[BETA] Fortnightly

Adopting a portfolio approach to credit risk is the answer.

How times have changed from the "good old days" of credit risk management. No longer can credit managers hide behind the false comfort that they only approve transactions with companies that pay their bills.

Now, what is needed for appropriately functioning credit risk quantification is a portfolio perspective and a long time horizon. The portfolio perspective accounts for the realization of an average low level of losses most of the time, punctuated with an occasional large loss, and an even more infrequent period of several correlated losses. The long time horizon is necessary to capture the risk associated with that period of correlated losses. This is highlighted by the graphic that depicts annual portfolio losses right ().

The key here is a long time horizon-something like a year. Credit managers cannot afford to set limits and manage credit risk based only on accounts receivables balances plus current mark-to-market exposures. A view of potential future exposure (PFE) is critical. ¹

PFE is an important driver of credit risk for two reasons that are highlighted by the table depicting the fallout from the Enron bankruptcy (). First, when Enron initially filed for bankruptcy it left these "Top-10" energy companies holding the bag for over $750 million ² of exposures. Exposure this large obviously came from somewhere other than accounts receivables. Secondly, as the last column highlights, it has taken time for the full effect of this credit event to run its course. It is now obvious, almost a year later, that the market believes several other Enron "look-alikes" will not survive the crisis. One may argue that the troubled companies today had separate and distinct problems of their own, but the liquidity crisis that has settled over the industry since Enron has certainly not helped their cases. Some believe that a sweeping round of industry re-regulation will cure the credit risk problem.

Don't count on it.

Look no further than the banking industry as a case in point. No amount of regulation in this industry has proved successful at eliminating bank failures from credit defaults. Instead, prudent credit managers of energy companies should be asking themselves what tools they can deploy to manage credit risk. Again, the banking industry is a case in point. It is here that the economic capital (EC) credit portfolio framework was first developed to measure and manage credit risk. Sure, energy companies are different from banks-but the credit risk is the same, and the EC framework can be adapted to account for the differences. In the remainder of this article we lay out the EC framework for credit risk quantification. Following that, we discuss how the framework can be successfully employed by an energy company to effectively manage firm-wide credit risk.

Economic Capital Framework for Credit Risk Quantification

There are two metrics required to quantify credit risk. The first metric is called expected loss (EL). EL in statistical terms is the average amount of credit losses per period that a credit manager should expect to lose. Strictly speaking, since