Global regulations are making it harder for banks to lend for much-needed infrastructure projects in the developing world even as governments globally are advocating for private finance to get more involved. Adrienne Klasa looks at possible solutions.

African infrastructure

After the 2008 financial crisis and subsequent bailout of major banks, global regulators set about creating new safeguards for the industry. However, critics say there is an inherent contradiction at the heart of global banking reform measures – and it is making it harder for banks to put their money where it is needed most.

An unintended consequence of the latest rules from the Basel Committee is that they constrain banks from lending on infrastructure projects in the developing world, according to market watchers. “Basel III means banking is stepping back from our markets,” says Cameron Khosrowshahi, investment officer in the private capital office of development agency USAID.

Minding the investment gap

According to the G20, there is a projected $15,000bn global infrastructure financing gap between 2018 and 2040. In the interim, 193 countries around the world have committed to achieving the Sustainable Development Goals (SDGs) – an ambitious framework for global economic development – by 2030.

This agenda hinges on a commitment to turn billions in public development spending into trillions in private investment. To raise the financing needed to achieve the SDGs, development organisations must leverage their funding commitments twelvefold every year.

The same G20 countries driving the Basel reform agenda are also “begging private capital to do blended finance deals. Therein lies the conundrum,” says Aron Betru, managing director at the Milken Institute’s Centre for Financial Markets.  

This pressure is unlikely to ease any time soon as major donor countries such as the US turn inwards, slashing foreign aid and contributions to international organisations.

“The fact is the political and economic mood right now is more for multilateral balance sheet optimisation rather than support for expanded capital bases,” says Christopher Marks, managing director and head of emerging markets for Europe, Middle East and Africa at Mitsubishi UFJ Financial Group (MUFG).

A capital shift

The good news is the world’s top international financial institutions are sitting on about $5000bn in capital above their requirements, according to Mr Betru. A 2014 study by the Organisation for Economic Co-operation and Development (OECD) also found that 100% of pension funds surveyed were unable to meet their infrastructure investment targets.

The issue, then, is how to get this capital off the balance sheets and into investing in SDG-aligned projects? For bankers, it is becoming increasingly difficult to get involved. “Clearly [project finance] is a very important part of the role that banks play in economies. It has been made harder in particular by the way the new Basel rules have been written,” says Mike Brown, CEO of South Africa’s Nedbank Group.

The political and economic mood right now is more for multilateral balance sheet optimisation rather than support for expanded capital bases

Christopher Marks

The squeeze is also visible to development financiers working to build up pipelines of investable SDG-aligned projects. “We see banks much more reluctant than, say, 15 years ago to take on large project finance – particularly in infrastructure, but elsewhere as well,” says Mattia Romani, managing director at the European Bank for Reconstruction and Development (EBRD).

Regulatory bottlenecks

Under Basel III, two main issues have emerged for infrastructure deals in challenging markets. Liquidity requirements – the assets easily convertible to cash that a bank needs to hold to cover short-term losses during a shock – will rise from 60% to up to 100% by January 2019 for any financing that exceeds one-year maturity.

At the same time, more stringent risk weightings mean banks can no longer use internal formulations as liberally and can be asked to hold up to 250% of the Basel minimum capital requirement against investments in higher risk markets, up from 150%. 

The result? The cost of long-term financing is set to rise. “If you have to charge more, then often the project does not work. So you have to figure out who else can put that piece of capital in without the same regulatory charges,” says Mr Brown.

And while implementation of Basel regulations is phased (with some parts of Basel IV not coming into force until 2027), banks seem likely to disregard this. "I would expect banks to look ahead to measure and disclose their capital position on a fully loaded basis, so they will ignore any phase-in or will assume it extends for a much shorter duration,” says Azad Ali, a partner at law firm Fieldfisher.

Blended finance – defined by the OECD as “the strategic use of development finance for the mobilisation of additional finance towards sustainable development in developing countries” – therefore has to work double time. Not only is it required to shoehorn private money into challenging markets at unprecedented levels, it has to do so while finding ways around these new limitations.  

“The solution is to identify projects that are marginally bankable and then work hard with the private investors to work out what are the elements pushing this project just over the limit, and can we do something about it?” says the EBRD’s Mr Romani. “The answer is often yes, through things that are not that expensive.”

Gains from guarantees

Political risk insurance, first-loss facilities and guarantees are some of the tools that development players have at their disposal to help ease banks’ pressure points. Sometimes, according to Mr Mattia, the comfort of having a highly rated multilateral or development finance institution co-investing is enough.

However, multilaterals are supposed to be moving away from direct lending in order to use their balance sheets to leverage private money instead. This means that other models are needed.

One successful example of blending is an EBRD-backed deal to finance a hospital in Elazig, Turkey, through a €288m euro-denominated bond issue. When it became clear the private sector was not able to invest due to high political risk in the country, the EBRD and the World Bank’s Multilateral Investment Guarantee Agency (MIGA) came together to take some of the risk off the table and boost the bond rating.

The EBRD put up €89m for a guarantee. This unfunded facility, in combination with political risk insurance from MIGA, allowed the bond to be rated two notches above Turkey’s sovereign rating. As a result, money from banks and institutional investors flowed in.

“If you do it right, if you partner with the right private sector that understands the issues, if you bring in the right partners from multilateral development banks, you can really go far,” says Mr Mattia. He concedes, however, that the number of success stories is still small. “I don’t have hundreds of these examples, I have one or two. We want 100, we want 1000.”

Working out the kinks

Research shows that guarantees and similar products have so far proven to be the best tools for getting private money into sustainable development. According to the Milken Institute and the OECD, guarantees leveraged 44%, or $35.9bn, of total private capital that went into development between 2012 and 2015.

Despite this promising track record, development finance institutions only spend 5% of their budgets on guarantees. “You would think we should be putting more money there rather than limiting that resource,” says Mr Betru.

Part of the problem is that most guarantees do not actually dovetail with Basel requirements. “Most development finance folks think: let’s do these deals, let’s teach the private sector how to evaluate the risk. I think that’s very naive,” adds Mr Betru.

Where guarantees have experienced some success is in alleviating pressure from the new risk weightings. If properly structured, Basel allows banks to weigh their risk against the development bank or donor institution issuing the guarantee itself. Many of these have top-notch credit ratings.  

The picture is more mixed on liquidity coverage. To counteract this disincentive, guarantees would effectively need to turn an SDG-aligned investment into high-quality liquid assets (HQLA). However, most of these guarantees do not follow deals once banks sell assets on secondary markets.

“That is a potential huge blockage because whenever a [guarantee] transfer mechanism is used... there are always issues in project financing because of consent requirements. Guarantors may look at acquirers and have questions, there may be friction there,” says Mr Ali at Fieldfisher.

Many guarantees also will only reimburse banks for shortfalls rather than paying out directly. This fails to eliminate the short-term liquidity risks Basel is designed to guard against.

Finally there is a lack of publicly available information on standard agreements that would allow banks to compare products across institutions. “This lack of standard approach all but eliminates the ability of projects to qualify as HQLA on the back of a development guarantee,” researchers at the Milken Institute and the OECD conclude.

Learning curves

Getting guarantees right is the key to unlocking infrastructure finance at scale, and in frontier markets this still means guarding against heightened uncertainty, whether real or perceived. “Blended finance is a bit of a red herring,” says Mr Marks at MUFG. “We still need a lot of risk mitigation to manage country risk; it’s not a question of return.”

For example, in 2017, Brazilian miner Vale and Japanese trading conglomerate Mitsui closed a $2.73bn deal to build the Nacala transport and logistics corridor linking Malawi to the coast of Mozambique. Despite the two African countries’ poor sovereign credit rating and weak finances, the deal attracted financiers including the African Development Bank and 10 commercial banks. 

Private capital 0618

Crucially for development watchers, Nippon Life (one of the world’s biggest institutional investors) came on board to insure $1bn in commercial loans from several Japanese banks. For policy-makers, getting institutional money into the SDGs is seen as a silver bullet.

However, getting Nippon Life involved required bold steps by the Japanese government. It provided full country cover through the Japan Bank for International Cooperation, the country’s export credit agency. “It shows that for strategic infrastructure, if there is some entity prepared to bear a lot of the country risk you can still get it done,” says Mr Marks.

For multilateral development banks, this would involve taking on much more risk than they have in the past. It also requires changing their ways. Despite talking the talk of enabling private capital, “the fact is providing guarantee for other investors is more complicated” than doing loans themselves, says Mr Marks.

Changing ways of working

Blended finance is still in its infancy, so growing pains are only natural. But while doing it at scale requires adjustments from private sector entities, multilaterals also have to adapt.

According to those working on infrastructure deals, most development banks are still largely doing what they have always done: direct lending. Despite acknowledging the constraints global reforms place on commercial banks, development finance institutions “remain overly focused on investing their own limited capital”, according to the Boston Consulting Group.

“Multilateral development banks haven’t changed the way they are operating in this space and direct lending activity… has not dissipated,” says Mr Ali.

So far, incentives do not favour acting as an enabler over getting money out the door. The OECD development assistance committee, which tracks aid and loan performance from most of the world’s top donors, does not count money crowded in 'per dollar spent only' funds deployed, while internal performance metrics still measure volume of loans made.

This appears to work against stated goals. In many cases development finance is competing with commercial lenders. “Ask most of the banks: the high-quality deals they are involved in are dominated by the multilaterals rather than them stepping in to de-risk private capital,” says Mr Betru at Milken.

Often there are barriers in understanding between organisations from different sectors that find themselves suddenly thrown together. “It is very difficult for the private sector to vocalise what the associated risks are; they feel that it’s expensive even to start a conversation about the project,” says Mr Mattia, who adds that banks usually spend a week evaluating a deal, whereas multilaterals can spend a year working on it.

Most observers anticipate that adjustments will come with time. After all, the complexity and incongruity of the many parties needed to finance basic infrastructure globally are matched only by the enormity of the task at hand. In an era when many people carry the power of a computer in their mobile phone, more than 1 billion others still live in homes without electricity.

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