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Project Finance

Basel II Assessing the Default and Loss Characteristics of Project Finance Loans

The Basel Committee


BIS headquartered in Basel, Switzerland. 1975: Basel Committee on banking Supervision Articulation banking standards and guidelines To develop Capital Adequacy standard for international banksguidelines for international banks Prior to this capital requirements were established by national regulators using simple capital ratios ex net worth to on balance sheet assets

Basel 1(1988)
Target capital ratio(Net worth to assets) 8% Actual amount of capital function of banks asset portfolio. $100 million PF loan needs $8 million of capital ( $100*100%risk weight* 8% target capital) Simple but not perfect No difference between loans within given asset category.
Asset Categories Cash Risk weights 0%

Residential mortgages Project Finance and Corporate Loans

50% 100%

Basel 2(June 1999)


Pillar 1 Minimum Capital Requirements Definition of regulatory capital and 8% target capital ratio as in Base1 Pillar 2 Supervisory Review - Increased regulatory oversight Pillar 3 Market Discipline - Increased bank disclosures Focus on individual asset classes not on banks entire asset portfolio

Capital requirements
Set capital requirements based on credit risk within asset classes using two approaches Standardized approach Internal ratings based ( IRB ) approach Mostly Banks using IRB approaches would have lower capital requirements than banks using the standardized approach.

Standardized approach
Banks to use ratings on their borrowers or loans using the ratings supplied by credit rating agencies approved by regulators , with risk weights set by the Basel committee to determine minimum amount of capital to be held. If borrowers or loans were unrated - use 100% risk weights

Internal ratings based(IRB) approach


Banks to classify loans into risk categories using their internal data provided they could prove that they had accurate historic data. Based on internal data available two approaches I) Foundation IRB approach: To be used when banks have only PD ( Probability of loan default) data

ii) Advanced IRB approach: To be used when banks have both PD and LGD ( loss given default ) data.

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 PF loans to have same risk weight as corporate loans under standardized approach and advanced IRB approach. Project Finance loans to have higher risk weight than corporate loans under foundation IRB approach

PF 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 $4million capital requirement $100 million*(150%-100%)*8% = $4 million

The incremental capital charge would add to the price of the loan.
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 standards would have a devastating effect on project finance lending by making loan spreads uneconomic to potential borrowers and by driving business to nonbank competitors Citigroup believed a quantitative study by the major banks could help convincing the Model Task Force

Four Bank Consortium


January 2002 Four Banks form a consortium and agreed to colloborate on Loan Loss Study Top 10 Project Finance Loan Arrangers in 2001
ABN Amro Citigroup Deutsche Bank Societe generale

Four Bank Consortium....


Combined they originated over 25% of all Project Finance Loan in 2001
US $ Millions Citigroup ABN Amro Societe Generale Deutsche Bank SubTotal 2000 $11927 7875 9616 6487 35905 2001 $15512 4019 5301 3623 28455

Total Market % of Total Market

110885 34%

108478 26.2%

Four Bank Consortium....


Objective
Convince Basel to reduce risk weights for PF Loans Build a Database that Participating Banks (Consortium) Could use to estimate PD and LGD to qualify for advanced IRB Approach
Approached Risk Solutions (S&P) to conduct Analysis

Four Bank Consortium....


Study was Conducted in 3 Phases Phase 1 Analyse LGD by March 2002
Analyse Defaults

Phase 2 Analyze PD by July 2002


Estimate Expexted Losses

Phase 3 Repeat Process with More banks by March 2003


Strengthen the Studys Statistically

Four Bank Consortium.... Phase 1


Determined Recovery Rate for Defaulted Loans Risk Solutions asked Banks to give data in template
Defaulted Loan Original Terms Cash Flow History Default Date Recover Amounts

Four Bank Consortium.... Phase 1


Distribution of Default Loan By Region & Sector
Region North America Europe No of Facilities 18 8 % Total 42% 18% Sector Power Oil & Gas No of Facilities 9 8 % of Total 22% 18%

Asia Pacific
Latin America Other Total

6
6 5 43

14%
14% 12% 100%

Infrastruct 7 ure
Metals & Mining Telecom Other Total 6 6 7 43

16%
14% 14% 16% 100%

Identified 43 Defaults across regions & Industries

Four Bank Consortium.... Phase 1


Descriptive Statistics on Recovery rates by Asset Type
Asset Type No of Mean Observation Project Finance Leveraged Loans Secured Debt Senior Debt 43 203 339 844 75.39% 78.03 68.85 67.33 Median 100% 98.26 78.86 78.05

Senior 311 Unsecured

46.20

40.38

Project Loans Mean Recovery Rate 75% Median 100%

Phase 1 ....Analysis
Data Suggests PF loans have better LGD Profile than Corporate Loans Proposed PF loans should require Appx Half as much Capital as claims on Corporate Loans

Proposed to Reduce Risk Weight for Project Loans

Phase 1 ....Analysis
Proposed Risk Weights
Rating PD CF loans Risk Weight Categoriz Basel Consortium -ation Proposal( Proposal (Mar Jan 2002) 2002)

AAA to A- .03-.09%
BBB+ BBBBB+ .25 .75

19-35%
55 90

Strong
Strong Fair

75%
75 150

10-18%
28 46

BB
BB+ B to C

1
2 3 5-20

100
130 150 186-376

Fair
Fair Fair Weak

150
150 150 300

50
65 75 93-188

Default

NA

635

Default

750

313

Four Bank Consortium.... Phase 2


Consortium Pooled Portfolios with 759 Facilities from Different Sector and Geographical Regions

Analysis was done by Risk Solutions Analysis Suggested PF loans has lower PD then Corporate Loans

Four Bank Consortium.... Phase 2


Default Rates on Project finance and Corporate Loans

Conclusion
Risk Solution has analyzed the data and found that Project finance Loans are less riskier then Corporate finance Loans from Both LGD and PD Perspective. Proposed to reduce the risk weights on PF loans More Banks to be Added in Study to further Strengthen the Analysis.

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