Project Risk Management
In order to achieve a sufficient speed of economic development in the future, the bank is required to increase significantly the loan for the purpose of investment and working capital. Meanwhile, for one reason, Indonesian banks indicate that lack of capital is hampering the increase of the loan.
Another reason, loan expansion is hampered by reluctancy of a number of banks to face the Credit Risk. Therefore, it is an urgent necessity for Indonesian banks to increase their skill in Risk Management, which now in fact become one of the core bankings skills that should be acquired by every bank.
Credit Risk dominates the rest of risk types to which the banks are exposed : Market Risk, Liquidity Risk, Operational Risk, Legal Risk, Reputation Risk, Strategic Risk and Compliance Risk. In order to handle all categories of risk, when a bank has projects to finance, the bank has to implement project risk management.
There are three stages in an investment project that the lender should carefully follow in order to do project risk management: (1) project appraisal (preparation and planning), (2) project implementation, and (3) operation of the assets. A project can be that of manufacturing plant or infrastructure.
In the first stage, the project owner will start approaching the lender. From the perspective of internal control, the lender should have developed procedure to screen out application that has no creditworthiness. The credit approval procedure is half of the risk management in the banking line of business. Therefore, it should be well designed and implemented in order to keep Credit Risk as low as possible.
First stage, the lender will approve the application if they are convinced that the project is economically viable and technically feasible. They need assurance that the project will generate output at its design capacity. Lenders generally require verifying opinions from independent engineering consultants, particularly if the project will involve unproven technology, high density technology, unusual environmental, or very large scale project.
Learning from the past, in the case of the debtor put the machineries as a collateral, some ugly debtors possibly do marking-up the price. To avoid such moral hazard practice, the lender needs a professional technical advisor in order to verify the worthiness of the machineries.
In the second stage, a major portion of the fund (including the loan) will be spent for the purpose of design, construction and commission. This is a critical stage, because most activities are not reversible as far as the cost concerned. Cost-overrun may implicate a down-grade in the economic viability of the project.
Also, a delay in this stage may implicate delay in commencing the next stage, which is the Operation of the Asset. If the completion of this stage is behind the schedule, it may implicate a bad timing for the output when entering the market.
The existence of strong technical supervision on the stage of Project Implementation is a necessity in order to protect the interest of all parties, including that of the lender. in the third stage, as long as it is still in the payback period, the lender need to periodically verify whether the technical capability of the debtor can sustain during the loan payback period. So that they are able to generate sufficient revenue. Are all assumptions that were set in the proposal still valid? Does the collateral still physically exist, in good condition and having a sufficient value?
Therefore monitoring and operational audit of assets (not only administration and financial audit) is very important stage to guarantee that credit released will be paid by debtor.
When an investment project is so large and the risk in unbearable by one party, the investor/project sponsor will consider to apply project financing scheme. This type of scheme is widely applied in large investment projects like power plant, telecommunication, infrastructure, oil and gas, mining, petrochemical, manufacturing plant etc. The global growth of total committed loan for project financing scheme is more than 20% per annum.
There are a number of participants involved in a project financing, depends on necessity: investors/sponsors, lenders, contractor, consultant, input supplier, off-taker/purchaser, operators, and government. A separated legal entity is established, and called “Project Company”. In view of risk management, various related risks are allocated among and absorbed by the participants who are best able to bear them.
These risk are related to the construction period of the project. It may consist of input availability risk, contractor performance risk, cost overrun risk, lateness risk, force majeure risk. One of the mechanisms to manage the construction and completion risk is by appointing independent consultant to supervise the EPC (engineering, procurement and construction) contractor.
Once the construction period is over, and operation period is commenced, the major related risks are raw materials/in-take/supply/reserve risks, output/revenue/off-take risks, technological/process risks, operator’s performance risks, and force majeure risks. To ensure the continuity of the input and revenue, in other words to manage the risks, the project company shall make long-range contract with supplier and purchaser. In some cases, the suppliers, purchasers and operator are also sponsors of the project.
The lender can periodically review the operator’s performance in order to prevent problem being detected too late and in an unsolvable stadia.
It concerns the risks caused by foreign exchange rate, interest rate, inflation rate, and price of the out put. The long-range agreement with the purchaser, as mentioned above, can manage one of the financial risks. The more confirmed the supply and off-take agreement, the higher credit-worthiness given by the lender.
One of the off-take agreement types, ensures a certain level of price, for example tolling fee in the toll-road project. As the selling price is crucial in the calculation of financial viability of the project, the lender will usually prefer government not to interfere price determination.
The debt of the project company that is funded through project financing can be very high, and makes debt-to-asset ratio reaching 60% – 90%. It makes sense if the project company gives the lender sufficient freedom to do periodic review on the project.
Lender’s Technical Advisory
One of important risk management in banking business is engineering and technology aspects. This makes sense since the credit is usually used for investment in infrastructure and machineries (or a plant as a whole). The collateral can be in kind of machineries (or plant) or properties. Consequently, the staffing for verification team, either pre or post credit approval, should be carried out in this perspective.
When a plant works as it should be, its value shall be higher than the total value of its machineries from which it is composed. And so is the price, it may be higher than booked value. If the credit appraisers miss this aspect, they will miss a business opportunity. Instead, they will find a prospectless credit applicant or unworthy collateral.
In the other hand, a machine or a plant is so complicated so that it is only a trained person can assess its worthiness. The quality can be so low such that the debtor will not be able to realize its planned revenue. Or, the reliability can be so poor such that it is most probably will completely breakdown before the end of payback period.
The bank should provide the verification team with certain capacity in engineering aspect. Meanwhile, the training, education and experience background of bankers is mostly in finance or economics. Therefore, there should be one or more person that has technical capability. Most probably this kind of person is not available inside the lender’s organization, then outsourcing will be the most logical decision to make.
The title of the profession with this capability can be “Loan Review Officer”, but we prefer to call it “Lender’s Technical Advisor” to emphasize the technical or engineering that become his or her experience and education background.
The role of Lender’s Technical Advisor will continue although after the credit has been released. The condition of the established plant may deteriorate and consequently need another verification to see if all assumptions forwarded in the beginning are still valid or not.
Founded in October 6, 1999, Immara Consulting is among the most recognized US based consulting groups dealing in turnaround and crisis management. Our specializations are in crisis intervention, turnaround planning, and performance enhancement for financial recovery.