It must be asked after the near collapse of the western financial system whether improved banking regulation can ever be sufficient to prevent structural failure when so much legislative attention is fixed on the investments and practices that sparked the crisis.
What's more, I find it hard to believe that regulation, however well designed and implemented, can "fix" a marketplace where technology and product innovation are continually shifting the floorboards under regulators' feet. We need look no further than the new craze for high-frequency trading that has reportedly captured up to 70% of the daily trade flow in major stocks to understand that regulation would be hard-pressed to keep pace with this rate of evolution. What is more, in an age when success in markets is measured overwhelmingly by quick results, the behavioral incentives remain overwhelmingly weighted toward exploiting any advantage that innovation makes available.
This is not to say that requiring banks to enforce tighter risk procedures and provide more appropriate regulatory capital, or forcing over-the-counter derivative trades onto multilateral clearing facilities would not help. Rather, it is that legislators should look beyond the specific tools and practices that brought about the financial meltdown and start addressing structural "buy-side" reasons why so many individuals and institutions ended up risking everything on overvalued homes or inherently unstable engineered financial products in the first place.
What they are likely to find is that the housing bubble was inflated as much by the lack of alternative high-yielding, long-term investment vehicles as by the historically low interest rates that made traditional investments so unappealing.
If high-quality and higher-yielding investments had been identified and made widely available during the early stages of the credit boom of the previous 10 years, they just might have drawn enough investment into alternative energy projects, rebuilding highways and bridges and other stable, long-term assets to prevent the housing bubble from inflating so disastrously.
Whether by design or circumstance, the Obama administration's focus on infrastructure development is encouraging state and municipal governments to develop just such alternative investments by engaging the greater long-term financing capacity of the private sector to invest in, design, build, operate and maintain these assets. Public-Private Partnerships, or P3, involve the public tendering of the design, delivery, operation and maintenance of public infrastructure for the long to very long term through the use of private-sector investment, expertise and risk management.
By its very structure, it requires long-term commitments from all sides — on the part of the private-sector partner for the initial financing, operation and maintenance of the assets and on the part of the public-sector partner for the repayment of the initial investment, plus interest. The model, which has been used successfully for more than 15 years in the United Kingdom and is being rolled out in nations around the world, has a track record of delivering projects on-time and on-budget.
The financing in P3 projects generates investable securities of a size and credit quality that can be sufficient to meet the long-term structural investment needs of many institutions. Moreover, the debt of such assets is secured by highly reliable cash flows linked either to the asset's use or directly to the government's tax revenue. And it tends to be indexed to the rate of inflation, which lets pension funds more easily match assets to their long-term commitments to provide for people's retirement needs. This is true as well for life insurers, university endowments, wealth managers and other institutions with liability-driven investment requirements.
There is no shortage of potential projects to be tendered in this manner. The American Society of Civil Engineers recently increased its estimate of the country's infrastructure deficit to $2.2 trillion, and this is just for existing infrastructure. It goes without saying that banks nationwide will have key roles to play in making this happen through the funding support they give companies that deliver and maintain those infrastructure improvements. But they will also need to develop greater capacity to structure investments linked to financing those assets to make them attractive to long-term investors.
The beauty of P3 investment is that it does much more than just create incentives for long-term investment by pension funds. Construction companies and the subcontractors who build or maintain P3 assets themselves become invested in the long-term success of projects, whether through the flow of maintenance work that they are eligible to win or through a share of equity in the project.
Increasingly, many of these contractors are looking to mandate renewals and equity investments to produce the long-term revenue streams that help smooth the notoriously cyclical construction business. P3 also benefits public procurement authorities by removing the risks of underdelivery, late delivery or spiraling costs from their hands and placing them with private-sector partners that are better able and have more incentive to manage and mitigate them.
P3 is a model that mobilizes the private sector to play a larger and increasingly indispensable role in financing, delivering and maintaining the public infrastructure that will be needed for all of society to function and thrive. It would do a world of good if banks began to plan seriously for the central role they will be required to take by investing in the wide range of skills and expertise needed to make these projects succeed.