Sometime in 1999, the Basel Committee is planning to change the banks' capital standards. The committee is of the opinion that project finance loans create more risks and should be charged more under the Basel II proposal. This case study allows students to decide whether to change the current proposal based on the loan loss study.
Benjamin C. Esty and Aldo Sesia
Harvard Business Review (203035-PDF-ENG)
December 05, 2002
Case questions answered:
- What are the Basel Committee’s objectives, and will the new capital accord achieve those objectives?
- How will the new accord affect the project finance industry? Why should banks like Citigroup care, and – more fundamentally – why do increased risk weights make PF loans “more costly”? How should the bankers respond, if at all, to the Basel Committee?
- What do the loan loss studies tell us about the risk of project finance loans? What kinds of project loans are likely to default? How do project loans compare to corporate loans? Why do regulators and bankers have such different views on the risk profile of these PF loans?
- Recommendation: Would you, as a Basel Committee member, revise the current proposal based on the loan loss study? Why or why not? Having closely investigated the current study, what are potential concerns that you as a regulator may have with the study. Elaborate and also comment on how the banks may address those concerns.
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Case answers for Basel II: Assessing the Default and Loss Characteristics of Project Finance Loans (A)
1. What are the Basel Committee’s objectives, and will the new capital accord achieve those objectives?
The Basel Committee wanted to provide more comprehensive and sensitive approaches to risks while maintaining the level of regulatory capital. The committee believed that capital requirements aligned closely to risk would allow banks to manage the business effectively, resulting in a safer, sounder, and more efficient banking system.
The new capital accord would focus on minimum capital requirements, supervisory review of an institution’s capital adequacy and internal assessment process, and the effective use of disclosure.
The minimum capital requirements have the most important role as it forces banks to maintain minimum capital ratios of regulatory capital over risk-weighted assets. The supervisory review makes sure banks assess the internal capital adequacy for covering all risks they can potentially face in the course of their operations.
Lastly, the disclosure of relevant market conditions by banks would ensure market discipline and informed trading decisions by the users of financial information.
The new capital accord would ensure banks have adequate capital for the risk the bank exposes itself through lending, investment, and trading activities. As a result, the new capital accord would achieve the Basel Committee’s objectives.
2. How will the new capital accord affect the project finance industry? Why should banks like Citigroup care, and – more fundamentally – why do increased risk weights make Project FInance loans “more costly”? How should the bankers respond, if at all, to the Basel Committee?
The new accord will result in increased capital requirements for the banks as they would now be required to use increased risk weights ranging from 75%-750% based on the sub-classification of the Project Finance loan as either strong, fair, weak, or default.
The increased capital requirements would mean that the banks would have to increase spreads on their loans and would no longer price their loans competitively in the project finance lending market.
This is because they would no longer meet their acceptable rate of return on equity (ROE) if they priced the loans as they normally would. As a result, the proposed framework on Specialized Lending would hinder the long-term financing for investors, particularly in the emerging markets.
Moreover, the borrowing capacity would also become limited as small banks might be precluded from participating in the syndicated loan market. Due to the higher spreads and uneconomic rates, the borrowers would prefer other sources like corporate finance solutions and other non-bank competitors who are not subject to capital requirements, which would ultimately put the banks out of business as far the project finance lending industry is concerned.
With their market for Project Finance loans at stake, the bankers should…