The Evaluation from LGD and PD Perspectives
Question:
Evaluate the banker’s argument that project loans and commercial loans are equally risky.
The paper evaluates the bankers ‘s argument that project finance loans are not riskier than comparably rated corporate loans either from Loss Given Default (LGD) or Probability of Loan Default (PD) perspective”. The evaluation is anchored on the perspective of LGD and PD based on the anlysis of default as well as loss characteristics of project loans portfolios. To this end, my evaluation is in support of the conclusion made by the consortium that finance loans remain less risky than corporate loans.
The commercial loans are risky to the borrowers who secure the loan with their assets as this leads to property loss. For example, where one secures his loan with the asset, one runs a risk of losing such an asset in case the loan goes bad. Once one is ninety days past the due date, the bank shall typically send one a default letter which demand instantaneous repayment of loan. Where one cannot get to repay this loan, the bank shall initiate foreclosure proceedings. Such a legal process will see the bank take possession of asset, characteristically real estate. This is a clear justification why the banks have argued that commercial loans are risky than project loans. This is because banks will have to be forced to sell the taken asset at auction as well as utilize the money in recouping the loss. This means that the commercial loans are not only risky to banks but also to borrowers as the borrowers will have to lose their assets which can be a car, a house or any other pledged collateral to secure the loan (Jiménez et al. 2014).
The commercial banks are risky because of the bad credit risk. For example, where one ends up in a condition whereby he starts to miss his loan repayment, it shall adversely affect the borrower’s credit score. Where few days late, it will not matter. And when the repayment is over thirty days late, nevertheless, the bank report such a delinquency to credit bureaus. It takes years for one to repair his ruined credit score because of the default risk associated with the commercial loans. A person or institution, will thus lack the ability to acquire financing for foreseeable future. This is a risk to the borrower and hence supports the argument by the banker that such a loan stays risky. The commercial loans also runs the risk of financial strain to the borrower (Bluhm, Overbeck and Wagner 2016). A commercial loan will add an additional debt. Based on the loan size, this can be an array of thousand dollars a month. Even where one examines his budget carefully, the commercial loan will still remain a burden. There is a further feasibility that the financial condition is able to alter abruptly and drastically as a result of job loss and illness. This is the reasons the commercial loans are viewed as risk as in many cases, the novel loan repayment has taken many borrowers to brink of their financial capacity.
Commercial Loans are Risky to Borrowers
Project loans is a long-term financing of the infrastructure as well as industrial projects anchored on the cash flows projected of the project instead of balance sheets of the project sponsors. Often, a project loan structure entails an array of equity, called ‘sponsors’ a ‘syndicate’ of banks or lending institutions which provide loans to a specific operation. These are commonly non-resource loans that are secured by the assets of the project as well as paid wholly from the cash flow of the project, rather than from general assets or creditworthiness of sponsors of the project, a decision partially supported by the financial modelling (Bluhm, Overbeck and Wagner 2016). The project loan is characteristically secured by all project assets, including revenue-generating contracts.
The lenders of the project are provided a lien on each of the assets as well as can assume a project control in case the project firms have challenges complying with terms of the loan. Overall, the special purpose firm is established for every project hence protecting other assets owned by a project sponsor from the detrimental impacts of failure of the project. As a special purpose firm, the project firm has no assets rather than the project. The capital contribution commitments by a project company owners remain sometimes essential to make sure that the project is sound financially or to guarantee lenders of commitment of sponsors. Project loan is usually more compounded compared to alternative methods of financing. The risk identification as well as allocation remain key elements of a project loan. A project could be subject to an array of technical, economic, political and environmental risks, especially in the developing economies as well as emerging markets.
Lending institutions alongside sponsors could reach a conclusion that risks inherent in development as well as operation of project remain unacceptable. Various long-run contracts like construction, concession, supply, off-take agreements together with a range of joint-ownership structure are utilized in aligning incentives as well as deter opportunistic conducts by a party to the project. The trends of implementation remain occasionally called “project delivery mechanisms or methods”. The loaning of such projects have to be disseminated amongst a range of parties in order to disseminate the risks attached to projects whereas concurrently guaranteeing profits for every party to a project. A riskier and more costly project could require a restrained recourse loaning secured by a surety from the project sponsors. A compounded loan structure could integrate corporate finance, derivatives, securitization, insurance provision and additional kinds of collateral enhancement for the mitigation of risks unallocated. The project loan is an innovative project financing technique which is utilized in funding multimillion dollar corporate project (Morris and Shin 2016).
Most project risk were noted to be syndicated thereby making the task substantially easier since multiple banks held positions in identical loans. As seen by the results, the bankers were effectively vindicated. This is because despite the fact that banks lent in absence of recourse to diversified corporate operations, the project loans remained less risky than relatively rated corporate/commercial loans. I support the fact that project loans have better security and contractual mitigation of key risks compared to corporate loans. Most importantly, project loans have more and better information as well as greater transparency than the corporate loans (Bluhm, Overbeck and Wagner, 2016). This is because, it is true that one gets access to project data and is able to analyze the influence of each input and output on the project finance unlike corporate loans. This is something that is lacking in corporate lending and hence gives corporate loans much risk in terms of LGD. The consortium effectively identified forty-three defaults across an array of industries and regions with the mean rate of recovery for projects loans being 75%; with 100% being median recovery rate. These are illustrated below:
Bad Credit Risk and Financial Strain
As indicated in the letter by consortium members dated on March 18, 2002 to the Basel Committee and their respective national bank regulation, it is true that project loans are less risky in terms of LGD. This is because with greater access to information and transparency coupled with better mitigation of key risk and better security than corporate loans, banks can lend only to those projects they are sure would not default. This is indeed supported by the data which rationally suggested that finance loans have a substantially better LGD profile than such claims on corporates. This makes me fully believe that this data validates the proposal by the bankers that project loans must receive more favorable regulatory treatment than the corporate loans claims across the complete credit spectrum. This was even further supported by the preliminary findings that indicated clearly that project loans must need approximately ½ as much as capital as corporate loans claims under the approach of IRB.
Thus, I am supporting the fact there is a need for the proposed decreased risk weighs for the project loans. This is clearly supported by eleven reasons that I concur to make project loans less risk and hence will always outperform corporate loans. Unlike corporate loans, project loans truly have their portfolio performance as seen in most banks demonstrating better results during the crisis situation. For example, it is true that the banks have shown much higher recoveries on their respective credit loans compared to commercial loans. This is supported by the fact that project loans finance projects with combination of well-structured as well as secured nature; amount of equity underlying project debt; need for output of project; sponsorship of project by firms with long-term commitment to respective industries as well as to nations engaged, careful analysis of downside situations linked to commodity pricing alongside additional factors that are apparently missing in corporate loans.
As observed in comparison of distribution of project loans recovery rates with those of corporate loans based on three statistical tests, the Risk Solutions effectively deducted that project loans performance stood similar to those of leveraged loans:
Control of Collateral:
There is a much better control of collateral in project loans as compared to corporate loans and hence less probability of default. This is because the perfected 1st preference liens on as well as pledges of the collateral of the project. This encompasses assets, shares as well as material contracts. This clearly preserves the exclusive accessibility to repayments from the project liquidation or for purposes of negotiations with lenders and sponsors unlike in the riskier corporate loans.
Strong Sponsors:
Unlike corporate loans that lack strong sponsors, project loans have higher engagement of deep-pocket sponsors and partners. These people have vested interests in these secure projects. Such stakeholders as sponsors, governments, insurers, contractors, off-takers as well as suppliers amongst other have key stakes in the project success and would make these loans less risky.
Covenant triggers:
The project loans have both covenant triggers as well as step-in rights which together act as ‘early warnings’ to the banks for effective and timely renegotiations of a structure prior to the deterioration of the credit quality of the borrower past redeemable points. Whereas commercial loans also have such characteristics, project finance loans remain structured with stringent covenants in a deliberate manner to trigger such loan terms’ renegotiations prior to any substantial occurrence of credit deteriorations. This indeed makes the project loans less risky as compared to the commercial loans.
Project Loans: Long-Term Financing for Infrastructure and Industrial Projects
Sponsor Interests:
The project loans remain less risky than commercial loans due to the interest of the sponsors. These sponsors usually serve as counterparties in such projects. In essence, sponsors thus have vested interests in the project success (Jiménez et al. 2014). Their frequent willingness to inject additional equity into the struggling project despite being unobligated contractually ensures project success and hence ability to repay the loans from the project.
Restrictions:
In project loans, there are effective restrictions on utilization of proceeds, facility drawdowns as well as mandatory repayments. All these together, serve in favor of the lenders and, hence making project loans less risky as compared to commercial loans. This clearly supports the above argument by the bankers that project loans have less risks attached compared to commercial loans.
Sponsor Incentives
The sponsors’ initiatives are protective to lenders in project loans as compared to commercial loans. This supports the argument by the bankers since project loans have contractual obligations; remedies as well as penalties used in project loans always effectively influence the sponsors’ activities that have proved to favor lenders hence greatly reducing the probability of default.
Cash Flow Protections:
In project loans, there are effective offshore as well as debt service account that efficiently mitigate the volatility of cash flow volatility where necessary. This has made the project loans less risky compared to commercial loans that lack such cash flow protections.
Debt Limits
Project loans remain less risky than commercial loans due to limitation of debts. The additional indebtedness is prohibited in project loans. This is merged with characteristically steady as well as rising project cash flows thereby raising coverage of debt service over time.
Transparency:
In project loans, there is increased transparency as compared to corporate loans because of its single-asset nature. Corporate borrowers, in contrast often have revenue streams which are further complicated by the subsidiary structures as well as treatments of accounting, and streams of cash flow which are hard to analyze. Thus in project loans, the bankers have the full information that help analyze the riskiness of the project before extending loans to any project unlike in the commercial loans that have less transparency. Therefore, with much transparency in project loans, the risk of default increasingly reduces thereby making project loans less risky as clearly discovered by the consortium.
Project Independence
In project loans, the sponsor bankruptcy and credit deterioration are both barred by the inherent independent viability of the cash flow and value of the project. The likelihood of avoiding bankruptcy as well as credit deteriorations of the supplier, sponsor and contractor is higher in project loans due to essential of the project commercial value.
Loan Syndication
The project loans are less risky than commercial loans as concluded by the consortium due to loan syndication. This has served to encourage the conservative structures which attract a vast array of retail market. In turn, this syndication limits the likelihood of unsophisticated banks to offer aggressive loans (bilateral). It hence makes sure that all the lenders gain from the controlled recovery procedure/process in the default scenario regardless of the size or significance of their corresponding participations.
Securing Project Loans and Avoiding Risks
Probability of Default (PD) Perspective
As highlighted in the second phases, analysis of PD, the 759 facilities portfolios pooled alongside loans from a vast array of industrial sectors alongside geographic locations confirms effectively that project loans are less risky than commercial loans. This is shown below:
From the above static pools established by Risk Solutions at the commencement of each year effective computation of portfolio default rates over a period was feasible thereby helping the consortium reach this effective conclusion. In this perspective, the conclusion project loans performed similar to commercial credits rated BBB-to BB. However, the Risk Solutions acknowledged that project loans showed a higher rate of recovery at 75% as compared to corporate loans at 50%.
The analysis confirmed that project loans stood less risky than commercial loans based on a lower PD than corporate loans. It was clear that a ten-year cumulative PD for project finance loans stood at 7.630 percent under broader definition as opposed to 9.380 percent for commercial loans. This is illustrated below:
As shown from this PD analysis, the consortium was right in its argument that project loans were less risky compared to commercial loans because project loans showed a PD of 3.680 percent against an LGD of 56.0%, identical to the BBB+ or BBB commercial loans rates. This is a clear indication that project loans stays less risky than commercial loans. Based on this PD analysis outcome, it is evidential enough that project loans are less risky.
The second letter sent to the Basel Committee dated August 23, 2002 was indeed backed by evidence that project loans are less risky than commercial loans based on the higher rate of recovery. It is true that the data showed that project finance loans outperformed claims on corporate loans irrespective of default risk definition (narrower or broader). For example, LGDs, under the broad definition stood low whereas PDs stayed average (Subrahmanyam, Tang and Wang 2014). In contrast, the LGDs stood average under narrower definition as PD staying low under the same definition. This conclusion was effective as it is evidenced-based hinged on the PD analysis (Ndungo, Tobias and Florence 2017).
Response Perspective
It was based on the effectiveness of the contents of two letters that the proposed amendments was approved. For example, the data was valid and reliable and tested both in terms of PD and LGDs analysis which all confirmed that project loans stood less risky (Morris and Shin 2016). This is why besides the analysis undertaken by the Risk Solution on behalf of the consortium, additional banks alongside related parties reached the same conclusion in their responses to the request by the Basel Committee for the feedback. This conclusion could then not be said to lack evidence because every analyst reached the same conclusion based on proper and valid and reliable data. Thus, the IPFA was right by raising such a significant point that recognized project loans to enjoy much better LGD history compared to commercial loans (Bielecki and Rutkowski 2013).
Disseminating Risks by Loan Structures
Based on this massive evidence in supporting the banker’s argument, the proposed regulatory structure indeed required the amendment to incorporate terms that favor project loans. This can as well be supported by the fact that IFC’s project portfolio loans had merely experienced a 2.10 percent loss rate against a 3.10 percent rate for all loans in a 45-year history. Thus in my view, I will totally disagree with the director of the syndication as well as international securities, Suellen Lazarus in reference to specialized lending paper. In my view, with all the information and transparency attached to the projects, it is untrue for Lazarus to argue that no adequate recognition is given to the range of risk mitigants in place for any given project loan transaction (Waemustafa and Sukri 2015). This is because it is clearly indicated under the PD analysis that there are effective offshore as well as debt service account that efficiently mitigate the volatility of cash flow where necessary. In my view, this is an important mitigation aspect that ensures that project loans stay less risk as compared to commercial loans.
Basel III
The Basel II led to Basel III based on the findings of the consortium. The Basel Committee was convinced by the Consortium to reduce the project finance loans’ risk weights. The outcome can be seen in the Basel III details below:
Summary
The conclusion is well thought and backed by evidence. This is because the proper collection of valid and reliable data analyzed deeply and properly reported to the Basel Committee. This analysis has led to fair results indicating that project loans are less risky than relatively rated commercial loans as clearly analyzed on the basis of PD and LGD perspectives. This was a sufficient and rational information capable of convincing the Models Task Force to amend their original stance and embrace risk weights which stay equal to, if not more favorable compared to corporate loans’ weighs.
The decision reached by the consortium was adequate. However, it must be noted that its validity will even be more reinforced if more banks are incorporated in the study. This will be effective as it avail more loan performance data for the respective banks’ internal purposes. This was even more buttressed by the concurrence made by Keisman, S&P’s Risk Solution. Keisman agreed that the results are strong but acknowledged the need for more analysis (Ang and Longstaff 2013). This is because the data used was only covering twenty-five percent of the project loan origination. There is a need for close to 50% coverage of project loan origination as this will further make the conclusion more generalizable and valid.
With the inclusion of more geographic coverage including banks from South America, Asia as well as Australia, both PD and LGDs analysis will clearly confirm that project loans remain less risky than the commercial loans. The analysts need to focus more on getting to the point in which addition of incremental bank doesn’t alter the overall outcomes. This will then show the optimal level and dispel any doubt that project loans are never less risky as compared to the commercial banks. Further, there is a need for analysis of the connection between loan characteristics, loan performance as well as credit behavior (Acharya, Drechsler and Schnabl 2014). When this is successfully done, we will get clearly see these associations thereby boosting our understanding of the risks attached to both commercial loans and project loans. This will help inform the need for the amendments.
References
Acharya, V., Drechsler, I. and Schnabl, P., 2014. A pyrrhic victory? Bank bailouts and sovereign credit risk. The Journal of Finance, 69(6), pp.2689-2739.
Ang, A. and Longstaff, F.A., 2013. Systemic sovereign credit risk: Lessons from the US and Europe. Journal of Monetary Economics, 60(5), pp.493-510.
Bielecki, T.R. and Rutkowski, M., 2013. Credit risk: modeling, valuation and hedging. Springer Science & Business Media.
Bluhm, C., Overbeck, L. and Wagner, C., 2016. Introduction to credit risk modeling. Crc Press.
Jiménez, G., Ongena, S., Peydró, J.L. and Saurina, J., 2014. Hazardous Times for Monetary Policy: What Do Twenty?Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk?Taking?. Econometrica, 82(2), pp.463-505.
Morris, S. and Shin, H.S., 2016. Illiquidity component of credit risk. International Economic Review, 57(4), pp.1135-1148.
Ndungo, J.M., Tobias, O. and Florence, M., 2017. Effect Of Risk Management Function On Financial Performance Of Savings And Credit Co-Operative Societies In Kenya. International Journal of Finance, 2(5), pp.38-50.
Subrahmanyam, M.G., Tang, D.Y. and Wang, S.Q., 2014. Does the tail wag the dog?: The effect of credit default swaps on credit risk. The Review of Financial Studies, 27(10), pp.2927-2960.
Waemustafa, W. and Sukri, S., 2015. Bank specific and macroeconomics dynamic determinants of credit risk in Islamic banks and conventional banks. International Journal of Economics and Financial Issues, 5(2)
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