The GI Hub’s Treatment of Infrastructure as an Asset Class in Regulations initiative aims to create a prudent but conducive environment for private investment in infrastructure. Following rigorous data analysis and extensive stakeholder consultations, a key priority of this initiative is to address regulatory barriers in the use of credit-risk mitigation instruments for the infrastructure asset class, with an initial focus on the Basel III framework of regulatory standards for the banking sector.
Recognition of credit-risk mitigation instruments in banking regulations can accelerate private investment in infrastructure
Banks are the largest financiers of infrastructure development, especially in emerging and developing economies (EMDEs). And, bank loans are less expensive than other forms of private capital: the average cost of infrastructure debt was 5.1% and the average cost of infrastructure equities was 10.2% in March 2023, according to EDHECInfra. Given that the share of bank loans in a total financing package can be increased (and therefore project profitability increased) if risk is lowered through credit-risk mitigation instruments, these instruments can offer some relief as rapid inflation and interest rate hikes intensify pressure on profitability.
Now, the wave of multilateral development bank reforms is providing the right environment to consider financial instruments and innovations that could meet the unique risk mitigation needs of infrastructure.
Currently, a large majority of infrastructure projects rely on concessional capital because it can directly reduce financing costs without any of the regulatory complications that are blocking the use of other credit-risk mitigation instruments. Many of these other instruments, like guarantees and derivatives, aren’t used up to their potential because of regulatory barriers – even though these instruments can have a large multiplier effect on private investment in infrastructure, and at lower costs to governments, if appropriately calibrated.
In addition, GI Hub data assessment determines a strong case for the use of credit-risk mitigation instrument to improve the risk-adjusted return of renewable energy or green infrastructure investments relative to non-renewable energy infrastructure investments (see below).
In this article, we explain the regulatory barriers that face the infrastructure asset class and that discourage the uptake of commonly used credit-risk mitigation instruments, and how we are working toward addressing these challenges.
Credit-risk mitigation instruments for infrastructure, and the Basel III framework
In the Basel III framework (the international regulatory standards for the banking sector), infrastructure is not recognised as a distinct asset class, so its unique requirements are not incorporated into the design of regulatory rules. This is concerning because private investments are required at scale to close worldwide infrastructure investment deficits, and the Basel III framework limits the use of internal ratings-based models that previously allowed banks to apply their own estimates of risk.
In theory, the Basel III framework allows for the reduction of capital charges in the presence of credit-risk mitigation instruments. The guiding principle is that ‘No transaction in which credit-risk mitigation techniques are used shall receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.’ In practice, the complexity of credit-risk mitigation instruments used for infrastructure means these instruments fail to satisfy the legal certainty requirements contained in Basel III, which requires that all documentation be binding on all parties, legally enforceable in all relevant jurisdictions, and continuously enforceable.
So what can be done? If we turn back to Basel III, we see the framework outlines capital relief rules for popular credit-risk mitigation instruments that include collateral, guarantees, and derivatives. Unfortunately, these rules are not conducive to investment in infrastructure.
It remains difficult to use collateral to improve financing terms for infrastructure exposures despite the asset-heavy nature of infrastructure, due to complications in liquidation and resale or transfer of ownership rights in infrastructure to private entities.
For a guarantee, the Basel III framework only accepts a comprehensive guarantee that:
- Meets the legal certainty requirement such that there are no clauses outside the control of the bank that could allow the guarantor to decline obligations
- Is issued by a lower risk creditworthy entity.
In contrast, optimal risk allocation for infrastructure recommends allocation of specific classes of risks to the entity best placed to manage them. This best practice is based on decades of sector experience that shows public and private sector parties are more inclined to form partnerships and deliver optimal performance under these conditions, and that these conditions improve the outcomes not only of the design and build phases of infrastructure, but throughout operation, maintenance, and even decommissioning.
In addition, the Basel III regulatory capital relief calculation formula uses a low-risk weight of the entity issuing the guarantee up to the share of exposure guaranteed. With a risk-specific guarantee like political risk insurance, it is difficult to measure the extent to which risk is mitigated and assign a share in total exposure, so capital relief is not provided. Governments and MDBs are willing to provide political risk guarantees as they are better placed to manage such risks, but risk-specific guarantees do not translate into lower financing costs due to regulatory barriers. Market participants seek guarantees that cover all risks comprehensively such as credit risk guarantees, or first loss guarantees. In recent years, several new and innovative initiatives have been launched to cater to this market demand.
Derivatives can hedge currency risks in moving large pools of private capital from developed economies to low-income countries in order to close infrastructure deficits, and can hedge interest rate risk over long time horizons. However, derivatives for infrastructure projects have higher notional amounts, longer tenors, and are not centrally cleared by counterparties through margining and collateralisation (periodic payments by the counterparty bearing the loss) – all the features for which higher capital charges are applicable in the Basel III framework. Credit Valuation Adjustment imposes a capital charge on potential losses from deterioration in the creditworthiness of a counterparty. These rules have reduced derivatives available for lowering currency risk for private investments from developed economies, where large pools of global private capital reside, to close infrastructure deficits in low-income countries where counterparty risk is high. The European Union Capital Requirement Regulation allows banks to waive Credit Valuation Adjustment capital charges for non-cleared derivative trades conducted with non-financial counterparties.
The way forward
The GI Hub has formed an advisory council comprising banks that lead in the financing of infrastructure worldwide, to develop and put forward market solutions that are compliant with regulatory requirements or proposals for prudent regulatory reforms considering the unique characteristics of infrastructure projects.
We are also considering pilot programs to develop innovative and scalable credit-risk mitigation instruments. On this, we are working in collaboration with governments, development banks, banks, and the private sector, and testing the compatibility of such instruments with regulatory concerns. The initiative will consider simplification of access to lower credit ratings for selected instruments.
As we move forward, the GI Hub will continue engaging closely with international regulators and standard-setting bodies including the Financial Stability Board, the Bank of International Settlement, and the Basel Committee on Banking Supervision. We will engage with regulators to ensure financial stability remains intact while supporting economic development with much needed investment in sustainable infrastructure.
Find out more about our work on Treatment of Infrastructure as an Asset Class in Regulations (TIC-R).