Baselheads are intent on crushing  European project finance

EU political leaders and financial regulators seem to be stumbling towards adopting a law that would simultaneously throttle the region’s infrastructure development, eliminate one of the few remaining global competitive advantages for its banks and reinforce the power of entrenched monopolists.

A bit dramatic, you think? Well, if the EU adopts the draft of “CRD IV”, the Capital Requirements Directive based on the Basel III guidelines of the Basel Committee on Bank Supervision, in particular the restrictions on Internal Ratings Based risk weighting for project finance and infrastructure finance, we are looking at world-scale unintended consequences.

Russian agents could not have devised a more fiendish plan, since they would have died of boredom before finishing the documentation.

Project finance has developed into a useful methodology over the years. A large-scale undertaking, such as an offshore wind farm, airport or set of bridges, can be sponsored by a development group challenging a monopoly, or by a smaller public sector entity. Those financing the project have distinct and well documented claims on the cash flows from its revenues, such as user fees, tolls, or payments for power or water. Experienced project finance groups know how to draw up “EPC” contracts for engineering, procurement and construction.

Within Europe, banks have typically taken the lead in structuring the funding of project finance. Insurers and pension funds can provide long-term finance, but banks have the systems and control over cash necessary to fund the construction phase of projects.

Because even most worthy projects cannot obtain an external rating from one of the accepted agencies, banks have developed internal risk weighting systems to determine a project’s creditworthiness. These “IRBs”, or internally based ratings, consider the specific cost and revenue structures, and the soundness of the planning, compared with previous projects.

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Project finance groups compete with each other for mandates, which helps drive down total financing costs for the developer or public entity. European banks have had a disproportionate share of the global project finance market. This has partially offset the EU’s competitive disadvantage in developing union-wide public capital markets.

All good . . . but bank regulators have been deeply suspicious of the project finance model, particularly since the financial crisis. To them, the IRBs sounded like creatively valued Lehman or Enron black boxes.

The project finance people argued that their IRB analysis was worlds removed from mark-to-myth derivatives, as the publicly available loss experience showed. But their public sector counterparts in the Basel discussions had a political, not financial, command from on high: no more bailouts. The Basel bros were, for the most part, lawyers with no banking or project development experience.

Also, while the project finance bankers could show their controls had kept losses low, their books of business were thrown into the same statistical pool as the notorious German “KG” deals.

The KG deals were a tax-advantaged scheme intended to keep Baltic shipyards busy by wasting bank and investor money. And for a while it worked: German dentists dodged even more taxes, and the shipyards beavered away building more Panamax size containerships than the world would ever need.

The customer-less ships were kept on the German banks’ books long after the KG scheme collapsed under its own uneconomic weight. They were misleadingly classed as “project finance” assets, among the biggest actual cans to ever be kicked down a road to the wrecker’s yard.

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To the lawyer-regulators the KG failures were put into the loss column of the project finance sector; it was all “specialised lending”.

The CRD-IV risk weighting for project finance does not prohibit the business. Rather, it requires the banks which engage in it to set aside much larger chunks of equity and loss reserves than is justified by the structures and past experience.

As one European project finance banker says: “The additional margins that will now be required for project lending will make it prohibitively expensive. The regulators seem to hope that project finance will now be taken up by long-term lenders such as the insurance companies. But the insurers will not take construction risk.” That is a problem for even the best projects.

The Baselheads also have hopes that European capital markets can take the banks’ place in project finance. But that is more of an aspiration for the future than a plan that can be executed now. Also, project finance is not especially well suited for public markets, with its lack of ready liquidity and technical complexity.

Before the promised land of capital markets union arrives, the capital charges on project finance will reduce the banks’ ability to support new renewables development. So much for sustainability. The development of green infrastructure will be in the hands of existing monopolies. Those have the bigger balance sheets favoured by CRD-IV. Competition? Un-finance-able.

There may be a tiny bit of hope. For the moment, CRD-IV is wending through the bureaucracy of the EC Directorate-General for Financial Stability, Financial Services and Capital Markets Union. Before it becomes law, it requires approval by the commission and the European Parliament. Either could modify the Baselheads’ plan for project finance.

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