Finance: Research, Policy and Anecdotes

Yesterday, I participated in an exciting panel discussion on infrastructure finance at the IFABS conference in Medellin, together with Eduardo Cavallo (IDB) and Alejandro Sanchez (Corficolombiana), thus combining practitioner, policy and academic viewpoints.  There are lots of things to be noted on this topic, so here just some highlights – linking also to some projects I have done in this area over the past years. First, on a theoretical and practical level, infrastructure finance (or project finance more broadly) shows several characteristics that increase cost and risk profile – large size (requiring syndicates), long maturities, a lack of collateralizable assets in the early stages of funding and repayment flows only feasible after the construction phase. There are also higher skill and capacity requirements in infrastructure compared to other financing modes. These challenges have been around for many decades and it is an on-going area of learning, both for practitioners and policymakers. This also implies that one segment of the financial sector might not be positioned well to take on this challenge by itself, nor the private or public sector independently. It also implies that there are many policy and regulatory challenges in this space and a close connection with the larger challenge of financial sector development.

Second, as pointed out by Eduardo, most of infrastructure financing in Latin America is undertaken by banks, rather than non-bank financial institutions, which would be much better positioned to do so. Specifically, pension and mutual funds are in a better position (especially the former due to long-term liabilities and the latter due to risk profile) to invest in infrastructure. My own case study for Colombia (undertaken a few years ago for the IDB) shows that pension funds are relatively well developed in Colombia, though mutual funds focus mostly on low-risk, low-return securities (also referred to as “AAA-itis”). So, infrastructure is still supported mainly by banks rather than by non-banks. On the upside, the Financiera de Desarrollo Nacional,  set up in 2011 by the government, with support from IFC and CAF, as well as – at a later stage – by the IDB, has evolved into a best practice example of public-private partnership taking on a critical role in structuring financing arrangements using a mix of instruments. It has successfully provided not only direct finance, but also been a catalyst in bringing in domestic and foreign private funding for infrastructure. However, broader challenges in long-term finance continue: how to bring a larger share of the active population into the pension fund system – mainly a problem of informality -, how to address the high concentration in the pension fund industry  and how to lower entry barriers. The ultimate challenge, however, is: how to increase the risk appetite of non-bank financial institutions?

Third, has regulatory tightening under Basel III resulted in banks moving even further away from infrastructure financing, given the recent regulatory focus on reducing maturity mis-matches? This FSB evaluation suggests that no,  but some caveats are due with such an assessment, including that the impact on infrastructure finance is likely to be slower moving than that on other segments because infrastructure finance involves fewer larger transactions, typically with longer maturities. In this taskforce report with Liliana Rojas Suarez, we point to several potential adverse effects that Basel III can have on infrastructure finance (through liquidity requirements, output floor, exposure limits etc.). Most important, however, seems the lack of infrastructure as asset class. If projects can be developed in a more standardized fashion, and if there is agreement on the different dimensions of risk and how they should be quantified, it may become easier to issue securities backed by infrastructure projects, potentially also resulting in lower risk weights. This could allow banks to finance infrastructure projects in the early stage before selling them off. It also makes investment by non-bank financial institutions in such projects more likely!

Finally, infrastructure finance is part of the larger long-term finance landscape. While the focus of researchers and policymakers has been on financial inclusion over the past decade, it is important to focus again more prominently on the challenges of long-term finance. I have earlier written about an effort to get data on long-term finance for Africa. The strong needs in infrastructure funding as well as long-term funding needs by firms and households calls for a comprehensive approach to strengthen the intermediation and maturity transformation capacity of banks and non-banks alike, taking into account their critical linkages and synergy effects.

Overview