A component of the Basel III banking regulatory package would make it more expensive for banks to guarantee municipal debt, possibly limiting options for municipalities seeking to sell bank-supported debt.

A proposed international regulatory framework introduced in December and formally approved over the weekend introduced a measure called the “liquidity coverage ratio.”

The liquidity coverage ratio measures to what extent a bank’s high-quality and liquid assets would be able to provide the cash it would have to come up with in what could gently be called a really, really bad month.

The Basel III framework, which would be implemented by regulators in most major economies, requires banks to maintain a liquidity coverage ratio of at least 100% of all lines of credit used for liquidity purposes.

That means a bank would have to hold in Treasuries, cash, or other risk-free assets an amount at least as great as the money it would have to round up in a “combined idiosyncratic and market-wide shock,” in which the bank’s rating is cut three notches, depositors withdraw their money, lenders refuse to lend, the markets banks rely on to raise money freeze up, and everyone the bank has promised to lend money to demands all of it, all at once.

Banking regulators would begin measuring the liquidity coverage ratio next year, and enforcing the 100% minimum in 2015.

The framework would require banks writing a letter of credit or standby-purchase agreement for a municipality essentially to buy and hold Treasury debt with principal equal to the size of the credit guarantee.

That would impose an additional cost on the bank, which market participants say would likely try to pass the cost along to the municipality.

“It will likely impact pricing because there will be an internal cost associated with holding more liquid assets on the balance sheet,” said Rich Raffetto, head of government banking at US Bank, the second-biggest provider of LOCs to municipalities.

Municipalities use bank guarantees to support variable-rate demand obligations. A VRDO is a long-term bond the interest rate on which resets regularly in a ­remarketing — effectively behaving like short-term debt.

To appeal to investors in the short-term market, VRDOs typically feature a put option, enabling the investor to sell the debt back to the municipality. Since few governments have the financial wherewithal to repurchase their own debt at the investors’ option, municipalities selling these bonds normally pay a bank to commit to buying the debt from the investor if nobody else will.

JPMorgan is the biggest provider of letters of credit to municipalities, followed by US Bank, Wells Fargo, and Bank of America. Royal Bank of Canada is the biggest provider of standby purchase agreements.

To illustrate the cost of this new requirement to the banks, imagine an airport wants to issue a $1 million VRDO supported by a two-year bank LOC. In order to keep the guarantee on its books, the bank would need to buy $1 million in two-year Treasury debt, to comply with the 100% liquidity coverage ratio. To derive the cost of this compliance, imagine the bank wanted to borrow the money to buy the Treasury debt.

The bank could borrow money for two years at a rate of about 0.77%, based on swaps on the London Interbank Offered Rate quoted by Thomson Reuters.

The two-year Treasury yield is 0.57%. That’s 20 basis points of negative carry — $2,000 annually the bank would have to pay on its debt that it’s not collecting on the Treasury investment.

Banks sold municipalities nearly $25 billion in letters of credit and standby bond purchase agreements last year, according to Thomson Reuters, implying that under the Basel III requirements the banks would have $50 million in costs for offsetting those exposures by buying risk-free debt with borrowed money. That negative carry has been as high as 55 basis points this year, and 80 basis points in 2009.

“The requirement to hold a Treasury or other liquid asset equal to the value of the liquidity facility will increase the cost of these facilities to banks, and they will undoubtedly try to recoup the cost by passing it on to customers,” JPMorgan analysts Alex Roever and Chris Holmes wrote in a report last week.

The proposal threatens to siphon supply from tax-free money market funds, which are already grappling with a shortage of eligible investments. The $336 billion tax-free money market industry almost exclusively buys variable-rate municipal debt with a credit guarantee from a bank.

Money market funds have stringent limitations on what they can purchase to ensure utmost liquidity and safety. If more municipalities opt for alternative structures to the VRDO, money market funds may face a market with even less eligible paper.

Competition for money fund-eligible ­VRDOs is so fierce that yields on money market funds have been less than 0.1% for more than a year.

The Basel III liquidity coverage requirement may also pose a credit challenge to municipalities, as there are a total of roughly $200 billion in credit facilities scheduled to expire through the end of 2011.

It is already unclear whether the banking sector has the capacity to renew all these facilities at reasonable prices.

Raffetto said it is now more likely that municipalities will explore in further depth alternatives to the VRDO structure for financings that take advantage of interest rates in the short-term part of the yield curve, such as put bonds.

Roever said if the availability of bank credit to municipalities shrinks, more issuers might attempt to use structures involving self-liquidity.

“But some VRDO issuers will be hard-pressed for alternatives since these are long-term financings that rely on access to the money markets for funding, and the money market investors need the liquidity these backstops provide,” he said.

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