Basel Ii: Assessing The Default And Loss Case Study Solution
Loan Loss Study
Project financing is done to support development of long term infrastructure, industrial or public assets. (Service). The loan loss studies tells us that project finance loans have longer maturities than other syndicated loans and the long term maturity of the loans is not perceived as much risky by lenders as compared to other short term loans. In project financing, credit risk is high at the time of inception, and is reduced at the end of the project’s life. Unlike other debts project finance loans have a hump shaped credit spreads. These loans are highly affected by the political risk and macro environment, therefore, these risks should be evaluated in detail and monitored throughout the project’s life. (Sorge, 2004)
The loan loss study conducted by Risk solutions tells us that project loan are less risky as compared to corporate loans, the loans with credit rating of AAA to A- have the interest rates of 10-18%, which are lower than 19%-35% interest rate of corporate loans determined by Basel committee. (See Appendix 3)
The project whose development does not have any impact on economy, will not be supported by the public or government, and can be considered as highly uncertain. It is likely that the loan obtained to fund such projects will be defaulted due to low or no cash flows earned by the project either as a result of cancellation and in completion of the project or delay in the development of the project.
The project loans are borrowed for a specified period of time, whereas time period for corporate loans is undetermined. The transaction costs of the corporate loans are much lower as compared to project loans due to increased documentation and longer development period. Similarly, the corporate loans are flexible.The amount of the loan has no limit whereas project loan are of small amount due to lower period compared to corporate loans and higher transaction costs. Corporate loans are granted on the basis of strong financial position and liquidity, whereas project loans are granted on the basis of project’s assets, cash flows and contractual arrangements(Weebly, 2019)Assets of the borrowed are used as collateral to obtain the corporate loan, whereas projects assets are used as a guarantee for obtaining the project loans. (Research Gate, 2019)
Revision of the current proposal
Any member of the Basel committee would first analyze the facts and results provided by the loan’s loss study, and the portfolio on which the study is conducted will be expanded to ensure that whether the results are correct or incorrect. If the results of the extended study comes positive, the proposal will be revised.However, same credit ratings and probability of default will be used.
Corporate loans will still be considered less risky as these loans are granted to a number of individuals and not only to an individual, if one loan defaults, other loans will still be secured. Also to obtain the corporate loans, the borrower has to submit assets as collateral makes it less risky as compared to the project’s loans. The project loans have higher interest rates as they are considered more risky due to the higher transaction costs and no recovery of cash in case a project is defaulted due to cancellation or delay of the project.
Therefore, the revised plan is calculated on the same credit ratings assigned and probability of defaults, but higher risk weights are assumed for project loans as they are more risky, and lowrisk weights are assumed for corporate loans as they are less risky. A risk factor is calculated for each credit rating on the basis of probability of default and risk weights. The amount of default project loan in comparison to total loan is amounted to $27823, whereas the amount of corporate default loan as compared to total corporate loan amounted to $77375, proving that corporate loans have high default probability as compared to the project loans.
As per the revised proposal, 1.35% corporate loans default is evaluated as compared to total corporate loans whereas only 1.1% project loans default is evaluated as compared to the total project. (See Appendix 4)
Conclusion
Basel committee had the objectives of enhancing the financial stability of the financial institutions, depositors and creditors, in order to achieve this.The committee proposed to revise the capital standards on project loans due to being more risky, and introduced two approaches to ensure that the correct risk weights and capital requirements are set. Various bankers conducted a loan loss study in challenge, and proved that LGD and PD of project loans are much lower than corporate loans, therefore risk weights and capital requirements should be revised…………
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