Basel Ii: Assessing the Default and Loss Characteristics of Project Finance Loans
Posted: 29 Jan 2003
SUBJECT AREAS: project finance, capital standards, bank regulation, risk management
CASE SETTING: August 2002, banking industry, Basel Capital Accord
In June 1999, the Basel Committee on Banking Supervision (part of the Bank for International Settlements) announced plans to revise the capital adequacy standards for international banks. As part of the new proposal, known as Basel II (the 1988 Accord is known as Basel I), the Basel Committee asserted that project finance loans were significantly riskier than unsecured corporate loans and, therefore, warranted higher capital charges. The Committee admitted, however, that their assertion was based on qualitative factors and that the industry lacked sufficient historical data to conclude otherwise.
Bankers, fearing that higher capital charges would seriously damage project lending by lowering profits, curtailing lending to developing countries, and driving business to non-bank competitors not subject to the same capital standards, formed a consortium to study the actual default and loss characteristics of their combined portfolios of project loans. The study showed that project loans had lower probabilities of default and higher recovery rates than corporate loans; in other words, project loans are not riskier than corporate loans. Armed with the results, the consortium sent a letter to the Basel Committee in August 2002 trying to convince them to lower the proposed capital charges on project finance loans.
This case challenges students to examine the new capital Accord, understand the differences between project and corporate loans, and critique the statistical analysis and the arguments advanced by the consortium to support its position. Students, acting as bankers, must present the data and try to convince other students, acting as Basel Committee members, to change the proposed capital standards on project finance loans.
The case not only presents entirely new data on the performance of project loans, it also describes the regulation of bank capital and the process of setting new capital standards. Even though the case focuses on project finance loans in particular, the issues are broadly applicable across the banking industry making this case appropriate for courses on project finance, financial institutions, and risk management.
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