Counterparty Credit Risk in a Post-crunch Economy

There are any number of reasons why firms should take enterprise counterparty risk seriously and manage it appropriately. A perceived failure will prompt investors, rating agencies and counterparties to question an organisation’s business processes and corporate governance procedures. The merest whiff of a rumour of default on a margin call, or over-exposure to a downgraded counterparty, will start the wolf pack circling.

Failure to manage credit risk across the entire company can put organisations on a collision course with a market that has shown little forgiveness for both real and perceived missteps, as well as regulators demanding greater transparency. It means that business decisions are being made on incomplete or inaccurate data. It severely blinkers a firm’s vision of the futur, and hampers its ability to move forward. And, at a time when cash is king, it can have a very deleterious effect on liquidity.

Constellation – a firm with a previously strong reputation for sophisticated risk management – knows all about credit risk failure. In August 2008, the power producer shocked investors when it revealed that it had made an accounting error and underestimated its potential liabilities in case of a ratings downgrade. Both Standard & Poor’s and Fitch Ratings swiftly downgraded Constellation’s credit. Constellation was so large and appeared to be dependent on multiple lines of credit from various banks that were, at the time, either in trouble or going under, that the perception developed that it was at risk.

Despite Constellation’s efforts to reassure investors of its excess liquidity, good balance sheet and solid commodities-trading business, it got caught up in the spokes of Lehman Brothers’ death spiral. Over three days in September 2008, Constellation’s stock lost nearly 60% of its value as it was dragged into a world of plummeting share prices and eventual sell-offs.

And yet, post-Constellation, post-credit crunch, even post-Enron, when we know that the wrong numbers can do untold damage, many companies are still putting a simple spreadsheet between them and potential ruin. Instead of managing credit risk in a holistic fashion, based on consolidated, auditable data from across the organisation, businesses rely on an error-prone processes that perpetuates the silioing of data sets.

Worryingly, a recent CommodityPoint survey of energy and commodity executives discovered that 70% of companies are using spreadsheets or internally assembled systems to manage counterparty credit risk, while 60% of the companies surveyed felt the need to upgrade their credit risk systems to manage counterparty risk effectively in the current business environment.

If companies do not wish to follow in the footsteps of Constellation, Lehman and Enron, they must grasp the central tenets of credit risk management, or the five Cs: counterparty, contract, collateral, concentrations and credit analytics.

Counterparty

In the current climate of the financial meltdown, antiterrorism and ratings downgrades, there are increasing internal and external pressures to understand and evaluate counterparties. Regulations, such as know your customer (KYC), enhanced due diligence (EDD) and anti-money laundering (AML), are regulatory attempts to enforce consistent comprehensive counterparty assessments and documentation. Internal pressures, such as credit policies and counterparty onboarding, scoring and credit limit-setting processes, are also being revamped and extended.

In an interconnected series of markets, a firm’s reputation and its financial position is only as good as that of its counterparty. And so, it must have a comprehensive view of all its relationships in order to understand its own financial and operational health. But creating a comprehensive risk profile requires the capture and management of significant data points for each counterparty.

This is rarely straightforward: physical and financial exposure, joint ventures, parent-child relationships, multiple business units, and diverse geographical divisions must all be navigated – not to mention exposure to lines of credit that create a whole new layer of exposure. Added to which is the required due diligence and scoring of a potential counterparty’s financial health.

It has become clear that organisations should not rely solely on third-party evalutions of counterparties. One of the more interesting consequences of the credit crunch is that it has highlighted the relationship between rating agencies and the firms they were assessing. An AAA-rated party is no longer a solid-gold guarantee. Indeed, all three major credit ratings agencies gave Lehman at least an A rating right until the day the firm filed for bankruptcy. Nor are auditors to be relied on without due diligence – after all, Bernie Madoff was audited for years while running the world’s biggest and possibly most damaging Ponzi scheme.

Collating and managing all this information – and applying custom scoring techniques – is critical for any organisation that wishes to protect itself from defaulting counterparties.

Contract

Getting contract administration wrong can have a potentially catastrophic effect. More often than not, hugely complex paper-based contracts are signed, sealed, and then forgotten about. Contract administration is a time-consuming, manual process often fragmented across multiple business units. And that’s the problem. If treasury and legal don’t have visibility of a contract’s terms, how can a trader be expected to know about clauses buried in a contract that’s been filed away for 10 or 15 years that might affect his or her trading decisions? Time and again no one knows the specifics of a contract until there is a problem. And then, when a counterparty suddenly doesn’t make a margin call, everyone runs around in a blind panic to find the contract and discover what it actually says.

Inadequate management also raises the possibility of a contract containing inaccuracies, missing a key renewal date or inadvertently oversetting an earlier version. An enterprise-wide agreement becomes a series of potentially contradictory piecemeal arrangements. Assumed contractual certainties become legal black holes in reality. Margin receipts go down, while costs for debt recovery go up.

All this puts huge strains on contract management, which can be made a lot easier through the deployment of a single centralised system. With the contracts digitised, the key terms can be pulled out and displayed on screen so that all departments have a consolidated view of contractual requirements on an ongoing basis. Decisions can be taken from a position of knowledge and, if something does go wrong, companies know exactly where they stand.

Collateral

In the last eight years, the number of collateral agreements worldwide has grown from 12,000 to 150,000, with the total value ballooning from US$200bn to US$2 trillion. But a lack of automation – and integration with contract management systems – means that tracking these deals is inevitably prone to error and duplication. It is not surprising, therefore, that the result is more often than not an inaccurate view of a firm’s liquidity, exposure and opportunity costs.

When that view is inaccurate, it is also expensive. Organisations are not getting value from their contracts if they not making margin calls in an opportune fashion – and on occasion not making them at all. In addition, delays in collateral receipts, the inability to make timely collections on outstanding payments and lengthy disputes in need of rapid resolution all have a negative impact on cash flow. And, unable to forecast expected or potential calls from counterparties accurately, firms find their trading mitigation strategies are less effective, their ability to access lower cost capital is compromised and they face both over-collateralisation and carry costs.

In other words, inadequate management of collateral agreements simply adds to the risk and cost of doing business, putting liquidity in jeopardy.

Concentrations

Once a counterparty has been assessed and scored, a contract set up and monitored, and a collateral agreement put in place, a firm may still find itself over-exposed, for example, to a specific commodity like US power. To protect themselves against undesired levels of exposure, companies need the ability to assess their cash, forward, current and potential exposure on a portfolio-wide basis, and manage credit risk concentrations by commodity, deal type, industry sector, credit rating or country as necessary.

That requires them to have the appropriate tools in place to ‘slice and dice’ a portfolio and highlight netting opportunities that will reduce both risk and unnecessary margin payments. Without the right systems, however, the questions that need to be asked in order to produce this information can often take hours, if not days, to answer – making it all but impossible to align a firm’s actual risk profile with its intended risk appetite.

Credit analytics

With the first four Cs in place, credit analytics is the cherry on the cake. It enables firms to run stress scenarios and ‘what-if’ simulations to calculate and – potential future exposure (PFE) and credit value at risk (CVaR) respectively. Combining market price movement and rating migration, it enables firms to take action by creating a hedge or diversifying strategy. They can also state within a given confidence level what cash flow will be, adjusted for risk.

The credit crunch and ensuing financial crisis have proved that many of the basic risk analysis and risk measurement techniques are not adequate and companies need access to more forward-looking information. Credit analytics does just that. It provides a consistent framework to forecast, evaluate, and respond to future credit events.

Conclusion

When credit is critical and liquidity hard to come by, cash flow, margins, loss avoidance and reduced exposure all take on renewed significance. Spreadsheets may give a sense of security, but it is a false one. Such a critical function as credit risk management cannot be left to generic applications, whose limitations have become all too painfully clear.

Every business operation needs to be realigned around risk and risk management. Many organisations have already invested in managing market risks, through the deployment of ( energy trading risk management (ETRM) or specialist commodity trading platforms. They now need to protect that investment with fully-integrated enterprise systems that manage all aspects of credit risk with automation, accuracy and auditability. Failure to do so means failure to manage the five Cs. And that, in turn, is failure to manage the business.

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