Effects of Basel III on the business segment of internacional project finance.

Abstract

The origin of this work is to be found in the subprime crisis and the resulting chain reaction via the financial crisis and the global economy crisis to the Basel III regulatory framework. The losses of the financial crisis had a direct impact on the banks’ capital value and thus on the leverage ratio. As a reaction to the financial crisis the Basel Committee was once again forced to act and, as a result, they published a first draft of Basel III in 2010. The international project finance has its origin in capital-intensive major infrastructure projects where the financing amount mostly ranges from hundreds of millions of euros or up to several billions of euros which are in jointly structured and financed by a number of global banks. Project finance has been established on the market as a safe and reliable financial product. Because of their special character with long-term agreements, market fluctuations only have little to no effect on running projects and that is why projects in operation do were largely not affected by the financial crisis. Also the long planning and start-up phase led to downstream effects of market fluctuations and had no immediate impact on project financing structures. However, the mentioned chain reaction from the financial crisis to the new regulatory framework of Basel III has led to a review of the impact of Basel III on the project finance sector. On account of a huge number of changes of the economic and legal framework conditions, classic project financing finds itself at a crossroads. The financial crisis and, as a result, the stricter requirements of Basel III regarding the granting of credit have rendered the financing of projects more and more complicated, especially in view of the changed willingness of the banks to take risks. The legal and regulatory framework conditions have also become more complex in the project financing business segment. This is why it has to be feared, for example, that the Basel III equity depositing regulations for risk-carrying credit will be tightened and, as a consequence, entire projects may be doomed to fail because of the increased cost structure for investors. Nevertheless, in spite of changed basic conditions it is to be expected that there will be a demand for suitable financing opportunities in the area of the financing of major, capital-intensive projects in the future. Insurance companies and other institutional investors are also facing massive problems with regard to the long-term investment of assets at favourable risk conditions and ROI terms (e.g. the reflection of guaranteed interests on life insurances). The empirical research strategy presents a precise definition and analysis of the hypotheses. Furthermore, the research strategy elaborates the impact of the framework conditions on the business segment of project finance. In conclusion, the research strategy has the focus on the following three crucial points: • Can the impact of Basel III be defined or at best measured within a standardised project finance case study? • Can the first project finance-related consequences of Basel III already be seen on the market? • Can solutions for the project finance market be identified? One of the central questions to be answered is whether classic project financing models can still be used in the future and whether there are possibilities / potentials for the advancement of project financing. Consequently, the overall objective is to find answers on the following hypotheses: Hypothesis I: The increase in capital costs resulting from regulation renders the implementation of large projects within the scope of project finance more difficult. Hypothesis II: With a downturn in demand or declining profitability, project finance loses its relative appeal in the orientation of the banks' business policy. Hypothesis III: Project finance has to be complemented by other forms of financing, or replaced, to financially ensure the realization of large projects also for the long-term. Within the scope of the previous information, analyses, characteristics of the subject of investigation and the research design will be defined. Due to the process of elimination there is no quantitative research method available and the selection process preceeding the case study research is the best suitable research design. In the further course of the empiric investigation the epistemological foundations together with the principles of the case study research led to the criteria-based selection of appropriate cases. As part of the criteria-based selection of appropriate cases, three major cases were been determined: field research, data analysis and literature review. The empiric investigation of the project finance business unit transfers the developed case study into a practical approach. For each case there are further theoretical adjustments, a practical implementation and a conclusion. In the conclusion, the results of the individual cases may not be linked to each other. Finally, the individual results of the single cases were analysed and evaluated in a case-cross-border analysis. The derivation of the same results from different data sources is triangulation, which forms the basis of qualitative research for scientifically recognized and reliable findings. This combination increases the internal and external validity of the results. Before the findings were transferred to a new and future-oriented project finance model, expert interviews excluded possible errors and generated a higher external validity. After an evaluation of all the results in the result analysis, the results will be transferred into a sustainable project finance model. This validity will answers along a chain of evidence and exclusions the scientific hypotheses and questions. The results of the case study research represent a mix of different financial products. The financial crisis and, as a result, the stricter requirements of Basel III regarding the granting of credit have rendered the financing of projects more and more complicated, especially in view of the changed readiness of the banks to take risks. The legal and regulatory framework conditions in the project financing business segment have also become more complex. The hypothesis can be answered as follows: Hypothesis I: Yes, this is true. Within the first case, the combination of field and laboratory research shows the impact of the changing regulatory framework conditions on the commercial bank facility, the dominating financing form. The impact on the banks’ internal process costs and the underwriting fee is so marginal that they can be neglected in the overall calculation. Basel II do not classify different types of banks, as it will be done under Basel III. In addition, Basel III also attempts to address varying market conditions with the countercyclical buffer. A first result illustrates that the spread between two varying ratings under Basel II is lower than under Basel III and thus ratings are gaining importance under Basel III. Consequently, the demand increases disproportionately for projects with a better rating and the interest in projects with a lower rating falls disproportionately. The equity provision under Basel II is significantly lower than in all calculation bases under Basel III. Furthermore, the larger the bank the more capital must be provided. In an extreme case almost twice as much equity has to be provided. Basel III will have a negative impact on project finance and that is particularly due to the high financing volume, the long loan maturities and the rather average rating. Hypothesis II: No, not necessarily. The calculations in Case I and in the sustainable project finance model have shown that the most powerful weapon is the margin range. In a balanced and offer-driven market the margin rates are so high that the banks are in a very profitable area and in a demand-driven market, there are good solution approaches which are summarised in the following hypothesis. Banks with a low accumulated profitability in the project finance business unit across the overall economic cycle have to reorganize their business unit or abandon the project finance business unit with the implementation of Basel III in 2019. Hypothesis III: Complemented – yes, but not fully replaced. First of all, a new or adjusted regulatory framework of Basel III especially for long-term project finance, will probably not be achieved. The results of the case study research represent a mix of different financial products. Nevertheless, in spite of changed basic conditions it is to be expected that there will be a demand for suitable financing opportunities in the area of the financing of major, capital-intensive projects. Finally, it is becoming apparent that there are two not entirely unknown financial engineering techniques, where raise hopes for a successful future of the project finance market. Therefore, development banks have to be increasingly supported in the future. Another solution approach lies, in fact, in the combination of the standardisation and separation of the project phases, but this solution approach can be used both with project bonds and development banks. The featured solutions which cannot be determined mathematically, like the shorter loan life through mini-perm financing or smaller commitments through additional funding, have already been discussed in detail in the expert interviews. When transferring the results into a new project financing model the impact is determined mathematically. As a result, collaterals between 24% and 39% of the funding amount can compensate the negative effects of Basel III in economically weak periods. But from a financial perspective this also means that the ECAs have to make great efforts to achieve a compensation of Basel III. According to the experts, such an amount would be Utopian and make a compensation by ECAs alone impossible.