Securitization in Infrastructure Finance

Bank loans are the dominant source of financing for infrastructure projects. This is truer in the case of developing countries like India, wherein more than 70% of all infrastructure projects are completely or partially financed by banks. The problem is that infrastructure loans tend to be extremely long term in nature. Banks, on the other hand, accept demand deposits which have an uncertain duration. Also, most certificates of deposits sold by banks have a short term duration. Therefore, there is an inherent asset-liability mismatch as short term liabilities are being used to fund long term assets. Most of this financing is happening upon the assumption that the banks will be able to recycle their deposits if required. However, this is an obvious systemic flaw since if the banks are not able to recycle their deposits, the result would be bank failures and bank runs.

It is easy to see why using bank financing for infrastructure loans is not very desirable. Also, new banking norms such as the Basel III regulations penalize banks for lending money to extremely long term infra projects. There is an obvious need to find a better alternative. This is where the concept of securitization has caught the fancy of many financial experts. In this article, we will understand how securitization can improve infrastructure financing.

Securitization in Infrastructure Financing

Securitization is the process of converting long term illiquid bank loans into highly liquid tradable securities. For instance, a $1000 bank loan can be converted into 1000 bonds worth $1. These $1 bonds can then be bought and sold on the stock exchanges, making them extremely liquid. These securities are called pass-through securities.

The advantage of using securitization is that banks can recycle their capital. Instead of being stuck in the same project for several years, banks can fund several projects. Securitization also helps satiate the ever-growing demand for high yield debt instruments. Individuals, as well as institutions, are willing to buy and hold on to securities since they are extremely liquid.

From the above description, it does appear that securitization is the ideal solution for problems related to infrastructure financing. However, that is not the case. Securitization itself has certain disadvantages. For instance, there are not many investors who are willing to buy securities from projects which have not started generating revenue. There are several other such issues with securitization, which have explained below.

Disadvantages of Securitization

• Difficulty in Risk Estimation: For security to be marketable, investors must clearly understand the risks involved. This is simple when the securities are being sold by corporations. However, in the case of infrastructure projects, the securities are sold by special purpose entities. This complicates matters a lot. This is because the entire concept of SPE has been created to diversify risks amongst various stakeholders. As a result, in an infrastructure project, some risks are under the purview of the infrastructure company, whereas most risks have been outsourced. For instance, the risk of timely completion of a project can be outsourced by giving out turnkey contracts that levy demurrages on the late execution of the project. Hence, risk estimation in an infrastructure project turns out to be a complicated exercise where the financial position of several stakeholders needs to be predicted.

• The problem with the securitization of infrastructure projects is that the loans seem to be large in size. As a result, only a few loans can be bundled up in every lot of securities which is issued. This is against the law of large numbers, which forms the basis of securitization. The idea is that a large number of diverse loans cannot all go bad at the same time. The large size of the loans makes predicting the risk difficult.

• Difficulty in Credit Rating: Credit rating agencies are not equipped to rate infrastructure projects. Most of them do not have a defined methodology. Only Standard and Poor has been able to publish its methodology until now. This is because of the fact that infrastructure projects tend to be complex. Evaluating a single infrastructure project is difficult in itself. Combining the cash flows and other financial elements of several different projects is a challenging task.

• Income Tax Issues: Lastly, the process of securitization only works if the tax regime of the country is favorable. This is because the sale of loans from the bank to a third party is considered to be a service. This could mean that a lot of taxes may be applicable to such sales. The problems are that taxations eat into the profits and therefore push the yields higher. In many countries of the world, the yields become so high that the idea of securitization loses its advantages. The transaction costs end up becoming greater than the benefit, which may be derived from securitization.

It would, therefore, be safe to say that although securitization is a useful technique, it is not free from encumbrances either! Depending upon the level of development of the financial ecosystem as well as the taxation rules, it may or may not be favorable.