Who's Afraid of Basel III?

Travis Lowder's picture

The Basel III Accords, the latest set of international banking standards from the Basel Committee on Banking and Supervision, are set to take effect in just a few short months. This new banking regime was designed to create a more resilient and robust international banking system with a suite of capital adequacy, leverage, and liquidity requirements. Basel III will have impacts across the broader commercial lending market, though the renewable energy (RE) sector, with its heavy reliance on project finance, will be particularly vulnerable to the new liquidity standards.

The general thrust of these standards is to ensure that banks withhold sufficient levels of high quality, stable, and unencumbered assets throughout all of their activities so that they may better weather both short-term and long-term periods of stress [1,2]. Regulating liquidity is a new feature of the Basel regime (neither Basel I nor II included any liquidity provisions), and it is expected to complicate the economics of certain types of lending. Project finance loans—which are characterized by long tenors (from 10 years up to 40 years in some cases) and are serviced by income-generating assets that may not have a ready secondary market during an economic shock—comprise one such type.

There are two Basel III provisions that address banks' liquidity stores: the Liquidity Coverage Ratio and the Net Stable Funding Requirement. The combined effect of these rules will likely foreshorten loan tenors and raise interest rates in the project—and by extension RE—finance market. To understand how, let's take a look at each provision individually.

The Liquidity Coverage Ratio (LCR) is designed as a short-term protection and requires banks to maintain a proportion of "high quality liquid assets" (such as cash and central bank reserves) to capital outflows (for example, drawdowns on loans) over a period of 30 days [1,3]. This provision will affect all commercial loans, though there is an additional requirement that banks hold 100% liquidity cover against loans made to special purpose vehicles, which will hit RE projects particularly hard. (These kinds of vehicles are universally employed in non-recourse project financing, though they are more commonly referred to as "project entities" or "project companies"). Requiring 100% cover for RE loans represents a heightened risk for banks, and lenders will likely raise interest rates in response—though by how much remains anyone's guess.

Additionally, the LCR allows national regulators to specify their own liquidity requirements on letters of credit—guarantee instruments issued by banks on behalf of the project entity and that are heavily utilized in the project finance marketplace. Raising the liquidity levels necessary to cover these guarantees could price them out of reach for some projects. This in turn may limit the project company's access to short-term funding options, putting it at greater risk of default [3,4]. Higher default risk in the project finance markets could be another impetus for lenders to bump up interest rates.

The second liquidity provision, the Net Stable Funding Requirement (NSFR), compels banks to demonstrate stable funding (such as customer deposits and equity capital) over the long term (one year) in rough proportion to the liquidity profiles of its assets. For example, if a bank had a loan with a one-year maturity, it would need to maintain funding of at least that long to back the loan. Tying up capital to match liabilities for a 10- to 20-year period (which has until recently been the typical tenor range for RE projects [5]) limits a bank's ability to "put its money to work" in the market and can act as a disincentive to longer-term lending. The market is already beginning to reflect this, and mini-perm project structures (5- to 10-year loans with built-in incentives to refinance afterward) have become more prevalent as a sort of stopgap [3].

Both the LCR and NSFR will likely create a contraction in the RE debt markets as several banks make their exit and as more capital is taken out of play to back existing loans. European banks have already sold over $11 billion of their project loan books off to U.S. and Japanese banks in preparation for the Basel III regime (implementation in Europe begins at the start of 2013 and will carry through until 2019), many taking a haircut in the transaction [4]. It is worth bearing in mind that European banks have been the biggest players in RE project lending, both in the Euro zone and in the United States. A large pullout of these institutions—certainly because of stresses related to Basel III compliance, but also because of the general turmoil in the Euro zone— could put a significant squeeze on the availability of finance for RE projects in the near term.

The United States will also implement its own version of Basel III. The Federal Reserve board just recently voted 7-0 to do so, and the U.S. Federal Deposit Insurance Corporation followed up five days later with a 5-0 vote. The big ticket item of these agencies' proposals is the requirement that U.S. banks of all sizes must hold a minimum of 7% high-tier capital against total assets, to be phased in over seven years [6]. The U.S. banking sector also has to adapt to the various provisions of the Dodd-Frank legislation which are slowly being phased-in. Many of these address some of Basel III's capital and liquidity requirements, while placing additional restraints on such practices as proprietary trading and swap dealing.

The looming storm clouds over the project finance markets is not without its silver lining however. Some analysts are expecting that, with a large bank pullout from the RE sector, developers will seek funding in the capital markets through instruments such as bond issuances. RE bonds could be regarded as short-term liquidity if they are of high enough quality, and thus would help banks to meet their required ratios under Basel III. Bloomberg New Energy Finance estimates that clean energy project bond issuance could grow from $2 billion annually today to $18 billion–$40 billion by 2020 [4].

And, to be sure, Basel III represents a positive development in a financial system that is highly leveraged and had previously been trading in complex instruments of dubious value. There is still a great deal of uncertainty about how the effects of Basel III will play out after implementation, but the long-term necessity to stabilize our banks is hardly debatable. Even if the shock of implementation is considerable, innovation in the face of regulatory impositions has long been the modus operandi of the financial markets; surely we will see new structures and clever means of leveraging the rulebook in the coming years to get steel in the ground.

[1] Basel Committee on Banking Supervision. Basel III: A Global Regulatory Framework for More Resilient and Banking Systems. Revised June 2011. http://www.bis.org/publ/bcbs189.htm

[2] Moody's Analytics. Basel III New Capital and Liquidity Standards — FAQs. 2012. http://www.moodysanalytics.com/~/media/Insight/Regulatory/Basel-III/Thought-Leadership/2012/2012-19-01-MA-Basel-III-FAQs.ashx

[3] Chan, Edward and Worth, Matthew. Basel III and Project Finance. Linklaters. Republished from Project Finance International (Issue 460). www.linklaters.com/pdfs/mkt/london/A13781114.pdf

[4] Bloomberg New Energy Finance. "Project Finance a la Euro Crisis, Topped with a Fresh Helping of Basel." March 29, 2012.

[5] Mintz and Levin. Renewable Energy Project Finance in the U.S.: An Overview and Midterm Outlook. http://www.mintz.com/media/pnc/2/media.2372.pdf

[6] Clarke, Dave. "New U.S. Regulators Question Bank Capital Rules." Reuters. http://www.reuters.com/article/2012/06/12/us-financial-regulation-fdic-idUSBRE85B16W20120612