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Demand Lines of Credit and Notes

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Under a Demand Note structure, the bank has the right to call the loan or line of credit at any time—for any reason or no reason at all.  Because there is no firm legal commitment for the bank to advance funds to the borrower, there is also no minimum regulatory requirement for the bank to hold capital on the unfunded portion of a Demand Note.  The lack of minimum regulatory capital requirements on unfunded portions of loans or lines distinguishes Demand Notes from Committed ones. 

 

Capital Treatment

A comparison of the Demand Note versus Committed Notes with respect to regulatory capital is shown below.  Under current capital regulations, a bank must hold capital against loans with committed but unfunded amounts.  This treatment is generally required on Lines of Credit and Construction Loans.  As noted above, there is no such requirement on Demand Notes.  (It should be noted that commercial lines are infrequently written as a Demand Note because this structure is not ideal for most borrowers’ operational needs.)

Regulatory Capital Calculation Line of Credit Example:

  • Given
    • Line of Credit with 40% utilization = (LU) 40%, therefore 60% is unfunded
    • Minimum Regulatory Capital requirement (RC) = 8%
    • Credit Conversion Factor on unfunded amounts <= 12-month maturity (CCF) = 20%
    • Credit Conversion Factor on unfunded amounts >12-month maturity (CCF)= 50%
  • Regulatory Capital Rate/average balance on the Committed Note=
    • Formula: ((LU*RC) +((1-LU) *RC*CCF))/LU or
    • 12-month example: ((40%*8%)+(60%*8%*20%)/40% = 10.4%
    • >12-month example: ((40%*8%)+(60%*8%*50%)/40% = 14.0%
  • Adjusted Regulatory Capital Rate on the Demand Note=
    • Formula: (LU*RC)/ (LU + (CCF*(1-LU)))
    • 12-month example: (40%*8%)/ (40% + (20%*60%)) = 6.15%
    • > 12-month example: (40%*8%)/ (40% + (50%*60%)) =4.57%

Demand Notes carry a lower regulatory capital requirement than other loan types of similar structure.  For institutions that are originating a significant amount of Demand Note structure, it is suggested that there may be the need for a demand note product in PrecisionLender.   In the example above, instead of using an 8% Regulatory Capital level, 6.15% or 4.57% would be more appropriate and accounts for the bank not needing to hold capital on any unfunded amounts.  Note the expected utilization rate plays a significant role in determining the appropriate Adjusted Regulatory Capital (ARC).

Some banks adjust regulatory capital rates by borrower credit rating as shown in the table.  When this rule set is used, PrecisionLender suggests that similar lifts are appropriate for Demand Notes.  For example, on the 12-month Line of Credit based on the example above:

Borrower Risk Rating

Committed Product Example-Regulatory Capital Rate

Demand Product Example-Adjusted Regulatory Capital Rate

1

6%

5%

2

7%

5.5%

3 and lower

8%

6.15%

 

With respect to Economic Capital assignments, however, there is no distinction between a Demand Note and a Committed Note.  Economic Capital is dependent on the credit capital rate, usage given default and risk rating of the borrower The line of credit example continues below.

Economic Capital Calculation Line of Credit Example:

  • Given
    • Line of Credit with 40% utilization = (LU) 40%, therefore 60% is unfunded
    • Credit Capital Rate (CC)= 8%
    • Usage Given Default = (UGD) 45%
    • Unmitigated Capital = UC 1%
  • Economic Capital Rate/average balance on the Committed Note=
    • ((CC*LU) +(CC*UGD(1-LU)) + (LU+(UGD*(1-LU))/LU
    • ((8%*40%)+(8%*45%*60%))+((40%+(45%*60%))/40%
    • ((.032) + (.0216) + (.0067))/40% = 15.075%
  • The Credit Conversion Factor is not a component of the economic capital calculation; Demand notes and Committed notes reach the same level of economic capital.

As a final note, the need for Adjusted Regulatory Capital is only necessary on those loans where the payment type is LOC, Schedule Draws and Scheduled Draws and Repays.  ARC is not needed for any other payment types.

 

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