Equator Principles III – “Good news for the environment and for communities around the world”?

On May 14, 2013, the members of the Equator Principles Association have published the third version the Equator Principles. Is this good news for the environment and for communities around the world, as the association’s press release says on its first page?

I have read these principles last week – first, because they are part the documents “you must have read” when you work in this area and, second, to learn something about environmental aspects of project finance. I have succeeded on the first point but, unfortunately, got pretty disappointed on the second point.

But let’s go step by step:

The Equator Principles Financial Institutions commit to finance only those projects that comply with the Equator Principles. So good, so far – But what are the Equator Principles?

In short, they address environmental and social risk in project finance transactions. These transactions not only include project finance as such, but also project related advisory services, corporate loans, and bridge loans.

Scope of application

The application of the Equator Principles depends on the size of the financial services: In case of project finance, connected advisory services, and connected bridge loans, the project capital costs must be at least 10 MUSD. In case of project-related corporate loans and connected bridge loans, the total aggregate loan amount must be at least 100 MUSD.

At first glance, this seems curious: Small projects can pollute, big projects cannot? Obviously not! The idea is more to avoid substantial administrative costs for small projects.

Principles

In total, there are 10 Equator principles:

• Review and categorization: Depending on the degree of environmental and social risks involved, projects can enter into category A, B, or C.
  
  
• Environmental and social assessment: Adequate, accurate, and objective evaluation and presentation of environmental and social risks and impacts for category A and B projects.
  
  
• Applicable environmental and social standards: Compliance with host country laws, regulations, and permits / International Finance Corporation Performance Standards on Environmental and Social Sustainability
  
  
• Environmental and Social Management System and Equator Principles Action Plan: I must simply quote here. I honestly don’t understand what this is about.
  
  

“[…] Further, an Environmental and Social Management Plan (ESMP) will be prepared by the client to address issues raised in the Assessment process and incorporate actions required to comply with the applicable standards. Where the applicable standards are not met to the EPFI’s satisfaction, the client and the EPFI will agree an Equator Principles Action Plan (AP). The Equator Principles AP is intended to outline gaps and commitments to meet EPFI requirements in line with the applicable standards.”

• Stakeholder Engagement: This intends to include affected communities.
  
  
• Grievance Mechanism: This mechanism intends to receive and facilitate the resolution of concerns and grievances about the project’s environmental and social performance.
  
  
• Independent Review of category A and, as appropriate, category B projects.
  
  
• Covenants: This refers to environmental and social engagements taken by the borrower in the financing documentation.
  
  
• Independent Monitoring and Reporting by and independent environmental and social consultant after financial close.
  
  
• Reporting and Transparency: This requires the final client to disclose environmental information online.

To make it even more theoretical, the Equator Principles are applied only indirectly. As a matter of fact, the participating banks shall implement them in their own internal environmental and social policies. Process rules that are implemented in internal policies – welcome to the world of banking!

Let’s finish with two quotes underlining the beauty of English administrative language:

“The EPFI will require that the Assessment process evaluates compliance with the applicable standards as follows: […].”

“The Assessment process will establish to the EPFI’s satisfaction the Project's overall compliance with, or justified deviation from, the applicable standards.”

Resource:

• Equator Principles III – June 2013

Legal meets Accounting – Provisions, contingent liabilities, and contingent assets under IFRS

How to account for litigation? I have touched upon this topic from different angles. When I was an attorney, clients asked to evaluate the risk of litigation and to put a total amount on such risk. When negotiating financing contracts, I often faced representations and warranties about litigation risk. The most important angle, the accountant perspective, is still missing in my career. It’s not very likely that I will ever be an accountant, but you never know...

Anyway, knowing the IFRS rules about this topic helps for any of the above perspective.

_____________________________________________________________________

“Perhaps you’re a scholar,” said the prize-fighter, after a moment’s reflection.

“I have been at school; but I didn’t learn much there,” replied the youth. “I think I could bookkeep by double entry, “he added, glancing at the card.

Double entry! What’s that?”

“It’s the way merchants’ books are kept. It is called so because everything is entered twice over.”

“Ah!” said Skene, unfavorably impressed by the system; “once is enough for me.”

(George Bernard Shaw, Cashel Byron’s Profession)

______________________________________________________________________

Provisions

A provision, in IFRS accounting jargon, is a liability of uncertain timing or amount. If you would like recognize a provision, three cumulative conditions must be met:

• A present obligation results from a past event. To make it more pompous, IAS names this past event an “obligating event”.
• An outflow of resources is probable.
• You can estimate the amount of the obligation reliably.

Four principles guide you when measuring the provision: You should

• take risks and uncertainties into account;
• discount the provisions if the time value of money is relevant;
• take future events, especially of legal and technological nature, into account;
• not take gains from the expected disposal of assets into account.

The final amount is then a “best estimate”, based on management judgment, experience of similar transactions, and reports from independent experts. In addition, where many outcomes are possible, a weighted average shall be determined (“expected value”).

Provisions shall be reviewed and readjusted at the end of each financial year.

Specific examples of provisions include future operating losses, onerous contracts (= the contract’s costs exceed its benefits), and restructurings.

Contingent liabilities

A contingent liability is

• a possible obligation that arises from past events but depends on uncertain future events not wholly controlled by the company, or
• a present obligation where it is not probable that such obligation requires economic resources for its settlement or where the amount of the obligation cannot be measured reliably.

Contingent liabilities are not recognized on the firm’s balance sheet. By contrast, they are disclosed as a contingent liability, unless the outflow of economic resources is remote.

Contingent assets

A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly owned within the control of the entity.

Firms shall not recognize a contingent asset on its balance sheet. However, when an inflow of economic benefits is probable, the contingent asset shall be disclosed.

Disclosure

In its financial statements, the company must disclose some basic information about its provisions, contingent liabilities, and contingent assets as follows:

Disclosure under IAS 37

Resource:

• IAS 37 – Provisions, Contingent Liabilities, and Contingent Assets

Pfandbriefe in Germany - "Pfand + Brief = Quality"!

Last Friday, I visited the homepage of the association of German Pfandbrief Banks. The first thing I saw was the picture below. It actually leads you to a short film:

www.pfandbrief.de

In a stormy night, a professor is sitting about his paperwork and thinks about mathematical formulas. The dramatic music indicates that he is about to discover something fundamental! Besides a charwoman who is walking on the floor, he seems to be alone in the office building. As the Professor thinks about the equation “Pf + brief”, the charwomen enters the room. Abruptly, all paperwork falls from the table. Upon helping the Professor to range the papers, she looks at the board and, instantly, finds the solution: “= quality”.

What is the message? Let’s be a bit cynical: Pfandbriefe are so simple that even charwomen can understand them!

Pfandbrief

A Pfandbrief is a covered Bond. The idea is that you issue a bond and secure it by some form of collateral. The advantage of a Pfandbrief is that mandatory German Law governs the type and extent of collateral very thoroughly. This makes it simple for financiers to invest because it creates standardization and transparency which, ultimately, builds trust.

Issuing a Pfandbrief requires a special authorization for each underlying in question. Banks which have obtained such authorization are called “Pfandbriefbanken”.


Type of collateral

Depending on the underlying collateral, there are four types of Pfandbriefe:

 

• Mortgage-backed bonds (“Hypothekenpfandbrief”)
• Bonds backed by guarantees of (German, EU, and some other) public institutions (“Öffentlicher Pfandbrief”)
• Vessel-mortgage-backed bonds (“Schiffspfandbrief”)
• Aircraft-mortgage-backed bonds (“Flugzeugpfandbrief”)

 

For any of the above underlying, the German legislator strictly defines how to fix its value (“Beleihungswert”) and which maximum portion of the underlying is available for coverage (“Beleihungsgrenze”).

 

Coverage principle
 

Pfandbriefe are characterized by the coverage principle (“Deckungsprinzip”) which guarantees that the underlying is sufficient in terms of

• nature of underlying;
• quality of underlying;
• insolvency remote character of the underlying;
• liquidity cushion consisting of liquid and stress-resistant assets for the next 180 days.

 

In other words, the idea is to separate normal creditors of the bank from covered bond creditors, even and above all when the bank goes bankrupt.

Statistics
 

Among other main international covered bonds’ markets, Germany’s Pfandbrief market is important. In 2011, it represents 22 % of total outstanding volume and 11 % of new issues. The trend is, however, negative as its share is declining steadily since 2003 (71 % of total outstanding volume and 53 % of new issues in 2011)

 

You can find some data on

• the international covered bond market;
• the German Pfandbrief market are available, and
• the financial performance of German Pfandbriefbanken

on my website.

 

Ratings of German Pfandbriefe and Pfandbriefbanken

Resources:

• German PfandBG
• Website of the Association of German Pfandbrief Banks
• Website of the European Covered Bond Council

Basel III or Brown-Vitter? – How the EU implements Basel III and a US alternative may look like

On April 14, 2013, the European Parliament has decided on the rules implementing Basel III in the European Union. They will take the form of a regulation, entailing direct application in all EU member states. Even though the legislative process is not formally finished yet, you can consider the regulation as almost final. Opening the document causes a shock: 1,276 pages! I admit that it is the longest word-document I have ever seen.

Just a few days later, on April 24, US Senators Brown and Vitter have proposed a new banking regulation for the US. And, guess what, the document is only 24 pages long!

What is going on here?

In short, Basel III rules are based on risk-weighted assets (For a bank, lending to a rich is not as risky as lending to a poor.) whereas Brown-Vitter does not differentiate the risk profile of a bank's assets.

Capital requirements under Basel III

The core of the Basel III regulation is capital requirements. Other components (large exposure regime, liquidity coverage requirements, and leverage ratio) play a minor role.

The regulation says that banks must meet three capital requirements:

• Common equity tier 1 ratio ≥ 4.5 %
• Tier 1 capital ratio ≥ 6 %
• Total capital ratio ≥ 8 %

All three ratios have the same denominator – risk weighted assets. The idea here is that you (or, more precisely, your computers) look at every group of assets on the bank's balance sheet and decide how likely it is that the client will pay. If your client is good (international organizations, reliable governments, etc.) you forget about the asset (0 % or other low %); if your client is very bad (low-rated corporates etc.) you will count your asset several times (for example 200 %). The reason for the inverse relationship is that risk-weighted assets constitute the denominator – the higher they are the lower the ratio.

The numerator changes:

• Most prudent is the common equity tier 1 ratio which counts only equity.
• The tier 1 capital ratio is somewhat in the middle because it counts not only equity but also financial instruments between equity and debt.
• The total capital ratio is the most lax ratio because it adds some additional debt instruments.

You can find a more detailed presentation of the Basel III rules here. “More detailed” is relative however – you can read entire books about Basel III if you want....

Capital requirements under Brown-Vitter

The Brown-Vitter Bill introduces equity capital requirements as follows:

Additional risk-based capital requirements remain possible for financial institutions with more than 20 BUSD in Total Consolidated Assets, in order to prevent investment in excessive amounts of riskier assets.

With regards to Basel III, the Brown-Vitter Bill is categorical: “The Board, the Corporation, and the Comptroller of the Currency shall be prohibited from any further implementation of any rules of the Federal banking agencies regarding Basel III […]”.

At first glance, the proposal of the US senators seems obviously wrong. Two banks might hold assets of completely different risk profiles and, nevertheless, be treated exactly the same way. However, when I compare the US proposal with Basel III, I am wondering what is better:

• A conceptually correct but 1,276 pages long regulation that almost nobody can understand and which has more room for interpretation than you can possibly imagine?
• An oversimplified and 24 pages long regulation that everybody can follow?

As oftentimes, the right answer is probably somewhere in the middle. Let's wait and see what the US will adopt in the end.

Resources:

• Brown-Vitter Bill Proposal dated 24 April 2013
• For a critic of the Brown-Vitter Bill, you can read Davis Polk – Brown-Vitter Bill, Commentary and Analysis – April 30, 2013. The article contains many additional references.
• European Regulation on Credit Institutions as adopted by the European Parliament on April 16, 2013