The persistent shortfall of finance for essential infrastructure in emerging markets and developing economies (EMDEs) remains one of the most significant hurdles to global economic stability and the achievement of international climate goals. Despite the catalytic role that infrastructure plays in driving sustainable growth, these regions continue to face a widening investment gap that threatens to leave the Global South behind in the transition to a low-carbon economy. While global liquidity remains high, the structural barriers embedded within international banking regulations—specifically the Basel III framework—have unintentionally created a prohibitive environment for project financing in the very regions that require it most.
According to the International Energy Agency (IEA), global clean energy investment is projected to reach US$2 trillion this year. However, a disproportionate amount of this capital is concentrated in advanced economies and China. For the rest of the world, particularly in Africa, parts of Latin America, and Southeast Asia, the infrastructure and energy transition finance gap remains as wide as ever. The binding constraint is not a lack of available capital, but rather the prohibitively high cost of that capital. In many EMDEs, the cost of borrowing for a renewable energy project can be three to five times higher than for a similar project in Europe or North America. This disparity is driven in large part by how international regulatory standards treat risk in developing markets, often overstating the likelihood of default and underestimating the efficacy of credit enhancement tools.
The Regulatory Bottleneck: Basel III and the Cost of Capital
The Basel III framework, developed by the Basel Committee on Banking Supervision (BCBS) in the wake of the 2008 financial crisis, was designed to strengthen the regulation, supervision, and risk management of the banking sector. While its primary goal of ensuring financial stability is undisputed, its application to project finance in EMDEs has had unforeseen consequences. As currently interpreted and implemented by national regulators, Basel III rules tend to discourage long-term lending to infrastructure projects in developing nations.
Under the framework, project finance is treated with extreme conservatism under both the standardised and internal ratings-based (IRB) approaches. This treatment persists despite a growing body of evidence, including data from the Global Emerging Markets Risk Database (GEMs), which shows that infrastructure project defaults in EMDEs are often lower than expected. Furthermore, recovery rates for these projects over time are significantly higher than for general corporate lending in the same regions. Because Basel III does not fully account for these real-world performance metrics, banks are required to hold higher levels of capital against these loans. This increased capital requirement is passed on to borrowers in the form of higher interest rates, which frequently renders essential projects unbankable.
The Impact of Country Risk Ceilings
A critical component of the current financing challenge is the application of country risk ceilings. In many regulatory jurisdictions, a bank’s internal rating for a specific project cannot exceed the sovereign credit rating of the country where the project is located. This "sovereign ceiling" often overstates the actual risk of a project, particularly when that project is structured with robust collateral, offshore escrow accounts, or the participation of multilateral development banks (MDBs).
When a high-quality, co-financed project is artificially capped by a low sovereign rating, bank participation is limited. This is particularly damaging for "bankable" projects that have strong cash flows and international backing but happen to be located in countries with fiscal challenges. The result is a paradoxical situation where the projects most likely to lift a country out of economic distress are the ones most heavily penalized by international banking rules.
Chronology of Regulatory Evolution and the Emerging Crisis
The tension between prudential regulation and development needs has been building for over a decade. Following the implementation of Basel 2.5 and the subsequent rollout of Basel III, global banks began a process of "de-risking," which involved withdrawing from many emerging markets to simplify their balance sheets and meet stricter capital ratios.
By 2015, with the adoption of the UN Sustainable Development Goals (SDGs) and the Paris Agreement, the international community recognized that trillions of dollars in private investment would be needed to meet global targets. However, the regulatory environment continued to move in a more restrictive direction. In 2017, the "Basel III Endgame" (often referred to as Basel IV) introduced further refinements to the standardised approach and set a "capital floor," which limited the extent to which banks could use their own internal models to determine risk.
In recent years, the International Chamber of Commerce (ICC) and various industry bodies have raised alarms that these rules are blunting the impact of MDBs. Even when an MDB provides a partial credit guarantee, the regulatory benefit to the private lender is often restricted or inconsistent across different jurisdictions. This lack of "recognition" for credit-risk-mitigation (CRM) tools means that the de-risking efforts of the World Bank or the African Development Bank are not fully translated into lower capital costs for private banks.
A Two-Stage Agenda for Reform
To address these challenges, the ICC has set out a practical agenda for reform that distinguishes between immediate technical adjustments and long-term structural changes. This approach is designed to unlock private investment without compromising the fundamental safety and soundness of the global banking system.
Stage 1: Technical Adjustments and Clarifications
The first stage involves small, targeted adjustments that could be implemented through new guidance or "frequently asked questions" (FAQs) issued by the Basel Committee. These clarifications would provide immediate relief by standardizing how national regulators interpret existing rules. Key proposals include:
- Enhanced Recognition of Guarantees: Clarifying that guarantees provided by highly rated MDBs and export credit agencies (ECAs) should provide a direct and significant reduction in the risk weight assigned to a loan.
- Standardizing Credit Risk Mitigation: Ensuring that CRM tools, such as first-loss tranches or insurance, are recognized consistently across all jurisdictions, preventing "regulatory arbitrage" and encouraging more banks to participate in blended finance structures.
- Project Finance Specificity: Allowing for more granular data—such as the GEMs database—to be used in assessing the risk of project finance, rather than relying on broader, more conservative corporate risk categories.
Stage 2: Structural Reforms
Beyond technical fixes, a mandate for the Basel Committee to establish new work programs is necessary to address the structural biases against EMDE exposure. These programs would focus on:
- Revising Sovereign Overlays: Developing a more nuanced approach to country risk that allows for "piercing the sovereign ceiling" when a project has sufficient structural protections or is of strategic national importance.
- Calibrating Capital Floors: Reviewing how the capital floor impacts project finance in the Global South, ensuring that the floor does not inadvertently penalize low-risk, high-impact infrastructure.
- Incentivizing Green Finance in EMDEs: Exploring the possibility of a "supporting factor" or a lower risk weight for projects that contribute directly to the energy transition in developing nations, similar to the SME supporting factor used in some jurisdictions.
Stakeholder Reactions and Global Implications
The call for Basel III reform has garnered support from a diverse range of stakeholders. Government officials in the Global South have long argued that the current financial architecture is "unfit for purpose" in the face of the climate crisis. During recent G20 summits, leaders from emerging economies have emphasized that without a change in how risk is perceived and regulated, the "Great Divergence" between wealthy and poor nations will only accelerate.
Financial institutions have also expressed a desire for reform. Many global banks have stated that they have the "appetite" to lend to infrastructure projects in Africa and Asia but are constrained by the capital hit they would take under current rules. By aligning capital requirements with the real-world risk demonstrated by decades of project finance data, regulators can empower these banks to move billions of dollars from their balance sheets into productive infrastructure.
Multilateral Development Banks (MDBs) are also key players in this dialogue. For MDBs to successfully "crowd in" private capital—a central pillar of the "World Bank Evolution Roadmap"—the private sector must be able to benefit from the MDBs’ preferred creditor status and risk-mitigation products. If Basel III rules continue to ignore these protections, the MDBs’ ability to leverage their balance sheets will remain limited.
Analysis of Long-Term Impacts
If the proposed reforms are adopted, the impact on EMDEs could be transformative. Lowering the cost of capital by even 100 or 200 basis points could make the difference between a solar farm in sub-Saharan Africa being a viable commercial venture or a stranded idea. This, in turn, would lead to increased energy security, job creation, and more resilient economies.
Furthermore, these reforms would support global financial stability in the long run. By encouraging a more diversified range of investments and supporting the growth of emerging markets, the global economy becomes less dependent on a few saturated markets. Sustainable infrastructure is a productive asset that generates long-term cash flows, making it an ideal investment for a stable global banking sector.
The proposals put forward are not intended to weaken the prudential safeguards that have protected the world from a repeat of 2008. Instead, they are an appeal for accuracy. When capital requirements are better aligned with actual risk, the financial system functions more efficiently. Unlocking private investment for essential EMDE infrastructure is not just a matter of development policy; it is a necessary evolution of the global financial framework to meet the challenges of the 21st century. As the world convenes for upcoming climate and economic summits, the reform of Basel III implementation stands as a critical litmus test for the international community’s commitment to a truly global and equitable recovery.
About the Author
