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A bridge in Vladivostok, Russia is part of a series of large infrastructure projects the city is preparing for the 2012 APEC summit. Around the world, funding for infrastructure projects is drying up.YURI MALTSEV/The Associated Press

Building sewers and power plants could yet be one way of powering a global recovery. But the stodgy world of project finance that funds such vital infrastructure is hardly booming.

Far from it. The sector is suffering collateral damage from the financial crisis and looming regulatory changes aimed primarily at tackling riskier banking activities.

Indeed, after a respectable $427-billion (U.S.) of deals last year, only $71-billion has been raised so far this year, according to Dealogic data. Many bankers fear that the market will continue to contract for the foreseeable future – with potentially a pernicious effect on many projects.

Project finance is an important source of funding for an array of developments vital to modern economies, such as roads, railways and hospitals.

These are financed by long-term, cheap loans, where the income is linked to, and secured by, the underlying development. Big banks largely put them on their balance sheets or sold portions of the loans to smaller lenders across the world.

Pierre Nicoli, head of BNP Paribas' energy and infrastructure group, warns: "There may be a significant shortfall in bank financing for the global economy in the coming years. Unfortunately, if you start having to slow down infrastructure work for any reason, it will have a negative effect on growth."

Many bankers blame new Basel III rules on bank funding for the market's woes. This regulatory framework increases the size of the capital buffer lenders have to hold against losses and requires that banks better match the duration of their own funding to their loans.

Although this does not directly affect project finance, the combination of higher capital reserves and focus on addressing asset mismatches is undermining interest in large, longer-term project-finance loans. "Where there is broad-ranging regulatory reform, there are likely to be unintended consequences – and, unfortunately, bank lending to projects will be amongst the areas to suffer," says Edward Chan, a partner specializing in banking and regulations at law firm Linklaters.

At the same time, the traditional "syndication" model – whereby a cabal of large banks initially underwrite, arrange and sell the project loans – is no longer functioning as effectively.

In the past, there was a network of smaller, mainly European banks that would snap up these low-yielding but safe loans. But many of these banks are now unwilling or unable to pick up project finance loans.

Some big players have fallen by the wayside. Royal Bank of Scotland, previously one of the world's biggest project financiers, has put its entire project-finance portfolio in its "non-core" arm.

Even French banks, traditionally dominant in the market, are seeking to shrink.

"Historic sources of debt capital have dried up and we are likely to continue to see pressures in the short term," says Nasser Malik, global head of project finance at Citigroup . "We're at an inflexion point in the market, where everything is largely frozen except for club deals."

Not all bankers are pessimistic. Some point out that the drop-off this year is also driven by a lack of demand from governments implementing austerity programs and from companies anxious about the fragile economic outlook.

Nor does Basel III necessarily sound the death knell for the traditional project-finance model, argues Annie McMahon, managing director of Société Générale's European structured finance loan syndicate. "There's no denying that the impact of Basel III is profound, but good projects are still attracting the required debt finance," she says.

Some succour can be found in capital markets. Project-finance bonds have never taken off in the past but a more concerted push may now be inevitable. There is, say bankers, a natural fit between long-term capital providers, unconstrained by banking regulations, and long-term capital consumers.

In the past one of the biggest constraints on project-finance bonds has been the dangers surrounding the initial, construction phase of a project. Few bond investors want to risk lending to a project that may fall by the wayside before completion.

Some bankers are proposing a hybrid model, where banks take the initial construction risks, but lend alongside bond funds or repay the initial loans through bond issuance once the project is completed. One example is the Topaz Solar Farm being built in California. The $1.2-billion debt package featured $850-million of bonds.

Political leaders have also identified bond markets as a potential saviour of the project-finance market. The European Union last year launched a "project bond initiative" consultation, and François Hollande, the Socialist candidate and front-runner for the French presidency, has also voiced support.

Yet bankers stress that it will take a long time before most bond investors are able to play a significant role in the global project-finance market.

Although pension funds and insurers have expressed interest, only $3.4-billion has been raised by unlisted infrastructure funds so far this year, according to Preqin, compared with $21.3-billion in 2011. Also, most of this was raised by funds aiming to own infrastructure assets, not lend towards them.

"Longer term, we think there are huge opportunities on the institutional investor side. They will be an important part of the solution, but [they]won't be an immediate panacea," Mr. Malik says.

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