Deregulation of the US energy market created a huge demand for capital. Financial institutions responded by lending large amounts to energy project companies, rapidly growing their project finance portfolios and creating a significant concentration of risk.
Since then, excess capacity and slack demand have caused energy prices to fall well below the levels predicted by forward curves used to underwrite these loans. Credit risk has increased dramatically as off-takers and sponsors were downgraded, causing some banks to exit the energy project finance market and others to restructure their holdings. The overall volume of project finance loans in the US market declined from $31 billion in 2001 to $5 billion in 2003.
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However, signs of a rejuvenation of the US energy sector are now visible. Ownership and management of energy assets have been rationalized and energy prices are beginning to stabilize, renewing the capital requirements of the sector. How can banks respond to this need without repeating the errors of the past?
We believe this is possible through better portfolio management. In PA’s experience, an active approach to project finance loan portfolio management can improve after-tax net margin by 200 basis points. For a $1 billion project finance portfolio, this translates to $20 million in incremental profit per year.
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An active portfolio management approach delivers three key benefits:
- reduced concentration risk through diversification across project types, commodity and geography and loan pricing sensitive to risk contribution
- reduced credit losses made possible by shortening reaction times to adverse credit events
- optimized use of credit capacity through securitization, credit derivatives and dynamic rebalancing of the credit portfolio.
Reduced concentration risk
In recent years, the most common mistake banks made in project finance was lending to concentrate. Often these concentrations were not apparent when the financing was made: underwriters did not fully understand how regional differences in energy markets could result in quite different outcomes. Engaging in an active portfolio approach would have significantly reduced the likelihood of large losses due to concentration.
In our approach, the portfolio manager works at the early stage of the underwriting phase with the underwriting team to gain an in-depth knowledge of the new transaction and, more importantly, to define the mix of new loans that will result in an optimal diversification of the portfolio. The key differentiator of an active approach (over the current practice in many banks) is the fact that by placing the portfolio manager at the beginning of the loans life cycle, origination activitiy is focused on deals that contribute to the best diversifiaction of the portfolio. This transforms the nature of the risk management function (see figure 2). Risk management‘s traditional monitoring and reporting role is replaced by a role in wich the portfolio manager, like an asset manager, seeks the best return on risk.
Price remains the key criterion for adding a new to the portfolio. However, instead of pricing a loan based on a traditional interest rate grid, the bank prices the loan relative to the contribution the new loan makes to the overall portfolio risk. The bank will quote a higher rate (a premium pricing) for loans that significantly increase the risk of the portfolio, and a lower (more competitive) pricing for loans that contribute to a better diversification of the overall portfolio. Such a pricing model also enables the bank to implement risk-adjusted performance based compensation schemes for loan origination, where loan originators are rewarded for over benchmark performance on their assets using measures such as RAROC or the Sharpe Ratio.
Reduced credit losses by shortening reaction time to credit events
Poor anticipation of and late reaction to deterioration in credit quality of counter-parties have severely affected banks in the energy project finance sector, resulting in larges losses. The challenge lies, in one part, on the credit system that a bank uses to model and quantify key credit risk measures, and in another part on the decision-making process built around these analytical tools.
According to a PA global survey of 50 large banks, the majority of banks (83%) have an IT system capability in place to assist their credit risk management process. However, at most banks, these systems don’t produce integrated portfolio views, nor do they enable clear decision-making around credit portfolios.
Many banks are still managing their credit assets on an individual transaction-by-transaction basis without any integrated view of the overall portfolio exposure. The result is that most banks are unlikely either to fully understand their exposure to extreme credit loss or to react quickly to adverse credit events.
An active portfolio approach enables banks to create this missing, integrated view of the portfolio. First, portfolio credit modelling tools are proactively used to implement appropriate risk mitigation techniques in a dynamic way in response to daily changes in the credit quality of sponsors and off-takers, the project default risk, and the credit market condition. This is even more important in the energy sector with the high volatility of energy prices. With increasing liquidity in the credit derivative and credit insurance markets, these products are becoming a good choice of risk mitigation, as they help move the credit exposure to another entity without impacting the borrower position, lessening the liquidity constraint imposed by customer relationships.
Second, by clearly giving to the portfolio manager the ownership and decision rights of the credit exposure, the decision-making process is shortened. This allows the portfolio manager to react quickly to any deterioration in counter-party/project key risk indicators, ensuring risk mitigations are triggered quickly or prior to a major loss.
Optimized use of credit capacity
Our experience has shown that, when it comes to project finance lending, many "big name" banks are still in a mode of "originate and hold", where they originate new loans oppotunistically and hold them until maturity. The active portfolio approach breaks this mould and moves banks into a mode of "originate, distribute and optimize". This will deliver benefits in three ways:
- optimize the risk-return equation
- reduce cost of capital and enable a greater utilization of credit capacity
- increase revenues from origination fees and reduce proportion of revenues from interest.
As noted earlier, most banks hold their loans to maturity. They still have no or few activities in the secondary market, while the increasing size of the syndication market and the nature of a project finance loan itself (a focused line of business and a transparent source of cash flow which makes it suitable for securitization in a form of collateralized debt obligations - CDOs) have made active portfolio rebalancing more accessible to banks.
In the active approach, the portfolio manager is focused on actively buying and selling credit exposures where possible to create a risk efficient portfolio, by definition the “best” portfolio. By engaging in active sale of CDOs, the portfolio manager is able to free up the regulatory capital that is tied up in the underlying project finance loans. This enables banks to lower their cost of capital without loosing their loan origination capabilities. At a time that credit capacity becomes a constraint on the business, the cash proceeds from the CDOs sales generate additional lending capabilities that can be used to create or originate new loans, which in turn can be sold. In so doing, the bank is transforming the credit risk function from a traditional buy-and-hold approach to an active originate-distribute-and-optimize approach, similar to an asset broker.
Another advantage of being an asset broker is that the bank increases the portion of its profits coming from upfront fees from loan origination. At a time when it is increasingly difficult for banks to earn an interest-based economic return on project finance loans, the bank’s profitability becomes more fee-dependent than interest rate-spread dependent.
Conclusion
The energy project financing market has gone through a lot of turmoil this past decade, causing some players to exit or reduce their lending activities. The alternative to an exit strategy is a better loan portfolio management.
By engaging in active portfolio management, banks involved in project finance lending can significantly improve their risk-adjusted returns to shareholder and enhance their regulatory status to comply with Basel II and other regulatory requirements. This is done, first, by placing the portfolio managers at all stages of the loan life cycle with ownership and decision rights over the credit exposure. Second and more importantly, it is done by structuring the project finance loans into “securitizable” assets in a form of CDOs to allow active rebalancing and attract investors who otherwise would not have a direct appetite for or access to this type of lending.
We believe most of the elements of a successful implementation of an active credit portfolio management already exist in many banks. They need the expertise to link these elements together within a clear business framework to create an integrated portfolio view.
