Basel II has been on the horizon for years, but with the first phase of implementation approaching at the end of the year, and some banks already putting the guidelines into place, Melanie Lovatt looks at the regulations and discusses their impact on project finance.
When the new Basel II regulations go into effect on 1 January 2007 they will determine capital requirements for banks exposure to various types of transactions, including project finance. The possible impact of Basel II has been a subject of speculation in banking circles for many years, not least because of revisions as the rules have been developed. The latest document was presented by the Basel Committee on Banking Supervision in November 2005. International Convergence of Capital Measurement and Capital Standards A Revised Framework, puts together the committees work over recent to years to secure international convergence on revisions to supervisory regulations governing capital adequacy of international banks. The 284-page report can be accessed on the Bank for International Settlements (BIS) website on http://www.bis.org/publ/bcbs118.pdf .
Generalizations about the complex rules laid out in such a document are difficult, but a few areas are directly relevant to project finance and some basic conclusions can be drawn. The regulations are organized into three pillars the first of which sets out minimum capital requirements for banks; the second discusses the key principles of supervisory review; and the third deals with market discipline to complement one and two, and encourage market discipline by developing a set of disclosure requirements.
In assessing the impact of Basel II on project finance, the first pillar is of direct interest. In the revised framework, the Basel Committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound, but also pay regard to the particular features of supervisory and accounting systems in member countries (including Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, UK and US). A significant innovation of the revised framework, said the Basel Committee, is the greater use of assessments of risk provided by banks internal systems on capital calculations. For the first pillar on minimum capital requirements, the framework provides options for determining capital requirements for credit risk and operational risk, to allow banks and supervisors to select the most appropriate method.
Banks are given a choice between two broad methods for calculating their capital requirements for credit risk. One measures risk in a standardized manner, supported by external credit assessments, while the other (subject to approval by the banks supervisory body) allows banks to use their internal rating system. Generally, larger international banks are likely to use the latter, with smaller ones choosing the former.
Risk Weighting For Specialized Lending
Rating Grade | Strong | Good | Satisfactory | Weak | Default |
Risk Weighting | 70% | 90% | 115% | 250% | 0% |
Capital Needed | 5.6% | 7.2% | 9.2% | 20% | Default |
External Credit Assessment | BBB- or better | BB+ or BB | BB- or B+ | B to C- | Not Applicable |
For calculating minimum capital requirements for specialized lending (such as project finance), banks not meeting the requirements for estimates of the probability of default under the corporate internal ratings-based method must map their internal grades to five supervisory categories associated with a specific risk weight (see table). The Basel Committee notes that each supervisory category broadly corresponds to a range of external credit assessments.
Prior to Basel II, the 1988 capital adequacy framework required banks to hold capital equivalent to at least 8% of their risk weighted assets, and this stipulation applied directly to project finance. This 8% weighting is still in effect. Now, under the Basel II revised framework, a risk weighting of 100% still requires the bank to apply capital of 8% to its direct exposure to the project; but if the risk weighting is higher or lower the amount of capital needed can be more or less. For example, if a bank agreed to lend $100mn to Qatargas 2, under the previous regulations, it would need to apply $8mn to the transaction. Given that Qatar Petroleum and the Qatargas 2 sponsors are highly rated entities, under the forthcoming Basel rules the bank need only apply $5.6mn.
Better And Worse
Banks have questioned whether the Basel II guidelines are better or worse for them in terms of minimum capital assignment, and the answer is both yes and no. For highly rated projects they will fare better, because they will have to apply less capital, but for lower-rated more risky projects, they will have to apply more, Karl Cordewener, Deputy Secretary General of the Secretariat of the Basel Committee on Banking Supervision told MEES . But he said the risk ratings could vary if the bank had approval to use the internal ratings based approach or the advanced internal ratings based approach.
Assessing which rating grade a project will fall into can be done using Supervisory Slotting Criteria for Specialized Lending which is found in Annex 6 of the revised framework. To arrive at the criteria it uses market conditions, financial ratios, stress analysis, financial structure, political and legal environment, operating risk, off-take risk, supply risk, reserve risk, strength of sponsor and security, such as the lenders control over cash flow (eg cash sweeps, independent escrow accounts, etc), strength of the covenant package and reserve funds.
Standard & Poors Recovery Ratings Definitions
Recovery Rating | Recovery Expectation | Indicative Recovery Expectation |
1+ | Highest expectation of full recovery of principal | 100% of Principal |
1 | High expectation of full recovery of principal | 100% of Principal |
2 | Substantial recovery of principal | 80-100% of Principal |
3 | Meaningful recovery of principal | 50-80% of Principal |
4 | Marginal recovery of principal | 25-50% of Principal |
5 | Negligible recovery of principal | 0-25% of Principal |
Standard & Poors launched its own recovery rating scale, separate to its traditional rating scale, which was applied to corporate transactions and as of 2005 is applied to projects. So far, it has not been used, but S&P expects that with the approach of Basel II it will be. For smaller banks with less sophisticated risk weighting abilities it could be a valuable tool, Jan Willem Plantagie, S&Ps Director, Infrastructure Finance Ratings, told MEES . The key question is whether banks have a credit scoring system in place which is approved by the regulators, he said. A study by S&Ps Risk Solution Group had measured 122 existing loans in the Middle East, of which only two had defaulted, but with eventual full recovery.
Mideast Oil/Gas Sector
Many of the international banks lending to the Middle East project finance sector are Basel Committee member countries, so Basel II is expected to have a direct impact on the sector. And the effect could be more pronounced because some of the countries in the region are expected to come on board, and individual banks, such as National Bank of Kuwait, have also announced their participation.
It has been suggested that by adding more assessment criteria, Basel II could make compliance more difficult for regional and local banks. Some are already struggling to compete with international banks on big project finance transactions due to the currently lean margins. Adding a layer of bureaucracy, and thus costs, will not be welcome, said one banker. But, others say, if capital allocation becomes more flexible, and forces banks to rigorously assess the chances of a project default, overall banking conditions will improve. However, smaller banks are in some cases having to pass on the highly rated projects because the margins are too lean. And if they go for projects with lesser ratings, under Basel II they face the possibility that capital requirements will be higher. Some believe the advent of Basel II has in part been responsible for pushing Gulf lending margins lower as a number of banks have already taken the Basel II criteria on board and have found that for transactions viewed as less risky, which form the bulk of their portfolios, they need to apply less capital. Hence their capacity to lend to projects increases and this could theoretically help drive down margins.
With Basel IIs implementation still 10 months away, it is too early to make a detailed assessment of the impact on Middle East lending. But, it appears, the regulations will not restrict project finance as some had initially feared. Generally they appear fair; and flexibility within the guidelines seems appropriate, given the range of banks internal assessment abilities. Above all, it makes common sense to apply greater capital reserves to riskier transactions. An energy project with strong sponsors located in a country with a high sovereign rating should not need to apply as much capital to satisfy regulators as a venture in a risky country with suspect partners.
