Financial markets Role risks and projects MPM programme

Financial markets Role, risks and projects MPM programme / University of Iceland October 2009 Benedikt Arnason

Overview 1. Role and risks of banks – Role – Risks – Credit ratings 2. Risk and return of portfolio 3. Financial management – Investment decisions – Financing decisions 4. Banks’ overview of projects 5. Project finance - PPP (Public private partnership) September 2020 2

1. Role and risks of banks a) Role

Role of financial markets • • Vital function in the economy. Serves as a lubricant. A necessity for a society to keep the financial market healthy. The link between savers and investors Medium of payment Trading vehicle which gives market price September 2020 4

Direct finance September 2020 5

Indirect finance September 2020 6

1. Role and risks of banks b) Risks

Major risks • • • Business risk – Credit risk (loan quality) – Market risk Financial risk – Interest rate risk – Liquidity risk – Funding risk – Capital risk Performance risk – Management risk – Income stability and diversity September 2020 8

Business risk Loan quality Seven deadly sins of lending 1. Excessive growth 2. Concentrations (sector, borrower, region) 3. Related party lending 4. Directed lending 5. Weak credit procedures 6. Poor pricing 7. Roll-overs of weak credits September 2020 9

Business risk Non Performing Loans: Typical Reserve Requirements Description Definition* Reserve %* Current 0 -2% Watch Areas of concern 0 -10% Sub-standard >90 days overdue 50 -100% Doubtful >180 days overdue 75 -100% Loss Non recoverable 100% or write off September 2020 10

Financial risk Bank Sources of Funding • Deposits Retail; wholesale; inter-bank • Money Market Repos, placements • Senior debt Floating rate notes, bank loans • Off balance sheet Securitization • Subordinated debt Dated securities Perpetual securities • Equity Preference shares Capital securities Ordinary shares September 2020 11

Financial risk Funding Stability & Diversity "Funding that is stable, diverse and low cost on an ongoing basis and reliable in a crisis" • Deposit base - type and sources • Other funding sources - type and diversity - commitment September 2020 12

Financial risk Off-balance sheet items • • • Derivatives – Potential future exposure Commitments – Committed un-drawn lines of credit Contingent obligations – Guarantees and letter of credit Other contingencies – Litigation – Operating lesae payment Off balance sheet entities – Special purpose entities – Investment funds September 2020 13

Source: Fitch September 2020 14

Early warning signals Financial Indicators • • • Excessive loan growth Excessive concentrations Earnings from non core businesses Creative accounting policies Interest receivable increasing Problem loans rising Reserves / problem loans declining High borrowing costs Liquidity declining September 2020 15

Management Mission Statements Challenges to evaluating mission statements. . . ENRON MISSION STATEMENTS • • • 1985: To become the premier natural gas pipeline in North America 1990: To become the world's first natural gas major 1995: To become the world's leading energy company 2001: To become the world's leading company 2002: To emerge from bankruptcy as a viable, albeit smaller, company September 2020 16

Management "Bad" Management: in the face of Problems • Admits to company weak performance • Blames it on any or all of the following: - The economy - Terrorist threats - Sars and bird flu - Bad summer - US $ exchange rates • Promises next year will be better! September 2020 17

1. Role and risks of banks c) Credit ratings

ANALYTIC OVERVIEW - Long Term Credit Ratings Agency Definitions Fitch & Highest credit quality S&P AAA Very high credit quality AA High credit quality A Good credit quality BBB Speculative BB Highly speculative B High default risk CCC Moody's Explanation Aaa Exceptionally strong capacity for timely payment of financial commitments which is highly unlikely to be adversely affected by foreseeable events. Very strong capacity for timely payment of financial commitments which is not significantly vulnerable to foreseeable events. AA+ AA AAA+ A ABBB+ BBBBB+ BB BBB+ B B- Aa CCC+ CCC- Caa A Baa Ba B Aa 1 Aa 2 Aa 3 A 1 A 2 A 3 Baa 1 Baa 2 Baa 3 Ba 1 Ba 2 Ba 3 B 1 B 2 B 3 Caa 1 Caa 2 Caa 3 Strong capacity for timely payment of financial commitments which may be more vulnerable to changes in circumstances / economic conditions. Adequate capacity for timely payment of financial commitments but adverse changes in circumstances / economic conditions are more likely to impair this capacity. Possibility of credit risk developing, particularly due to adverse economic change over time. Business / financial alternatives may be available to allow financial commitments to be met. Significant credit risk with a limited margin of safety. Financial commitments currently being met; however, continued payment is contingent upon a sustained, favorable business and economic environment. Default is a real possibility. Capacity for meeting financial commitments is solely reliant upon sustained, favorable business or economic developments. Probable default CC Ca Default of some kind appears probable. Likely default C Default imminent. C September 2020 19

Analytical overview Statistical measurement of default risk 1970 - 2005 Average cumulative default rates (%) 1 year 5 years 10 years Aaa 0. 00 0. 11 0. 56 Aa 0. 01 0. 19 0. 58 A 0. 02 0. 51 1. 42 Baa 0. 18 2. 06 4. 89 Ba 1. 23 10. 57 19. 86 B 5. 65 29. 06 46. 12 Caa 1 - C 21. 12 56. 52 74. 72 Inv. Grade 0. 07 0. 90 2. 23 None Inv. Gr. 4. 75 21. 29 32. 72 September 2020 20

2. Risk and return of portfolio

Rates of return 1926 - 1997 September 2020 22

Measuring risk September 2020 23

Exponential growth in future value September 2020 24

Value of an investment of $1 in 1926 September 2020 25

Why should one diversify? • Don´t put all your eggs in one basket • Portfolio therory provides an exact mathematical formulation of this saying September 2020 26

Why do people still not diversify? September 2020 27

Diversification styles September 2020 28

Systemic and unsystemic risk September 2020 29

3. Financial management a) Investment decisions

Financial management September 2020 31

Investment decisions September 2020 32

Cash flow September 2020 33

Procedures for evalating investments September 2020 34

NPV rule September 2020 35

Example September 2020 36

Example continued September 2020 37

Payback method September 2020 38

Problems with the payback method September 2020 39

Accounting rates of return September 2020 40

3. Financial management b) Financing decisions

Sources of capital September 2020 42

Equity September 2020 43

Debt September 2020 44

Cost of debt September 2020 45

September 2020 46

September 2020 47

What capital structure has lowest cost September 2020 48

Impact of leverage September 2020 49

WACC (traditional view) September 2020 50

M&M Proposition September 2020 51

M&M Proposition September 2020 52

4. Banks´ overview of projects

Funds providers´ considerations • Macro economic – Legal regime that permits security / enforcements of contracts – Political commitment – Competition environment – Availability of service providers – Availability/Capacity of Long-term debt market – Availability of project equity – Established exit route for equity – Transparant procurement process September 2020 54

Funds providers´ considerations • Micro economic – Well defined projects; clarity of output specification – Strong experienced contractors – Credible completion undertakings – Appropriate allocation of risk in the payment regime – High quality predictable cash flow - low volatility – Alternative service providers in the event of bank step-in – Protection from other adverse events, e. g. change in law September 2020 55

September 2020 56

Assessing the cash flow • • • Capital costs / Construction costs Sales forecast assumptions – Price elasticity – Sales volatility – What may be the competitive response to a new service Operating costs Sensitivity analysis Break-even analysis September 2020 57

Lenders´ yardsticks • • • Debt service cover ratio (DSCR) = free cash flow / fixed charges Free cash flow = Net operating profit – (+) Depreciation – (-) Changes in working capital – (-) Incremental capital expenditures – (-) Taxes – = Free cash flow (Available to service debt) Fixed charges = Principal + interest + lease payments September 2020 58

Group structure complications September 2020 59

5. Project finance - PPP

Project finance • • Financing of long-term infrastructure, industrial projects and public services based upon a complex financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project rather than the general assets or creditworthiness of the project owners. Secured by the project assets Special Purpose Vehicles (SPV) created for each project PPP - Public Private Partnership - special kind of project finance September 2020 61

Design Build Finance and Operate • During the life of the project – Project company has incentive to complete the building works on time and operate a full service – Repays debt – Makes a profit – "Hands back" the facility to the public sector at end of the contractual term - usually at no cost September 2020 62

Phases of DBFO • • Phase I – Private Sector forms a Project company Obtains financing, builds facilities and Public Sector pays nothing. Phase II – Private Sector Makes facilities available and provides services Design and construction services could include security, maintenence, cleaning, catering, IT etc. – Public Sector Pays a monthly payment (average 25 year contractual term) September 2020 63

Government incentives • Risk transfer: – Design in hands of private sector – Private sector raises finances – Time and cost overrun absorbed by private players – Unexpected life cycle costs (maintenance/asset renewal) are transferred – Usage or demand risk may be shifted September 2020 64

Private incentives • Investors in projects – Take contractual risk, or pass on to a sub-contractor – Must price risk appropriately – Adjustments to the "Unitary Charge" negotiated – Benchmarking / market testing for "soft" operating services September 2020 65

Project risks • • Construction risk – Cost overruns, completion delay, force majeure Sponsors – Commitment, additional equity Operating risk Market risk Environmental risk Financial risk Political risk September 2020 66

Typical Project finance structure September 2020 67