Pricing the increased costs: Basel’s latest invoice

Increased costs: A useful too?

Increased costs provisions (ICPs) sit within the broader architecture of risk allocation mechanisms under lending documents, allowing lenders to preserve their intended economic return against regulatory change, as well as change in law, at the cost of the borrower. ICPs are necessary because banks' balance sheets, and the ultimate yield derived from a facility, are subject to a wide range of capital requirements. These capital requirements can convert legally unchanged credit exposures (both from a documentary and a cashflow perspective) into materially different economic positions for the bank; and any change in the cost of capital can have material impact on the economic viability of a transaction for the lender.

Facility agreements (whether in accordance with Loan Market Association Standard or more bespoke arrangements) frequently include ICPs allowing lenders to unilaterally demand that any increased costs be indemnified. Changes that may trigger an ICP are frequently negotiated but typically include changes in law or regulation (or changes in the interpretation of such laws and/or regulations) after the signing of the facility, and specific legislative updates (such as Basel III) which are expressly scoped into the ICP.

Borrowers may seek to include additional guardrails, such as a requirement for a lender to deliver a certificate documenting with sufficient evidence the basis for the increased costs claim and the calculation of amounts payable, or a provision where the lender confirms that it has adopted a consistent approach amongst similar borrowers. In practice, whilst lenders may rely on the ICPs without the borrower's co-operation, the provision is generally helpful as a starting point for bringing the borrower to the table for a more consensual negotiation. This is generally preferential for lenders from a commercial and relationship perspective.

Basel III: What changes could impact lenders?

The Capital Requirements Regulation (CRR) requires banks to maintain regulatory capital intended to absorb losses and strengthen resilience in stress conditions. For prudential purposes, banks determine an exposure value for each exposure and apply an appropriate risk weight by reference to the relevant exposure class and applicable methodological approach. The resulting risk-weighted amount is designed to approximate the relative credit risk of the position: exposures assessed as higher risk attract higher risk weights and therefore generate larger risk-weighted assets (RWAs), increasing the minimum capital that must be held to support them. For example, a £100m term loan to an unrated corporate (which would be risk-weighted at 100%) would yield a minimum capital requirement of £8m which the lending bank must maintain. Meanwhile, that same term loan which was guaranteed by an AA-rated corporate parent would have a five-fold reduction of risk-weighting (at 20%) and therefore a minimum capital requirement of £1.6m. In practice, banks will likely hold additional buffers in addition to the 8% minimum capital requirement, but these examples are illustrative of the base level of risk weighted capital required.

Drawn exposures

Once a facility is drawn, the bank's prudential treatment is anchored generally to the credit exposure which has crystallised on its balance sheet (i.e. the borrower's repayment obligation).

Taking the above scenario the regulators' position is that the lender can be expected to lose up to £8m of the full £100m exposure. This would reduce the assets on the bank's balance sheet but, given the bank must hold £8m in regulatory capital buffer to absorb such decrease, this loss would not result in the bank's insolvency or financial distress. Of course, given the conservative nature of the regulations, the (usual) expectation is that actual losses will be significantly less than the £8m.

Basel III introduced a number of changes to the credit risk framework which, as implemented via the CRR, affect the calculation of risk-weighted amounts (and therefore the total regulatory capital which banks need to hold). The impactful changes include revisions to the rating methodologies for credit risk mitigation and expansion of the exposures category. Therefore, previously applicable risk-weights applied to different categories may change and attract a higher capital charge which could therefore form the basis of a legitimate increased costs claim by a lender in relation to drawn exposures, subject to the drafting of the ICP.

Undrawn exposures

Although the predominant focus has always been on the drawn amount, based on the maximum amount that a lender could “lose”, the prudential treatment for a bank's undrawn but “committed” amounts has, over the years, become a key consideration for regulators. The justification is that a borrower may quickly draw on the remaining balance before defaulting, or a lender may be slow to cancel a commitment due to commercial or reputational reasons. The developments relating to undrawn exposures are particularly crucial as there have been material changes under Basel III relating to the amount of capital a bank may be required to hold. This is likely to be even more significant where commitments are not fixed, but instead vary over time by reference to leverage, net asset value and/or the value of underlying collateral. In those circumstances, the amount of the commitment against which the bank must assess its prudential exposure may itself fluctuate in line with the applicable reporting, valuation and testing mechanics.

(a) Committed but undrawn (credit risk)

Where a facility remains undrawn, the bank's accounting exposure value at that point will be zero (given there is no asset on the bank's balance sheet). Such exposure is treated as an off-balance sheet item as no contractual payment obligation has crystallised. However, under the CRR, a bank is required to recognise the contingent credit exposure arising under its commitment to fund. Depending on the type of exposure, the CRR applies a credit conversion factor (CCF) ranging from 0%-100%. A 0% CCF means the bank is not required to hold capital and a 100% CCF equates to the bank treating the entire undrawn commitment as if it were fully drawn. Basel III amended the buckets in respect of which the CCFs would be applied, creating more granularity and, as in the case of undrawn commitments, with a maturity of less than one year a doubling of the CCF from 20% to 40%.

From 1 January 2025 in the EU (and, in the UK, on the basis of current implementation timelines, anticipated from 1 January 2027), the relevant UK and EU CRR frameworks also introduce an express definition of “commitment”. In the absence of a harmonised definition, banks had historically adopted a more contextual interpretation of what constituted a commitment for the purposes of applying credit conversion factors, with the result that certain less formal or “soft” funding arrangements might not have been treated as falling within the relevant CCF framework. The new definition clarifies that arrangements may constitute commitments even where the bank retains an unconditional cancellation right and/or where the availability of credit is conditional upon the obligor satisfying specified pre-conditions prior to drawdown. In addition, the framework clarifies that the absence of a commitment fee or commission is not, in itself, determinative of whether an arrangement constitutes a commitment. As a consequence, arrangements that may previously have been regarded as economically uncommitted could now attract an exposure value for prudential purposes.

(b) Unconditionally cancellable commitments (credit risk)

A key change is the treatment of “unconditionally cancellable commitments” (UCCs), or commitments where the bank may cancel the commitment in full without any prior notice to the obligor or which otherwise provides for automatic cancellation due to a deterioration in a borrower's creditworthiness. These were previously subject to a 0% CCF on the basis that the bank's unilateral right to cancel was viewed as materially limiting the likelihood that credit would be advanced. However, new Basel III requirements have increased this to 10%, albeit as currently implemented in the EU, subject to a transitional period until 31 December 2032.

In addition, the EBA published draft regulatory technical standards in August 2025 which provide that banks must take into account factors that may constrain their ability to cancel commitments unconditionally; these include deficiencies in risk management procedures, IT systems and processes, commercial considerations of the bank in avoiding negative impacts on the creditworthiness of the client, reputational and litigation risks. The impact of these factors is that a bank may be required to apply an even higher CCF (on the basis that their UCC will, from a prudential perspective, be considered a more binding commitment). So, a particular funding line that was subject to conditions precedent and a discretionary approval by the bank, perhaps with the added requirement of further credit committee approval, may constitute a UCC with a 10% CCF. This would require the bank to treat 10% of the undrawn portion as fully drawn or, if there were particular reputational risks or other factors at play, a potentially higher CCF of either 20% or 40%. This may be particularly problematic for banks lending to borrowers which are not able to as readily obtain alternative funding, as one could argue that removing, or failing to provide, such a facility during a financially stressed period for the borrower would actually exacerbate reputational, litigation and business relationship risks and as a result would unlikely qualify under the 10% CCF bucket for UCCs.

(c) Liquidity risk

Banks are also subject to minimum liquidity standards alongside credit risk capital requirements. The principal metric is the liquidity coverage ratio (LCR), which requires banks to maintain sufficient unencumbered high-quality liquid assets (HQLA) to cover 100% of their net liquidity outflows over a 30-day stress horizon. Any portion of a facility that the borrower is able to draw with less than 30 days' notice is treated as a potential liquidity outflow over the LCR stress horizon and therefore may increase the bank's HQLA requirements. The size of that outflow depends on the regulatory outflow rate, which varies by counterparty and facility type. For example, undrawn committed facilities extended to credit institutions (i.e. banks) attract a 40% outflow rate (that is, the lender has to assume that 40% of the facility will be drawn in the next 30 days), whereas facilities to non-financial counterparties may carry a lower outflow rate of 10-30% (depending on the purpose of such facility).

The LCR provides a useful lens through which to assess the impact of an ICP. In the EU (and, at the time, the UK), the LCR became fully binding from 1 January 2018. A particularly significant consequence was the inclusion of a 100% outflow rate to committed liquidity facilities provided to securitisation special purpose vehicles (SPVs). Although such facilities were historically designed primarily as a credit rating support mechanism and were, in ordinary course, infrequently drawn, the LCR treatment required banks to assume full drawdown over the 30-day stress horizon and to maintain additional HQLA accordingly. This materially increased the economic cost of maintaining these commitments notwithstanding historically low utilisation.

In practice, the contractual features of securitisation liquidity facilities further amplified the relevance of this regulatory change. Non-renewal or cancellation of liquidity facilities by the banks normally precipitated “standby” drawings (effectively requiring the SPV to fully draw the facility as a reserve until a replacement provider was appointed). At the same time, SPVs could not amend the facilities without public noteholder consent, which was unlikely to be forthcoming given any additional fees payable to liquidity facility providers would rank ahead of public noteholders. Therefore, many banks were forced to either transfer their positions or exercise rights under ICPs against the SPVs in order to increase the commitment fees for their facilities.

Both the EU and the UK are currently reviewing aspects of their liquidity regimes, though expected changes mainly concern HQLA classification, not the underlying inflow or outflow rates that drive LCR treatment.

Output floor

One of the major developments under Basel III was the creation of the output floor (OF). The OF operates as a backstop to constrain the extent to which banks using internal models for the calculation of RWAs (IRB) can reduce their capital requirements relative to banks using the standardised approach (SA). Although the OF is expected to be implemented in full over a transitional period, the end result will be that the RWAs under the IRB will be floored at 72.5% of the RWAs under the SA. Whilst the OF is intended to reduce unwarranted variability in model outcomes and enhance comparability, its practical effect is that capital requirements for IRB banks may increase. The EBA Basel III monitoring report in October 2024 estimated that this would result in a minimum required capital increase of €65bn across banks in the EU.

Although banks may, for management and pricing purposes, seek to attribute the impact of the OF to particular transactions or business lines, the OF binds at an aggregate level across the bank's consolidated portfolio. In consequence, the extent to which the floor becomes constraining depends on the composition of the overall balance sheet and not any isolated exposure. This may create cross-subsidisation, whereby relatively capital-efficient positions offset more capital-intensive firm-wide exposures, including where standardised-approach positions mitigate the binding effect of IRB models. As a result, even where the institution's overall capital requirement increases, the incremental impact may not be directly allocated to individual exposures. Borrowers may therefore question, and lenders may need to consider from an OF perspective, as to whether any internal capital reallocation reflects the lender's broader balance-sheet management and general cost of doing business, or an incremental cost properly attributable to a specific facility.

What next for borrowers?

The proposed changes under Basel III in the EU and the UK include a number of changes which directly impact the regulatory capital required to be held by banks. Although transitional periods exist, these changes are not grandfathered and, when entering into force, will apply to all exposures of the banks (regardless of when such exposures were created). Depending on how increased costs provisions are drafted in individual facility agreements, borrowers may, therefore, be exposed to potential claims under ICPs by lenders, although to date in our experience most banks have been reluctant to employ this fairly unilateral right. A few observations can be made:

• Attribution and evidencing: Where increased costs apply on an institution-wide basis (notably in the case of the OF) rather than arising due to a facility-specific issue, exercise of rights under an ICP may be subject to greater scrutiny and challenge. Borrowers may argue that the binding OF applies to the overall bank's balance sheet and is not attributable to a specific facility. Lenders will need robust and well-documented evidence to support an argument that the OF impacts an individual facility and is subject to an ICP.
• Timing, kwledge and foreseeability: Negotiations often focus on whether ICPs should capture regulatory developments that were already in force, under active development or were reasonably foreseeable at signing. For example, although the OF was agreed internationally in December 2017, it is implemented through jurisdiction-specific legislation and phased in over an extended period. Borrowers may therefore argue that lenders should have priced the anticipated impact into the original economics. Lenders, by contrast, may contend that the realised incidence of the reforms depends on subsequent legislative detail, supervisory interpretation and transitional calibration, which may vary materially across jurisdictions (including between the EU and the UK) and, in some cases, may not yet be operative. Expressly excluding (or including) identified forthcoming legislation from the scope of the increased costs clause may facilitate greater certainty.
• Equal treatment: Borrowers may consider negotiating provisions requiring increased costs to be applied consistently with amounts charged to similarly situated borrowers. Whilst appealing, such requirements are often difficult to implement in practice. Regulatory capital outcomes depend on numerous proprietary inputs and internal methodologies that are not readily transparent to borrowers, with the result that ostensibly comparable facilities may attract different capital charges. Also, portfolio-level constraints such as the OF may influence internal capital allocation and thereby affect pricing in ways that are not exposure-specific. Additionally, banks may manage increased costs through relationship-based discretion, absorbing costs for strategically important clients across products while passing them through to smaller or non-core borrowers. Consequently, equal treatment language is frequently diluted to an obligation that the lender apply its methodology reasonably consistently with its general approach, though this affords borrowers limited practical ability to test or challenge compliance absent insight into the lender's treatment of other exposures.
• Replacement of Lender: The LMA provides for an ability for the borrower to replace any lender which has submitted an increased costs claim. In some facilities, the borrower would also include a voluntary prepayment right, and specify that where the facility was otherwise subject to a make-whole or prepayment fee, such fee would not apply to voluntary prepayments of that lender's outstandings arising following an increased costs claim by that lender.
• Information: Borrowers may seek to mitigate information asymmetry by requiring the lender to provide reasonable supporting evidence and/or a certificate from a senior officer substantiating any increased costs claim. Such requirements are more readily satisfied where costs may be directly linked to a particular exposure. Where the asserted cost arises from portfolio-level constraints, borrowers may struggle to get full transparency. The evidential burden is further constrained by the proprietary nature of banks' internal methodologies, including their approach to allocating additional regulatory capital or excess capacity for the output floor. These confidentiality limitations may materially curtail a lender's willingness to provide this information and a borrower's practical ability to test or challenge the basis of the lender's claim, if that information can be provided.

Conclusion

The ongoing finalisation of Basel III underscores how regulatory change can alter the economics profile of lending and increase the likelihood that lenders will revisit legacy pricing where new capital and liquidity requirements render existing facilities less attractive. In this environment, ICPs are increasingly important as a mechanism for reallocating regulatory burdens, whether through consensual repricing or, where relevant, unilateral claims.

However, the practical use of such claims depends on the prudential driver and the drafting of the ICP. Changes that operate at the level of a particular exposure, such as revised risk weights, altered CCFs or LCR outflow rates, generally are more readily evidenced and more intuitively linked to a specific facility. By contrast, reforms that bind at an aggregate level, such as the OF, may complicate questions of attribution and quantification and therefore risk disagreements as to whether the resulting costs are properly facility-specific or instead reflect broader balance-sheet management.

For both borrowers and lenders, ICPs can no longer be treated as boilerplate. Parties should address explicitly:

• the scope of capture of regulatory change (including liquidity and capital);
• the treatment of known or foreseeable reforms and phase-ins; and
• the evidential and procedural mechanics for substantiating and, contesting claims.

Clearer allocation of these risks at origination may reduce the scope for disruption of relationships between borrowers and lenders as reforms continue to be implemented across jurisdictions.

This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.

Authored by George Kiladze and Jane Griffiths.