Q451 Lord Forsyth of Drumlean: On the secondary markets, has the stalling of the securitisation markets effectively made it impossible to have a secondary market?
Mr Waterston: In terms of the secondary market for senior debt, I would argue yes, it certainly has affected the secondary market. SMBC has an active securitisation programme, we have closed two synthetic securitisations, senior debts in PPP projects and we are working on our third one. There are several other banks which have done this. That is important to banks such as SMBC because it frees up capital which we can then use to lend in the products on a primary basis again. I would say that the fact that has stalled has meant that it has not been possible to free up capital to allow more lending to projects. That has affected the market on a fairly wide basis. We are starting to see the securitisation markets recover to a certain extent because we are working on the third securitisation vehicle at the moment but we need to see a much wider recovery of securitisation markets to have a marked impact on the market as a whole and improve the primary market and secondary market.
Q452 Lord Forsyth of Drumlean: Given the previous answer to Lord Griffiths of Fforestfach about the importance of the secondary market to reduce the cost of capital, does that mean that PFI will be less attractive as a way of moving forward because it will be more expensive.
Mr Waterston: I do not necessarily think the securitisation markets are solely linked to that. The securitisation markets are important to some banks that use securitisation to create capital so they can lend to the projects. What is resulting is that there are fewer banks in the market to lend long-term debt to PFI projects because the securitisation markets have dried up. So some of the banks that had been lending are doing less. It is really a question of whether there are enough banks in the market to lend. There is certainly no doubt that banks' liquidity costs have gone up across all forms of lending not just PFIs. It is not solely related to securitisation markets drying up but that has certainly had an impact on the amount of liquidity available to lend to PFI.
Q453 Lord Forsyth of Drumlean: Just to be clear, in simple terms, as I understood it the previous answer said that the benefit of the secondary market is that contractors would be able to refresh their balance sheets and go on to the next project and if that were not available, the cost of capital would be higher. Does it not therefore follow that if there is less capital available and if the cost of capital is higher, that the effect will be that the contractors' costs under PFI will be greater than they were before?
Mr Waterston: We need to differentiate here between the secondary market for contractors' equity stakes and the secondary market for senior debt. Being on the banking side, commenting on the secondary market for senior debt, what I am answering particularly there is the availability of a secondary market for senior debt and the fact that a securitisation market that is liquid allows us to free up capital for new primary lending. It is important to differentiate between that and a secondary market for equity stakes.
Q454 Lord Forsyth of Drumlean: I understand that but if there is less debt available, does that not mean there has been more equity and equity is more expensive and the overall thing will be more expensive.
Mr Olsen: Yes; correct, if it were the case that the debt markets dried up to a point where we needed to inject more equity to make the funding whole.
Q455 Lord Forsyth of Drumlean: For clarity, does that not mean in the current circumstances that PFI will be more expensive?
Mr Olsen: Yes, in the current circumstances, it would tend to be more expensive.
Q456 Lord Best: I would like to hear your views on the creation of a government-backed national infrastructure bank along the lines of the Scandinavians on the grounds that this potentially gives the best of both worlds. It brings all the PFI benefits, on budget, on time, whole life contracting and all that, with lower interest rates as well. What do you feel about that?
Mr Turville: Yes, the discussion on a national infrastructure bank is very topical at the moment. It really depends on what the objectives are for that bank. There has been less liquidity in the PPP market but liquidity is returning. I think we have seen the high watermark in terms of the cost of debt. Projects like the M25 where 16 or 17 banks came into the syndicate for that transaction and at one stage it looked likely that the TIFU, the Treasury bank that was established was going to be needed to fund a shortfall in debt for that transaction, that turned out not to be the case. That demonstrates that very large PPP projects can still be done but size is very much a driver of the terms which are achieved on transactions. From my perspective, it is unclear what a national infrastructure bank would actually achieve, what its purpose would be. Is it to fund shortfalls in the debt markets? As TIFU demonstrates, they have done one transaction and that need was perhaps there six or 12 months ago; perhaps there is less of a need today, apart from absolutely jumbo projects which, to be honest, we are not really seeing in the UK. We are seeing them more in continental Europe, in France in their high-speed rail projects for example. A national infrastructure bank which is there to bridge that gap perhaps is not required. There is no doubt a national infrastructure bank could apply the PFI principles that the banks apply and go through the same due diligence process as any of the bankers active in the PFI market and that is really what TIFU has already done; it has applied those principles. Yes, it could happen but the actual need to bridge liquidity has past.
Q457 Lord Best: Why do you think then the Americans seem likely to set up just such a bank?
Mr Turville: It may be to do with the scale of the transactions. The largest projects in the UK, the two I have mentioned, Allenby and Bart's, and the London Underground PPP programme, are all £1 billion or £2 billion transactions. In a number of projects in the US and high-speed rail in Europe you are talking about £5 billion to £10 billion transactions and the banks and the market are just not there for those transactions.
Mr Olsen: In the US, the banks have historically been absent from this market, the project finance market, not just the PFI market. Most of the US banks, if not all of them, prefer not to lend long term and they have been very conspicuous by their absence over many years.
Q458 Lord Best: It is just a matter of scale though. In Scandinavia the banks, who all participate in this central bank, have total lending of only about £4.5 billion, something like that over a period of 25 years or however long they have been going. It is not because of the scale; there must be a lot of relatively small projects in Scandinavia. They seem to be very enamoured with this.
Mr Olsen: Yes, that would be the case. I am not personally familiar with the process up in Scandinavia. From my perspective, I would mirror Philip's comments. What is the infrastructure bank going to do? What is its raison d'être? Is it to provide cheap finance? It can certainly do that on the basis that the state can borrow far more cheaply than the banks can at the moment; most banks anyway. Is it to fill a funding gap? I think that funding gap has largely disappeared. We are certainly not out of the woods yet but it has largely disappeared. Or is it something else? Those questions have to be asked before you can decide whether it would make sense to go ahead with that NIB.
Q459 Lord Lipsey: Sorry to jump about but can we just go back to where Lord Forsyth of Drumlean was, about the equity proportion in some of these things? I take your point that in current market conditions the equity share when funding a project may tend to be rising. Taking a layman's view, some of the examples before this Committee have rather suggested that there is really quite a small equity share in some of these projects and as a result, if they do go belly up, the people who are ultimately responsible are not losing much money and that really brings out the question of whether a true risk transfer is taking place to begin with. I would welcome your observations on that problem.
Mr Olsen: Project finance, which is the style of finance which we use in PFI, has been around for about 30 years. In particular it grew out of the financing in the North Sea in the early 1970s and it has always been the case that project finance uses a very high gearing rate, which is the ratio between debt and equity, typically something between 90:10 and 80:20, something of that order. The structures which have grown up around PFI therefore grew out of that method, that system of finance. The passing of risks, yes, you are right, if equity has only 10% say in the total funding you could argue that equity is only taking a relatively small part of the risk. However, what one must not forget is that the remaining 90 or 80% is still coming from the private sector, albeit in the form of debt rather than share equity. The risks are still being passed to the private sector, it is just that banks, or the capital markets in the case of bonded projects, are taking the lion's share of the risk with equity providing an equity net. They sit at the bottom of the pile if a problem happens. Equity takes the first risk with senior lenders taking the second or third layers of risk depending on the financial structure.
Mr Waterston: The other point to add to that is that the sub-contractors also take a high degree of risk even if they are not putting equity into the project. If you are an operational contractor, you are typically taking 200% of your annual fee as a risk and if you under-perform you get terminated, which is a very large incentive to a lot of operational contractors; a building contractor is also taking a massive risk if it cannot complete the project on time.
Q460 Lord Griffiths of Fforestfach: If, on the other hand, equity holders were to walk away when things went wrong, would it not be disastrous for their reputation? If they want to survive in this market and play a role going forward, it seems to me that is not the way to go about it.
Mr Olsen: Yes, it is a small market. It is a relatively small group of institutions which play and, absolutely right, there is a reputational risk for everybody in this market. You do that once; I suspect you might just get away with it. You do it twice; you are going to have banks and funders walking away and not supporting your bids and presumably the public sector too will get a very clear steer as to which bidders are reputationally sound and which are not. Yes, there is a very strong reputational risk in the process. Again, I suspect a kind of self-policing goes on.
Chairman: That probably covers most of the ground that we were expecting from this session, so if no members have any other questions, we will draw to a close. Thank you very much indeed for spending the time with us and for your answers. We look forward to that additional little note on Norwich. Thank you.