Basel III has now been adopted into law in the United States, European Union and Japan. The members of the Basel Committee on Banking Supervision substantially agreed the new accords in 2010 and Basel III is intended to be an evolving framework for capital adequacy and enhanced liquidity for internationally active banks. Project finance market participants, wherever they are located, are considering the effects of the new regime on their businesses.

The Basel III standards have acquired a reputation for being overly complex and costly to comply with. Despite the burden of ensuring that their balance sheets meet the requirements of these reforms, Japanese banks are well-placed to benefit from natural competitive advantages in their project finance business relative to overseas peers. Many of these peers are reducing their project finance activity as they adjust their business strategies and restructure to improve their leverage and liquidity profiles. Japanese banks have had little difficulty in meeting the Basel III standards and, furthermore, are not likely to face the same pressures to exceed the Basel III standards as many banks in the US and the EU have experienced. As a result, Japanese pre-eminence in the market is likely to be further strengthened.

Basel III’s impact on global project finance

Basel III is making it more expensive to provide project finance debt. Two new liquidity ratios, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), aim to ensure that banks have sufficient liquid assets available to adequately manage risks as and when they arise. Both the LCR and the NSFR are calibrated to measure, in a stressed-market environment, banks’ potential cash outflows (such as drawdowns on lending facilities) against hypothetical inflows derived from the activities of the bank (such as the sale of high quality assets).

Taking such hypotheticals into account, however, drives up banks’ cost of business and affects the pricing of loans. Lenders and borrowers will continue to negotiate heavily over who is to bear the costs of Basel III compliance.

The LCR, which imposes short-term liquidity requirements, requires banks to hold enough liquid assets (such as government bonds) that can, if needed, be converted easily into cash in private markets to survive a 30-day stress scenario. Among other requirements, banks would need to hold high-quality unencumbered liquid assets in an amount that is at least equal to its liabilities for any undrawn amount under a revolving credit facility, to the extent that these are a feature of any project finance transaction’s structure).

The NSFR, on the other hand, imposes long-term liquidity requirements. From 1 January 2018, the NSFR imposes requirements that aim to prevent banks from relying on wholesale short-term funding to fund long-term assets, by requiring banks to maintain stable funding for their activities over a one-year horizon. The NSFR counterbalances the cliff-effects of the LCR, by providing offsetting incentives to fund liquid assets with short-term funds that mature just outside of the LCR’s 30 day stress-tested period.

Despite the phase-in of the LCR (the minimum requirements rise 10% year-on-year from 60% in 2015 to 100% in 2019) and the delayed effective date of the NSFR of 1 January 2018, many banks have begun to withdraw from project finance lending on the basis of the expected rise in the cost and feasibility of long-term, illiquid lending and the resulting adverse impact on their liquidity ratios.

Loan tenors, however, have already shortened as a result of the cost of providing long-term debt (mainly due to the requirement to maintain stable funding under the NSFR), and as lenders look to ensure sufficient liquidity across their balance sheets. There is apparently relatively little appetite, post-financial crisis, for loan tenors of more than 15 years.

But concern that loan tenors may shorten so much that the financing of large-scale projects is no longer feasible is, however, certainly misplaced, as banks will inevitably seek to manage their commitment to long-term exposures in other ways. A traditional solution would be for a bank to securitise its loan book. Other options include short-term mini-perm facilities that would, for example, assume a repayment of debt after a limited period of time (typically, around five to seven years) through re-financing, but with an amortisation profile extending beyond maturity.

Mini-perms are often used on large-scale projects, and many Japanese banks have shown an interest to participate in such transaction structures. Such facilities are not without dangers, because no bank would want to hold a loan with prohibitively high interest if it proves that refinancing is not possible. In any case, banks will want to be able to commit to shorter project finance loans by drafting documentation to allow easy transferability of loans, and will seek to do this without borrower consent to ensure strong liquidity across loan portfolios.

The Japanese perspective

Few corners of the world are untouched by Japanese project finance interests. There are two main reasons for this: Japanese investment strategies naturally suit investments that yield a stable cash flow over a long period rather than short-term gains and, weak domestic demand for loans over the past decade has caused Japanese banks to look overseas for investment opportunities. Japanese government support on many project financings, mainly through its export credit agencies and government-owned financial institutions, has also assisted Japanese competitiveness in the project finance market. Japanese banks’ pre-eminent position in the market pre-dates the implementation of Basel III in the US and EU. But there are reasons to suggest that the global implementation of Basel III is likely to further increase the competitiveness of Japanese banks relative to their overseas peers.

US and EU banks are finding it costly to comply with Basel III as a result of national implementing rules that, in many cases, exceed (or are proposed to exceed) Basel III. Further, shareholder pressure is forcing many banks to go further than the minimum requirements. Japanese banks, on the other hand, do not face similar pressures. The significant costs that US and EU banks face in meeting onerous Basel III requirements is affecting their appetite to make project finance loans, at the same time as Japanese banks’ appetites in the project finance sector remain strong. Japanese banks to a large extent survived the financial crisis in a relatively strong position (largely due to limited sub-prime involvement) and are approaching Basel III compliance with relatively robust balance sheets. This makes any required equity capital-raising and the meeting of leverage requirements less difficult to achieve.

In the US and EU, there has been a race to the top on the part of many banks that want to show strong capital ratios relative to their peers. Japanese banks, on the other hand, are operating in an environment where comparable regulatory and market peer pressure does not exist. Japanese banks are, in most cases, unlikely to volunteer to significantly exceed the Basel standards, despite upward market pressures to exceed Basel III in the US and Europe.

The shareholders of many UK banks, for example, appear to be pressuring banks to ensure solvency by moving towards core equity tier 1 (CET 1) capital ratios that far exceeding those required by Basel III. CET 1 is the ratio of required capital relative to a bank’s risk-weighted assets, which is of the highest quality and most loss-absorbing form, relative to other capital.

Further, there are reports that the UK government may interpret the Basel III implementing rules with the flexibility that EU law allows, to insist on significantly higher CET 1 ratios than required under Basel III, at 13%. This is about 5% higher than the ratio to which many banks are currently subject, and would force UK-listed banks to raise an additional £100 billion of equity capital. The US is set to implement a higher-than-Basel III 4% ratio for the largest banks. According to the Basel Committee on Banking Supervision, Japan has no implementing provisions that are super-equivalent to Basel III.

US and European lenders, previously dominant in the project finance market, are likely to remain constrained by Basel III, and many more may consider leaving the market to some extent. Japanese banks will fill the gap, as Bank of Tokyo-Mitsubishi UFJ’s acquisition of Royal Bank of Scotland’s £3.9 billion project finance loan portfolio, agreed at the time of the Basel III accords, demonstrates.

Japanese bank lending volumes, 2005-2013


Source: Infrastructure Journal

Basel III is having a global impact on banks’ business structures and strategies. While many Japanese commentators have protested that reforms may be unnecessary in the Japanese context, the reforms may create a competitive advantage which is likely to further strengthen Japanese pre-eminence in the project finance market.