bank can be subject to several different rates, depending on the amount of its MELs.

Until 2001, supervisory fees were, in outline, £51 per £1 million of MELs for UK banks. Rates then decreased annually, with the average for the year 2008-9 being roughly £24 per £1 million MELs. Rates for 2009-10 range from £32 to £47 per £1 million MELs for the biggest banks.

The rates for “Incoming firms”, whether “EEA firms” or “Treaty firms”, are 20% of the rates applicable to UK banks.

Since the introduction of supervisory fees by the FSA, the LMA has recommended that banks should charge Borrowers for them, and included them in the formulae in their Mandatory Costs Schedule, as item E. The formulae ensure that, where the advance is denominated in a foreign currency, the Borrower pays 33.3% of the rate applicable on a sterling advance. The amount payable by the Borrower is calculated on the basis of the rates applicable to the Reference Banks. Each Reference Bank is required to quote its average supervisory fee rate, so that the Agent can compute the average of those quotations.

In practice, however, it is not clear whether or not banks have in fact been routinely charging Borrowers for these fees, at least on non-sterling loans.

Banks have often taken the view that the costs incurred in recovering these fees are disproportionate to the amounts involved. From a Borrower perspective, supervisory fees are an overhead of the bank. In addition, given the disparity between the charges for UK and Incoming firms, the averaging process used by the LMA means that some Lenders are significantly over-compensated, and others significantly under-compensated. As a result, some Lenders have historically conceded the right to recover these fees, on bilateral facilities in particular. It has been more difficult (though not unknown) for Lenders to agree to omit item E from the formula on syndicated facilities, partly for reasons of transferability in the secondary market and partly because of the approach taken to the issue by the LMA. It remains to be seen whether market practice will change in the light of the increases in supervisory fees which have now been announced.

Borrowers may like to note the potential impact which the selection of the Reference Banks may have on item E. For the reasons explained above, Reference Banks which are “incoming firms” with large MELs are likely to quote a lower rate

ECB costs: Lender with Facility Office in the euro-zone

ECB reserve requirements apply to all euro-zone branches of banks, wherever incorporated. They are calculated, broadly speaking, by reference to the bank’s short term liabilities (ie less than 2 years) in all currencies, not just the euro. Liabilities owed to other banks within the ECB regime are excluded. The impact of these reserve requirements is that Lenders which are euro-zone branches of banks will incur a cost in respect of their funding of a loan made to a Borrower, unless (as commonly happens) they obtain the funding from another euro-zone bank branch. Where ECB reserve requirements apply, a sum equal to 2% of the bank’s short term liabilities must be put on deposit with its local national central bank (“NCB”). Even in that case, however, the Lender is unlikely to suffer a significant loss, because the deposit bears interest at a commercial rate (the ECB’s open market refinancing rate for euro from time to time). As a result, the only loss that a euro-zone Lender could suffer is the difference between the rate it is paying to fund the deposit and the rate paid by the NCB.

Historically, Lenders have not generally passed on ECB costs to Borrowers. Market practice may however change.

Lenders are obliged effectively to try to ensure that ECB costs are not charged, under Clause 16 (Mitigation). Although in the form of the Investment Grade Agreement published in May 2004, the LMA deleted the right (which existed previously) for a Borrower to prepay a Lender which charges ECB costs and cancel its Commitment, it is expected that banks will not object to the reinstatement of that right in practice. Borrowers may want to negotiate that concession.

A warning: unilateral changes to the Mandatory Costs Schedule

Borrowers should beware of paragraph 13, which permits the Agent unilaterally to make any amendments which are “required to be made to this Schedule in order to comply with any change in law or regulation” imposed by the Bank of England, the FSA or the ECB. The Agent is required merely to consult the Borrower. The Borrower can however argue that in most cases this situation is covered by Clause 14 (Increased Costs): any Lender suffering a loss should use that procedure to recover (thus allowing the Borrower to cancel and prepay, or replace the Lender); and if many or all of the Lenders are affected, the Schedule should be re- negotiated, but not amended unilaterally by the Agent.