Risk-adjusted pricing of project loans

Abstract

Commercial banks were inspired to apply risk-adjusted pricing models for their corporate exposures in the last decade. Project loans represent a sub-segment of corporate loans, where risk parameters are hard to measure, and estimations of default probabilities rely on specific cash-flow simulations. Our research question is whether project finance loans were properly priced based on their risk. We take the usual corporate loan model for calculating risk-adjusted pricing and adapt it to project loans. In our simulation we focus on the European market andestimate the minimum required margins and also the implied maximum probabilities of default, where project loans could produce a value added to lenders besides different margins and leverages. We compare these maximum probabilities of default with reference points of other empirical studies. We conclude that in 2006-2007 several projects were very unlikely to produce any value added for shareholders and pricing did not even reach the minimum margin. We also show that market and regulatory circumstances of 2016-2017 have significantly increased minimum margin levels and must have shifted lenders to a more conservative pricing and leverage policy.