While banks play a leading role in structuring and financing private investments in new infrastructure projects, recent banking regulations discourage them from prioritising infrastructure investments. Other private financiers are not ready to fully replace the crucial role of banks; at least not within the timeline required to close climate-related infrastructure deficits. The banking sector is important in ensuring bankability and affordability (which are top priorities amid the ongoing inflation crisis), with debt financing that is cheaper than equity financing and reduces financing costs.
As banking regulations are not explicitly defined for the infrastructure asset class, they impose higher capital charges and equity investment than appropriate. These higher financing costs either translate into higher prices for infrastructure services (straining consumer affordability), or higher government support (impacting the already record-high global government debt levels).
Overall, the regulatory neglect of infrastructure as an asset class worsens the low infrastructure investment trap, especially in emerging and developing economies which have higher infrastructure deficits and reliance on banks. This jeopardises the hope of closing the USD3 trillion sustainability and climate-related infrastructure investment deficit through private investments in the wake of crunched government budgets.
The United Nations estimates that 88% of the required climate adaptation costs are for infrastructure, 79% of global greenhouse gas emissions can be averted through climate-friendly infrastructure,[1] and 92% of the SDG targets are dependent on infrastructure development.[2]
Banking regulations discourage private investment in infrastructure through multiple channels
1. Infrastructure is not defined as a distinct asset class in the Basel Framework
The lack of recognition in the Basel Framework (the international regulatory standards for the banking sector) of infrastructure as an asset class or its subset means that the regulatory rules applied on infrastructure loans are not attuned to its risk sensitivities.
The risk weights used for infrastructure loans are typically based on the credit profile of the issuing entity (government, multilateral development banks (MDBs), or corporates). This is problematic mainly for infrastructure loans given to project finance entities which are newly created for a given infrastructure project and have no credit history. The project finance route is taken so public and private sectors can work together for infrastructure development.
Current risk weights applied on project finance loans are much higher than those seen in historical risk profiles of infrastructure projects. A GI Hub data assessment finds there is scope to reduce regulatory capital charges by 60% if historical data are used to define risk weights for the infrastructure asset class.
2. Basel III introduced an output floor
Ensuring internal ratings based (IRB) outputs are not less than 75% of those from the standardised model, the output floor was introduced for consistency between the different approaches used by banks. Prior to the introduction of the output floor, the lack of treatment of infrastructure as an asset class was not a major problem. Through the IRB route, banks could use actual risk values observed in the historical performance of infrastructure loans. While banks can still use IRB models, the output floor reduces the incentive to do so. As infrastructure projects do not constitute a large share in their total asset portfolios, banks may not adopt the IRB approach just for the infrastructure asset class. Under the standardised approach, it will be more costly for banks to finance infrastructure projects due to high capital charges.
3. A default LGD input floor for unsecured lending is applicable to the asset class
For the IRB approach, the Basel Framework has defined Loss Given Default (LGD) input floor by asset class. As regulatory rules are not specifically defined for the infrastructure asset class, the default LGD input floor of 25% for unsecured lending applies. Historical data shows that average LGD values for the infrastructure asset class are highly attractive at less than half that for non-financial corporates. The estimated capital charges based on historical LGD data from actual infrastructure projects are lower than the charges implied by the 25% LGD input floor.
Estimated captial charges for 10-year unrated infrastrucutre project loans (%): Basel III Framework[3]
4. Infrastructure projects do not benefit from new credit-risk mitigation instruments
For infrastructure project finance, risks are typically allocated to the entity best suited to handle the risk. For example, political risks are allocated to a public sector entity, while operational risks are assigned to a private sector entity. To increase the attractiveness of infrastructure investments for sustainable development and net-zero carbon emissions, governments, MDBs, and philanthropic entities are offering credit-risk mitigation instruments.
In the Basel Framework, the benefits of credit-risk mitigation instruments can be availed if the legal language of unconditional, continuous, and irrevocability is met. Project finance contracts are not straightforward and have legal obligations defined for all parties for different categories of performance outcomes and risk categories. Such contractual complexity curtails the benefits of credit-risk mitigation instruments (i.e. lower capital charges and better terms of finance) for infrastructure project finance loans.
5. Basel III discourages long-term investments by banks
Banks transform short-term deposits into loans. Infrastructure projects are long-term in nature and have highly attractive and resilient performance in the long run. The expected loss on a 10-year unrated infrastructure debt is similar to an ~A-rated corporate debt, according to Moody’s. However, the risk curve is hump shaped during the 10-year period. Initially the risk is high, and increases during planning and construction phases, then declines to very low levels during the operations phase. Banks are the main providers of private finance during the initial high-risk phase, however recent banking reforms such as higher liquidity ratios discourage banks from long-term investments. The risk thresholds of other private financiers often do not allow financing of the initial phase, leaving the construction of infrastructure assets in a state of financing crunch.
6. Credit ratings for infrastructure projects are often not obtained
Project preparation activities for infrastructure have limited funding to obtain credit ratings, and the complexity of project finance contracts makes ratings difficult and expensive to obtain - despite the Basel Framework’s high reliance on them. Additionally, many rating agencies do not follow a recovery-based approach, which should be used to rate infrastructure projects given their superior recovery rates over most other asset classes.
Some regulators are introducing reforms to support infrastructure investment
The International Association of Insurance Supervisors (IAIS) - the international standards-setting body for the insurance sector - conducted an extensive definition and data review for infrastructure investments and is reforming the Insurance Capital Standard to introduce risk-sensitive regulations for the infrastructure asset class. In Europe, the Solvency II regulations were amended in 2016 to lower capital charges for ‘Qualifying Infrastructure Investments’, and the same followed in South Africa. China’s Risk-Oriented Solvency System (C-ROSS) also has distinct capital charges for infrastructure exposures. The European Banking Authority (EBA) introduced ‘Infrastructure Supporting Factor (ISF)’ to provide a 20% regulatory capital discount to eligible infrastructure investments. EBA found that the market adoption of ISF was lower than expected.
Some other banking regulators see merit in such reforms but require more credible evidence to advance them.
Recommendations for a conducive regulatory environment
The Global Infrastructure Hub (GI Hub)’s initiative on the Treatment of Infrastructure as an Asset Class – Regulations (TIC-R) is advancing policy actions to create a prudent but more conducive regulatory environment for infrastructure investment. The initiative has formed a coalition of interested parties from across the banking and broader finance sector to provide advice and shape proposals to the G20 and standard-setting bodies.
The infrastructure asset class or its eligible subsets need to be defined with a simple, clear, and tailored taxonomy to enable market adoption of the regulatory discounts being introduced for the asset class. The monitoring exercises of regulators should include specific metrics for the infrastructure asset class in their data collection workbook. This will build confidence in introducing regulatory capital discounts for the infrastructure asset class, such as the 50-60% reduction in capital charges or low LGD input floors indicated by the Moody’s database.
All stakeholders need to collectively find a way to make credit-risk mitigation instruments work for sustainable infrastructure investments. The providers of these instruments need to meet the legal requirements of the Basel III Framework to effectively support the investments through capital discounts.
Regulatory Treatment of Infrastructure as an Asset Class
