Bank credit facilities used to roll over variable-rate debt have so far been up to the task of handling the initial wave of enhancements that has been expiring this year.

But as banks’ extensions last for another two years on average, by 2013-14, new tests await the variable-rate market that should concern municipal investors, Citi analysts wrote in a recent strategy report.

Another wave of variable-rate demand notes will have surged by 2013-14 for issuers to address. But this time, the banks they have used in the past may be less willing or able to help them with debt enhancements, such as letters of credit. By then, banks will be required to have more capital in-house through the recently introduced Basel III rules.

The main concerns are for issuers and for potential new fixed-income supply in 2013-14, Citi analysts wrote.

“The issuers have enough time to get ready, but market participants should be well aware that, going forward, LOC availability is going to decline and the cost will likely increase,” the analysts wrote. “Hence, they should be adequately prepared.”

The Basel III accords, which come into effect on Jan. 1, 2015, will call on banks to establish two new liquidity ratios to ensure that their assets are funded through a minimum amount of secure sources, and to ensure that they have sufficient liquid assets to support banking needs over a 30-day stress period. And because banks are going to be forced to set aside a higher amount of liquid assets, the cost to extend LOCs should increase. Subsequently, Citi analysts wrote, banks’ willingness to extend them should wane.

U.S. banks dominate the variable-rate market, Citi noted, led by Bank of America Merrill Lynch and JPMorgan. European banks are cutting back on their business, as are some regional U.S. banks. Still other, healthier regional banks, such as Branch Banking & Trust and PNC Bank, are entering the business.

Wells Fargo is one of the industry’s primary letter-of-credit providers. Through the first quarter of this year, it did almost $28.5 billion in the business, or a 9% market share, according to Citi Investment Research and Analysis.

But the bank doesn’t expect the Basel III rules to have a significant impact on its LOC business, said Phil Smith, its head of government and institutional banking.

“With regard to Basel III, we definitely track, plan, and monitor that contingent liquidity risk,” Smith said. “While Basel III rules or implementation periods have not been issued by the U.S. regulators, based on our understanding of the international guidelines as written, we would expect to meet all of the 2019 ratio minimums outlined by the Basel Committee during 2011. However, from our perspective, we don’t think [Basel III] will have a dramatic impact on how we do our business in government and institutional banking.”

Citi expects the unsecured floating bond market and direct lending by banks will play a more important roll in replacing VRDNs, such as LOCs and standby bond purchase agreements.

A recent report from Moody’s Investors Service showed that a record wave of expiring bank credit facilities did not tax the muni market in the first quarter as expected. LOCs and SBPAs that support $130 billion of floating-rate debt are set to expire in 2011, an amount equal to more than one-third of the $380 billion VRDN market. Another $94 billion of credit support will come up for renewal in 2012.

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