The bank problem

Over the same period, the natural alternative to the capital markets, bank debt, was having its own problems. Through the first half of 2008, banks faced substantial increases in their own liquidity costs, as the wholesale money markets became more and more concerned about the credit losses they faced. These increases applied particularly to medium term funding. The stronger banks could still fund themselves for tenors of up to 6 months without paying a premium, but were having to pay a premium over short-term rates for funding in the wholesale money market over longer periods (as shown in Figure 1). Banks also had to pay a premium (albeit a smaller one) for financing in the capital markets, and were finding it difficult to raise debt for more than a 5-year tenor. Weaker banks had to pay a premium even for short-term funding.

Source: CBA Spectrum

Figure 1: Banks' Wholesale term funding spreads

Hence, banks became unwilling to continue with their traditional model of borrowing short-term and lending long-term, for fear of being committed to lending at fixed margins over short-term reference rates without being able to borrow at those rates, even in the short-term. Increasingly, they match-funded their loans: they borrowed in the money markets over similar tenors to those of the loans they were making. Indeed, some countries' bank regulators are requiring such matched-funding. To avoid making a loss on new business, banks increased interest margins in line with their term funding spreads. Banks' difficulties in raising longer-term finance in the wholesale money markets also meant that many banks began to restrict loan tenors from the 20+ years that had been common to 10 years or less.

Banks also re-evaluated the risks of PPP projects as part of an overall tightening in credit standards, leading to further upwards pressure on margins and fees, coupled with financing structures that became more conservative. This conservatism has led, for example, to reductions in gearing, longer 'tails' between the economic life of the debt and the end of the project term, tighter loan covenants, etc. However, there has been relatively little change in the allocation of risk between the government and PPP Co.

This conservatism has applied particularly to economic infrastructure projects, where the project company (and hence its financiers) bear significant usage risk. Several toll road projects have seen actual traffic volumes and hence toll revenue fall well short of original projections. As a result, lenders have become very cautious about lending to economic infrastructure projects involving market risk.

This situation worsened considerably in the third quarter of 2008, following events such as the bankruptcy of Lehman Brothers, the American Government's $85 billion bail-out of American International Group (AIG), the sale of Merrill Lynch to Bank of America, and the nationalisation and government bail-out of various European banks. At this time, many banks were unable to fund themselves at wholesale money market reference rates, and there was speculation that some rates had become unrepresentative. Consequently, banks focused on ensuring that loan documentation contains 'market disruption' clauses that, if invoked, permit them to charge their actual cost of funds plus the margin, rather than the reference rate plus the margin.1

The provision by the Commonwealth of a guarantee of Australian banks' liabilities in October 2008 improved their ability to fund themselves in the capital markets, though there is a fee for this guarantee (0.70% p.a. for the 'Big Four' and other AA banks) and tenors covered by the guarantee are limited to 5 years.

Also during 2008, banks increasingly became reluctant to provide large underwriting commitments, as they lost confidence in other banks being willing or able to lend to projects, and hence in their own ability to syndicate loans. (In the past, large banks were willing to underwrite bank debt at a fixed interest margin. Typically, the arranging banks would then syndicate the debt to other market participants.) For the time being, the syndication markets are effectively closed.

Banks also have found it increasingly difficult and expensive to raise regulatory capital, as investors' concerns about future prospects increased and as banks' balance sheets deteriorated due to loan and trading losses. Consequently, and as part of an overall risk mitigation strategy of their loan portfolios, they have restricted their own final takes. In Australia, banks' final takes seem to be in a range of $50 - 150 million for most projects, though higher amounts may be available as part of a bank's wider strategy (for example, for existing clients with which it has other business). Balance sheet pressure also has led to some

banks restricting their areas of business, both in terms of products (such as loans to PPP projects) and geography, particularly away from their home markets. (Banks' increased focus on home markets often has been linked informally to governments' support for their capital bases.) Hence, many international banks previously very active in the Australian market currently may focus only on those PPP projects where an existing client is involved, and some have withdrawn from the Australian PPP market completely.

The only way to raise funds successfully from the bank market - especially for a larger project - is via a club deal, which involves a number of banks clubbing together to offer and set the funding terms. A club deal may proceed where an underwritten transaction may not, because each bank commits to a limited buy-and-hold position on its own account (i.e. no financier is reliant on a sell-down of the debt to third parties). Even then, the transaction's success is dependent on having enough banks within the club and the club holding together. Such club deals result in further upwards pressure on interest margins, as they become determined by the marginal bank.

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1 However, to the best of our knowledge, no market disruption clauses have been invoked for PPP projects.