BASEL II: ASSESSING THE DEFAULT &

LOAN CHARACTERISTICS OF PROJECT

FINANCE

GROUP 2 | Section A
BIRANCHI PRASAD SAHOO
PARTH LIMBACHIYA (089)
NISARG PATEL (101)

Comment on the initial Basel

recommendation? Do you agree with it?

Evaluation of Basel-I
Pros

Easy to implement

Cons

Failed to acknowledge the difference between loans within given asset categories and
bank specific loans
Does not take into account the impact of time to maturity of the loans in the various
asset classes on the default probability

Evaluation of Basel-II
Pros-

More comprehensive and sensitive to the risks than Basel I

More flexibility of capital ratios
Well structured approach: 3 pillars
Takes into account portfolio diversification
Extends the rules of the supervisors and of the market
Internal models as a source of competitive advantage
Takes into account the difference in riskiness of individual assets in an asset group
The IRB approach takes into account a banks specific risk profile as well as its history with loan
default and LGD

Dependency on agency ratings

Banks that do not qualify for the IRB, will have to maintain higher capital
Risk weights for PF loans likely to be higher than CF loans making spreads on low rated PF loans
higher thereby affecting lending in emerging markets

Cons-

Feasibility of Basel-II
Basel-II addresses inherent problem of Basel I by specifying capital
requirement based on credit risk within asset classes. This has improved
assessment of capital requirement based on riskiness of project
Under foundation IRB approach, spreads on low-rated project finance
loans increases as internal capital allocation systems are based on notion
of Risk adjusted return on Capital (RAROC)
Basel-II approach assumes all the project finance loans are riskier than
corporate loans
Standardized approach and IRB approach should be normalized to avoid
arbitrage in minimum capital requirement so that there more banks opt
for external rating agencies review and take advantage of their expertise.
Basel-II takes into account credit risk, market risk and operational risk in
calculating Capital requirements.
Failed to address any liquidity requirement or business risk inherent in
the project

Did the banking consortium act reasonably? Do you

agree with their analysis? What pressures the banks
to act? Why a consortium?
Pressure to Act:
To earn adequate RAROC, Banks have to price project loans higher
which lead borrowers to look for corporate finance solutions to fund their
investments
It may affect lending in emerging markets
Preclude smaller banks from participating in the syndicated loan market
Additional capital requirement will be 14% under Basel-II
Why a
consortium?
Objectives of the consortium were to convince Basel committee to
reduce risk weights for project finance loans and build a database to
estimate PD and LGD to qualify for advanced IRB approach
Most of the project financing loans were syndicated loans.
Consortium would have been useful to collect data on different
project involving same consortium partner. This data was to be used
to calculate PD and LGD
Moreover volume of the syndicated loans arranged by consortium
members was was significant (25%)
Data can be pooled from large number of consortium members and
this would have helped to move towards advanced IRB approach (as

Outcome of the study- Phase 1

The banks identified 43 defaults across regions and industries under broadly defined default
Number of defaults declined to 18 under narrowly defined default
Mean recovery rate was 75%; median 100%
Statistical test revealed that performance of project finance was similar to leveraged loans
and they performed more like senior loans than subordinated leveraged loans
Reasons for better performance
Sponsor Interest, Cash Flow protections, Debt Limits, Better security, contractual mitigation
of risks, well structured and secured nature of projects

Outcome of the study- Phase 2

PD for project loan was 7.63% under broader definition compared to 9.38% for CF loans and
3.68% using narrower definition
PF loans performed like BBB- to BB (broader) and BBB+/BBB (narrower) corporate loans with
a higher recovery rate of 75% (broader) and a LGD of 56% (narrower)

Analysis of outcome:

The study brings to light that PF loans are less riskier than the CF loans both in terms of LGD
and PD
Cons:
Project finance is a small component of the business for most of the banks. So the number of
PF loans considered for the LGD study is quite small when compared to other categories of
CF loans
Project finance loans in emerging countries constitute a very small portion of the total
sample of PF loans for the loan loss study. This could mean that the country/political risk may
not be captured entirely in the sample

What would you have done? Comment on your assessment of the

riskiness of project finance loans (Insights beyond the case are
welcome).
Findings of the study are subjected to limitations as identified previously
Of the 43 defaults, 41.9% defaults were from North America which indicates
higher default rates in emerging markets
Sample data doesnt have sufficient observations from emerging markets
Sample size should be increased before passing any judgment about riskiness of
the loans

Riskiness of Project Finance:

Restrictions on additional debt combined with cash flows of the project increases
debt-service coverage ratio
Project financing safe-guards parent companies from financial risk.
Due to securitization of the loan in addition to control on asset make it easy for
repayment of loan.
Pledges of the project collateral ensures repayment in the event of distress.
With the involvement of stake in the project, information about project is easily
available which can be used to monitor and restructure loan.
Due to sponsors vested interest in the project, they are frequently willing to
inject equity in the project.
Due to syndicated approach of loan in the project financing, limits the possibility
of unsophisticated banks being able to offer aggressive bilateral loans.