Is Over-Regulation Choking Growth?

The world needs trillions to meet climate and development goals — but the money isn’t flowing. Why? A well-meaning financial rulebook built after the 2008 crisis may now be holding back the infrastructure revolution, especially in emerging markets.

We are at a turning point in global development, and the agenda is straightforward: ensure net-zero emissions, pursue sustainable development goals and get millions out of poverty. This Sisyphean effort, as anyone familiar with economic realities understands, depends upon one major building block: infrastructure. The proverbial backbone of a sustainable future is not just the abstract idea of resilient buildings, green transportation and protective coastal defense, but the concrete reality of using these solutions to create a more livable future.

And yet, we are doubling a near-$3 trillion shortfall in investment each year – about the size of the UK economy – with approximately 70% of the shortage in capital concentrated in emerging and developing economies (EMDEs). This is where the epigrammatic paradox lies: the world is flooded with capital. According to the United Nations Development Program, global wealth is estimated at a whopping $430 trillion. Then, why is this capital not gravitating where it is most direly needed? What is the problem behind the starvation of these critical projects?

The largely unintended solution has something to do with an unintended consequence of a framework aimed at bringing a financial salvation: Basel III banking regulations.

The Regulatory Straitjacket of Basel III

Basel III was rooted in the aftermath of the furnace that was the 2007-08 Global Financial Crisis, a worthy attempt to introduce resiliency and stability into a global financial system edge of collapse. And it has, in fact, played a vital role in saving a second systemic breakdown. However, even as a perfectly engineered machine intended to do one greater purpose ends up killing another, Basel III, despite all its virtues, has ended up discouraging banks, in swathes, in making infrastructure investments, particularly in EMDEs.

Commercial banks are still the major independent financiers of new infrastructure developments, providing cheaper debt to equity financing and maintaining affordable service prices for consumers. However, recent regulations have placed the proverbial albatross around their necks with such investments often deemed more expensive than justified by their real risk. So what is wrong with this regulatory miss?

• Infrastructure identity crisis: The Basel Framework, despite its robustness, has failed to accept infrastructure as a separate asset class. This is not an oversight – but a deep-rooted systemic failure. Without specific regulations, capital charges imposed on infrastructure loans are not calibrated well enough to their corresponding risk sensitivities.

Consider project finance entities, which are frequently formed especially to undertake a particular infrastructure project and do not have a credit history. Their loans are usually risk-weighted in regard to the profile of the loan issuer and not as strongly to the long-term cash generation potential of the project to be financed. The Global Infrastructure Hub (GI Hub) forecasts the use of historical information to specify risk-weights associated with infrastructure would see the cost of regulatory capital decrease by a whopping 60-70%.

• The Output Floor: Basel III replaced the one-size-fits-all approach with an “output floor”, meaning that internal ratings-based (IRB) model outputs would need to be at least 75% of the standard outputs. Although banks are free to use IRB models, this floor lessens the incentive to do so, in particular, for cases involving infrastructure – not a significant portion of their portfolios either. The consequence? Banks take to the standardized approach, which owing to its generic nature, attracts high capital charges on infrastructure projects. The system in effect makes them inclined to avoid nuance and to engage in the unattractive and expensive virtue of being over-cautious.
  
  
• LGD Misnomer: In the case of IRB, an input floor of 25% is used as the Loss Given Default (LGD) on unsecured lending in the absence of appropriate asset-class classification. These projects are being subsidized on an inappropriate and generic specification, but not on the improved recovery rates that they actually have shown.
  
  
• The Unrewarded Mitigators: Governments and multilateral development banks (MDBs) are, admirably, contributing credit-risk mitigation instruments to de-risk infrastructure financial costs. Such are essential to sustainable development. And yet the strongest point of Basel Framework with these instruments would be stringent legal requirements of being “unconditional, continuous, and irrevocable,” all of which are at odds with the sensitivity and the complexity of project finance. A laudable effort, but too many times it is crippled by legalism; thereby limiting the benefits it sought to bring.
  
  
• Short-Termism Trap: Infrastructure projects are of a long-term nature and have been running strong over decades. Banks, however, convert short-term lending deposits and of late, reforms such as increasing liquidity ratios do not encourage banks to make such long-term commitment. The two stages, the pre-operational construction phase and the operational phase have the highest risk. A large supply of those initial stages (banks), in turn, get discouraged (pulling the sector towards permanent financing shortage) as they are not provided with financial incentives to invest in infrastructure.

Widening Divides

EMDEs feel the brunt of the implications of this regulatory straightjacket most acutely. These countries, due to their greater deficits of infrastructure and more dependence on bank finances, remain in a low infra-investment trap. The direct effects of such miscalibrated regulation are higher financing costs, which either translate either into further increases in the price of necessities, already impoverished consumer incomes, or more government backing, further exacerbating already record high global government debt.

The irony is bitter: prudential regulations are necessary in order to forestall global economic meltdowns; but they are standing in the way of the very cross-border flows of private capital without which transformational development is impossible. The risks associated with financing infrastructure in EMDEs may be exaggerated, in turn, causing excessive accumulation of capital among the banks. Historical figures, however, indicate that infrastructure loans in EMDEs are as good as in an advanced economy by the fifth year of project when such projects usually start yielding revenues. This misconception habitually leads capital into low-impact projects at the expense of the high-impact ones in favor of those that appear to be safer.

A New Course

Some of the more visionary regulators are starting to come round. The International Association of Insurance Supervisors (IAIS), for example, is reworking its standards, while Europe has developed Solvency II and China C-ROSS, introducing risk-sensitivity to infrastructure regulation. Even the European Banking Authority (EBA) has been experimenting with an Infrastructure Supporting Factor, a 20% discount on capital requirements, but its take-up has been, unfortunately, disappointing, perhaps because of the lack of a specific and customized taxonomy.

The solution is obvious, albeit politically stressful. A straightforward, non-technical, and fit-for-purpose infrastructure asset-class taxonomy is necessary, particularly one that accurately represents the unique risks faced. Regulatory oversight has to improve to incorporate some of these measures to instill further confidence and bring in much-needed capital discounts. And most importantly, all parties – not just MDBs and governments, but also the private sector needs to find a way to replace the use of credit-risks mitigation tools with instruments that are actually effective in the prevailing legal possibilities.

MDBs have an oversized role to play here. Their involvement besides direct financing translates into a reduction in risk taken by the private financiers because it demonstrates the possibility and stability of a certain project, especially in difficult environments. They, per se, are the beacons that are signaling currents towards the private capital.

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Infrastructure-specific regulation is an economic and regulatory necessity. And as the only worldwide organization that has the weight to affect the Bank of International Settlements, the G20 should primarily assume this burden.

Read: Songwe, V., Mendez-Parra, M., & Attridge, S. (2025, July). Basel III rules must be reformed to drive investment toward developing economies. Project Syndicate.