00447624 en non sovereign portfolio credit risk review

8/14/2019 00447624 en Non Sovereign Portfolio Credit Risk Review

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NonNon--Sovereign PortfolioSovereign Portfolio

Credit Risk ReviewCredit Risk Review

20042004--20062006

Prepared by FFMAPrepared by FFMA

October 2007October 2007

African Development BankAfrican Development Bank


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MarketRisk Review

Interest rate,currency,

liquidity risks

Objectives,

practices and

strategies,

effectiveness

Non-SovPortfolioReview

Project rating

changes

Impact on portfolio

risk profile

Impact onprovisioning,

capital adequacy,pricing, etc.

SovereignPortfolioReview

Country rating

changes

Impact on

portfolio riskprofile

Impact on

provisioning,

capital adequacy,concentration

FinancialPerformance

Outlook

Consolidate risksassumed with risk

bearing capacity

Risk capital

utilization

Sensitivity

Income allocationdecisions

Overall Institutional Risk Management Framework

The Board of Directors oversees compliance through fourannual risk management presentations

2

Risk Management Framework Period Reporting

o The financial performance outlook consolidates all risks assumed by the Bank with

its risk bearing capacity, determines the risk capital utilization, discusses the factorsaffecting the Banks outlook and provides guidance on income allocation decisions.

o The Market Risk Review provides information on the monitoring of the interest rate,currency and liquidity risks.

o The Non-Sovereign Portfolio Review focuses on project rating changes, and their

impact on the portfolio risk profile, provisioning, capital adequacy and loan pricing.

o The Sovereign Portfolio Review assesses country rating changes, and their impacton the portfolio risk profile, provisioning, capital adequacy and portfolio concentration.


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Introduction ...

The Banks medium-term strategy calls for increasing investments

without sovereign guarantees. Private sector

Enclave projects

Commercially-oriented public sector entities

A number of measures have been taken to maintain the desiredportfolio risk profile.

Private sector development strategy

Exposure limits and risk profile benchmarks

Portfolio management division for effective monitoring

This presentation examines the evolution of the credit risk profile of

the non-sovereign portfolio over the past 3 years.

3

Purpose of the Report

Over the past two years the non-sovereign operations of the Bank has recorded significantgrowth. Further expansion is expected with the heightened emphasis on the private sectorand other non-sovereign operations as one of the key priorities of the Bank's Medium Term

Strategic Framework.

Recognizing the inherent risks of development lending without a full sovereign guarantee, theBank has taken several measures to ensure that adequate safeguards are put in place tosustain the growth of the desired portfolio and foster the enabling environment to supportproject lending. These measures also include a risk management framework that willstrengthen the transaction origination and portfolio management functions within the Bank.

As part of its compliance monitoring role, the Financial Management Department (FFMA) isactively involved in all facets of the Banks internal process for non-sovereign operations. It isentrusted with the preparation of several risk review report to assist the Boards in theiroversight function of the financial integrity of the institution

This presentation is one of the reports prepared by FFMA to provide the Board with an

independent assessment of credit risk profile of the non-sovereign portfolio. The report coversessentially the three-year period 2004-20061 and high recent developments in 2007.

1 - The Financial Management Department prepares four annual reports on various aspects of the Banks risk profile: 1) market riskreview; 2) non-sovereign portfolio credit risk review; 3) Sovereign portfolio credit risk review, and 4) medium-term financialperformance outlook;


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This presentation is organized into three principal

parts

Rating Trends

Portfolio Risk Profile

Risk Management Implications

4

Structure of the Report

The report is organized into three principal sections.

o The first section presents the project rating trends within the active non-sovereign portfolios.

o The second section summarizes the combined impact of new projects, disbursements andrating migrations on the risk profile of the outstanding non-sovereign portfolios.

o The third section reviews the Banks capital adequacy framework and the provisions fornon-sovereign operations, analyzes the past pricing of non-sovereign loans and concludeson the effectiveness of the Banks non-sovereign credit process.


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All non-sovereign projects are rated on a unified 10-

point rating scale

Very Low Risk

Low Risk

Moderate Risk

High Risk

Very High Risk

Risk Class

A - BBB

BB

B

CCC

CC - D

InternationalScale

1

2

3

4

5

6

7

8

9

10

Risk Rating

Excellent

Strong

Good

Fair

Acceptable

Marginal

Special Attention

Substandard

Doubtful

Known Loss

6

Rating Methodology

Rating Scale 1 to 10

The Bank has developed its own internal 10-point rating scale to reflect the risk profile of itspotential borrowers. These ratings are calibrated to reflect prescribed ranges ofexpected-losses.

o At the first tail of the spectrum 1to 6 - the lowest risk end is a project rating of 1.

Projects rated 1 are considered excellent credit risks. The Bank normally considers newprojects from risk rating 1 up to risk rating 5 (acceptable). Under special circumstances anew project with a risk rating of 6 could be considered.

o At the other end of the scale are project risk ratings from 7 to 10.

Typically, a project rating of 7 indicates that the project is experiencing some repaymentdifficulties and immediate remedial actions should be taken;

A project rating of 8 means that the project is having severe operating problems and the Banksassets are in jeopardy;

A project rating of 9 implies re-structuring of the project or some other form of work-out is almostcertainly required to save the Banks interest; and

A project rating of 10 implies that liquidation is the only feasible solution envisaged.Risk Classes

o As illustrated above, the 10 point risk rating scale can be categorized into a five-class scale fromvery-low risk to very-high risk.

o These internal rating classes broadly correspond to the international ratings of A to BBB at thetop and CC to D at the bottom.

o To facilitate comparison of the sovereign and non-sovereign portfolios, the principal analysispresented in this report measures the risk profile in terms of the Banks 5 risk classes. However,all portfolio average risk ratings are derived from the project ratings on the 10-point scale.


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Cash Flow strength

Earning generation

Balance sheet strength

FINANCIAL

Industry

Competitive position

Management quality

Information quality

BUSINESS

Terms and conditions

Facility tenor

Third party support

Security

FACILITY ADJUSTMENT

PROJECT SPECIFIC RISK FACTORS

Non-sovereign project ratings are determined using four

groups of factors

Project RiskRating

COUNTRY RISK

Macro-economic

Debt Sustainability

Portfolio performance

Socio-political

Business environnement

COUNTRY RISK

7

Rating Factors 4 Step ProcessNon-sovereign project risk ratings are derived on the basis of four groups of factors:

Financial

The rating process begins with an assessment of the overall financial strength of the project companywhich factors:

oThe capacity of the project to generate cash flow to service its debt;

oThe project companys capital structure, financial flexibility, and liquidity position; andoThe companys operating performance and profitability.

Business

In the second step, four main non-financial parameters are analyzed:

oThe outlook for the industry of the project;

oThe competitive position of the company within the industry;

oThe caliber/strength of the project management with a particular emphasis on capacity to sustainadverse conditions; and

oThe quality of the information on which the analysis is based.

Facility adjustment parameters

oIn the third step, the company rating is further fine-tuned using four facility adjustment parameterssuch as

oThe existence of any third party guarantees;

oThe tenor of the facility;

oAny conditions that would provide credit support for the Bank; and

oThe value of any assigned collateral.

Overall Country Risk

In the final step, the project risk rating is ultimately adjusted to reflect the overall host country riskrating.


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All new non-sovereign projects are reviewed on the

basis of a three-step process

Project Review and Approval Process

BoardApproval

Governance Organs

Due Diligence Assessment8

Review Process

As illustrated schematically in the graphic above, all new non-sovereign project proposals follow aninternal review process that consists of three primary steps before the Board final approval..

Project Filtering by OPSM

The first step in the process is the initial filtering of proposals by the Private Sector & MicrofinanceDepartment (OPSM). Each year OPSM receives hundreds of applications for financing that must bescreened for consistency with the Banks policies and strategies and then assessed for commercialviability.

Due Diligence Review of the Investment Proposal - PSOCThe second step is the review by an inter-departmental team called the Private Sector Operations

Committee (PSOC). The PSOC typically meets at least twice for most projects.oThe first PSOC review is based on OPSMs Project Concept Note (PCN) and usually leads to a

preliminary risk rating by FFMA. Projects that successfully pass the PCN review are presented toSenior Management for concept clearance followed by appraisal and drafting of the first InvestmentProposal (IP).

oThe PSOC meets a second time to review the full IP and a risk rating is usually assigned at thisstage.

IP Clearance and Rating Confirmation - PSICThe third step consists of senior management review by the Private Sector Investment Committee(PSIC). The PSIC examines the IP for policy and strategic issues. The risk rating is normally confirmedat this point.

Approval Board

Projects that successfully pass the PSIC review are then sent to the Board for final consideration andapproval. In addition to the final IP, the Board receives a summary credit note on the salient issuesunderlying the credit risk rating assigned to each new proposal.


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The risk ratings of all outstanding non-sovereign projects

are reviewed quarterly

Risk Rating Review Process

ProjectRatings

9

Risk Rating at Entry and Quarterly Portfolio Rating Review

In addition to assigning a risk rating to all non-sovereign projects at entry, the risk ratings ofall outstanding non-sovereign projects are reviewed quarterly.

As illustrated in the graphic above, the quarterly review process consist of :

Project Review

Project-by-project reviews by the Portfolio Management Division within OPSM and the CreditManagement Division of FFMA, with the objective of highlighting the principal downside risksof active projects and identifying trigger events that may affect each projects rating. Thereview generally covers recent financial performance, compliance with covenants, and anexamination of any supervision or management implementation and progress reports.

Non-sovereign Credit Risk Working Group Review

Based on these project reviews, the Non-sovereign Credit Risk Working Group prepares areport summarizing the proposed project risk ratings and highlighting any projects where

rating changes are proposed or appear likely in the future.

The report also assesses the impact of the risk ratings in the Banks non-sovereign portfolioand proposes any changes to loan, guarantee, or equity provisions.

ALCO Review

The quarterly report is submitted for review by ALCO before any rating changes arecompleted and any provisioning changes are implemented.


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The bulk of the non-sovereign country risk ratings fall

into the moderate risk class

2222

1414

6655

55

As at 30.06.200710

Outcome of the Risk Rating Process

The chart above shows the distribution of non-sovereign country risk ratings at the end of2004, 2005, and 2006. The horizontal axis shows the Banks five risk classes and the verticalaxis shows the number of countries in each class. Non-sovereign country risk ratings are akey factor in determining the credit risk ratings of non-sovereign projects in any country. Thesituation as at June 30, 2007 is illustrated by the arrow lines.

Overall Rating Distribution

In terms of overall distribution, the bulk of the countries fall into the moderate risk class. It isalso apparent that there are more high and very-high risk countries than countries in thelow and very-low risk classes.

In general, the non-sovereign country risk ratings are weaker than the sovereign ratings. Thisis a reflection of the weight assigned to the business environment for the private sectorratings and the significant operating challenges that most non-sovereign projects must

overcome to survive.

Movements within the Portfolio

During the period 2004-2006 there was a modest decline in the number of countries rated asvery-low risk. The number of countries rated very-low risk decreased from 6 to 4. At thesame time the number countries rated low risk increased from 4 to 6. The year 2007 ismarketed by a net improvement in the portfolio with an increase in very low risk and decreasein high risk groups as at 30 June.


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In 2006, 8 new projects were added to the non-

sovereign loans and 6 existing projects were dropped

* As at 30.06.2007, 5 new projects were added to the non-sovereign loans and 2 existing projects were droppedcompared to December 2006

1515

1414

4444

44

As at 30.06.2007

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Risk Rating Trend - Active Portfolio of Loans and Guarantees

The chart above shows the distribution of the project risk ratings for all active non-sovereignloans and guarantees from 2005 to 2006. The horizontal axis is broken down into theBanks five risk classes and the vertical axis shows the number of loans andguarantees in each class.

Movements in the Portfolio in 2006

o New Loans

7 new loans and 1 new guarantee were added to the active non-sovereign loan andguarantee portfolio.

o Repayment and Cancellations

During the same period, 4 loans were repaid and 2 loans were cancelled. As a result,the net growth was 2 new projects in the active non-sovereign loans and guarantees.

Rating Distribution

o In terms of the rating distribution of the Banks non-sovereign loans and guarantees,the bulk were rated in the moderate risk class. At the lower risk end of the spectrum,

there were two loans in the very-low risk class and three loans in the low riskclass. At the other end of the spectrum, there were fourteen loans and guarantees inthe high risk class and four loans in the very-high risk class.

o With respect to the rating movement during the year one project was upgraded andone loan was downgraded.


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Banks equity investment portfolio is under the full

management of OPSM.

As at 30.06.2007

12

Risk Rating Trend - Active Portfolio of Equity Investments

The chart above shows the distribution of project risk ratings for all active non-sovereignequity investments. The horizontal axis is broken down into the Banks five risk classes andthe vertical axis shows the number of projects in each class.

Movement in the Portfolio

The Banks public equity investments (8) made in the past have been transferred to the non-sovereign portfolio under the full management of OPSM. As a result of this transfer to OPSM,

the number of active non-sovereign equity investment increased to 17. In 2006, there were nonew investments added to the active non-sovereign equity investment portfolio.

Distribution of the Ratings

In terms of overall distribution of the ratings at the end of 2006, 35% (6) of the Banks non-sovereign equity investments fell into the moderate risk class, another 35% (6) fell into thehigh risk class while another 24% (4) fell into the very high risk class. One equityinvestment was classified as low risk class.


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In the second part of this presentation ...

Rating Trends


Portfolio trends

Structure by country, industry, instrument, age, etc.

Outlook


13

Risk Profile of the Banks Portfolio

The second section of the report examines the risk profile of the Banks portfolio of disbursedand outstanding non-sovereign loans, guarantees, and equity investments;

o It assesses the combined non-sovereign loans, guarantee, and equity investmentswith a focus on how the overall portfolio has grown and how the overall risk rating hasevolved from 1998 to 2006. This analysis takes into consideration both changes in therisk ratings of individual projects as well as changes in the composition of the portfoliodue to the effects of disbursements, activation of guarantees, repayments, anddivestitures;

o Following the review of the overall portfolio risk profile, a more detailed assessment ofthe portfolio composition by country, industry, type, instrument, age, and repaymentperformance is provided; and

o Finally, prospective assessment is presented by reviewing not only the risk profile ofundisbursed commitments, approved but unsigned projects, but also the projects in

the pipeline to see how the overall portfolio risk profile is likely to evolve over the nextfew years.


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The average risk rating of the non-sovereign portfolio

slightly weakened due to prepayment of low risk assets

LowestRisk

HighestRisk

* total non-sovereign loans, guarantees, and equity investments **As at 30.06.200714

Risk Profile of the Banks Portfolio

The chart above shows the size of the total outstanding non-sovereign portfolio (blue bars)and the weighted average risk rating (red line) from 1998 to 2006. The left vertical axismeasures the size of the outstanding portfolio in UA millions and the right vertical axis

measures the weighted average risk rating on the Banks 10 point rating scale.Key highlights can be summarized as follows:

o Over the past nine years, the size of the outstanding portfolio (loans, guarantees,and equity investments) has grown almost nine-fold from about UA 50 million to UA440 million at the end of 2005;

o However, in 2006, the size of the outstanding non-sovereign portfolio contractedmarginally to UA 404 million (reduction of 8%);

o During the same period, the weighted average risk rating of the portfolio hasimproved from about 5.8 (high risk) at the peak in 1999 to about 3.2 (moderate risk)in 2005. In 2006, the average risk rating dropped slightly to 3.5;

o Much of the weakening in the average risk rating in 2006 can be traced to the

prepayment and repayment of low risk and very low risk assets ; ando A slight upward movement was recorded as at June 2007.


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The high and very-high risk classes now account for

less than 21% of the total outstanding portfolio

* ( ) is the weighted average risk rating for this portfolio segment

**As at 30.06.2007 the weighted Average rating was 3.7

51%51%

23%23%

6%6%

12%12%9%9%

As at 30.06.2007

15

Portfolio Distribution by Risk Class

The chart above shows the distribution of the combined outstanding non-sovereign loan,

guarantee, and equity portfolios by risk class at the end of 2004-2006 and June 2007. The

share of risk class is shown as a percentage of the outstanding portfolio at the end of eachyear.

oIn terms of overall profile, the non-sovereign portfolio continues to be predominantly

centered around the moderate risk class. There has been a migration in the lowest andhighest end tails of the risk classes;

oAssets in the very-low risk class decreased from 14% to about 11% of the outstandingportfolio;

oAssets in the low risk class declined from 20% to 15% of the outstanding portfolio as aresult of prepayment of Mauritius Commercial Bank, which was rated low risk;

oIn 2006, moderate risk assets accounted for about 53% of the outstanding portfolio;

oThe high risk and very-high risk classes accounted for about 21% of the portfolio upfrom 13% in 2005. On the other hand,

This profile calls for targeting low risk class assets for entry in the portfolio.


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Lines of credit to financial institutions (FIs) continue to

remain the largest sector in the non-sovereign portfolio

11%11%

2%2%

15%15%

10%10%9%9%

5%5%

* As at 30.06.200717

Portfolio Risk Profile Exposure to Sectors

The chart above shows the percentage distribution of the outstanding non-sovereign loans,guarantee, and equity investments by risk class when grouped by general sector. For thisanalysis we limit the segmentation to four broad sectors: (i) LSE (large-scale enterprises

including infrastructure projects); (ii) FI (financial institutions); (iii) Funds (equity funds); and(iv) SME (small and medium-size enterprises). At the end of 2006, the portfolio depicts thefollowing features:

o Lines of credit to financial intermediaries (FIs) was the largest sector accountingfor 45% of the outstanding portfolio as compared to 41% in 2005.

The Banks exposure to FIs was distributed principally between the low risk andmoderate risk classes and had a weighted average risk rating of 3.1.

o LSEs accounted for 36% of the total portfolio compared to 39% in 2005. Most of theBanks direct exposure to LSEs was in the very-low risk and moderate risk classesand had a weighted average risk rating of 3.2.

o The Banks equity investment funds accounted for about 9% of the outstandingportfolio and was distributed over the low, moderate and high risk classes withan average rating of 3.9.

o Direct lending to SMEs represented the remaining 10% of the portfolio and had anaverage risk rating of 6.0.

The higher risk profile of the portfolio with SMEs is not unexpected given the nature oflending to SMEs.


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The outstanding portfolio is largely made of debt rather

than equity instruments

* As at 30.06.2007

43%43%

17%17%

4%4%

10%10%9%9%7%7%

18

Portfolio Risk Profile Loans versus Equity Investments

The chart above shows the percentage distribution of the outstanding non-sovereign loan,guarantee, and equity portfolios by risk class when grouped by instrument at the end of 2006

o 85% of the Banks outstanding non-sovereign portfolio consisted of loans andguarantee facilities while the remaining 15% consisted of equity investments.

o The risk profile of the portfolio by instrument shows the expected relationships,namely, that equity investments tend to be higher risk than debt instruments.

o The weighted average risk rating of loans and guarantees was 3.4 whereas theaverage risk rating of equity investments was 4.3. It is notable that this differential hasprogressively decreased over the past few years.


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Only about 4.5% of the outstanding portfolio is having some

form of repayment difficulty

51%51%

23%23%

4%4%12%12%9%9%

* As at 30.06.200719

Portfolio Risk Profile Repayment Performance

The chart above shows the percentage distribution of the outstanding non-sovereign loan,guarantee, and equity portfolio by risk class when grouped by repayment performance.

o As expected, projects with the weakest risk ratings are generally the same projectswhich have experienced difficulties to service their debts to the Bank.

In 2006, about 4.5% of the outstanding portfolio was experiencing debt servicingdifficulties; a marginal increase as compared to 4% in 2005 but still much lowerthan the 14% level of four years ago.

This marginal increase in 2006 was mostly due to the decline in the size of theoutstanding portfolio.

o It should be noted that because higher risk equity investments are reported as not inarrears (technically no dividend is yet due), this distribution may in fact modestly under-

state the extent of potentially non-performing projects.


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More recent transactions account for most of the lower

risk part of the portfolio

Approval Year

* As at 30.06.2007

Age Analysis of the Portfolio

The chart above shows the distribution (in %) of the outstanding non-sovereign loans,guarantee, and equity investments by risk class when grouped by age of transaction. Tosimplify the analysis, all transactions are grouped into three time buckets: (i) deals approvedbefore 1997; (ii) deals approved from 1997 to 2001; and (iii) deals approved from 2002 to2006.

o Approximately 72% of the outstanding non-sovereign portfolio consisted of projectsapproved in the last five years. Another 21% of the portfolio was approved between1997 and 2001 while only 7% of the portfolio dates back to approvals before 1997.

o It is interesting to note that the distribution of projects by transaction date shows astrong risk rating bias. The older projects dominate the higher risk classes while thenewer projects tend to dominate the moderate and lower risk classes. The average riskrating of projects approved from 2002-2006 was 3.0, compared to 4.4 for 1997-2001,and 6.6 for projects approved before 1997.

o On major factor to contribute to this change in distribution profile is the Banks recentreforms that have strengthened the internal credit processes and resulted in betterselection of projects.

o Rating trends have shown a tendency for weakening of the risk profiles of projectsafter implementation begins. Although this trend was expected to a certain extent it is

another indication that the Banks processes for supervising and monitoring of projectsafter disbursement need to be given particular attention.


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The portfolio risk profile is expected to improve over the

medium-term

Overall Portfolio Risk Rating - 3.5 3.0421

Future Evolution of the Portfolio Risk Profile

Elements of the Portfolio

The chart above shows the projected distribution of the non-sovereign loan, guarantee, and equityportfolios by risk class when grouped by processing stage. For this analysis we consider two

processing stages:o Current outstanding portfolio; and

o Projected Portfolio which comprises of: (i) undisbursed commitments, (iii) approved butunsigned operations, and (iii) new projects in the advanced pipeline. New projects are definedas in advanced pipeline if they had passed concept clearance for full appraisal at the end of2006.

o This segmentation should provide insights into the future evolution of the portfolio risk profile.

Key highlights

The analysis indicates that:

o Given the large number of projects in the advanced (190% of the outstanding portfolio), withan average risk rating of 2.8, the risk profile of the overall portfolio will improve;

o There is a significant stock of projects in the unsigned portfolio (accounting for 30% of the

outstanding portfolio) with an average risk rating of 2.8, will also contribute to an improvementof the portfolio risk profile; and

o Assuming that all projects are approved, signed, and fully disbursed, the non-sovereignportfolio would significantly increase from its current size of UA 404 million to about UA 1.3billion in the next few years. Given the risk profile of these new assets, the weighted averagerisk rating of the portfolio would improve to 3.04 from 3.5.


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In summary...

The average risk rating of the outstanding non-sovereign

portfolio slightly weakened due to prepayment of low risk

assets.

Loans to financial institutions (FIs) continue to remain the

largest sector in the non-sovereign portfolio.

The risk profile of the portfolio shows a strong correlation

with transaction age and country rating, with older

projects being riskier.

In the medium term, the non-sovereign portfolio is

expected to increase threefold in size and the average riskrating is expected to improve.

22

Key Highlights

Salient features of the risk profile of the outstanding non-sovereign loan, guarantee, andequity portfolios can be summarized as follows:

Lines of credit to financial intermediaries (FIs) remained the largest sector accounting

(they account for 45% of the outstanding portfolio as compared to 41% in 2005;

The portfolio risk profile shows a strong linkage between the age of the deal and itsrisk rating.

o As the Bank gains private sector experience it is getting better at avoiding riskierprojects.

o The older projects appeared to be lower risk at inception but have becomeincreasingly risky as implementation has progressed and difficulties have arisen

o This highlights the importance of intensive project supervision during projectimplementation.

Over the medium term, the portfolio is expected to continue its pace of strong growth.

Given the profile of the unsigned loans and the advanced pipeline, the risk profile ofthe non-sovereign portfolio is expected to improve over the next few years.


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In the third part of this presentation ...

Rating Trends



Provisioning

Capitalization and Exposure

Risk Pricing

Credit Process

23


This third section of this report examines the risk management implications of the currentstate of the non-sovereign loan and equity portfolios. It looks at the implications from four

perspectives: First, it examines the adequacy of the Banks provisions for non-sovereign operations at

the end of 2006. It should be noted that in compliance with the revised internationalfinancial reporting standards (IFRS), the Bank has switched to the incurred-lossapproach with respect to provisioning;

Second, after reviewing the risk framework, it evaluates the adequacy of the Banks riskcapital to support the risks assumed in the non-sovereign portfolio. It also looks atcompliance with the non-sovereign exposure guidelines;

Third, it analyzes the past pricing of non-sovereign loans to determine whether theBanks margins have been adequate to recover the cost of assuming the credit risksassociated with these projects. This section also presents the results of the economic

valued-added analysis of the non-sovereign portfolio.

Finally, it draws some conclusions on the effectiveness of the Banks non-sovereigncredit process and evaluates the pace of implementation of the recommendations madein previous years.


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The Bank uses the incurred- loss provisioning methodology

Impairment is estimated using an incurred-loss

methodology model.

Loan impairment is measured based on an estimate of the

present value of recoverable cash flows.

For equity investment for which fair value can be reliably

measured, changes in fair value flow directly through

changes in reserves.

Methodology for Provisioning

24

Adequacy of the Banks provisioning The Methodology

International financial reporting standards (IFRS) Requirement

Prior to 2004, the Bank based its provisioning for loans, guarantees and equity investments on

an expected-loss model. However, since January 2005 the revised international financialreporting standards (IFRS) require financial institutions to estimate impairment of assets usingan incurred-loss methodology eliminating the concept of general provisions for statisticallyprobable future loss.

Loans

For loans where an impairment is deemed to have occurred, the magnitude of the impairmentbased on computation of the present value of the cash flows that are likely to be recovered.The financial institutions are required to include estimates for the realizable value of anycollateral or other security on impaired assets.

Equity Investments

For equity investments whose fair value can be reliably measured, the (IFRS) requires thatchanges in their fair value is passed directly to the Banks reserves. While equity investmentsfor which fair value can not be reliably determined are reported at cost less provisions.

Looking ahead, Management expects that provisioning will be highly sensitive to the defaultstatus of individual borrowers (i.e. provisions could increase or decrease substantially whenborrowers default). As such, it is likely that provisioning will be more volatile in the future.


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The average provisioning rate has evolved in line with the

portfolio risk profile

* As at 30.06.200725

Evolution of the Banks Provisions for Loans and Guarantees

The chart above shows the evolution of the Banks outstanding non-sovereign loan andguarantee portfolio (blue bar), the associated provision (green bar), and the averageprovisioning rate (red line) since 1998. The left axis measures the outstanding portfolio and

provisions in UA millions while the right axis measures provisions expressed as a share of theoutstanding portfolio in each year.

Throughout the period 1998 to 2004 the outstanding portfolio increased faster than therequired provision. As a result the average provisioning rate decreased from the peak of59% in 1998 to 33% in 2000, 19% in 2001, and 8.4% in 2004.

The implementation of the new incurred-loss provisioning methodology in January 2005,has resulted in an overall decrease in the Banks non-sovereign portfolio provisions. In2005, the average provisioning rate decreased to 4.1%. However in 2006 the averageprovisioning increased slightly to 4.4% mainly as a result of the reduction in the

outstanding portfolio.


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In 2006, provisions for equity investments increased to 5.8%

of the outstanding equity portfolio

* As at 30.06.200726

Evolution of the Banks Provisions for Equity Investments

The above chart shows the evolution of the Banks outstanding non-sovereign equity portfolio(blue bar), the associated provision (green bar), and the average provisioning rate (red line)since 1998. The left axis measures the outstanding portfolio and provisions in UA millions

while the right axis measures provisions expressed as a share of the outstanding portfolio ineach year.

o As illustrated above, the Bank made its first provisions for non-sovereign equityinvestments in 2000. The UA 1.7 million provision represented an equivalent of about5% of the outstanding portfolio.

o By 2003, the accumulated provision had increased to about UA 8.1 million representingclose to 20% of the equity investments outstanding portfolio.

o As a result of write-back of provisions, provisions for non-sovereign equity investmentsdeclined sharply in 2004 representing about 3% of the outstanding equity portfolio.

o However, due to the implementation of the new incurred-loss provisioning methodology

declined substantially to zero in 2005.o In 2006, provisions increased to UA 3.5 million representing about 5.8% of the

outstanding portfolio. This was mainly due to the fact that the fair value of the 9sovereign equity investments transferred to OPSM could not be reliably measured andtherefore reported at cost less provisions. These equity investments typically relate toinvestments in sub-regional and national development institutions whose shares are notlisted and also not available for sale to the general public.


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In summary...

The Bank complies with IFRS incurred-loss approach.

In 2006, the average provisioning rate increased slightly to 4.4% from

4.1% (2005)

Total provisions for the equity portfolio increased to UA 3.5 million in

2006 as a result of transferring 8 equity investments to OPSM

27

Key Highlights on the Adequacy of the Bank's Provisions

o The Bank has been fully compliant with the incurred-loss provisioning requirement of theIFR since its inception in 2005 and the provision levels for both loans and equity areadequate

o Total provisions for the loans and guarantee in 2006 decreased by UA 0.7 million but the

average provisioning rate increased 4.4% from 4.1% in 2005, mainly as a result of thereduction in the outstanding portfolio. As at 30 June 2007 the provisioning rate is 4.1 %

o Total provisions for the equity investment portfolio in 2006 increased to UA 3.5 million andthe average provisioning rate increased to 5.8% from 0% in 2005. The provisioning rate as

at 30 June 2007 stood at 5.9%. The increase in the provisions for equity was mainly due tothe fact that the fair value of the 9 sovereign equity investments transferred to OPSM couldnot be reliably measured and therefore reported at cost less provisions. These equitiestypically relate to investments in sub-regional and national development institutions whoseshares are not listed and also not available for sale to the general public.

o The implementation of such methodology has led to an initial reduction in the requiredprovisions. It may also lead to increased volatility of provisions in the future.


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The capital adequacy policy requires the Bank to hold

more capital backing for riskier assets

Portfolio ofAssets

Used RiskCapital

High

Very High

Total UsedRisk Capital

Moderate

Low

Very Low

Equity

25%

28%

35%

50%

75%

100%29

Capital Adequacy Assessment

As illustrated schematically above, the Banks policy on capital adequacy specifies theamount of risk capital that is set aside to cushion against low probability unexpected-lossesin the Banks outstanding loan and equity portfolios.

Risk Capital factorsThese risk capital requirements increase for riskier assets in both the sovereign and non-sovereign portfolios and are expressed as a percentage of the balance of outstanding assetsin each of the Banks five risk classes. For example

o Very-low risk loans require 25% risk capital backing. At the other end of the scale,Very-high risk loans consume three times as much capital at 75%.

o By policy all equity investments, regardless of the project rating, require 100% capitalbacking.

o For derivative instruments, such as guarantees or risk management products, thecapital requirement is computed on the basis of the loan equivalent exposure of theinstrument.

Risk Capital RequirementsTo determine the risk capital required to support the Banks non-sovereign portfolio, the riskcapital consumed by each non-sovereign loan and guarantee is aggregated by risk class plusequity investments. The total used risk capital is the aggregate of the risk capitalrequirements for each risk class.

Risk Capital Requirement = (Asset Value by Risk Class * Risk Capital Class by Risk Class )

The Bank is adequately capitalized for the size and risk profile of its non-sovereign portfolio


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Outstanding non-sovereign operations have consumed

just 4% of the Banks total risk capital

Uses of Risk Capital for Non-Sovereign Operations(31/12/2006)

Equity

Very High Risk

High Risk

Moderate Risk

Loans & Gtees68%

Equity32%

Very Low Risk

Low Risk

4.5%4.5%

* As at 30.06.200730

Unused Risk Capital Available for Portfolio Development

The pie chart above decomposes the usage of the Banks risk capital by major portfolio. Atthe end of 2006, the combined non-sovereign loan, guarantee and equity portfoliosconsumed about 4% of the Banks total available risk capital compared to 41% for the

sovereign portfolio.The right-hand chart shows that within the portion of risk capital required to support the non-sovereign portfolio, about 32% is required to support equity investments and 68% to supportloans and guarantees.

Available Headroom

The 4% utilization of risk capital is well below the 20% risk capital limit set for non-sovereignoperations.

Given the large number of projects in the advance pipeline in 2007 coupled with the projectedexpansion of non-sovereign operations, this large available headroom (20% - 4%) for non-sovereign operation would reduce significantly in the near future.

However there will still be enough headroom to sustain future expansion of the portfolio.


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Projections show that both single country limit and

single obligor limit will be exceeded soon

Limit 2006

20% 4%Total Non-Sovereign

15% 4%Single Country

25% / 35% 8%(Fin. Services)

Single Sector

4%Single Obligor 2%

Projected**

12%

* As at 30.06.2007

15%

27%(LSE)

11%

2007*

4.5%

* *Assuming all approved projects plus the advanced pipeline fully disbursed

6%

15%(Fin. Services)

2%

31

Credit Limits

Total Non-Sovereign

A formal limit of 20% of total risk capital was set for exposure to non-sovereign operations. At the end of2006, the Banks outstanding non-sovereign portfolio had used just over 4% of the Banks risk capital.This percentage stood at 4.5 % as at June 2007.

The current level of exposure is well within the global limit of 20%. However, in view of the large numberof projects in the advanced pipeline, the gap is expected to narrow significantly.

Single Country Limit

No more than 15% of the risk capital for non-sovereign operations should be deployed in any singlecountry. At the end of 2006, the highest level exposure was 4% for Nigeria (6 % as of June 2007).However, due to the large number of projects that are being booked, it is projected that South Africa willexceed the 15% single country limit very soon.

The increased exposure to South Africa is not a big concern, as South Africa is one of the largesteconomy regional member countries with very low risk profile. Moreover, the limit will remain within theglobal sustainable lending program for South Africa which comprises of sovereign and non-sovereign.

Single Sector Limit

No more than 25% of the risk capital for non-sovereign operations should be deployed in any singleindustry (35% for the financial sector). At the end of June 2007, the largest single sector in the portfolio

was financial services, which accounted for about 15% of non-sovereign risk capital (as compared to8% at the end of 2006). However It is projected that Large Scale Enterprises (LSE) Will reach 27%.

Single Obligor

No more than 4% of the risk capital for non-sovereign operations should be deployed for any singleobligor (project). This is commercially-oriented public sector entity with very low risk profile and diversecustomer base.


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In summary...

The Banks risk capital requirements reflect the size and

riskiness of the outstanding portfolios.

At the end of 2006, about 4% of the Banks risk capital was

deployed for non-sovereign operations compared to a

20% limit.

Over the near-term the risk capital utilization rate for the

non-sovereign portfolio is projected to rise to about 12%.

32

The Highlights on Capital Adequacy and Exposure

The Banks capital adequacy policy prescribes the amount of risk capital that should be setaside to support the Banks operations. The amount of risk capital required reflects both thesize and the risk profile of the portfolios. All exposure limits are expressed in terms of riskcapital deployed.

o Currently, about 4% of the Banks risk capital is utilized to support the outstanding portfolioof non-sovereign loans, guarantees and equity investments. This is well below the riskcapital limit of 20% that was established for total non-sovereign operations. Over the near-term the risk capital utilization rate for the non-sovereign portfolio is projected to rise toabout 12%.

o In addition to a global limit for non-sovereign operations, a number of exposure limits areapplied to ensure adequate diversification of the non-sovereign portfolio. Currently thereare no specific portfolio concentrations in terms of country, sector or obligor distribution.However, projections show that the loan for ESKOM will exceed the single obligor limit.This is commercially-oriented public sector entity with very low risk profile and hence theconcentration risk is mitigated by its diverse customer base.

o It is projected that South Africa will exceed the 15% single country limit very soon. This isnot a concern, as South Africa is one of the largest economy regional member countrieswith very low risk profile. Moreover, the limit will remain within the global sustainablelending program for South Africa which comprises of sovereign and non-sovereign.


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In the third part of this presentation ...

Rating Trends



Provisioning

Capitalization and Exposure

Risk Pricing

Credit Process

33

Adequacy of the Past Pricing

This part of this report looks at the adequacy of the past pricing of the Banks non-sovereignloans and guarantees to cover the cost of assuming the credit risks associated with theseprojects as well as the direct costs of originating and supervising these assets.

o It reviews the mechanics of the Banks pricing policy followed by an analysis of actualpricing experience for the non-sovereign portfolio.

o It concludes by examining recent trends for the overall financial performance of thenon-sovereign portfolio.


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The Banks pricing policy allows for flexibility within

a cost recovery framework

For each level of risk, the Bank estimates the cost of

extending its risk bearing capacity.

Bearing in mind the cost of risk, each transaction is

negotiated to be competitive in the market.

Cost recovery is monitored and managed at the

portfolio level.

Pricing Non-Sovereign Credits

34

Adequacy of Pricing

Flexible Cost Recovery

The Banks policy for pricing non-sovereign credits can be described as one of flexible cost recovery.

Cost Structure and Pricing Elements

Base Price

For each level of credit risk the Bank estimates the cost of extending its risk bearing capacity. The twomain cost components are: (i) the costs of provisioning for expected-losses, and (ii) the costs of

holding risk capital to cover unexpected-losses.

Transaction Specific Spread

o On a transaction by transaction basis the Banks investment officers negotiate the pricing ofeach credit in an effort to recover the cost of extending the Banks risk bearing capacity while

being competitive within each respective market.

o In practice, this means the Bank is flexible in pricing its credits to avoid being uncompetitive on

individual transactions but also bearing in mind the consequences of consistently under-pricing

risk.

o Although each new transaction is priced to be competitive in its market, the Bank monitors and

manages cost recovery at the portfolio level. This allows management to adjust the pricing onindividual transactions while ensuring the Bank is able to maintain a portfolio that is financiallyviable from a risk-adjusted perspective.


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In summary...

The Bank prices non-sovereign loans within a flexible

cost recovery framework.

The cost of extending the Banks risk bearing capacity is

estimated for each risk rating.

In the recent past, the Banks loans have generally been

priced to cover the risks at entry.

Non-sovereign operations positively contributed to the

overall financial performance and to the banks

development assistance effort.

35

Key Highlights on the Banks Risk Pricing

o The Banks policy for pricing non-sovereign loans can be described as flexible costrecovery. This means the Bank seeks to recover the cost of extending its risk bearingcapacity but remains flexible to price individual transactions to be competitive within eachtarget market. Cost recovery is monitored ex-post at the portfolio level.

o The cost of extending the Banks risk bearing capacity is estimated for each risk ratingfrom two components: the cost of provisioning for expected-losses; and the cost ofdeploying risk capital to protect the Bank from unexpected-losses.

o Analysis of the active non-sovereign loan portfolio shows that the Bank has generallypriced its new credits to reflect the cost of risk as estimated at entry.

o Since 2005, the net economic contribution from non-sovereign portfolio positively

contributed to the Banks overall financial performance .


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A number of measures have been taken to strengthen

the Banks non-sovereign credit process

The Bank has successfully:

Reorganized the private sector into functional divisions

The responsibility of strengthening and supporting private sector micro-finance

enterprises has been transferred to OPSM

Enhanced the quality of portfolio reporting to ALCO

Transferred all the Banks equity investment under the management of OPSM

But more needs to be done:

Credit risk management function needs to be strengthened

Investment committee structure and mandate needs to be redefined

Credit review process and procedures needs to be enhanced and strengthened

37

Toward further strengthening of the Banks non sovereign credit process

In line with the private sector development strategy, OPSM was reorganized into fivefunctional divisions. The key objective was to provide a resource framework and expand theBanks role in non-sovereign operations by strengthening OPSMs transaction origination

specialization.To enhance the support the Bank extends to private sector micro-finance enterprises, OPSMcapabilities and capacity has been strengthened with the addition of micro-financespecialists. Moreover, all the Banks equity investments are presently included in the in thenon-sovereign portfolio under the exclusive management of OPSM.

As the Banks non-sovereign operations expand it would be appropriate to ensure that suchexpansion is sustained by adequate safeguards, review process while maintaining theflexibility required for private sector operation. It would be therefore appropriate to:

o Further strengthening of the investment committee structure and its mandate in order tomake the investment decision making process and procedures more transparent andinclusive. In particular, the decision making procedures should be streamlined to ensurethat credit decisions fully reflect the collective will of all committee members.

o Re-examine the credit review process and work flow process between OPSM and otherdepartments with a view of ensuring adequate due diligence assessment and streamlinethe approval process. A full fledge credit committee would be more appropriate than thecurrent institutional organ governing the review process (PSIC)

o The departments supporting the non-sovereign operations review, assessment andmonitoring such as FFMA and GECL needs to be strengthened with the addition of morestaff in order to carryout its risk management function more effectively.


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In conclusion...

Due to prepayment of low risk assets , the risk profile of the non-sovereign

portfolio weakened in 2006, also, the outstanding non-sovereign portfolio

declined by 8%.

The credit risks in the portfolio are under control:

The average risk rating of the non-sovereign portfolio has been brought down from

5.8 to 3.5.

Only 4% of the 20% risk capital limit for non-sovereign operations is used. Given

the huge headroom available, the Bank has the capacity to accommodate the

large number of projects in the advance pipeline.

However, the single country and single obligor limits are already becoming

constraint and are being reviewed.

Loan pricing has generally covered the cost of risk and the portfolio has positively

contributed to the overall financial performance of the Bank.

A number of measures have been taken to strengthen the Banks non-sovereign

operations, but further challenges remain.38

Conclusion and Recommendations Going Forward

The key conclusions and recommendations of this report can be summarized as follows:

o Low risky assets at entry are required to maintain the positive momentum towardsfurther improvement of the portfolio quality. This report has shown that during 2006,

there were a number of new projects added to the non-sovereign portfolio and that asresult of prepayment of low risk assets the risk of the portfolio weakened from 3.2 to 3.5.The size of the outstanding portfolio declined by 8%.

o The level of Provisioning is adequate - The average provisioning rate for the loan andguarantee portfolios increased slightly in 2006 to 4.4%, while the average provisioning forthe equity portfolio increased to 5.8%.

o There is enough headroom to support further expansion of non-sovereignoperations - From a capital adequacy perspective, the outstanding non-sovereign portfoliocurrently consumed about 4% of the Banks total risk capital, well below the 20% globallimit. However, over near future, the risk capital utilization is projected to rise to 12%. Also,the single obligor and single country limit are expected to be exceeded soon.

o In terms of credit pricing, the spreads and other charges set on loans and guarantees

have generally been in line with the Banks cost recovery objective. In 2006, the neteconomic contribution from non-sovereign portfolio positively contributed to the Banksoverall financial performance.

o A number of measures were taken to strengthen the Banks non-sovereign operations. Butas more functions and responsibilities are shifted toward private sector, it would beappropriate to re-examine the credit review process with a view to strengthening thecommittee structures and the approval workflow.

00447624 en non sovereign portfolio credit risk review

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