New Emerging Business Models for Long-Term Funding of the Economy
Interview with Wim Leemen (General Manager Corporate Banking Centre, KBC Bank), Lode Verstraeten (Head of Project Finance, KBC Bank) and Filip Tanghe (Partner, Allen & Overy)
Interview by Ignace Combes and Bjorn Cumps from the Vlerick Centre for Financial Services, Vlerick Business School.
The Vlerick Centre for Financial Services – KBC Corporate Partnership
KBC is very pleased to now become a chair partner for the Vlerick Centre for Financial Services. As a socially responsible company, we believe it is important to support focused scientific research and education that can foster the development of the financial services industry in Belgium and abroad. In the same context KBC also thinks highly about the continued education of people which will also be stimulated by this initiative. The Vlerick Centre for Financial Services is very close to the heart of a leading financial institution like KBC where customer focus/client centricity, performance and innovation are key priorities. - Johan Thijs, CEO KBC Group –
Allen & Overy is a member of the Vlerick Centre for Financial services
What are the most important reasons for the increased mismatch between LT capital supply and demand?
Wim: What we have seen over the last couple of years, after the fall of Lehmann Brothers, is that the disintermediation process in Europe is gaining pace. Funding and capital pressures have severely constrained lending in the Eurozone. Therefore, we have also noticed that, in respect of lending, corporates especially had to look for alternatives. In the Euro-zone bank credit to non-financial institutions decreased from €900 billion to €825 billion. Simultaneously, debt securities increased from €650 billion to over €1000 billion (Source ECB, SG Cross asset Research/global asset valuation). There are 3 main reasons that explain this. First of all, there is the tremendous increase in bank regulation, especially related to the higher capital ratio. This can be seen in an Allen & Overy survey called “the Basel tower”. Secondly, systemic risk and divestment by foreign investors. The severity of the recent sovereign debt crisis especially on weak sovereigns was a catalyst for many investors to cut and significantly reduce their exposures (mainly USD investors) to European banks. This has caused problems with wholesale funding by some European banks. And finally, the decrease in European securitization which nearly came to an end in 2008.
Let’s focus on the disintermediation in Europe, and contrast this with the situation in the U.S. Traditionally, the U.S. is more of a debt capital intensive market. There are several historical reasons this, with at the core, a high involvement in public interest projects. This trend was already well developed at the end of the 19th century with huge investment programs, especially in public infrastructure. But also, the impact of the Glass-Steagall Act, which separates commercial and investment banking and which has been eased in recent years. In Europe, the main source of funding for corporates has always been traditional bank funding. If we look at the data for 2012 we see that in the Eurozone credits were €4,640 billion versus €978 billion in bonds whereas in the U.S. credits were $1,641 billion versus $5,415 billion in bonds (Source ECB, Federal Reserve Data for Q3 2012 in the US and OCT-NOV 2012 for the Euro area). This illustrates the 80/20 (Euro-zone) versus 20/80 (U.S.) rule.
Increased regulation is certainly a major factor in the mismatch in the long-term financing sector between the supply of and demand for capital. Basel III has had a major impact on the banks’ asset-and-liability (ALM) management, for example, the requirement to have coverage in stable funding/weighted long-term assets of more than 100%. But the requirement that banks increase their capital after 2008, is certainly also an important factor in creating this mismatch.
What we need in Europe is an originate-to-distribute (OTD) model. This is the model where banks originate the credit and sell or securitize part of it at origination. The European model has traditionally been an originate-and-hold model. The OTD model has been heavily criticised, given the sub-prime securitization problems, yet, what we now see is that this market is picking up with new interested parties becoming involved such as institutional investors (pension funds, insurance companies, …). As to the prospects of the OTD model, we don’t really see a way back. In the future, banks will on average have to make a RoRWA (Return on Risk Weighted Assets) of between 160bp and 200bp (see also Bain & Company 2013, European Banking; Striking the right balance between risk and return) in order to remunerate capital. Given continued deleveraging, the banks will have to generate more fee business and part of that fee business will come from the debt capital markets. We will focus more on this model, later in the interview.
What are the main inhibitors preventing the OTD model from taking off more rapidly, as long-term funding is so crucial?
Filip: Focusing on European private placements, there are still important differences between the U.S. and European models. The U.S. has long benefited from an active private placement market, where companies can raise finance by offering a small group of chosen institutions (often pension funds and insurers) the chance to invest in their debt. The US private placement market also adopted well-established standard documentation and a common approach to documentation.
With the exception of Germany, which has a vibrant Schuldschein market, few other countries have traditionally seen this as an attractive route to raise finance, especially when banks were better placed to lend than they are today. Since private placements in Europe operate nationally, rather than as part of a general European market, the transaction also tends to be in the local currency, avoiding cross-currency complications such as swaps. But there are disadvantages too. The European private placement market still has to deal with regional approaches, with countries adopting different regulations (eg bank monopoly regulations, national tax regulations) and non-standard documentation. I think the sector is now looking for more standardisation and ultimately this will benefit both the funders and the borrowers. Finally, this market maturity does not happen overnight. If we look at the U.S. we see that this very mature private placement market is the result of decades of evolution. We cannot expect to just copy this in Europe. This will take time to develop.
Focusing on the insurance companies as institutional investors, there has been a lot of uncertainty around Solvency II and how this will impact on the institutional investors’ appetite in the future. While a political agreement on Solvency II has now been reached, it will need to be implemented. We are currently seeing these institutional investors playing a more important role in the OTD model, eg project finance.
Lode: The regulatory frameworks applicable to both banks (Basel III) and institutional investors (Solvency II) has indeed a big impact. Especially when, like Filip has already mentioned, Solvency II could result in the same constraints on institutional investors as on banks now in relation to long-term debt. Institutional investors are now becoming important players in these new long-term financing models but if they are hit with comparable constraints there is a risk that they will also refrain from these long-term financing models, which will have a particular impact on capital intensive infrastructure projects, which would be a negative step.
However, not all projects and long-term funding will pass through institutional investors’ markets, which at this stage are primarily focused on the bigger projects. As a consequence, local and smaller projects will still rely on bank financing and, as a consequence, governments will have to understand that the notion of long-term may shift from what is now 20-30 years, to perhaps 10-15 years. This will result in long-term infrastructure projects being funded and re-financed to complete the 20-30 years cycle with, of course, the resultant interest rate risk. Of course, that means more uncertainty, less predictability, hence a different risk approach. If we focus in on that point for a moment: most governments now demand certainty and therefore a flat availability payment in the long-term for their infrastructure projects. However, if they were to accept a revision of these availability payments at refinancing date, they could stimulate the funding market. An element to take into consideration is that this could even match the economic cycle: in times of crisis and low economic activity the interest rates applicable to (re)financings and overall taxable income tend to be low. When indeed they need to refinance in times of higher interest rates, this will typically be accompanied by increased economic activity and higher revenues from taxable income. There is a certain natural hedge between their income and their funding cost that can to a certain extent absorb the interest rate risk.
As regards the impact of regulation, and more specifically of Solvency II on institutional investors, how would you qualify this risk and are there other risks?
Filip: We have seen the start, especially in some of our neighbouring countries, of a more active insurance market, lending directly to corporates. Regulators sometimes question whether alternative investors have the right internal risk structures, tools and competences to do so. This is one of the main reasons why the European Commission is in the process of imposing new regulations on the shadow banking industry. This is to prevent debt funds and other funds from starting to lend directly without any limitations, without constraining regulations, supervision or transparency.
Lode: Regarding those competences and capabilities, what you see is that these institutionals sometimes buy entire teams that used to work in banks. But that is mainly reserved for the bigger players in the industry. Smaller or mid-sized institutionals therefore are more keen to work alongside banks in direct lending, especially in a rather complex area such as project finance. Another risk I see is again the risk of over-regulation. We now have new and interesting financing models where banks and institutionals work together in, for example, project financing, and we should be careful not to inhibit models that work.
Filip: That is right, but even there a distinction needs to be made between the very large projects and the smaller, local projects. The bigger institutionals will probably remain active in large international projects but what about smaller Belgian projects? Again, for these smaller local projects it seems that the OTD model, where banks and institutionals work together, looks like an interesting model.
What different win-win models could there be between banks and an insurance company. KBC is both a bank and insurance company. Is that an advantage? How do you collaborate? Are there constraints or conflicts between the models?
Wim: Today KBC bank has started cooperating intensively with KBC insurance on this. And yes, the bank side and the insurance side each have their own goals and constraints. What we do see is that, for example, in public tenders for social housing projects with traditionally long tenors, insurance companies have made their entrance. Banks simply cannot compete with the prices insurance companies are offering. Ageas, Axa, KBC insurance are all quite competitive in this market. So here, KBC Bank and Insurance have made a combined effort to tender together and structure the deal. This is a win-win, as KBC bank has the expertise and is competitive and interested in the short-term part of these deals and KBC insurance has an interest in the long-term part. Our main interest in making this combined effort is targeted at low-risk, long-term social housing projects where we can also contribute to the community.
Lode: From a project finance point of view in general, I would say that the involvement of insurers in direct lending works at different speeds. There are, on the one hand, the large insurance companies like AG, Allianz, Axa, …: they acquired teams from ex bankers, and as such have or are building the in-house capabilities to become involved in large international direct-lending projects. In the second-tier market, there are a number of mid-scale insurance companies also looking at that market to benefit from interesting long-term yields in the “real assets” asset class, but often without possessing entire teams and specific expertise. They are therefore keen to work alongside banks with proven expertise in the field and, as such, KBC Bank can create win-win solutions with these mid-scale insurers.
One of the win-win solutions in the way the financing of these deals/projects are structured, is for instance, banks focusing on shorter-term financing and institutionals on the longer tenors. Once projects come into operation and the main risky construction period has passed (construction, delays, cost-overruns, …), insurance companies step in for the rest of the long-term funding period, sometimes with banks staying in for a few additional years to show an aligned interest. That is a clear win-win as banks are interested in tenures up to 10-15 years and insurance companies are focused on long-term investments. Banks have expertise on how to structure these kind of projects and how to asses risks. Insurance companies benefit from this expertise and take up the remaining long-term funding part as part of the deal.
Filip: The figure below gives a good overview of how these deals can be structured. The left-hand side (green) shows that in the first period the banks finance the construction, the CAPEX, being the project cost of the project. Once the project becomes operational, the institutional investor takes over and refinances the construction lenders. Another possibility is that both the bank and the institutional investor step in at the beginning of the contract each offering one tranche: the bank the short-term tranche and the institutional investor the long-term tranche.
Lode: Indeed, and in addition, the red part shows the aligned interest between both. The red part shows that banks do not just create a product that they then pass on to the insurers, but remain involved and at risk for a certain period after the construction period. This gives comfort and shows the bank’s commitment to their institutional partner in these structures.
In these kind of structures, how do you then include or give access to the debt markets?
Filip: We currently see a very active project bond market, with deals that have reached financial close in Spain and Turkey. Project bonds, at their simplest, are bonds issued publicly or privately to the domestic or international capital markets which finance the whole or part of a project. Again this trend builds upon a long well-established U.S. tradition of using bonds to finance public infrastructure projects. Most of the placements are offered to institutional investors and require a rating. Capital markets may provide access directly to fixed rate or index-linked funding, thus eliminating the need for separate hedging arrangements, and may provide access to longer-term funding other than traditional funding sources. To stimulate the use of capital markets for long-term infrastructure funding and to attract a suitable rating, The European Investment Bank (EIB) has launched the Project Bond Credit Enhancement Scheme. The EIB either funds part of the financing through a subordinated mezzanine loan (so called “EIB funded structure”) or by providing a Letter of Credit (so called “EIB unfunded structure”). This credit enhancement technique for project bonds is now also being used for an infrastructure project in Belgium called “A11 (Bruges)”.
Lode: It is a promising way of structuring, yet primarily feasible for large capex-intensive projects of which “A11 (Bruges)” is indeed a good example.