The Basel III bank capital requirements proposed earlier this month threaten to eviscerate the supply of eligible investments for tax-free money market funds — an industry already struggling with a severe supply shortage.

Bankers and analysts have argued that the proposed capital requirements would make it more expensive for banks to guarantee municipal debt.

In a research report this week, Chris Mauro, head of municipal strategy at RBC Capital Markets, estimated the requirements, if phased in, would add 100 basis points to banks’ cost of writing letters of credit and standby bond purchase agreements guaranteeing floating-rate debt issued by triple-A rated municipal governments — and presumably more for lower-rated governments.

Though the implementation of these proposals is many years off, it could eventually spell bad news for tax-free money funds, which invest almost exclusively in municipal products guaranteed by banks.

“Our initial take on it is that it’s going to have an impact on the available amount of supply out there for LOC-backed variable-rate demand obligations,” said Michael Sebesta, director of liquidity management at StableRiver Capital Management.

The proposals are scheduled to be ratified at a Group of 20 meeting in November, and then implemented in phases until January 2019.

The $333 billion tax-free money fund industry offers investors supreme safety and liquidity, an equivalent of cash. Money market funds are bound by the Securities and Exchange Commission’s Rule 2a-7, which forces the industry to invest in super-short-term and super-liquid paper.

That primarily means floating-rate municipal debt with a put option, enabling the investor to sell the debt back to the municipality if nobody else will buy it.

Because few municipalities have the financial wherewithal to repurchase their own debt at the investor’s option, these VRDO structures typically entail paying a bank to commit to buying the debt from any investor exercising the put option.

During the credit bubble, these types of guarantees were cheap and easy to find. Municipalities issued $284.4 billion in puttable VRDOs from 2005 to 2008, according to Thomson Reuters, representing 18% of all state and local government borrowing during that time.

The financial crisis forced many banks out of the business of guaranteeing municipal debt because their credit ratings were no longer strong enough to meet money fund requirements.

The market is now dominated by a half-dozen banks, which enjoy significant pricing power and market concentration.

Last year, municipalities sold just $32.3 billion in puttable VRDOs, the smallest total in a decade. This year they’re on pace to sell $16.5 billion — the lightest supply since 1992.

RBC Capital Markets estimates the amount of VRDOs outstanding has shrunk to around $390 billion, from a peak of $525 billion in 2008.

This contraction in supply fortunately coincides with an evaporation in investors’ interest in money market funds.

With the Federal Reserve keeping interest rates pinned to zero, and signaling repeatedly it intends to keep them there for a long time, the short-term products money funds invest in offer very little yield.

The Securities Industry and Financial Markets Association swap rate, which measures the average short-term yield on the municipal VRDOs purchased by tax-free money funds, is 0.29%. After fees, tax-free money funds deliver returns of just 0.04%, according to iMoneyNet.

That has spurred a momentous exodus from money funds. According to the Investment Company Institute, investors have withdrawn $156.2 billion from tax-free money funds since the end of 2008.

The outflows have muted the impact of the supply shortage.

Sebesta, though, wonders what happens when interest rates eventually rise and investors once again start putting money into money market funds.

It is hard enough for money market fund managers to find paper when investors are withdrawing $1.7 billion a week from tax-free money funds, as they have on average in 2010. Just imagine how bad it would be if they start putting money in.

“At some point, when rates begin to normalize and move back up, supply will become a significant issue for tax-exempt money market funds,” he said.

Even more so with these Basel III requirements, some argue. The proposal would require banks to commit more of the safest form of capital to these guarantees, as well as hold a portfolio of uber-safe assets it can liquidate to cover the cost of honoring the facility.

“Once fully implemented, the Basel III capital and liquidity rules will significantly increase the cost and decrease the availability of bank credit facilities for issuers of LOC and SBPA supported municipal securities, and will likely result in more banks curtailing their presence in the U.S. municipal credit backstop market,” Mauro wrote.

Joseph Fichera, chief executive officer of Saber Partners LLC, said there is “no need to panic or switch to other products.” First of all, even if adopted with no amendments, the first wave of Basel III implementations is not until 2015. Most liquidity facilities meanwhile have a term of one to three years, Fichera said.

Further, Fichera, whose advisory firm specializes in structuring liquidity facilities for municipal utilities, said: “For municipals, many, not all, banks are already overcharging on liquidity facilities” relative to what corporations pay for these types of guarantees.

Fichera estimates a double-A rated municipality might pay 65 to 100 basis points for bank liquidity, versus 20 to 40 basis points for a comparably rated corporation. That implies banks have room to bear more costs before the burden of guaranteeing municipal debt becomes even comparable to backing corporations.

Mauro’s 100-basis-point estimate was derived from an internal RBC model used to compute costs of capital.

The Basel proposals would impose greater costs on banks in three categories: capital, liquidity, and leverage. The bulk of the estimated increase in costs comes from the capital requirements. By requiring capital to come from safer tiers, Basel III would force banks to pay more for the capital used to finance municipal VRDO facilities. Most of the rest comes from a “liquidity coverage ratio,” which would require banks to maintain a pool of safe, liquid assets capable of covering the costs of honoring the facility in a doomsday scenario.

The capital and liquidity requirements essentially mean “more than $2 in bank balance sheet will be needed to provide a $1 credit facility,” Mauro wrote. For every $1 in guarantee, the bank would need $1 in low-risk capital plus $1 in liquid assets that can cover the guarantee.

Municipalities will likely explore alternatives to VRDO financing, Mauro said, including tax-exempt index-based floating-rate notes.

Many of these would not be eligible for purchase by money funds. For example, since the Basel liquidity proposals would require banks to maintain liquidity to cover potential losses over a 30-day period, banks may try to structure VRDOs with put options of more than 30 days, Mauro said.That would not tempt money market funds, most of which rarely venture into securities that cannot be liquidated for that length of time.

Sebesta said he would not be surprised if municipalities devise structures eligible for purchase by money markets, citing some instances in which taxable issuers have found ways to accommodate money fund buyers.