Who’s afraid of Basel III?

In a recent report, the European PPP Expertise Centre (EPEC), a European Union initiative to support public-private partnerships (PPPs), offered the sort of encouraging news that infrastructure investors like to hear:

“The European PPP market bounced back in 2010” with “loan tenors increasing and margins slowly easing” for PPP debt, EPEC stated. Average loan tenors exceeded 20 years in 2010, with half of the PPP deals closed registering maturities of more than 25 years. For the first time since 2007, the European PPP market actually increased in size instead of contracting.

But while these tentative signs of recovery are positive, there’s a shadow clouding the sunlit uplands: a set of new global banking regulations known as Basel III, to be implemented from 2013 to 2019, which has the potential not only to make debt more expensive again, but also to severely impair banks’ ability to lend over the long term.

Third time unlucky

Basel III is global regulators’ answer to the 2008 financial crisis that saw the world’s taxpayers having to contribute trillions of dollars to help prop up distressed banks.

To prevent a similar situation from happening again, regulators decided last September that banks would have to triple the size of their capital reserves to protect against losses, thus strengthening themselves against future financial shocks.

Under the new rules, banks’ highest quality capital – known as Tier 1 capital – will have to increase from the current 2 percent to a core capital ratio of 4.5 percent by early 2015, plus a counter-cyclical buffer of 2.5 percent, to kick in when lending is growing faster than the economy itself.

Perhaps more importantly, Basel III tightens the rules for what can be considered Tier 1 capital. This means that even banks with a strong Tier 1 capital ratio under current regulations (Basel II) might see their ratio decrease under Basel III. That’s the first thing infrastructure investors should pay attention to: banks will need to have more core capital to cover their operations.

The second thing investors should get acquainted with is Basel III’s net stable funding ratio, which requires banks to match their liabilities with stable sources of funding. This means that the more long-term loans banks provide, the more stable sources of liquidity they will have to hold to offset these loans.

At first glance, Basel III seems very bad news, promising to deliver a one-two knockout punch to the infrastructure market: debt in general will become more expensive because banks need to be better capitalised; and long-term debt in particular might get priced out of the market completely because it requires banks to come up with funding to match 20-year-plus project finance maturities.

Devil in the details

At this point in time, there is a lot of anxiety about the impact of Basel III – but its impact may be more nuanced than people are fearing.   

“People are not certain on where Basel III will end up and this is what is generating a lot of concern and confusion,” points out Laughlan Waterston, head of infrastructure and PPP at Japanese bank SMBC.

Waterston continues:  “It is unclear whether the price of infrastructure debt will increase more than other types of structured debt. The proposed stable funding ratio under Basel III applies to any lending greater than one year in tenor, which will affect many types of loans. Depending on the banking institution and its mix of capital and funding sources, the cost impact of Basel III will differ. But ruling out further changes to the new regulations, long-term lending should continue to be sustainable for well-capitalised banks with diversified funding sources,” he concludes.

Waterston’s reasoning is based on a number of factors: Basel III is still under discussion, and thus fluid; it has a fairly lengthy implementation time; and, importantly, the new rules will affect different banks in different ways.

“Banks that are relatively well capitalised already have Tier 1 capital ratios of between 7 percent and 10 percent so, for them, the new capital regulations will have less impact. Under-capitalised banks that are more dependent on the short-term interbank market for funding will, of course, incur higher costs to adjust,” Waterston explains.

According to data from Infrastructure Investor Assets (www.iiassets.com), the five most prolific mandated lead arrangers of infrastructure projects in 2010 were BNP Paribas, Societe Generale, Credit Agricole, Santander and HSBC. All of these have Tier 1 capital ratios of between 8 percent and 10.5 percent, well above the 2 percent currently required under Basel II, according to data from research firm Morningstar.

Furthermore, most of them will not need to issue new shares to shore up their capital under Basel III, Morningstar forecasts. HSBC, for example, which currently has Tier 1 capital of 10.5 percent, expects Basel III to “reduce its core Tier 1 by 250 to 300 basis points, putting it at 7.5 percent – already compliant with the 2019 requirements,” Morningstar wrote in a report.

Portfolio maturity

Where things may get trickier is in complying with Basel III’s net stable funding ratio. As Waterston explains above, its impact will vary from bank to bank, partly depending on the average maturity of banks’ loan portfolios.

Since banks with portfolios skewed toward the long term will be required to match them with more stable sources of funding, this creates the possibility that providing long-term loans might become harder and more expensive.

Thus, if you are a bank with a substantial long-term lending business – like Dexia, for example – then Basel III could make that business less attractive. If, on the other hand, banks have a healthy mix of tenors on their loan books, then long-term lending should continue, in Waterston’s words, to be “sustainable”. What Basel III looks unlikely to do, though, is to incentivise banks to orient their portfolios toward the long term.

Liam O’Keeffe, head of project finance in the global loan syndications group at French bank Credit Agricole, believes Basel III is likely to have “some impact on long-term pricing”. However, he notes the impact should be positive, as it will force banks “to properly price the back end of loans”.

O’Keeffe explains: “Banks have tended to under-price the back end of loans. Ideally, [long-term loans] should have good margin step-ups and a cash sweep kicking in around year 7 or 10, so as to reflect the long-term nature of the risk.” The banker readily admits, however, that project developers are not big fans of cash sweeps, which tend to channel part or all of a project’s free cash flows to service debt, encouraging borrowers to refinance loans earlier.

A high level of competition, argues O’Keeffe, led many banks to offer their clients long-term loans with static margins prior to the global financial crisis, landing them in trouble when market conditions took a turn for the worse. Basel III may have the positive outcome of making sure this doesn’t happen again.

The good, the bad and the ugly

Ultimately – and even though the implementation of Basel III is still some time away – there is a pattern starting to emerge around the new bank regulations.

If you are a conservative, well-capitalised bank, adjusting to Basel III is unlikely to push your funding costs up significantly. Furthermore, if your loan book and funding sources are well balanced and diversified, new requirements like the net stable funding ratio are unlikely to alter your long-term lending capability substantially – although you will almost certainly not increase it.

If, however, you are a bank that has built a sizeable long-term lending business, Basel III could threaten its sustainability. And if you happen to be the type of bank that went large on long-term lending, but is highly dependent on the short-term interbank market, then Basel III’s impact might feel like an earthquake.