BASEL II: PROJECT
FINANCE RISK
EVALUATION &
PRICING
Prof David K. Linnan
LAWS #602
October 11, 2004
CONCEPTS I
BASIC CONCEPTS FOR TODAY
1. Traditional differing regulatory
concepts in capital, insurance &
banking markets (i.e., financial sector)
2. Changes in banking from old
regulation, to Basel I, now Basel II
coming
3. New risk and disclosure emphasis of
Basel II affects both regulation &
pricing, plus risk calculations as
effects profitability
CONCEPTS II
BASIC CONCEPTS FOR TODAY (CONT’D)
4.
Expectation theory of interest rates
(decomposing elements of risk in interest
rates)
5.
Credit spread concept & empirical
observations re project finance as affects
deal structure (political risk insurance), term
(risk on short vs long) & pricing (spread)
6.
Interpretation re regulatory policy and
structuring transactions in Indonesia
7.
Reflection in Indonesian materials provided?
FIN SECTOR REG
FINANCIAL SECTOR STRUCTURES & HISTORIAL
REGULATION
1.
Going back 25+ years, differing patterns of
financial sector development
a.
Japan & Continental Europe (old-style)
bank-based, stressing private
companies
b.
UK & US tradition (old-style) capital
market-based, stressing public
companies
c.
Underdeveloped financial sector
elsewhere, chiefly state directing
development finance
CAPITAL MARKETS REG I
SECURITIES HOUSES & SYSTEMIC RISK
1.
Underwriter-dealer functions risking
professionals’ capital, broker function
buying & selling nominally risking client
capital only
2.
But systemic risk because brokers
guaranty clearing & settlement, so if their
client disavows order they pay anyway
3.
Capital adequacy traditionally a liquidity
calculation as regulatory approach, mark to
market each day (net working capital, e.g.,
Bapepam regulation V.D.5)
CAPITAL MARKETS REG II
SECURITIES HOUSES & SYSTEMIC RISK (CONT’D)
4.
Relatively low capital as long as acting as
agent (broker) vs principal (dealerunderwriter)
5.
Differing traditions w/in capital markets world
of exchange-based (gentlemens’ club vs SRO)
vs central government regulation
6.
From an operational viewpoint lawyer’s
focus on regulation as danger of capital market
manipulation misplaced as operational issues
more typically clearing & settlement (systemic
risk issues)
CAN RAISE CAPITAL REQUIREMENTS, OR MAY BE HIGHLY
CAPITALIZED IN UNIVERSAL BANKING SYSTEM, BUT
BENEFIT OF CAPITAL MARKET SYSTEM RELATIVELY
OPEN ENTRY (SOCIAL CHOICE)
BANKING MARKET REG I
DIFFERENT RISKS IN BANKING
1.
Banks borrow short (via deposits) and lend
long, so always liquidity problems (triggering
feared bank run) and negative economic
effects
2.
Traditionally, relatively high capitalization
required of banks alongside prudential
regulation to ensure no problems on lending
side where bank acting as principal (risking
own equity)
3.
Risk diversification among banking
institutions traditionally via practices like
syndicating loans, lending in different
markets, etc.
BANKING MARKET REG II
DIFFERENT RISKS IN BANKING (CONT’D)
4.
Problem starting early 1980s with derivatives & banks
increasingly engaging in own account trading, raising
principal risks because lending markets became
competitive & generic
5.
Prudential regulation of the loan portfolio becomes
increasingly misplaced as sole regulatory focus as
banking activities increase internationally
6.
Basel I (1984) source of 8% capital adequacy idea,
originally attributed capital via lines of business (but
regulators realized relatively quickly that old prudential
regulation model with inspectors coming annually was
problematic given new trading risks, etc. which could
sink institutions overnight (and could not understand
newer derivatives risk, etc.)
BANKING MARKET REG III
DIFFERENT RISKS IN BANKING (CONT’D)
7.
Basel II represents a split under which can adhere to
something that looks like older capital adequacy
system by activity category but also INDIVIDUAL credit
risk too re credit ratings, or go to new internally
managed risk system allocating capital & managing
risk INDIVIDUALLY (by computer)
8.
Basel II details addresses different risks in banking,
but begins to look more like liquidity-based regulation
in capital markets to avoid systemic risk (also with
deposit insurance to stop bank runs, etc.) plus
disclosure obligations
9.
BIS as advisory, plus newer fin sector reg as OJK?
PUT ASIDE PROBLEMS OF INSURANCE REG, BUT THERE
PROBLEM IS LONG-TAILED RISKS AND ABILITY TO MEET
FAR FUTURE PROMISES BASED UPON CURRENT
INVESTMENTS (E.G., TASPEN & JAMSOTEK ISSUES IF
THEY MAKE THE SAME KINDS OF LOANS THAT BANKS
DID BEFORE 1997)
FIN SECTOR RISKS AGAIN
DIFFERENT RISKS IN CAPITAL MARKETS, BANKING &
INSURANCE
1.
In capital markets, feared risk is systemic problem at
clearing & settlement stage (freezing markets, etc.) &
arrives from either clients disavowing trades or bad
trades as principal (BUT NO “GOVT” EXPOSURE
BEYOND FEAR OF FREEZING MARKETS)
2.
In banking, feared risk is illiquidity due to obligationasset mismatch (risk of run on bank) & arises from
nature of business in borrowing short while lending
long leading to systemic risk plus possible loan losses
(GOVT EXPOSURE TYPICALLY VIA DEPOSIT
INSURANCE OR SIMILAR GUARANTiES)
3.
In insurance, feared risks are correctly interpreting
long-tailed risk at underwriting stage for claims to be
paid in far future, linked with investment risk re what is
done with premiums paid until then (WHETHER GOVT
RISK OR NOT DEPENDS UPON EXISTENCE & NATURE
GUARANTY FUNDS)
BASEL II’S 3 PILLARS (I)
BASEL II 3 NEW REGULATORY PILLARS (BIS RELEASE 06/26/04)
Basel II represents a split under which can either mostly adhere to
something that looks like older capital adequacy system by
activity category (but individualized credit risk too), or go to new
internally managed risk system allocating capital & managing risk
individually (by computer):
1.
Pillar 1 requires higher capital levels for those
presenting higher levels of credit risk
(a)
“Standardized approach” using
external measures of credit risk for
individuals (e.g., credit rating agencies)
(b)
“Internal ratings based” (IRB) approaches, IRB
Foundation & IRB Advanced
(c)
Explicit capital charge for operational
risk caused by systems, processes, staff or
natural disaster failures (e.g., BNI phony
loans)
BASEL II’S 3 PILLARS (II)
BASEL II 3 NEW REGULATORY PILLARS
(BIS RELEASE 06/26/04)(CONT’D)
2. Pillar 2 requires supervisory review of
bank’s internal risk assessment (so
reviewing controls rather than loans,
etc.)
3. Pillar 3 as market discipline, meaning
pricing of bank’s securities & credit
spreads, assuming disclosure of asset
risk mandated
BASEL II QIS 3 (I)
BASEL II THIRD QUANTATATIVE IMPACT STUDY RE
BANK CAPITAL CHANGES 05/05/03
1.
Note that Standardized approach to Basel II
requirements led to increase in capital
requirements averaging 11% (including
Indonesia, see page 3 QIS 3)
2.
Note that the IRB Foundation approach lead
to an increase in capital requirements
averaging 4% (including Indonesia, see page
3 QIS 3; no figures given for comparable
banks under IRB Advanced, but for major int’l
banks led to a further decrease)
BASEL II QIS 3 (II)
BASEL II THIRD QUANTATATIVE IMPACT STUDY RE
BANK CAPITAL CHANGES 05/05/03 (CONT’D)
3.
How to interpret and act on presumption
under table 1 page 3 QIS 3?
[INSERT VIA DOC CAMERA?]
EXPECTATION THEORY
REMEMBER COMPOSITION OF INTEREST RATES?
1.
Time Value of money .07 – 3.0%
2.
Purchase Power Risk (inflation expectation)
3.
Default Risk (0% for government, credit risk for
corporate)
4.
[Currency Risk Internationally (depends upon revaluation
expectations]
5.
[Liquidity Risk]
DISCUSSION OF CREDIT SPREADS IN BIS WP NO. 159
EMPIRICAL RESEARCH PAPER IS LARGELY A
DISCUSSION OF THE DEFAULT RISK PREMIUM
DIFFERING OVER TIME OVER A YIELD CURVE
BIS WP NO. 159 (1)
BIS WP NO. 159, TERM STRUCTURE OF
CREDIT SPREADS IN PROJECT FINANCE
(AUGUST 2004)
1. Paper looks at specific character
of project finance with a view to Basel
II since now necessary to better
understand risk for capital adequacy
(and implicitly pricing)
2. Variety of empirical determinations
comparing regular corporate loans to
project finance loans (non-recourse)
BIS WP NO. 159 (2)
BIS WP NO. 159, TERM STRUCTURE OF
CREDIT SPREADS IN PROJECT FINANCE
(AUGUST 2004)(CONT’D)
a.
Leverage ratios in project finance (WB)
Sector
Transport
Waste/water
Power
Roads
Telecoms
Mean (%)
77.86
75.00
73.07
63.07
61.25
BIS WP NO. 159 (3)
BIS WP NO. 159, TERM STRUCTURE OF CREDIT SPREADS IN
PROJECT FINANCE (AUGUST 2004)(CONT’D)
b.
(i)
Credit spread different lending forms
Bonds upward sloping (same slope), lineal spread
function average (p. 26)
(a)
investment grade circa +25 to + 120 basis
points
(b)
speculative grade circa +525 to +660 basis
points
(ii)
Project finance loans humped shaped, flattening
then decreasing around 5-7 years even without
agency guarantee circa +125 basis points to +125
basis points @ 30 yrs, peaking circa + 200 basis
points @ 7 yrs (p. 28)
(iii)
Project finance loans hump shaped also with agency
guarantee (lowering credit spread overall circa 50 basis
points), flattening then decreasing around 3 years
circa +125 basis points to -10 basis points @ 30 yrs,
peaking circa +175 basis points @ 3 yrs (P. 28)
BIS WP NO. 159 (4)
BIS WP NO. 159, TERM STRUCTURE OF CREDIT
SPREADS IN PROJECT FINANCE (AUGUST
2004)(CONT’D)
c.
Distinctive nature of project finance
(i)
Non-recourse, so different form of
lending (not regular corporate credit,
rather all cash flows, etc)
(ii)
Political risk due to duration in
regulated infrastructure sphere
(iii)
Agency guarantees essentially
sovereign risk equalizer (so in theory
trading at sovereign credit, although %
coverage not entirely clear)
PRICING & POLICY (I)
INFERENCES FROM BIS WP NO. 159?
1.
For regulatory & capital adequacy purposes, project finance loans in
banking different creature from regular corporate loans, regardless
whether agency guarantee
2.
Given hump-shaped curve, loan duration of project finance loans
means different risk treatment visible at different maturities
a.
Unusually shorter loans may be riskier
(i)
Most likely to default around 5-7
years without agency guarantee
(ii)
Most likely to default around 3
years with agency guarantee
b.
Refinancing risk if project life longer than loan
duration?
c.
How to interpret political risk aspects of
agency guarantee over time (prob with
short-term cashflow calculations vs
sovereign credit longer term)?
PRICING & POLICY (II)
INFERENCES FROM BIS WP NO. 159?
(CONT’D)
1. What are regulatory (capital adequacy
plus) inferences in Indonesia for
different kinds of project finance deals
(with or without agency guarantees,
loans versus bonds)?
2. What are pricing inferences first in
project finance loans, second in
infrastructure regulatory setting itself?
PRICING & POLICY (III)
INFERENCES FROM BIS WP NO. 159? (CONT’D)
3.
How should regulatory/government side
recognize the nature of sovereign guarantee
bodies in case of default
a.
Retorsion problem (cutting foreign
assistance, voting against in IFIs
because defaults treated as sovereign
issue)
b.
Difference on private issuers?
c.
Pluses/minuses agency guarantees,
ultimately contingent government debt
BALI WORKSHOP?
EVIDENCE IMPLICATIONS UNDERSTOOD IN BALI
WORKSHOP?
1.
What is picture in agenda & powerpoint of
implications from BIS WP No. 159?
2.
What about powerpoint emphasis on sound
deals vs financial engineering (meaning
agency guarantees, apparently)?
3.
What about investment grade/non-investment
grade country distinctions and risk
distribution/minimization?