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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

of increasing the transparency of risk reporting and a positive influence on the energy sector's credit ratings.

What Is the Role of Stress and Scenario Testing?

The CCRO's capital adequacy is heavily VaR focused. VaR generally is not considered entirely suitable to the energy industry given the structural presence of leptokurtic returns, or "fat tails." The presence of "fat tails" indicates that energy price returns do not follow a normal distribution, that extreme price spikes occur with greater frequency than a value-at-risk analysis would indicate (e.g., California power price spike in 2001, December 2003 natural gas price spike). Therefore, using only a VaR-based approach to capital adequacy without stress testing or scenario analysis will fundamentally underestimate the levels of capital required. 10

But few energy companies rely solely on VaR for this reason in structuring their risk management limits, so the CCRO is deficient in not discussing the role of stress and scenario testing in evaluating capital adequacy. A survey of financial institutions by Capital Market Risk Advisors in 2001 revealed that approximately 36 percent of financial institutions use scenario analysis testing and/or a combination of VaR with scenario analysis to set capital adequacy levels.

An IRB bank must have in place sound stress testing processes for use in the assessment of capital adequacy. Stress testing must involve identifying possible events or future changes in economic conditions that could have unfavorable effects on a bank's credit exposures and assessment of the bank's ability to withstand such changes. 11

The insurance industry also widely uses scenarios to test capital adequacy. Insurance compaines must consider the effect of at least seven interest-rate scenarios in performing asset adequacy analysis. 12

It has been almost two years since the energy industry's liquidity and credit crisis started to produce tangible capital adequacy recommendations, but the CCRO has not come forward with any definitive recommendations. With the devastation visited upon shareholders, employees, and the public good by laissez faire risk standards in the energy sector, it is reasonable to expect more.

It is difficult to believe that investors, credit analysts, and regulators will view the CCRO's effort as credible given the vacuousness of the capital adequacy recommendations and the fact that the participating CCRO companies make no commitment to implementation. The CCRO seems more interested in writing tepid papers than making the tough choices required to facilitate structural change in the energy merchant and trading sector-changes that are necessary to return vitality and stakeholder confidence.

Endnotes

  1. The CCRO was formed in the spring of 2002 as a reaction to the massive upheaval in the merchant energy sector.
  2. Issued in September 2003 at www.ccro.org.
  3. "Where the CCRO Fell Short," Public Utilities Fortnightly, January 2003.
  4. 99-percent confidence level, 10 day time horizon
  5. Jorion, Financial Risk Manager Handbook, Second Edition, Chapter 31.
  6. Standard and Poor's, Debt Treatment of Contingent Capital for Energy Marketing and Trading, March 20, 2003.
  7. Market Risk: 99-percent confidence level, 10-day holding period. Operational Risk: 50 percent of Market Risk. Credit Risk: exposure times default probability.
  8. CCRO Capital Adequacy Whitepaper, "Executive Summary," p. 2.
  9. Jorion, p. 673.