The implementation of the new capital adequacy requirements has led to the development of new approaches to the management of banks’ project finance loan portfolios, and may also prove to be a factor in the consolidation of the banking market.
Financial institutions have been preparing for the implementation of Basel II for some time. Those that operate in the project finance market have an additional incentive to be prepared because, unless they qualify for the ‘advanced’ internal ratings based (IRB) approach, from 1 January 2008 the capital reserve requirements for those loans are likely to significantly increase beyond the 100 per cent reserving requirement under Basel I. In addition to motivating financial institutions to develop the risk management systems required to qualify for advanced IRB, which they have been doing for some time, the imminent implementation of Basel II has also led to the development of alternative methods for offsetting Basel II’s impact on project finance assets.
Solution 1: securitisation
One way of freeing up regulatory capital is by issuing collateralised debt obligations (CDOs) for project finance debt. CDOs involve pooling together a portfolio of loans and securitising the repayment obligations. The rated notes or bonds are then placed with investors either privately or publicly.
Two CDOs backed by UK PFI loans have been launched to date: EPIC 1 (2004) by Depfa Bank; and the Stichting Profile (2005) by Sumitomo Mitsubishi Banking Corporation and NIB Capital Bank. Each followed a similar structure in the synthetic securitisation of a portfolio of UK PFI loans. Depfa closed a further CDO backed by project finance loans in June 2006, synthetically securitising public-private partnership credits from 11 jurisdictions around the world (EPIC 2). Both Stichting and EPIC 2 involved projects in the (riskier and so, under Basel II, more heavily capital weighted) construction phase, as well as projects that had reached their operational phase.
A stated primary objective of these transactions is to reduce the regulatory capital requirements of the relevant loans. Also driving the recent popularity of project finance CDOs is increased investor appetite for exposure to infrastructure markets through bonds, and the fact that CDOs offer investors a range of credit exposures (from AAA-rated to BB-rated) and an efficient diversification of risk across project sectors gained by using the portfolio approach.
Take for example the first Depfa CDO, EPIC 1 (which was mirrored by the EPIC 2 and Stichting deals). It is a synthetic securitisation, as Depfa remains as the lender of record, and transfers the credit default risk into a securitisation structure (apart from a specified first-loss portion, which will attract a different capital weighting) by entering into a credit default swap with KfW (a German government bank) under which KfW guarantees (in return for a premium) the payment of principal and interest on the pooled loans. Depfa achieves a 0 per cent weighting for the portion of the portfolio covered by the credit default swap, derived from KfW’s governmentowned status.
KfW (the intermediary) then protects itself from credit default on a part synthetic and part cash-funded basis as follows:
- For the senior tranche of the deal, by entering into another credit default swap with a monoline insurer, whose triple A rating ensures a 0 per cent risk weighting for KfW. The monoline is therefore left with the real credit risk for the senior tranche.
- For the mezzanine tranche, the credit risk of the loans is transferred into a special purpose securitisation vehicle (using credit-linked promissory notes) which in turn securitises the credit risk by issuing notes to investors. So the investors are left with the real credit risk for the mezzanine tranche. KfW protects itself by using the cash paid by the investors for the notes, which flows through the securitisation vehicle to KfW in consideration for the credit-linked promissory notes, as cash collateral against its obligation to pay Depfa under the credit default swap.
Another common feature of such deals is to include an ability for the originating bank to take the credit risk for the loans back after a stated period (for example, seven years in EPIC 1) to take advantage of any later capital adequacy upside once Basel II compliant procedures have been implemented at the bank.
In terms of the rating process for these transactions:
- The portfolio of loans as a whole, and each individual loan, will be rated.
- The rating of the underlying loans will include an assessment of events relevant to a credit analysis (changes, variations, waivers) since financial close.
- The portfolio rating will take into account the risk of default correlations (if one loan goes into default, the probability that other loans in the pool will go into default) that could occur due to concentration of the loans in one market (the UK PFI or European PPP market) or concentration on common sponsors or key counterparties. To date the rating agencies have held to the view that pools of PFI/PPP loans are to some extent insulated from such correlations as each project finance loan is tightly structured on an individual project-specific basis and so is protected somewhat from the impact of wider economic activity.
Another issue in such transactions is the need to refresh the pool of loans occasionally. Given the regularity of refinancing PFI loans, a mechanism needs to be included that permits the pool to be topped-up with new loan assets of comparable credit quality and maturity to the refinanced loan. Criteria for the introduction of top-up loans need to be agreed, aimed at maintaining the portfolio’s overall credit quality. For example the tests agreed for the EPIC 1 transaction included:
- a ratings estimate;
- an appropriate repayment profile;
- avoiding over-concentration on certain subcontractors
- and shareholders; and
- limiting the value of loans to projects in the construction phase.
Limitations on the use of project loan securitisation as a capital management tool include:
- The rating process is intensive – the cost savings achieved by the freeing up of regulatory capital needs to make the process worthwhile.
- A sufficient pool of appropriate assets is required: originally to make the transaction worthwhile and, looking forward, to enable the portfolio to be toppedup if deals are refinanced (and so no longer require credit protection). To date, deals have been limited by jurisdiction (UK and EU) and by sector group (satellites, cable, telecom, air transport, power generation, defence equipment, primary medical care, primary education instruction and war zone assets have all been specifically excluded from existing deals and from top-up criteria). This was one of the reasons that NIB and SMBC pooled their loan assets in the Stichting deal.
- The counterparty on the credit default swap and the risk weighting it attracts is crucial to making the deal worthwhile. In the three deals to date, KfW and its zero weighting has taken this intermediary position, but the economics of the deal might be questionable if a bank (and its likely 20 per cent weighting) had been the counterparty.
- The definition of credit events for project finance loans can be tricky to resolve given the different nature of the projects in the pool and the variance in the underlying loan documentation. This was one reason why the EPIC 1 and Stichting deals limited themselves to UK PFI projects, which (with market maturity and standardisation) had a higher degree of homogeneity than multi-jurisdictional deals would have.
- Post-default recovery settlement values can be difficult to derive for project finance loans given the limits on market liquidity.
- Any first-loss piece retained by the originating bank (as a sweetener to make the deal more marketable, and which will require separate capital weighting) may undermine the underlying economics of the CDO.
- In certain jurisdictions, there may be limits on the ability to assign underlying security.
- Some of the underlying project documentation may contain confidentiality restrictions, preventing full due diligence on underlying loans.
- There may be stamp duty or withholding tax implications if a true sale securitisation structure is used rather than a synthetic structure.
- Lastly, there is a possible impact on relations with the relevant project sponsors, who might expect relationship banks to retain an economic interest in their loan as a sign of commitment to the sponsors’ business.
Solution 2: wrapped bank debt
Monoline guarantees are usually associated, in a project finance context, with a bond financed project: a monoline guarantee guaranteeing to the bond/note holders that the bond will be serviced and repaid on a timely basis.Wrapped bank loans are also becoming an increasing feature of the project finance market, that is, a monoline insurer guaranteeing to the lending banks that the loan will be serviced and repaid. As well as the inherent structural advantages of wrapping a loan instead of a bond (banks and bank debt are generally more flexible than bonds and bond investors, and so will be easier and cheaper to refinance/restructure wrapped bank debt as opposed to a wrapped bond), a monoline wrap of a bank loan will lower the risk weighting attributed to the loan.
But the use of wrapped bank debt has been rare, because it has generally been uncompetitive in terms of pricing compared with the more traditional unwrapped bank debt or capital markets funding. This is now changing, due in part to tighter pricing by the monolines to gain more business, and to the impact the impending application of Basel II has on the cost-benefit analysis of including a wrap.
A number of recent deals that have featured the use of wrapped bank debt. The most recent, the Autovia del Camino toll road refinancing in Spain (2006), followed the earlier successful wraps of Norway’s E18 road (2006), the Ajman wastewater project in the Middle East (2006) and the Golden Ears bridge project in Vancouver (2006).
Solution 3: merger?
Some commentators have suggested that Basel II’s effect on the capital management of financial institutions’ loan books could provide an additional motivation for bank mergers. The potential advantages arising from such mergers in the context of project finance loans are:
- Access to additional information – smaller banks that lack sufficient exposure to particular products, such project finance, to enable them to use the advanced IRB approach could gain this information through merger.
- Access to more sophisticated risk management systems: smaller banks that lack sufficiently sophisticated risk management systems to use the advanced IRB approach could gain access to these as part of a merged entity.
- Access to a larger pool of assets for securitisation: to make a securitisation viable, the pool of assets in a project finance loan portfolio securitisation needs to be sufficiently diversified. In the Stichting deal, SMBC and NIB Capital dealt with this issue by pooling their PFI loan exposures. A similar result could be achieved with the right merger giving the merged entity a larger pool of assets from which to structure a CDO.
Other points to consider
It is also worth mentioning other points to consider regarding the impact of Basel II on project finance loans
- Deals will be structured to minimise the regulatory capital requirements of the loan. This will already be occurring as a matter of prudent banking practice, but may become more of a focus in negotiations.
- As capital costs could fluctuate during the life of the loan (for example, they are likely to go down after construction has completed, or increase if technical problems occur), it is yet to be seen how loan documentation will be drafted to deal with this, in particular whether banks will seek to pass any increased (or decreased) costs on to the borrower (we distinguish here the general increased regulatory costs/Basel II clause included in the Loan Market Association’s recommended forms of loan documentation).
- For bigger deals, the more focused regulatory capital requirements of Basel II mean that banks arguably have more incentive than usual to use multiple sources of financing that attract more diverse (and more favourable) treatment under Basel II, such as export credit agencies and multi-lateral banks, to enable the funding structure to incorporate various tranches of debt achieving different capital treatments, therefore broadening the potential syndication market.
- ‘De-risking’, a PPP structure that has been used in Norway and France, has also been mooted by commentators as a potential method of reducing capital reserve requirements of PPP project loans once construction is completed. Under a de-risked structure the public sector pays the availability payments for the relevant PPP assets and service, without any performance deductions, direct to the banks, and the project company indemnifies the public sector for any performance deductions. Under Basel II, the banks’ capital reserves requirements during the operational phase would be assessed on the credit quality of the public sector entity rather than that of the project company, and so the bank debt is likely to achieve either (depending on the type of public sector entity involved) a 0 per cent or 20 per cent capital weighting. The incentive for the public sector is a lower cost of finance from which it should benefit economically in the form of lower availability payments, though of course the balance sheet implications for the relevant public sector entity will also need to be considered.
The implementation of Basel II has had several effects on banks’ project finance business. It has placed an even greater emphasis on risk and credit analysis of project finance loans than there has historically been in the normal course of prudent banking practice. In addition, deals are being structured from the outset with the objective of achieving the necessary capital treatment required by participating banks.
Further, to give future flexibility in the form of an additional capital management tool, deals are being concluded in anticipation of future CDOs of bundles of project finance debt – both in terms of ensuring that the structure of deals will facilitate CDOs, and in terms of banks achieving the diversity of debt (geographical and sectorial) required for a successful rating