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Capital Reserve Margins: Hardly Adequate

A pseudonymous executive tells why the CCRO's recommendations don't pass muster.
Fortnightly Magazine - March 2004

is that it does not make any recommendation about the level of capital required for safety. The CCRO paper openly admits that it will not address the "amount" (of capital) a company should have.

This stands in stark contrast to the committees and working groups in the banking and insurance industries that have defined parameters for capital adequacy. Through the Basel Accords, banking industry stakeholders developed capital adequacy standards that are now internationally accepted. Basel provisions require that banks keep capital reserves greater than 8 percent of the sum of market, credit, and operational risk.

Guidance for the calculation of the specific risk components is also defined:

  • Market Risk: Max(Previous day's Value at Risk (VaR), 3 * last 60 days' VaR); 4
  • Operational Risk: 17 percent to 20 percent of gross income, or 99.9 percent one year VaR; and
  • Credit Risk: Defined risk weight by credit rating. 5

The insurance industry serves as another data point for comparison. The National Association of Insurance Commissioners' task force on risk-based capital works with industry participants and stakeholders to develop and maintain capital adequacy standards for life, property, and health insurers. Currently, these standards stipulate calculation of the ratio of "total adjusted capital" to "risk weighted liabilities," with a sliding scale of corrective action, from voluntary correction to regulatory response.

Most importantly and immediately relevant are the credit rating agencies' views on this matter. Standard and Poor's issued its own methodology for capital adequacy for energy companies in March 2003. 6 S&P's methodology calculates capital adequacy as a multiple of VaR. Specifically, four times market, credit, and operational risk is treated as debt equivalent. 7 The CCRO indicated that it was not interested in addressing the appropriateness of S&P's methodology when it states "(our) paper offers an alternative to a capital adequacy assessment that imputes VaR multiples as debt to a firm's capital structure" 8-even though these methodologies (Fitch and Moody's each have developed similar methodologies) have a direct impact on energy companies' credit ratings.

Considering the amount of pain the credit rating agencies have dealt recently to the energy sector, it is surprising that the CCRO did not collaborate with the rating agencies on developing its capital adequacy standards, or, at the very least, address the appropriateness of the credit rating agencies' methodologies within the context of proposing its own guidelines.

What Source Data Is Appropriate?

The CCRO also is silent on the criteria for the data used in the capital adequacy calculation. This is a significant hole in the CCRO's capital adequacy standards, since an energy company in debt hypothetically could claim surplus economic capital under the CCRO's framework by selectively choosing the source data used for risk calculations.

In comparison, the Basel Accords stipulate that banks' source data be based on an observation period of at least one year of historical data and updated at least once a quarter. 9 Again, the point is not to adopt banking standards for the energy industry but rather to provide the appropriate parallel criteria. Defined criteria for the underlying data will have the effect