REMEMBERING FINANCIAL CRISES: THE RISK IMPLICATIONS OF THE RISE OF INSTITUTIONAL INVESTORS IN PROJECT FINANCE.

• Author: Park, David J.
• Position: COMMENT

Barely a decade ago, a cascading sequence of market failures threatened to topple the global financial system. Public responses to the recent Financial Crisis were immediate and drastic to resuscitate the global economy while attempting to make the markets safer. Many financial services sectors have since recovered to pre-crisis levels. One such industry is project finance, which comprises various financing arrangements often used to fund long-term infrastructure or industrial projects. Curiously, significant post-crisis banking regulations and other global credit enhancement initiatives are pushing banks out of project finance and giving rise to institutional investors. This Comment argues that animated institutional activity in project finance may increase both financial and, more notably, governance risks. Further, increased institutional investment in project finance shifts the risk intended to be captured under new banking regulations to unregulated markets and makes the financial system more complex and interconnected. Ultimately, public responses to the Financial Crisis may have the unintended consequence of increasing project-level risks and injecting seemingly regulated systemic risk back into the global financial system.

TABLE OF CONTENTS INTRODUCTION I. THE RISE OF INSTITUTIONAL INVESTORS IN PROJECT FINANCE A. Revival of the Project Bond Market B. Increased Role of Institutional Investors in Project Finance II. PROJECT-LEVEL RISKS A. Financial Risk B. Governance Risk III. SYSTEMIC RISK IN THE GLOBAL FINANCIAL SYSTEM A. Migration of Risks Outside of the Banking System B. Complexity and Interconnectedness CONCLUSION. INTRODUCTION

In 2013, Paul Tucker, the former Deputy Governor of the Bank of England, famously commented, "It will be a while before confidence in the system is restored, and never again should confidence be so blind." (1) But others are less sure about Tucker's prediction. They argue that faith in the market will be restored in less than a decade, (2) pointing to the human tendency to be forgetful of financial crises and engage in similar risky behaviors, so-called "financial crisis amnesia." (3) Similarly, the former Chairman of the Board of Governors of the Federal Reserve System once quipped that "about every 10 years, we have the biggest crisis in 50 years." (4) Although it has been more than a decade since the beginning of the Financial Crisis, we have not yet experienced a similarly catastrophic event.

The Financial Crisis resulted in losses estimated at more than $500 billion. (5) In its aftermath, many people, even those outside the financial sector, lost their jobs and retirement savings. (6) A number of financial services came to a screeching halt, including project finance for large infrastructure and industrial projects. (7) Project finance has been widely used as a funding mechanism for various projects, such as constructing Disneyland in Paris and improving and expanding Buenos Aires's water and sewage services. (8) This funding mechanism has allowed governments and private companies to spread the risks and responsibilities of constructing and operating large projects by creating a legal vehicle to pool investments from private parties. (9) After the Financial Crisis, this market momentarily contracted. (10)

The vitality of project finance has been tested repeatedly, (11) but the market remains resilient and has rebounded since the Financial Crisis. (12) Observers of this phenomenon express great optimism, likely because project lending has not generally been viewed as inherently risky. (13) The recent revival of the project finance market, however, is notably different from past recoveries. Global regulators and policymakers took drastic measures after the Financial Crisis that resulted in the rapid growth of project bonds and institutional investment activity in project finance. (14)

To demonstrate the negative effects of financial crisis amnesia, this Comment discusses the potential ramifications of the increased role of institutional investors in project finance. Part I introduces the current state of project finance and discusses the idiosyncratic growth of the project bond market and institutional investment. Part II argues that the rise of institutional investors in project finance may increase financial and governance risks at the individual-project level, mostly because of such investors' active involvement in the project bond market. Finally, Part III argues that institutional investors' elevated role in project finance may correspond to an increase in systemic risks in the global financial system. It contends that institutional investors encourage migration of risks away from the highly regulated banking sector and increase complexity and interconnectedness in the financial markets.

1. THE RISE OF INSTITUTIONAL INVESTORS IN PROJECT FINANCE

   The project bond market developed in the early 1990s following important changes in federal securities laws. (15) Since then, the project finance industry has evolved, adapting to new technologies and financial innovations. (16) It has expanded and contracted commensurate with debt capital market demands and the relative competitiveness of banks in project finance. (17) As the industry continues to fund global infrastructure and energy projects, many of the key players have changed as well. (18) Commercial banks or a syndicate of banks, while still important, are no longer the sole project lenders. (19) Institutional investors are establishing their stronghold in project finance, primarily through project bonds. (20) The various institutional participants of project finance include pension funds, insurance companies, specialist infrastructure funds, hedge funds, sovereign wealth funds, and private investment funds. (21) These entities are not a unitary class of investors; they do not necessarily share the same skill sets or investment strategies with each other. (22) Importantly, institutional investors have traditionally approached project finance differently from banks. (23)

   Project bonds provide an alternative to the traditional debt financing method of bank loans. (24) These bonds often fund single-asset projects on limited recourse or nonrecourse terms. (25) There are certain private placement restrictions on who can hold project bonds, (26) but a wide variety of institutional investors typically invest in project bonds, including pension funds and insurance companies. (27) The Sections below explore the recent revival of the project bond market and the rise of institutional investors in project finance.

   1. Revival of the Project Bond Market

      Historically, global economic conditions and the natural competition between the banks and the debt capital market controlled the ebb and flow of the demand for project bonds. Bank loans tend to surge when the financial markets are liquid and robust, (28) and project bond activity increases to fill the void when banks are less active. (29) For example, the international project bond market developed in the 1990s largely because banks were unable to meet the global demand for expansive privatization of infrastructure projects. (30) Banks responded by offering commercially competitive, long-term project loans after the Asian financial crisis in the early 2000s, which correlated with a brief contraction of the project bond market. (31) And before the recent Financial Crisis, investors seeking high-yield investments in a global liquidity crunch environment were purchasing project bonds in droves. (32)

      The demand for project bonds also tends to surge when the financial markets become more knowledgeable about the characteristics and risks associated with certain projects or regions. (33) In the early 1990s, for example, the U.S. power market experienced a spike in project bond activity. (34) Banks previously dominated the U.S. power market, and the project bond market hesitated to venture into this unfamiliar market. (35) Eventually, project participants acquired the requisite knowledge and skills to analyze large power projects. (36) With increased market confidence in project participants' ability to structure bond offerings in the U.S. power market, investors flocked toward the seemingly long-term, safe, and predictable revenue streams of project bonds. (37)

      But the Financial Crisis was no ordinary event. Catastrophic market failures stymied project lending activities. (38) Banks had historically emerged triumphant in the project finance market during recessionary periods. (39) After the Financial Crisis, however, banks approached project lending cautiously. They hesitated to act as sole underwriters and demanded terms unfavorable to project sponsors. (40) Project bonds also became riskier and less attractive because certain industries, such as monoline insurance companies, were no longer providing important services. (41) Many investors lacked the appetite to dip into the volatile project bond market. To make matters worse, governments mired in economic doldrums and hamstrung by fiscal constraints stalled public spending on infrastructure projects. (42) The need for infrastructure and other special projects remained high, (43) and in response, global regulators and policymakers took extraordinary steps to buoy up the project finance market while also curbing risky financial activities (44) Their actions ultimately revived the project bond market. (45)

      First, in an attempt to mitigate financial risks identified during the Financial Crisis, global regulators (46) developed a series of rules that indirectly increased the demand for project bonds. Chief among them are the Basel III rules, adopted to recalibrate the existing financial regulatory framework and ensure that the financial markets are better able to withstand future economic shocks. (47) The Basel III rules have had a significant impact on project lending, namely through the ramping up of Tier 1 capital requirements...