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 banks-

guidelines 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 Risk weights

Cash 0%

Residential mortgages 50%

Project Finance and Corporate Loans

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 bank’s 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 IRBFour 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 CitigroupDeutsche BankSociete generale

Four Bank Consortium....• Combined they originated over 25% of all

Project Finance Loan in 2001US $ Millions 2000 2001

Citigroup $11927 $15512ABN Amro 7875 4019Societe Generale 9616 5301

Deutsche Bank 6487 3623

SubTotal 35905 28455Total Market 110885 108478

% of Total Market

34% 26.2%

Four Bank Consortium....• Objective

Convince Basel to reduce risk weights for PF LoansBuild 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 PhasesPhase 1 Analyse LGD by March 2002

Analyse DefaultsPhase 2 Analyze PD by July 2002

Estimate Expexted LossesPhase 3 Repeat Process with More banks by

March 2003Strengthen the Study’s 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

• Identified 43 Defaults across regions & Industries

Region No of Facilities

% Total Sector No of Facilities

% of Total

North America

18 42% Power 9 22%

Europe 8 18% Oil & Gas 8 18%

Asia Pacific

6 14% Infrastructure

7 16%

Latin America

6 14% Metals & Mining

6 14%

Other 5 12% Telecom 6 14%

Total 43 100% Other 7 16%

Total 43 100%

Four Bank Consortium.... Phase 1• Descriptive Statistics on Recovery rates by Asset Type

• Project Loans Mean Recovery Rate 75% Median 100%

Asset Type No of Observation

Mean Median

Project Finance

43 75.39% 100%

Leveraged Loans

203 78.03 98.26

Secured Debt

339 68.85 78.86

Senior Debt

844 67.33 78.05

Senior Unsecured

311 46.20 40.38

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 ....AnalysisProposed Risk Weights

Rating PD CF loans Risk Weight

Categoriz-ation

Basel Proposal(Jan 2002)

Consortium Proposal (Mar 2002)

AAA to A- .03-.09% 19-35% Strong 75% 10-18%BBB+ BBB-

.25 55 Strong 75 28

BB+ .75 90 Fair 150 46BB 1 100 Fair 150 50B- 2 130 Fair 150 65B+ 3 150 Fair 150 75B to C 5-20 186-376 Weak 300 93-188Default 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.