Short versus long: a fatal mismatch

What can you expect if you are a bank that depends on short-term money to provide long-term loans during a financial crisis? Looking at Franco-Belgian bank Dexia, the answer is: extreme volatility and a double implosion.

No one but the most distracted will have failed to notice that Dexia has again been bailed out – the second time since the 2008 global financial crisis – and is now being broken up.

The trigger for Dexia’s recent woes: its exposure to peripheral Eurozone sovereign debt – it holds close to €5 billion of Greek debt, according to the Financial Times – spooked the short-term interbank market Dexia was heavily dependent on, restricting the bank’s access to credit. A downgrade warning from ratings agency Moody’s ensued and the rest, as they say, is history.

The need to offset

At first glance, Dexia seems to vindicate apologists of Basel III’s net stable funding ratio, which requires banks to match their liabilities with stable sources of funding. This means the more long-term loans banks provide, the more stable sources of liquidity they will have to hold to offset these loans.

In short, under Basel III, a bank like Dexia – which has some €228 billion committed to long-term loans (including close to €28 billion in project finance loans), but was heavily dependent on short-term money – wouldn’t be allowed to operate as it does.

There’s at least one good reason for this, which Dexia seems to exemplify only too well: if a significant part of your loan book will only be repaid in the long term, but your short-term funding needs are enormous, what happens when liquidity stops flowing? The answer: you go bust, unless taxpayers rescue you.

The real tragedy, however, is that Dexia’s imminent collapse illustrates how hard it will be to get banks to lend long in the future. And that’s because it demonstrates that long-term lending, at a time of high volatility, presents significant risks for banks.

In a special report on risk published in the June 2011 issue of Infrastructure Investor magazine, we wrote that if you are a bank with a substantial long-term lending business – like Dexia – then Basel III could make that business less attractive.

If, on the other hand, banks had a healthy mix of tenors on their loan books, then long-term lending should continue to be sustainable. The conclusion, however, was that Basel III was unlikely to incentivise banks to orient their portfolios toward the long term.

Whether you believe Dexia’s ‘fund-short, lend-long’ model would always make it vulnerable to a liquidity crisis, or that it’s just an unfortunate victim of the ballooning European sovereign debt disaster, one thing is certain: conditions in the market, together with future regulations, are likely to make it hard for dedicated long-term lenders like Dexia to emerge again.

That’s bad news not just for the infrastructure market – Dexia was, after all, one of the main project finance lenders prior to the global financial crisis – but also for governments. Let’s not forget that the vast majority of Dexia’s long-term loans – some €191 billion of its €228 billion long-term book – were channelled to the public sector via countless municipalities across Europe.

As infrastructure once again becomes a buzzword with politicians and as cash-strapped European governments seek to attract more and more private sector investment for the asset class, they should bear in mind that infrastructure – an asset class with long-term characteristics – now faces strong market and regulatory headwinds that threaten to deprive it of long-term funding.

Regarding the latter, governments should acknowledge that, at this point in time, they are actually part of the problem and not part of the solution. As various recent reports have noted, a combination of regulatory and accounting requirements (to say nothing of politically motivated pot-shots at certain private finance models) are tying the hands of those most capable of entering into long-term investments: pension funds and life insurers.

As banks – long Europe’s traditional infrastructure funders – gradually exit centre stage, it’ll be up to politicians to end this funding mismatch. For an asset class ruled by the short-term electoral cycle, creating sustainable models beyond a four-year term is going to be quite a challenge.