Reproduced from Energy Metro Desk. Copyright 2009. Scudder Publishing Group. ISSN 1552-5090
Better practices for credit measurement and management protect capital and liquidity
By Nathan Stein
Energy Trading & Risk Management Consulting Practice, The Structure Group®
Increasing defaults, loss of credit, and widespread liquidity challenges are the casualties of a tough credit market and a beleaguered economy. As a result, organizations have become even more protective of remaining capital and available liquidity, and managing these precious resources much more carefully by improving credit risk measurement, best practices and systems.
Better Measurement Means Better Utilization of Capital
A company measures credit risk to understand its exposure to potential loss and the amount of capital necessary to balance that risk. However, we are now seeing that changes to existing assumptions and methodologies are leading to a more accurate and timely measurement of credit risk -- and that promotes more efficient utilization of capital.
A historical challenge to the measurement of credit risk is that calculations are not linked with accounting to track actual receipt and payment of amounts owed and due. It has not been uncommon for the calculation to simply assume that all invoices are paid or collected on time.
This assumption is frequently untested. Exceptions could result in unrecognized limit violations or an improper restriction of trade when the availability calculation is inaccurately low. Because the threshold for use of capital is tied to limits, and its actual use are tied to exposure, improving the accuracy of the exposure calculations and resulting availability calculations promotes a more efficient utilization of capital.
How Do You Improve Exposure Accuracy?
A variety of solutions are being used to improve exposure accuracy, including: manual adjustments to the credit department's existing calculation, cash application within the ETRM system, and a bi-directional interface with the accounting system. Assess the magnitude of any difference between estimated and actual exposure to determine what solution makes sense for your organization.
In another leap forward, many companies are moving from a daily credit exposure report to management of exposure in real-time. The daily report represents progress from the less frequent measurements common in the more distant past, but it does not capture the effect of intra-day transactions and price fluctuations.
At present, traders in many organizations are left “eyeballing” proposed trades to estimate if the resulting exposure will fit within the availability shown in the report, and must contact credit to verify availability before executing a trade if it appears close to a limit violation. This method is less precise and consumes valuable time in the trading day. Also, when the exposure calculation is not done in real-time, organizations face the risk of traders simultaneously doing deals with the same counterparty. This can lead to an unexpected violations.
A real-time credit exposure calculation provides a more timely measurement, including all executed trades up to the present point in time. With this change, organizations also seek “real-time” limit violation notifications to concerned parties (either via email or “pop up”) when an executed deal exceeds (or is close to exceeding) a counterparty's credit limit. Furthermore, a real-time system provides the ability to enter hypothetical “what if” trades in the system to determine the impact on credit exposure if a certain transaction was executed. However, the decision to include “real-time” price curves in the calculation is often debated. In deciding which curves meet their needs, companies weigh the needed precision, impact on system resources, and available market data.
In addition to increased efficiency in capital utilization, the benefits of real-time exposure calculation can include reduction in credit limit violations, increased speed in decision making, and better utilization of the credit staff's time.
Managing to the Limits
Organizations actively manage credit exposure to ensure acceptable credit-risk remains within defined limits. To properly maintain those levels, counterparties rely on available liquid assets. In the present economic environment, many companies find maintaining sufficient liquidity more difficult. To prevent a negative impact, companies are seeking ways to address limit violations more efficiently, and to reduce exposure (and thus capital and liquidity requirements) via settlement term changes. One such way is margining. Margining involves a company seeking additional financial assurances (cash, letters of credit) from a counterparty when unsecured exposure exceeds the established limit. Existing practices in this area are frequently manual and prone to errors (e.g., use of spreadsheets and manual margin requests).
As credit terms tighten, liquidity is in higher demand. Quick pursuit of required margin could mean the difference in having or not having the request met. Companies are therefore seeking greater automation of the process, including the margin requirement calculation and initial request for margin. Non-system improvements include reduction in the window of time to provide the required assurance (e.g., reduced from three days to two).
Since margin thresholds are frequently tied to agency ratings, companies are also beginning to assess the impact that future rating changes could have on margin requirements. This scenario analysis helps a company evaluate its appetite for additional business with counterparties and plan for the needed liquidity where it must post margin.
Shortening the Settlement Period
An emerging trend at Independent System Operators is a reduction in settlement periods. ISOs are moving towards reducing their settlement periods from monthly to weekly. This is already in place today at ISO NE and Midwest ISO. In fact, there is movement at some markets to move towards daily settlement like ICE and NYMEX. The more frequent collection reduces the ISO's exposure to credit risk, resulting in less capital required to support it.
However, this can be problematic for market participants. The change to shorter settlement periods impacts traditional monthly accounting processes and may necessitate a variety of changes from systems to reporting. On the other hand, market operators such as ISO New England, claim the benefits of lower financial assurance requirements (frees some liquidity) in shorter periods actually increase the attractiveness of market participation.
While the implications of making these changes will be different for each organization, the conditions that necessitate them will continue. On the positive side, any improvements in practices for credit exposure measurement and management will be valuable no matter what the economic climate in the future.