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2. COMMERCIAL BANKS

PROFILE

Commercial banks are institutions that primarily accept deposits and extend credit to serve consumer and corporate needs for capital (1). In contrast to most other financiers, commercial banks extend credit rather than taking an investment position in a corporate enterprise. Commercial banks receive deposits in two main ways: (a) consumer or commercial deposits, and (b) central bank and other bank deposits. Commercial banks generate revenue from the interest charged to consumers at rates above those received, and through a variety of customer service fees. Figure 2.1 summarizes four key characteristics of commercial banks of particular importance to the public interest community.

Size and Leaders

Commercial banks, which exist in nearly every country, represent the largest individual pool of available private sector capital in the world, the majority of the world's debt financing, and the largest global funding of project finance activities. Globally, 10 of the top 25 commercial banks (in terms of total assets and deposit holdings) are from Japan. They include the Bank of Tokyo/Mitsubishi (BTM), Dai-Ichi Kangyo, and Sumitomo. The other leading commercial banks are from Germany, Switzerland, the Netherlands, the United Kingdom, China, and the United States. They include the Union Bank of Switzerland (Switzerland); Chase Manhattan (U.S.); Hong Kong Shanghai Bank, or HSBC (U.K.); Barclays Bank (U.K.); Deutsche Bank (Germany); ABN Amro Holdings (the Netherlands); Bank Nationale de Paris, or BNP (France); Societe Generale (France); and Citigroup (U.S.) (2). Many of the large domestic commercial banks in developing countries are government-controlled, such as the Industrial and Commercial Bank (China).

Key Features

The focus of commercial banks on debt finance rather than on investment results in three specific characteristics. First, a bank is more interested in the borrower's cash flow and ability to repay the loan with interest than in the underlying value of the borrower's assets. Second, a bank is linked to the physical assets of the borrower only if those assets are pledged as collateral. Third, a bank is not always able to sell its involvement with a borrower to a third party.

In years past, banks tended to make loans and extend other forms of credit, and then waited for the borrower to repay the money. In the modern banking era, many credit extensions (although usually not project finance transactions) are sold to servicing agents or bundled together with other similar debt instruments (securitization) and sold in the secondary market to other financial intermediaries, thus spreading the financial risk. This practice is most frequently done with high volume, low value, standardized loans such as mortgages and credit cards.

Project finance refers to any large long-term loan specifically tied to a particular capital-intensive project, with future project cash flows serving as the primary source of repayment for the loan and the physical assets of the project serving as the primary collateral for the loan. One of the objectives of the corporate borrower in the structuring of project finance is to limit or eliminate the recourse nature of a project - the direct liability of the corporate project sponsor in the event that the borrower defaults. So-called "nonrecourse" financing limits the potential liabilities of a project finance deal to the project itself and provides no obligation for the sponsoring corporation to repay the debt if the project fails. "Limited recourse" is usually a more accurate description than nonrecourse, because most project financings have some degree of recourse to the sponsoring or equity entities (3). Recourse liability in project finance deals can be allocated to third parties (public or private) through various credit enhancement guarantees.

Project finance funding is traditionally designed for 10 to 15 years, but it can have a term of 30 years or longer, with the amount rarely less than US$10 million. If the risk is to be spread, the commercial bank will typically form a loan syndication, that is, a group of several commercial banks working together on a deal prior to loan approval. The syndication can occur at any point up until the transaction is closed with the borrowing corporate client. Chase, the largest underwriter of project finance in the world, underwrote 92 projects in 1996 totaling US$8.75 billion (4).

Regulation

Commercial banks, particularly those in industrialized countries, are heavily regulated institutions. The central bank (in the United States, the Federal Reserve System) is usually the single most important regulator. The central bank sets overall monetary policy for the country, controls the country's currency, and oversees any major regulatory or compliance issues that may face the commercial bank in its lending and other credit-related activities. At the international level, the Bank of International Settlements (BIS) serves as a forum for central bankers - primarily from industrialized countries - to discuss international regulatory standards and coordinate central bank policies. For example, the Basle Accord on guidelines for assessing the capital adequacy of banks operating globally was formulated under the auspices of the BIS (5). In the United States, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) are also significant in that they provide regulatory/audit guidelines and monitor currency flows. The OCC implements the Uniform Financial Rating System, referred to as "CAMELS," which examines capital adequacy, asset quality, management administration, earnings, liquidity, and sensitivity to market risk (6). Banking regulators in the United States are served by an umbrella organization called the Federal Financial Institutions Examination Council (FFIEC). This council requires U.S. banks to disclose international lending data by country. This information is made public in the "Country Exposure Lending Survey," which reports aggregate loan flows by country of destination. Individual bank exposures remain confidential (7).

Attention to Environmental Issues

In the United States, commercial banks ignored environmental issues until the advent of the so-called Superfund liability. In the spring of 1990, a U.S. court found a bank liable for the clean-up costs of a site contaminated by a corporate client of the bank, on the grounds that the bank was in a position to influence decisions made by the corporate client. As a result, nearly all major U.S. and Canadian banks have invested time and money establishing and maintaining an environmental due diligence process for any loan for which real estate serves as the primary source of collateral. European banks, and a few Asian and Australian banks, have followed suit. Some have also placed more emphasis on identifying possible opportunities for increased lending to firms with "good" environmental performance based on management, regulatory compliance, and other selection criteria. Of the largest commercial banks, the following are most often mentioned as the leaders in voluntarily integrating environmental considerations into their lending practices: Nat West Group, Bank of America, Royal Bank of Canada, Credit Suisse, Union Bank of Switzerland, HSBC, Barclays, Deutsche Bank, Sumitomo Bank, and Westpac.

Few countries at present have any direct legal environmental requirements or regulations for commercial banks. However, guidelines published by the FDIC in the United States in 1993 require all banks to reserve a senior-level position for environmental risk management. The central banks of a few other countries such as the United Kingdom, Canada, and Switzerland have provided similar guidelines. World Bank environmental guidelines exercise indirect influence on commercial banking activity overseas. Although these guidelines are not mandated or imposed upon transactions not involving the World Bank, they have become the default standard of environmental assessment from which a bank may model a minimal standard of its own (8).

Since 1991, the United Nations Environment Programme (UNEP) has worked with the international banking industry to encourage integration of environmental practices and management into banking operations. At this writing, there are 115 signatories to the UNEP Statement by Financial Institutions on the Environment and Sustainable Development. (See Chapter 10, Box 10.1.)

Relevance to Developing and Transition Economies

Commercial banks in industrialized countries are providing loans to the developing world to support the construction of roads, power generation projects such as dams and coal-fired powerplants, and other projects with significant environmental and social impacts. The structure of a limited recourse finance project in a developing or transition country may include a public sector guarantee from a bilateral or multilateral financing source, such as the U.S. Overseas Private Investment Corporation (OPIC) or the World Bank Group's Multilateral Investment Guarantee Agency (MIGA). In 1995, the World Bank Group supported about US$25 billion of private sector finance, amounting to approximately 10 percent of all investment by private enterprise to developing and transition economies (9).

Worldwide, new commercial bank loans to developing countries totaled US$34 billion in 1996 (10). Japanese banks, with US$495.3 billion in outstanding loans, account for the largest aggregate lending to developing and transition economies. European banks rank second with US$167.5 billion. U.S. banks, however, are experiencing the greatest rate of increase in this sector, growing 10.4 percent during the first half of 1996 to US$114.9 billion. Lending to the developing world by U.S. banks is concentrated among a few institutions such as Bank of America, Citigroup, and Chase (11). According to the American Banker, Asian borrowers rely heavily on commercial bank loans for capital needs whereas Latin American borrowers rely increasingly on capital markets; three-quarters of new commercial bank lending activity in 1996 took place in Asia (12). By the close of 1997, however, net lending to Asia appeared to have dwindled to zero as a result of the currency crisis in the region (13).

COMMERCIAL BANK DIAGRAM

Figure 2.2 illustrates a commercial bank's role in a project finance transaction. Project finance is depicted for the following reasons: (a) it is the primary focus of lending into developing and transition economies, and (b) it is long term in nature and thus more likely to be influenced by environmental concerns. Each project finance transaction begins with the need for funds by the corporate client, the borrower. The demand for credit extension usually begins with the client contacting one of its commercial banks to discuss various financing options available for the particular need. This may be a new banking relationship, but normally it is an expansion of an existing one. The typical transaction involves the building of a structure (e.g., dam, manufacturing plant, resort) with the revenues generated from the sale of products or services produced paying off the loan and the interest due.

The corporate client, represented by the Chief Financial Officer (CFO) or his or her designee, approaches the commercial bank via an account officer, usually in geographic proximity to the potential borrower. The account officer functions as the corporate client's representative in dealing with the bank's internal review and approval of the transaction. The local community (NGOs, government, business) where the corporation is operating may be in contact with the corporate client through the facility manager, external advisors, or legal and technical staff.

The account officer's team works with the corporate client in clearly defining the financial needs of the project and the most effective way to structure the transaction. The proposed deal is then reviewed and discussed internally within the bank, driven by the account and credit officers. The goal is to receive approval for the requested amount, from the credit officer and credit committee who serve, in effect, as the final authority on each extension of credit. The credit committee is responsible for the overall credit quality of a bank's portfolio, deciding how much risk a bank will support against expected rates of return. The credit committee, with guidance from senior management, helps set the overall credit criteria and process to achieve the targeted risk levels, and thus influences the policy and portfolio of an entire institution as well as influencing each transaction. Senior management and the Board of Directors serve to establish the bank's broader credit guidelines and policies and oversee the long-term health of the institution. Banking associations provide information and education to their members.

If the credit officer and credit committee agree to proceed, the account officer then coordinates with external counsel (for all documentation, regulatory, statutory, and other legal requirements) and technical services (for all physical requirements such as environmental and structural) to confirm that no significant problems exist with the project. It is at this point that environmental and social factors may be considered in a legal or scientific context. The bank likely will perform environmental due diligence for site contamination, regulatory compliance, legal titles to property and physical structures, as well as engineering and legal issues. If the bank does not have its own environmental guidelines, it may refer to World Bank guidelines. If the project finance deal is in a developing or transition country, the loan may be packaged with a public guarantee by a public sector guarantor to ensure against commercial risk (e.g., insufficient cash flow) or noncommercial risk (e.g., political instability).

The following questions would be considered by the account officer as the transaction is processed in the bank:

· Does the transaction need to be cleared with regulators? Are there any relevant legal issues with the transaction? If yes, then the internal counsel, in conjunction with government relations, will need to walk the entire transaction through the necessary regulatory guidelines and protocols. If this process is not managed closely, it could significantly delay the financing transaction.

· Will stockholders care about it? Is the transaction important from either a financial, political, or reputational perspective? If the answer to any of these questions is "yes," then stockholders would most likely care and the bank must decide whether shareholders should be informed. Most commonly, shareholders are informed through the firm's annual report, proxy statement, or, in the United States, the 10-K filing.

· How does it affect the local community (where the bank is based or where the structure will be built) ? Who will be affected negatively or positively? Based on this evaluation, the bank needs to consider how to maximize the bank's opportunities and minimize the negative implications.

· Will the transaction be sold into the secondary market? This decision, driven by the Board finance committee, should be made early on since the disclosure, due diligence, and public affairs will be different if the transaction is to be offered in the public secondary market.

· If the deal is to be syndicated, at what time should the other banks be brought into the transaction by the syndications staff?

· What will the rating agencies think? For any transaction to be sold into the secondary market, the review and "rating" by the rating agencies is critical to the pricing and eventual selling of the offering. If the transaction is syndicated, however, this may not be critical if each participant has had the ability to influence the due diligence process early on. If, however, the syndication is formed late in the process, then the other financiers would have almost no input into the due diligence process and would rely on third parties' opinions of the transaction.

· Should the transaction be promoted by public affairs to the press and/or the general public?

Assuming no significant issues exist that cannot be addressed by contractual covenants, the deal is closed. The bank then funds the transaction with deposits received. Incoming deposits are received from customer deposits and short-term deposits from the central bank and other banks. The former tend to be for long- or medium-term periods, while the latter ("inter-bank deposits") tend to be overnight deposits made at the end of each business day as each bank "balances" its books.

LEVERAGE POINTS

Regulators - Policy leverage. Regulators could be urged to broaden existing FDIC and OCC guidelines requiring banks to report to the government their performance on environmental due diligence. The CAMEL rating system could broaden its analysis of market risk to include environmental risk factors.

Corporate Client CFO - Bottom-line leverage. One of the best potential educational resources on environmental issues for banks are their clients that are currently leaders in sustainable business practices. CFOs within client companies could exert influence by conveying quantitative data that demonstrate the economic value of environmental activities. Bankers in turn would be able to use the newly acquired expertise to evaluate all clients and extend preferential credit terms to companies utilizing best practices.

Credit Officer/Credit Committee - Bottom-line leverage. If the credit officer and credit committee could be convinced that increased attention to environmental issues is in their own and the bank's financial self-interest, they will act. Documentation of how environmental issues can have a positive or negative effect on cash flow is critical.

Board of Directors/Senior Management - Reputational/Bottom-line leverage. Officials at this level were pivotal in banks' decisions whether or not to adhere to the so-called Sullivan Principles regarding South African divestment. Issues related to institutional image, costs, or loss of customers will likely get the attention of senior management. Although this group is difficult to reach, their actions and decisions will influence the entire bank, and perhaps other banking institutions as well.

Technical Services - Bottom-line leverage. These technical experts are hired or employed by the bank to identify factors that may affect the cash flow of a transaction, either directly or indirectly. They are frequently the only individuals involved in the financing transaction who understand environmental issues from a scientific or engineering perspective, and are regarded as the "experts" by the borrower and the credit officer.

Internal/External Counsel - Bottom-line leverage. Frequently, lawyers are the final ratifiers of the deal. They provide legal expertise on environmental issues and regulations. Both groups of attorneys (internal and external) are significant influencers with the delegated responsibility to create contractual covenants and, in some cases, supervise technical staff.

Rating Agencies - Bottom-line leverage. Rating agencies have an impact upon a bank's ability to syndicate loans in the secondary marketplace. If these agencies can be convinced of the financial value of proactive attention to environmental issues, they could alter their ratings of various offerings based on environmental characteristics of the loans. These agencies are interested in the same issues as credit officers, and are most likely to be influenced by quantitative demonstrations of the impact of environmental considerations on financial rates of return.

Public Sector Guarantor (e.g., OPIC or MIGA) - Bottom-line/Reputational leverage. Bilateral export credit agencies and private sector arms of development banks are in a strong position to require that project finance deals to which they provide guarantees adhere to environmental standards and information disclosure requirements. Officials of these agencies should be sensitive to analyses showing the relationship between environmental and financial risk.

NOTES

1. This profile does not examine savings institutions or credit unions, which are primarily consumer focused.

2. "The World's 100 Largest Banks." The Wall Street Journal. September 18, 1997. p. R27.

3. Limited recourse ranges from substantial recourse during construction through completion testing, to more limited, very specific recourse after completion to the end of the term loan.

4. Andrew Taylor. "Private Sector Fills the Gap." Financial Times. Friday, May 23, 1997. p. 5.

5. Kavaljit Singh. A Citizens Guide to the Globalisation of Finance. New Delhi: Madhyam Books. 1998. p. 159.

6. Office of the Comptroller of the Currency website: http://www.occ.treas.gov/

7. Personal communication with the FFIEC: http://www.ffiec.gov

8. Personal communication with several commercial bankers.

9. The World Bank. 1995 Annual Report. Washington, DC: World Bank. 1995.

10. Hilary French. "Assessing Private Capital Flows to Developing Countries." State of the World. Washington, DC: Worldwatch Institute. 1997. p. 152.

11. James R. Kraus. "U.S. Banks Gaining Ground in Loans to Developing World." American Banker. Vol. 162 No. 6 (January 9, 1997).

12. Ibid.

13. "Capital Flows to Emerging Markets." Institute of International Finance. January 28, 1998. Available online at: http://www.iif.com

AVAILABLE INFORMATION

Central bank (the Federal Reserve in the United States): http://www.bog.frb.fed.us

Federal Financial Institutions Examination Council (quarterly report on "Country Exposure Lending Survey"): http://www.ffiec.gov

Federal Deposit Insurance Corporation (FDIC): http://www.fdic.gov

Office of the Comptroller of the Currency (OCC): http://www.occ.treas.gov/

Securities filings by companies (SEC in the United States): http://www.sec.gov

World Bank environmental guidelines on project finance: http://www-esd.worldbank.org/pph/

Rating agency reports on companies (produced by Standard & Poor's, Moody's, and others in each country where an active public securities market exists)

Independent Bankers Association of America, Washington, DC: http://www.ibaa.org

American Bankers Association, Washington, DC: http://www.aba.com

Environmental Bankers Association, Alexandria, VA, (703) 549-0977: http://www.envirobank.org

World Business Council for Sustainable Development: http://www.wbcsd.ch

UNEP Financial Services Initiative on the Environment: http://www.unep.ch/eteu/envr-fin.htm

Bank of International Settlements: http://www.bis.org

Trade periodicals:

Project and Trade Finance
American Banker
Journal of Project Finance
Bank Accounting and Finance
Journal of Commercial Lending
ABA Banking Journal
Project Finance International
Global Finance
EBA Bank Notes

BIBLIOGRAPHY

Byrne, John. "Rx for Banking's Environmental Itch." ABA Banking Journal. Vol. 89 No. 2 (February 1997). p. 59.

Chamberlain, Denise. "10 Rules for Developing an Environmental Risk Program." Journal of Commercial Lending. Vol. 77 No. 5 (January 1995). p. 44.

Chan-Fishel, Michelle. Anatomy of A Deal: A Handbook on International Project Finance. Washington, DC: Friends of the Earth. 1996.

Fullano, Genaro. "Introduction to Transactional Project Finance." In Nixon, Hargrove, Devons, and Doyle, LLP. Project Finance: A Tutorial. May 19-20, 1997.

Internet Sources for Bankers: A Selective Guide to Financial Websites. Washington, DC: American Bankers Association. 1997.

Kraus, James R. "U.S. Banks Gaining Ground in Loans to Developing World." American Banker. Vol. 162 No. 6 (January 9, 1997). pp.1-2.

Missimer, Thomas M. A Lender's Guide to Environmental Liability Management. Boca Raton, Florida: Lewis Publishers. 1996.

O'Brien, James. Environmental Risk: A Guide to Compliance with the FDIC's Environmental Risk Program. Washington, DC: Chapman & Cutler. 1993.

"Regulators Clarify Lenders Environmental Liability." Banking Policy Report. August 4, 1997. p. 4.

"Survey: Banking in Emerging Markets." The Economist. April 12, 1997.

Taylor, Andrew. "Private Sector Fills the Gap." Financial Times. May 23, 1997.

Ward, Elizabeth. Lender's Guide to Developing an Environmental Risk Program. RT Communications, Inc. 1995.

"The World's 100 Largest Banks." The Wall Street Journal. September 18, 1997.