In the project finance lending operations, the bank are principally exposed to credit risk. Credit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally the failure to make required payments on loans due to an entity.
As a financial intermediary, the project finance division of a bank is exposed to risks that are particular to its lending and trading businesses and the environment with in which it operates. The major goal of project finance firm in risk management is to ensure that it understands, measures and monitors the various risks that arise and that the organisation ideas strictly to the policies and procedures established to address this risks.
Firms have structured credit approval process which include a well-established procedure for comprehensive credit appraisal.
In order to assess the credit risk associated with any financial proposal, the project finance division of the firm first assesses a variety of risks relating to the borrower and the relevant industry.
The borrower credit risk is evaluated by considering:
Industry specific credit risk is evaluated by considering:
After conducting an analysis of the specific borrower’s risk, the credit risk management group assigns a credit rating to the borrower. Generally firms accept a scale of ratings ranging from AAA to BB (varies from firm to firm) and an additional default rating of D. Credit ratings are the critical input for the credit approval process as it helps the firm to determine the desired credit risk spread over its cost of funds by considering the borrowers credit rating and the default pattern corresponding to the credit rating.
Every proposal for a facility is reviewed by the appropriate industry specialists in the credit risk management group before being submitted for approval to the appropriate approval authority. Generally, the approval process for non-fund facilities is similar to that of fund based facilities.
Credit rating for every borrower is reviewed at least annually and is typically reviewed on a more frequent basis for high credit risks and large exposures. Generally, the ratings of all borrowers in a particular industry are also reviewed upon the occurrence of any significant event impacting the industry.
Working capital loans are generally approved for a period of 12 months. At the end of the 12 months validity period, the loan arrangement and the credit rating of the borrower is reviewed and the firm takes a decision on continuation of the arrangement and changes in the loan covenants as may be necessary.