The constantly changing regulatory landscape is altering the way debt markets operate. Norton Rose's Kenneth Gray and Alison Baxter look at the new measures used to access liquidity

Since the 2008 global financial crisis, banks and other financial institutions have been hit by a tsunami of regulatory proposals.

Take for instance Basel III (and its European offshoot, CRD IV-CRR); the Vickers and Liikanen reports; the proposed single supervisory mechanism; recovery and resolution proposals for banks in the European Union; Dodd-Frank in the US; Solvency II for insurers within the EU; and the Financial Stability Board's (FSB) proposals for shadow banking.

The volume and complexity of new regulation has been routinely criticised as the root cause of the continuing financial challenges.

Compliance by a financial institution with these proposed regulations – in all its business sectors and everywhere it does business – will be a Sisyphean task, made more difficult by continuing debate over just how the financial sector should be regulated.

Even under the currently proposed regulations, the new liquidity standards and capital ratios put forward by Basel lll, as well as the ring fences suggested by Vickers and Liikanen, will push banks away from long-term structured products towards other, supposedly safer, activities.

This constantly changing regulatory environment, combined with the continuing fallout from the global financial crisis and uncertainties within the eurozone, has fundamentally transformed the market for long-term structured debt and the role of banking lawyers advising both borrowers and lenders.

While debate continues over the shape of a new regulatory framework, infrastructure still needs to be built, energy projects financed, natural resources extracted, and aircraft and ships delivered.

A new way of financing these vital assets is springing up to address the funding gap and although common themes are emerging, no two clients, countries and projects are the same. A bespoke approach is needed.

Which way to go?

Clients are asking two questions:

• If the traditional sources of liquidity for much of the world – the commercial and investment banks – are required to reduce the debt funding they make available, what will replace them?

• If the availability of the traditional debt product – the bank loan – becomes further restricted, what alternative products can take its place?

In 2011, the corporate debt in continental Europe provided by banks was more than 80% and, in the UK, 70% (compared to less than 30% in the US, where the capital markets are much more active).

Those levels will be unsustainable in the current market and the new liquidity ratios imposed by Basel III mean those hardest hit are likely to be the long-term structured finance markets.

Borrower clients know they need to diversify their funding sources. Many are looking at institutional investors – such as insurers, pension funds and shadow banks – to plug the funding gap, either acting independently or through fund managers, or in the capital markets.

Governments, including export credit agencies and multilaterals, are also being asked increasingly to provide liquidity.

On the lending side, a number of banks have been quick to recognise the need for alternative sources of liquidity and have developed a model they call 'distribute to originate'.

They form clubs with less experienced banks and other non-bank financial institutions who have no, or limited, expertise in the relevant field but who trust the lead bank to originate safe and profitable business.

Non-bank investors face their own regulatory challenges, exacerbated by the lack of certainty concerning Solvency II and the FSB proposals.

If they are going to play a role in providing finance, their regulatory constraints also need to be taken into account, remembering that different investors face different challenges: a commoditised product that satisfies everyone does not exist.

Innovation through collaboration is emerging as a new model for the long-term structured debt markets as we approach 2020. Each institution needs to think about what they want to do, what they can do, and what they are allowed to do.

Together, this could lead to the creation of the debt solutions the market needs. Two financial structures, either completed or evolving in the European market, show how differing needs can be united to bring about a single solution.

At one end of the spectrum, structures such as PEBBLE (or Pan-European Bank to Bond Loan Equitisation) are being promoted by banks, particularly in the Netherlands.

In these structures, the funding for a project is split so that an institutional investor will provide the core funding – for example, 85% of the debt – while the traditional banks provide a subordinated, first loss tranche for the remaining 15%.

The net result allows the investors to provide relatively secure liquidity while shifting the top-slice risk onto the commercial banks.

However, structures seeking to deliver the exact opposite results – where banks keep the liquidity but move the risk onto other investors – have also been seen in the market.

An example is the 'Blue Rock' transaction managed by Norddeutsche Landesbank (Nord LB).

In this structure, the bank created a higher risk, mezzanine tranche from a Public Private Partnership/Private Finance Initiative loan portfolio which it placed with a third-party infrastructure fund (which receives an enhanced interest rate).

By divesting itself of the higher risk, Nord LB has reduced the capital charge of the loans, so freeing up its balance sheet.

Between the two examples cited are a variety of tailor-made structures which involve different investors coming together to re-allocate risk and roles to suit their particular requirements and capabilities and to maximise regulatory and economic efficiency.

State support

The government also has a role to play and a number of sections of the market are calling for greater government involvement in the provision of long-term debt.

But the government response may differ according to the country/sector involved, leading to questions such as, in cross-border deals, which states should be involved? What is the role of the multilateral?

What form should the support take: the provision of liquidity, assumption of risk, both or something else entirely?

In the same way that no two commercial investors are the same, no two governments are the same. Some will provide funding either directly or through a capital markets vehicle; some will assume the totality of risk; some will share risk.

Examples abound, including the Europe 2020 Project Bond Initiative, which contemplates the credit enhancement of senior secured project bonds to a level that is intended to be attractive to institutional investors.

Credit enhancement may take the form of either funded subordinated debt, or an unfunded partial guarantee of senior debt service, provided by the EU with the involvement of the European Investment Bank (EIB). 

In the UK, the Government has recently revised its private finance initiative under a new scheme dubbed Private Finance 2 (PF2).

This involves the Government taking an equity stake in the infrastructure project and explicitly encourages the development of structures not reliant on bank debt.

(The government department UK Export Finance recently announced a £1.5bn direct lending facility for small and medium-sized transactions.)

For clients within some sectors, state support will be nothing new. For example, aircraft manufacturers have benefited from export credit support for many years.

However, the support is often risk-based – guarantees rather than funding – and so does not address the liquidity challenge. Nevertheless, governmental support can be valuable when it comes to tapping alternative, more risk-adverse liquidity sources.

Indeed, the combination of capital markets funding with export credit support is a growing trend. Common for many years in the aviation industry in the US, the trend looks likely to extend into other geographical regions (particularly Europe) and asset classes such as energy and infrastructure.

In the US, Eximbank has guaranteed three notes issues totalling $1.2bn (£743m) by PEMEX, the Mexican state oil company.

Another trend is collaboration between export credit agencies and other governmental organisations across different states.

In Uzbekistan, the Export Import Bank of Korea, Korea Trade Insurance Corporation, the Asian Development Bank and China Development Bank are financing the $4bn (£2.4bn) Surgil gas-to petrochemicals project, the first time that both Korean credit agencies and the two banks have financed a project jointly.

Export credit-supported bonds and loans from non-bank sources reveal a common theme that may prove to be the foundation for the future development of the debt markets: by coming together to share ideas and expertise and assess how roles, risks and responsibilities can be allocated between them, both borrowers and lenders are working their way through the challenges, creating new products and structures and thereby finding solutions they could not deliver individually.

And as part of this process, legal advisers find that their own role is changing too, as they are increasingly being asked to share their own, broad market view and to effect introductions between interested parties.

Kenneth Gray (pictured, top) and Alison Baxter (pictured, above) are consultants at Norton Rose.