The Era of "Free Lunch" Finance Comes to an End

In many respect, the past decade was the era of "free lunch" finance. Banks, brokers and other financial institutions believed they could engage in all sorts of insurance-like activities without worrying too much about the difficulties they might face in honoring the many commitments they had made. In other words, they collected up-front premiums or recurring payments without having contingency plans in place should markets not function as "normal" or if too many "insurees" came to collect at the same time (even though that was virtually assured once the cycle had turned).

One example includes the aggressive and widespread promotion of standby lending facilities. In these types of arrangements, banks receive a fee in return for essentially guaranteeing that a client will be able to borrow money up to a preset maximum at any time while the agreement is in effect. However, among the issues that banks didn't seem to consider, especially in recent years, was: 1) they might not want to lend when prospective borrowers exercised their rights; 2) too many clients might come calling at the same time; 3) and, the banks might have real trouble honoring those commitments.

In "Financial News: Banks Urge UK Clients To Stop Borrowing," Dow Jones Newswires reports that banks are apparently going cap-in-hand to clients begging them not to do what they are legally allowed to do.

Banks have asked top U.K. corporate clients not to draw on lending facilities to which they are entitled in order to preserve their balance sheets as they approach the financial year end.

The banks are urging some of their biggest clients not to draw on standby credit facilities as the sub-prime crisis and squeeze on interbank lending have affected banks' ability to fund themselves.

The problems started with the closure of the commercial paper market as a means of cheap funding for companies in the summer. Banks have to provide standby financing of up to 100% to backstop commercial paper programs. With banks struggling for their sources of financing through the interbank market, the drawdowns are having a direct effect on their balance sheets.

Several bankers have said Citigroup is one of those most affected and that the bank was asking some clients not to use standby facilities, which are part of the normal relationship banking arrangements made between banks and companies.

A Citigroup spokesman said: "Citigroup honors its commitments to its clients but, as part of our normal business, we discuss with clients the potential use of our balance sheet. This is standard industry practice."

Simon Allocca, head of non-French corporate origination at BNP Paribas, said: "By the end of the summer, the principal problem facing banks was not U.S. sub-prime or collateralized debt obligation exposure but the drawing down of standby loans and bilaterals. In some cases banks are seeking to avoid further balance sheet capital pressure by asking clients not to use their standby facilities."

Standby financing is typically for 364 days and when undrawn has a zero risk weighting. When it is drawn, the risk weighting goes to 100%. This makes the sums involved significant. If a company is unable to tap the markets for commercial paper to the tune of, say, GBP4 billion (EUR5.6 billion), banks may have to provide that amount in standby financing