Assessment and mitigation of credit risks in project financing

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Lending to long-term investment projects in fragile countries requires additional financial instruments to control the sustainability of project cash flows and to increase the borrower’s financial discipline in debt servicing. This paper analyzes the special aspects of using financial covenants as credit risk mitigation instruments in project financing in Ukraine. It also argues that regulatory requirements to maintain financial strength indicators at the appropriate level have an indirect impact on the change in project finance loan rates. The study primarily aims at developing approaches to defining a credit rate corridor for an investment project, depending on changes in the values of financial sustainability indicators. The implementation of the proposed approach allows increasing the validity of credit risk components for investors and optimizing capital value for borrowers.
As required by international practice, violation of covenant terms is the trigger for satisfying the creditors’ claims. According to the authors’ conclusions, the use of financial covenants as a tool for protecting the creditors’ interests should not be an instrument of unreasonable financial pressure on borrowers. The study reveals benefits and drawbacks of using financial covenants to mitigate credit risk and reduce the probability of a borrower default in the field of project financing in Ukraine.

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    • Figure 1. Main stages of determining the value of borrowed capital to finance an investment project by reference to financial targets
    • Figure 2. Determining the loan rate change corridor for an investment project adjusted for the DSCRi and LLCRс targets (to achieve target DSCRi and LLCRс)
    • Figure 3. Acceptable interest rate for a project with financial covenants, %
    • Figure 4. Interval changes of the annual NPV of an investment project while meeting the target financial covenants
    • Table 1. Supervisory grades for project finance exposures according to Basel II
    • Table 2. Test results for banking institutions’ compliance with covenant terms for 5-year lending to an investment project in Ukraine
    • Table 3. Range of increasing the loan rate for an investment project based on the target financial covenants (DSCRi and LLCR), % of borrowers
    • Conceptualization
      Svitlana Naumenkova, Ievgen Tishchenko, Volodymyr Mishchenko, Viktor Ivanov
    • Formal Analysis
      Svitlana Naumenkova, Ievgen Tishchenko, Svitlana Mishchenko, Volodymyr Mishchenko
    • Investigation
      Svitlana Naumenkova, Ievgen Tishchenko, Viktor Ivanov
    • Methodology
      Svitlana Naumenkova, Ievgen Tishchenko, Svitlana Mishchenko, Volodymyr Mishchenko, Viktor Ivanov
    • Project administration
      Svitlana Naumenkova
    • Supervision
      Svitlana Naumenkova, Volodymyr Mishchenko
    • Writing – original draft
      Svitlana Naumenkova, Ievgen Tishchenko, Volodymyr Mishchenko, Viktor Ivanov
    • Writing – review & editing
      Svitlana Naumenkova, Svitlana Mishchenko
    • Visualization
      Ievgen Tishchenko, Svitlana Mishchenko