I am quoted extensively in this article. It is from a new group providing news and intelligence for the infrastructure market,
Inspiratia.com.
Inspiratia.com
Basel III – from the other side of the table
Having last week looked at Basel III from the banking sector’s perspective, this time we are switching sides and representing opinions of the global banking regulation from those who will have been less influenced by the Institute for International Finance.
Last Friday’s market view focused on match funding and the requirement for banks to hold sufficient capital to absorb losses. To refresh your memories, the key points from Basel III are:
· tighter definitions of Tier 1 capital – 4.5% by January 2015, and a further 2.5% taking it up to 7%
· introduction of a leverage ratio
· framework for counter-cyclical capital buffers
· measures to limit counterparty credit risk
· short- and medium-term quantitative liquidity ratios
This week, sees a response from everyone but the bankers – infrastructure professionals who are not so convinced by the banks’ fears that these global banking regulations will have such a negative impact on business, pricing long-term lending out of the market.
Talking this week to players in construction, financial advisory and third party equity, there is a widely-held belief that Basel III will not be the bugbear some fear it to be.
For a start, many believe the price of debt issue has been over-hyped. One of this week’s interviewees echoes a point made by one of the PF bankers over the all-in cost of debt. “To the argument that if you increase bank capital requirements they won’t be able to lend any more or it will make lending far too expensive – you have to say: ‘relative to what?’ What we are doing today is still cheap relative to 20 years ago.
“The banks have demonstrated that they are very hard to kill. I can’t see that a few basis points on pricing will kill the infrastructure sector.”
It goes without saying that the price of debt has been pivotal to project finance and infrastructure finance over the years. It also goes without saying that when the banks have had the whip hand, they have used it with gusto… as did the sponsors when they were riding the price of debt down to historic lows.
At the very apex of the market – when monoline insurance (and hence the bond solution) was still in play – banks were squeezed until the pips squeaked. Competition drove down PPP pricing to 50bp, plumbing a depth that should never have been permitted and that many banks drew a line far north of. But still deals made it over the line… too many according to the banks (with 20:20 hindsight) that are stuck with this uncomfortably cheap debt on their books for the next 20 or so years.
However, one issue that was not broached last week in discussions with the bankers is that higher capital requirements will make banks less risky and hence bank equity will not be called on to generate such a high return. It’s not simply a case that double the capital requirements equals double the capital charge.
The market generally agrees that it will be difficult to arrange the really long tenors because of liquidity pressure. Fair enough, but that should not be fatal to project finance as this can be dealt with by amortising out more quickly, which in turn reduces the risk of the loan and thus the credit spread. Alternatively there’s always the option of mini-perms and allocating the refi risk elsewhere [hello Australia].
The hard-of-thinking have long insisted that a rising price of debt will kill off long-term investments into infra. This is patently wrong as it is a pass-through cost to the awarding authority.
“If you are a project sponsor and your debt is more expensive, then you just bid more,” says another senior PF source. “Where it becomes difficult is when governments look at the value for money issue. The more expensive the bank debt becomes relative to the cost of government funding, people start accusing PPP of not offering VFM and saying that the government should be financing these projects itself.
“But that has not been the motivation for PPP for a long time. Governments have not been doing PPPs – in Europe at least – because they think it was good value. They did it to get the expense off balance sheet.”
Here we have two glorious contradictions – the VFM stick with which the industry is regularly beaten, and the reality that the private sector is needed to finance that which the public purse cannot.
Truth is, if you want a realistic view on the price of long-term debt, better look at what’s being arranged in the Power and Oil & Gas sectors, rather than PPP and Transport which are so heavily influenced by home governments.
All about returns
Everyone should have read Andrew Haldane’s paper “Banking on The State” in which he looks at the increase in leverage in banks' balance sheets over the last century and identifies a dramatic increase in recent years. Even with Basel III we will still be far above historical bank leverage ratios.
As one source says: “The idea that banks need to generate a 20-30% return on equity is one that people got conditioned to over the last few years. But if you think about it, it makes no sense at all.
“The long term equity premium – the return generated by stock markets overall relative to the risk-free rate – is probably in the order of 3-8% over the last century. Since the 1990s banks have been trying to generate an equity premium of 20-25%.”
As Haldane observes in his fascinating paper, the banks can only achieve this sort of return by taking massive business risk (risk in their operations) and financial risk (by leveraging up their balance sheets). Of course, with this risk inevitably comes bank failure.
The source continues: “People have observed that banks are meant to be the safest of institutions, not the riskiest. The Volker Rule in the US is designed to remove a major source of business risk – trading.
“Basel III goes some way to reducing financial risk with its focus on leverage on bank balance sheets. What disinterested people – those not employed by banks – really want to see is Boring Banking, banks generating only 5-10% returns on equity, the sort of investment for the widows and orphans of old.”
That’s all about the wider banking picture, though. But how this will impact on project finance?
PF business is low risk, but the tenors are long – just like prime mortgage lending which is staple business for a bank. The liquidity costs of long tenors may be slightly higher than they used to be.
“Although we have had big funding premia built into project finance pricing since 2008, deals are still being done,” says another learned source. “But if that liquidity cost is fatal to PF then it is also going to be fatal to mortgage lending. I can't see that being the case.”
