BASEL COMMITTEE

The bank for International Settlements (BIS), headquartered in Basel,

Switzerland, served as a bank for central banks and help to set
international monetary policy
In 1975, the Basel committee was formed on Banking Supervision to
articulate banking standards and guidelines
The committee developed capital adequacy standards for international
banks, which served as guidelines for national bank regulators
Prior to this capital requirements were established by national regulators
using simple capital ratios like net worth to on-balance sheet assets
CAPITAL ACCORD (BASEL-I)
The basel committee published its first report in 1988 for the creation of
minimum capital standards
The committee chose 8% as the target capital ratio (net worth to assets)
The actual amount of capital required varied as a function of a banks
asset portfolio
It identified 5 broad asset categories and assigned risk weights of 0%,
10%, 20%, 50%, and 100% to them
$ 100 million PF (Project finance) loan needs $8 million of capital
($100*100% risk weight * 8% target capital)
The five categories simplified implementation but ignored important
differences between loans within a given asset category
NEW BASEL CAPITAL ACCORD (BASEL II)
In June 1999, the Basel committee announced plans to revise the capital
standards.
Objective was to provide approaches which are both more comprehensive
and more sensitive to risks than the 1988 accord.
The new regulatory framework consisted of three pillars:
Pillar 1 (Minimum capital requirement): same definition of regulatory
capital and the 8% target capital ratio
Pillar 2 (Supervisory Review): called for increased regulatory oversight
Pillar 3 (Market Discipline): requirements for increased bank disclosure
The committee hoped to finalize the new accord by the end of 2002 and
implement it by 2005.
This new proposal focused on individual asset classes, not on banks entire
asset portfolio or its integrated balance sheet.
CAPITAL REQUIREMENT
Standardised Approach

Here banks would use ratings on their borrowers or loans as supplied by

credit rating agencies approved by regulators, with risk weight set by the
Basel committee to determine the minimum amount of capital needed to
hold.
If borrowers or loans were unrated use 100% risk weight
Internal Ratings Based(IRB) Approach
Here bank would classify loans into risk category using their internal data
provided they could prove that they had accurate historic data.
Based on internal data available two approaches:
-> Foundation IRB approach: Banks with PD (probability of default) data
only, would use the foundation IRB approach in conjunction with
supervisory estimates of LGD (loss given default) to determine their
capital charges.

-> Advanced IRB approach: To be used when banks have both PD and
LGD data
Although the IRB approach implied there would be different standards at
different banks, the committee favoured the internal approaches because
they incorporated the banks specific risk profile, loan loss experience, and
risk-mitigation techniques.
PROJECT FINANCE AS AN ASSET CLASS
The new accord treated Project Finance asset class distinct from corporate
lending asset class.
Project finance classified as form of specialized lending
Specialized lending involved loans secured by an assets cash flow rather
than by corporate balance sheet and earnings.
The MTF believed specialized lending was riskier than corporate lending
and therefore, warranted higher risk weights.
Project Finance loans to have same risk weight as corporate loans under
standarized approach and advanced IRB approach.
Project Finance loans to have higher risk weight than corporate loans
under foundation IRB approach because supervisory estimates of LGD for
project loans were likely to be higher than LGD estimates for corporate
loans
PROJECT FINANCE UNDER FOUNDATION IRB
Four categories of PF loans with risk weights from 75% to 750%
Strong
Fair
Weak
Default
So $ 100 million PF loan rated fair need to have extra $ 4 million capital
requirement [$100 million * (150%-100%) * 8% = $4 million]
The incremental capital charge would add to the price of the Loan
The Basel committee predicted that total capital for project loans would
increase by 22%
If Banks use IRB approaches for their corporate loans then IRB approaches
required to be used for project loans also.
INDUSTRY REACTION TO BASEL-II
Strong reaction from Project Finance bankers
Bankers feared that new capital would have a devastating effect on project
finance lending by making loan spread uneconomic to potential borrowers
and by driving business to nonbank competitors
Citigroup believed a quantitative study by the major banks could help in
convincing the model Task Force.
It hoped to achieve two objectives:
To convince the Basel committee to lower the risk weights
altogether, which will reduce the capital requirement
To benefit smaller banks who participate in loan syndicates as they
will not qualify for the advanced IRB approach and hence will have
to face higher capita charges
Despite these arguments, some bankers declined to participate for many
reasons: they did not perceive Basel II as a serious threat, they were
already preparing their own replies or they did not believe there was
enough time.
THE FOUR BANK CONSORTIUM
In Jan 2002 four banks agreed to collaborate on loan loss study

 They were ABN AMRO, Citigroup, Deutsche Bank and Societe Generale;
Each of these was one of the top 10 project finance loan arrangers in 2001
Two main objectives of the study were :
a) To convince the Basel committee to reduce the risk weights for project
finance loans
b) To build a database that participating banks could use to estimate PD and
LGD so that they would qualify for advanced IRB approach
Approached Risk Solutions- a division of Standard & Poors corporation
that provided customised credit analysis, models, and data to help clients
manage risk
Study was divided into 3 phases
Phase 1 Analyse LGD by March 2002
Phase 2 Analyse PD by July 2002
Phase 3 repeat the process with six to 10 additional banks by March
2003
PHASE I- RECOVERY RATES (LOSS GIVEN DEFAULT)
The first part of analysis determined recovery rates for defaulted loans.
In present value terms, the recovery rate equalled the amount of the
default settlement divided by the sum of the loan principal at default plus
accrued interest plus interest penalties.
The four banks identified 43 defaults across a range of regions and
industries.
The mean recovery rate for project loans was 75% and median was 100%
Risk solutions compared project loans against four types of corporate
debt- leveraged loans, secured debt, senior debt and senior unsecured
debt; Project loans exhibited higher average recovery rates than all but
leveraged loans.
The distribution of project finance recovery rates with corporate finance
recovery rates revealed that the performance of project finance was most
similar to the performance of leveraged loans
It was concluded that project loans are less risky than comparably rated
corporate loans; primary reasons- greater transparency and better
information
The consortium proposed that project finance loans should require approx.
half as much capital as claims on corporate s under the IRB approach.
PHASE II PROBABILITY OF DEFAULT
For the PD analysis, the consortiums pooled portfolio comprised of 759
facilities and included loans from a broad range of industrial sectors and
geographical locations.
Risk solutions first analyzed the PD with default broadly defined and then
with narrowly defined (i.e., excluding restructured loans with no
accounting loss but with changes to amortization or maturity)
The analysis suggested that Project finance loans had a lower probability
of default than corporate loans.
The 10-year cumulative PD for project loans was 7.63% under the broader
definition of default compared with 9.38% for that corporate loans; this
meant that project loans performed like corporate credits rated BBB- to BB
Using the narrower definition, the project loans had a PD of 3.68% and an
LGD of 56%, similar to the rates of BBB+/BBB corporate loans
Thus the data indicated that project finance loans performed better than
claims on corporates, regardless of the definition of default.
The consortium sent a second letter to the Basel Committee stating the
same.

IPFA AND IFC RESPONSE TO BASEL

In addition to the consortium, other banks and related parties responded
to the Basel Committees request for feedback.
The International Project Finance Association (IPFA) presented a working
paper to the committee stating that project finance loans enjoy a much
better LGD history than Corporate Finance and the regulatory structure
need to be amended with terms more favourable to project finance
The International Finance Corporation (IFC), responsible for promoting
private sector investment in developing countries sent data on its portfolio
of project loans to the Basel Committee
The IFCs portfolio of project loans had experienced a 2.1% loss rate
compared with a 3.1% loss rate for all loans in its 45 year historyrecommended that project finance should not be included in Specialized
lending as separate from corporate lending
CONCLUSION
After completing the first two phases of the study, the results were clear:
Project finance loans are not riskier than comparably rated corporate
loans either from an LGD or PD perspective.
The consortium hoped that this information would convince the Models
Task Force to change their original position and adopt risk weights that
were equal to, if not more favourable than, the risk weights for corporate
loans.
They also recognized the need to add more banks to the study to
strengthen its validity; they had data covering approx. 25% of the project
loan origination- need to bring this number to 50% and also incorporate
broad geographic coverage with banks from Asia, South America and
Australia
The consortium invited other banks to join in the study. While some
showed interest, others did not perceive Basel II as a serious threat.
Meanwhile, the consortium members were less sanguine about the future
under Basel II. They believed it had the potential to inflict serious damage
on the industry and hoped that the loan loss study would avert such a
scenario