What are Commitment Fees?
A commitment fee is a fee charged on the undrawn portion of a lending facility.
Banks often give companies a ‘credit facility’. Often in the form of a revolving credit facility, but sometimes in the case of project finance structures as part of a term loan. A facility means the borrow doesn’t have to draw down the loan immediately, but they have the right to draw the funds at any time within an agreed period up to an agreed limit. Interest is only charged on the drawn part of the loan.
When banks calculate the amount of equity capital they must set aside for regulatory purposes regulators take a worst-case scenario so they force banks to use the facility amount and not the drawn amount.
Key Learning Points
- A commitment fee is a charge on the undrawn portion of a lending facility
- A revolving credit facility is a common type of short term credit, where the borrower has the right to draw the funds at any time within an agreed time period
- Return on Equity (ROE) is a key value driver for banks due to the correlation between their ROE and price to book value
- Regulators require banks to hold a minimum level of equity against the facility even if a high proportion is undrawn
- Due to minimum equity capital requirements, banks use commitment fees to generate a reasonable return on equity by charging a fee on the undrawn facility for ‘committing’ its equity capital
- Commitment fees increase the firm’s profit before tax line in the income statement
How do Commitment Fees work?
For example, if a bank gives a company a revolving credit facility of 100m at an interest rate of 5%, but the company has only drawn down 30m the interest expense is:
Drawn amount x interest rate = 30m x 5% = 1.5m
The bank now has a problem as the regulators force it to allocate equity capital to the whole 100m, not just the 30m drawn, and that capital needs a decent return based on lending, not just 30m but the whole 100m.
The Economics of Bank Lending
It is worth understanding the economics of bank lending before going further. Let’s assume the loan is 100% drawn, after making a few assumptions we can calculate the profitability:
We are assuming a capital ratio of 12% so 12m of the loan is funded by equity and 88m is funded by deposits. We can then calculate an income statement using the interest rates, an assumption for the expense ratio and an assumption for the tax rate. Finally calculating the return on equity is important as that is a key value driver for a bank. So assuming the loan is fully drawn the bank gets a return on equity of 13.7%.
Now look at the return if only 30m of the loan is drawn and the bank still allocates 12m of equity capital against the facility:
The key problem is the regulators still require 12m of equity capital against the facility despite only 30m being drawn. So the bank only makes 0.5m net income against equity capital of 12m and generates a terrible return on equity of 4.4%.
The way the bank generates a reasonable return on equity is by charging a fee on the undrawn facility for ‘committing’ its equity capital. Usually, loans are priced off the bank’s benchmark funding cost LIBOR (soon to be SOFR and SONIA). As the bank doesn’t need to fund the undrawn facility it’s just the spread they are losing. Given an expense ratio of 50%; then the lost profit on the undrawn facility is typically 50% of the spread and that’s usually the level of the commitment fee.
Now let’s take a look at our example with a commitment fee representing 50% of the spread between the interest rate and the deposit funding cost:
So here we are assuming there are less expenses if the loan is not drawn down as it doesn’t need to be serviced. The commitment fee increases the income and results in a much higher return on equity giving the bank a reasonable return on the overall loan.
Usually, commitment fees will be baked into the interest income line of the income statement and won’t be shown separately – however, we wanted to illustrate the issue clearly so put the commitment fee into its own line.