A raft of new regulations, designed to shore up banks’ capital and reserves, and ensure regional lenders are better-positioned to withstand future financial pressures, is expected to have a profound impact on project lending in the GCC. However, the manner and extent of this impact is difficult to gauge.

[Taqa’s project bond issuance] provides a template for the region’s independent water and power producers”

Stephen Kersley, Taqa

US ratings agency Standard & Poor’s (S&P) has warned that new capital and liquidity rules under Basel III will result in banks having diminished appetite for relatively illiquid assets such as project finance. In a new report issued on 21 January, S&P said the implementation of Basel III would curb local banks’ appetite for exposure to long-term infrastructure schemes. As a consequence, it expects project bond issuance, which has so far been limited in the Gulf region, to gradually increase. 

Changing tenors

Late last year, S&P also warned that the implementation of the Basel III framework could have a direct impact on the tenors for long-term project financing and reduce the involvement of European financial institutions in long-term lending in the GCC. This has already been a feature of regional financings since 2007, when credit constraints precipitated a withdrawal of the main Western project lenders from the Middle East.

Qatar is expected to become a more regular visitor to the debt market, with state-owned firms considering sukuk issuance in 2014

GCC banks for their part have spent recent years increasing minimum capital requirements, and in general regional lenders are in advance of the Basel Committee on Banking Supervision’s requirements. For example, Qatari banks’ average capital adequacy rate of 19 per cent in 2013 is substantially higher than the 10.5 per cent ratio recommended by the Basel committee by the end of 2014.

Basel III requirements are not the only regulatory pressures affecting Gulf banks’ lending practices. S&P also cited the adoption by the Saudi Arabian Monetary Agency (Sama) of new regulations and the likelihood of similar controls in Kuwait and Qatar that would introduce capital charges for banks lending to projects, which were previously not required.

In June 2013, Qatar Central Bank introduced new regulations intended to encourage banks to increase their exposure to the government debt market. The measures limit banks’ securities portfolios – comprising equity instruments, bonds and sukuk (Islamic bonds) – to 25 per cent of capital and reserves, excluding government debt and national bank debt. Capping banks’ security portfolios at a quarter of capital reserves forms part of an effort to transfer liquidity from the public capital markets into government securities, and enable the local debt capital market to fund the substantial project requirements looming in the Gulf state.

The underlying aim is to bolster Qatar’s financial sector in light of the considerable project spending associated with its multibillion-dollar infrastructure buildout, with big schemes including the Doha Metro and the 2022 Fifa World Cup stadiums coming up.

These regulations are unlikely to smother banks’ appetite for project lending. “There is a lot of local liquidity and I do not see any indication that regulations have particularly stifled appetite for project lending in the region,” says Samer Eido, managing partner of the Doha office of UK law firm Allen & Overy. “Certain banks have taken the necessary steps to shore up their regulatory capital, but we have not seen any of them refraining from lending as a result of this process. In Qatar at least, the deal flow in terms of project finance and general lending is increasing exponentially, with much of this drive coming from the preparations for the 2022 World Cup.”

Lending limits

In the UAE, meanwhile, limits are being placed on banks’ exposure to single-name, state-owned entities, as part of a generalised effort to reduce these institutions’ risk profile. The UAE central bank initiated a move in 2013 to strengthen banks’ balance sheets, with the granting of a five-year period to local lenders to reduce their excess balance sheet exposure to government-related entities by 20 per cent each year, with the overall cap set at 100 per cent of a lender’s capital base. Exposures to banks operating outside the UAE are not to exceed 30 per cent of the bank’s capital base.

Most UAE banks are well-positioned to meet these targets, and only two of the country’s largest banks were found to have exceeded the 100 per cent cap, namely Emirates NBD and National Bank of Abu Dhabi. These banks have been given until 2015 to comply with the ratios.

According to Chiradeep Ghosh, a bank analyst at Bahrain-based Sico Securities, the UAE has been one of the most proactive in the region in seeking to overhaul regulation and make the sector fit for purpose. “The central bank has been very active and this obviously has had some negative impacts on the banking sector in the short term, but over the long term it is a positive move,” he says.

If the impact of national-level regulations on project lending is mixed, Basel III requirements overall have exerted a dampening effect on project finance lending in the GCC. As S&P noted, the implementation of Basel III may encourage state-backed corporates to raise capital through a joint-venture scheme or structured financing, given the lower availability of long-term financing from banks.

One Gulf project finance lawyer tells MEED that a Saudi-based project sukuk it was advising on was almost killed in early 2011, when Sama communicated to banks that they should be immediately compliant with Basel III minimum requirements, which forced the arrangers to obtain a special exemption.

Phasing regulations

The negative consequences of Basel III reforms for project lending may be mitigated by adjusting the phasing of the regulations. In early 2013, banks secured a delay in the timetable to meet the so-called liquidity coverage ratio (LCR), giving them four more years. Furthermore, they are now able to choose from a longer list of approved assets, including equities and securitised mortgage debt, as they seek to build up their liquidity buffers.

Even so, Basel III will continue to constrain Gulf banks’ ability to lend long term, and project sponsors and lenders alike will be forced to consider alternative financing options. While the GCC debt markets are less active than their international peers, S&P envisages that project bond issuance will increase in the next few years.

The starting point is low, with only a few significant project bond transactions getting off the ground – a reflection of the ample bank liquidity that has existed in the local market. Furthermore, with many GCC schemes backed by sovereign-related entities that have robust creditworthiness, there has not been a pressing need for them to deploy project-related bonds.

In many cases, state-backed project sponsors have favoured corporate borrowing at the holding company level as a means of long-term investment in assets, rather than funding them directly through project financing vehicles.

There remains some scepticism about the scope for project-related debt issuance, even if Basel III and other regulations may have precipitated a need for alternatives to traditional long-term lending in the region.

“People have been talking about project bonds being the next big thing in the region for some time now, probably since the beginning of the financial crisis, and it just hasn’t happened in a significant way,” says Eido. “I see no reason why this would change now. Local and regional banks have largely filled the gap left by international banks in the regional lending and project finance market.”

A Dubai-based project finance lawyer agrees that for all the hype about project bonds, few have materialised, and there is no guarantee that the ambition of regional authorities to have debt capital markets used to finance Gulf projects will be realised anytime soon.

This is not to say that the bond markets will never have the capacity to emerge as a significant source of long-term capital for infrastructure projects. There have been some big-name sponsors that have turned to project bonds in recent years.

Landmark deal

Abu Dhabi got the ball rolling in July 2013, when Abu Dhabi National Energy Company (Taqa) issued $825m in project bonds for the development of the Shuweihat 2 independent power and water plant, in the first tradable power project bond to be launched in the GCC.

Stephen Kersley, chief financial officer at Taqa, which is the majority shareholder in the Shuweihat facility, described the bond refinancing as the first of its kind and one that would prove to be a landmark deal for Abu Dhabi, providing a strong precedent for future transactions. “It demonstrates Taqa’s ability to incorporate debt capital market solutions into complex financing structures, and provides a template for independent water and power producers throughout the region,” he said in July last year.

The raft of regulations imposed on Gulf banks clearly opens avenues for capital market instruments to account for a stronger component of project funding packages.

The global trend towards greater bond issuance to support project financing will provide an incentive for regional sponsors to consider such issuance. In the Gulf region, a noted upswing in debt capital market issuance is already under way, despite a $8bn fall in overall bond issuance last year to about $29bn, according to figures from US journal International Financing Review, as Abu Dhabi and its government-related entities stayed away from the market. Qatar is expected to become a more regular visitor to the debt market, with state-owned entities such as Qatar Petroleum considering sukuk issuance in 2014. 

The need to provide financing for the Gulf’s growing array of project activities provides a new impetus for regional banks to focus on how best they can participate with long-term lending. Regulations have proved a near-term obstacle, but if the process achieves its aim, regional institutions may ultimately be better-positioned to participate, whether in the form of project bonds or traditional structured financing models.