The Hindu Business Line : An alternative model for infrastructure funding — Transferring loan assets from banks by pooling securities that can be sold to investors

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An alternative model for infrastructure funding — Transferring loan assets from banks by pooling securities that can be sold to investors

Padmalatha Suresh

Securatisation is here
Banks set to play a key role in delivering infrastructure assets.
The regulator must explore and adopt new options to enhance the attractiveness and liquidity of this asset class to investors.
Some answers could be: Collateralised Debt Obligation which constitutes an asset pool with varied risk and return profiles;
Credit derivatives, a risk transfer mechanisms preferred by banks; or
Organised market syndication, an im portant mode of diversifying credit risk, that is booming globally.

One can almost hear bankers heave a collective sigh of relief. The RBI's detailed document on `Securitisation of Standard Assets' signals that `Securitisation' in India has come to stay.

Simply put, securitisation involves transfer of loan assets from the bank (the `originator') through pooling and re-packaging by a Special Purpose Vehicle (SPV) into securities that can be sold to investors. Securitisation benefits banks by providing liquidity to loan portfolios and mitigating credit risk by removing assets off banks' books.

But applying the RBI's securitisation guidelines in their present form to infrastructure financing in the country would be difficult because the characteristics of large project financing are potential weaknesses in a securitisation.

The RBI's document on `Securitisation of Standard Assets' therefore, falls short of addressing the exacting demands and the unique risks of financing the `crying need of the hour' — infrastructure.

Why should large infrastructure projects be treated differently? Consider two recent projects financed by Private Public Partnership (PPP) projects in India — the Noida Toll Bridge and Bangalore International Airport. Each of these is based on a single, very large asset, with substantial upfront investments expected to be followed by cash flows spread over several years. If successful these projects could generate significant financial and social returns, but also likely are the possibilities of failure and hence, financial distress.

The project assets — which form the lenders' security and generate the cash flows for debt service — are indivisible, immovable, have specific use, take a long time to construct and assume value only after construction is complete. In both the above-mentioned projects, lenders have assumed considerable financial risk (leverage over 70 per cent), and they look only to the inherently limited project cash flows for their debt service. This is called `limited recourse' lending as opposed to the conventional corporate lending, where the creditors technically have recourse to the borrower's entire assets to meet their claims.

It is, therefore, evident that such heterogeneous project loans cannot be securitised as `homogeneous' pools of assets, as is being done for retail or housing loans. So, how can the securitisation structure be modified to mitigate credit risk of infrastructure lending?

With banks set to play a key role in delivering infrastructure assets in India, it is imperative for the regulator to explore and adopt new options to enhance the attractiveness and liquidity of this unique asset class to investors.

The primary issues for project lenders are the potential illliquidity of financing long-term limited resource infrastructure transactions, and the attendant credit risks. Hence, enabling risk diversification should be the foremost objective of the regulator if the enormous funding needs of infrastructure (one estimate puts it at Rs 2,00,000 crore over the next three years) in India are to be met.

Some aspects deserving immediate consideration by the government and the regulators are:

Collateralised Debt Obligation: Let us assume the lenders to the Noida Toll Bridge and other PPP transport projects want to securitise or `sell' the project loans. They have the following alternatives - `sell' each asset separately, or pool them and securitise.

The first method could turn out to be cumbersome and costly, while the second would constitute an asset pool with varied risk and return profiles. Structuring a CDO would be the answer in this case.

CDO pools typically have fewer than 100 loans (retail loan securitisation pools could have thousands), carefully selected to ensure investment grade rating for the pool as a whole.

In 2002, ICICI had structured India's maiden CDO for its corporate loans, but failed to attract investors. There has not been much growth in India's CDO market thereafter (Rs 1,900 crore and Rs 2,600 crore), in contrast to the phenomenal growth in the retail loan securitisation market from about Rs 1,300 crore to Rs 25,600 crore between 2002 and 2005 (ICRA).

It is hoped that the earlier failure will not deter the regulators from creating the right environment for a vibrant CDO market.

Credit derivatives: CDO structures will have to be supported by strengthening bond markets and credit risk transfer mechanisms. After issuing draft guidelines in 2003, RBI has not pushed the extensive use of credit derivatives in India. With adequate regulation, the advantages of using credit derivatives in project finance will outweigh the risks. Credit derivatives enable banks to transfer credit risks alone without taking the assets off the balance-sheet. Securitisation not only takes the assets off the bank's balance sheet, but also requires substantial information sharing among participants, thus increasing costs and obligations for banks. Further, the visibility of transferring ownership to a securitisation vehicle could affect client relationships and future loan activity. In such cases, banks prefer synthetic options such as credit derivatives.

Credit derivatives are also an option for investors unwilling to participate in the securitisation market.

Organised market syndication: An important mode of diversifying credit risk, syndicated credit markets are booming globally. Syndicated credits are increasingly being traded on secondary markets, imparting immense liquidity. Data show that the Asian markets have been lagging behind in this respect.

In his third quarter review of the Monetary Policy on January 24, 2006, the RBI governor expressed concern about "credit quality in the expansion phase".

He urged banks to "undertake a comprehensive review of credit quality, with special reference to those sectors where credit is expanding rapidly."

Where has most of the credit gone? The review provides the answer — significant increases to infrastructure sectors such as power, iron and steel, roads, ports, engineering; automobiles, chemicals, textiles, gems and jewellery, petroleum, coal products and nuclear fuels; and services.

With infrastructure shifting to the forefront of lending activity, there is an urgent need to treat large projects differently at the regulatory level. Banks' lending capacity could be constrained if margins are volatile and capital weighting requirements are made more stringent. Will the RBI bite the bullet?

(The author is a finance consultant and visiting faculty at IIMs. Feedback can be sent to padmalathasuresh@yahoo.com)

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