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4.4 CASE STUDIES OF DEVELOPMENT PROJECTS

We shall now take a closer look at the type of action a development institution can take in order to offer help to a developing country. These are sample projects, and while realistic, they are in no way identical to actual ones.

The goals of these examples is to show how developing projects are structured and also to show, once the deal is structured, how the risks are shared among the different participants. Often in these projects, the introduction of financial risks in the local market is accompanied by thorough technical help on the part of the development institution so that, by dealing with the risks, the local capital market grows in sophistication.

4.4.1 Rural Development in X

ABC Development Bank and the government of X agreed that a hurdle that needed to be overcome in order for X to grow was the development of its vast rural areas. In this context three points were essential: an encouragement toward private enterprise; a development of market economy, in particular, the banking sector; and easier access to funds for the rural poor.

The project was structured as a wholesale banking operation, meaning that the initial lending was done not to the individuals but to participating financial institutions. This had several advantages including an automatic development of the country's banking system through the competition between the participating financial institutions; a more specific tailoring to the ultimate project through a more personal connection between the participating financial institution and the final borrower; and, in this type of operation, the decrease of the initial lender's credit risk through diversification. This type of operation decreases, through diversification, the credit risk of the initial lender.

The initial lender, the tip of the pyramid in the wholesale operation, was going to be the central bank of X. ABC would offer the initial loan to X and technical assistance to the central bank of X in order to learn how to supervise a wholesale banking operation, to the participating financial institution to teach how to appraise projects and the fundamentals of accounting and financial control, and to the rural poor to increase financial literacy.

The loan was structured as shown in Figure 4.7. ABC would lend to the central bank of X, the central bank of X would lend to the participating financial institutions, which in turn would lend to each individual project. For every 100 units of currency finally used for the project

┠Fifteen were put up by the ultimate borrower, the undertaker of the rural project.

┠Ten were put up by the participating financial institution.

A schematic representation of the project for rural development in X explaining the provenance of the final 100 units of funds dedicated to an individual project.

FIGURE 4.7 A schematic representation of the project for rural development in X explaining the provenance of the final 100 units of funds dedicated to an individual project.

┠Seventy-five were put up by the central bank of X, which was disbursing the funds obtained by ABC.

Taking account of each actual exposure, the risks were such that

┠The participating financial institution would bear the credit risk of the final borrower on 85 units of principal.

┠The central bank of X would bear the credit risk of the participating financial institution on 75 units of principal.

┠The central bank would bear the currency risk linked to the exchange rate between the currency X of the loans disbursed to the participating financial institutions and the USD loan it received from ABC.

┠ABC would bear the credit risk of X (in the form of its central bank) on 75 units of principal.

As seen in Figure 4.7, the loan from ABC was a fixed-rate loan and the loans from the central bank to the participating financial institutions and subsequently to the final borrowers were variable-rate loans where the rate was fixed quarterly using the deposit rate as a benchmark on top of which a spread was included to cover the costs of operations.

 
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