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 million2 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 this is an expectation, it is not risk, and should be built into the cost of a transaction. The second metric gets to the heart of credit risk and is referred to as economic capital (EC). Where EL measures the anticipated average loss from a portfolio over the relevant time horizon, EC captures the variance or the uncertainty of the losses around the average. With its focus on uncertainty, EC quantifies the portfolio credit risk. These concepts are depicted in the loss distribution in Figure 3.
Expected Loss. EL is measured by multiplying together three factors, probability of default (PD), expected exposure (EE), and loss given default (LGD). The logic behind multiplying these factors together is straightforward, as depicted in Figure 4.
The probability of default is determined by a counterparty's or customer's credit quality. In the case of large, long-term deals with energy marketers, this can be based upon credit quality measures such as agency debt ratings. The way to measure expected exposure depends upon the nature of the exposure. For retail customers, this could be measured by current accounts receivable. In contrast, for merchant energy counterparties, the appropriate measure is not only accounts receivables, but also current mark-to-market exposure of contracts, plus the expected potential future exposure of contracts. Loss given default is determined by what remedies may be needed to mitigate credit losses (e.g., letter of credit, parent guarantee). The resulting EL calculated for each individual counterparty in a portfolio is additive across all counterparties to identify the portfolio level EL.
Economic Capital. Economic capital is a bit trickier. To be specific, EC is a measure of the amount of resources a firm must maintain to cover a "worst case" credit loss, and still remain solvent. It should be clear that the amount of EC is driven by how an organization defines a "worst case" loss. The drivers of EC for a "worst case" loss are the same three drivers of EL, plus two more:
- Counterparty/customer credit quality-The more likely a customer or counterparty is to default, the higher the "worst case" loss is.
- Expected exposure-The more exposure to credit losses obviously leads to higher amounts of "worst case" loss.
- Loss given default-The less that can be recovered from defaulted exposures, the higher the loss given default and "worst case" loss will be.
- Portfolio concentration and correlation-Having exposures to limited numbers of counterparties or concentrations in certain types of counterparties is like having all your eggs in one basket. This results in potentially large amounts of losses when things start going bad, resulting in larger "worst case" losses.
- Target debt rating-The more creditworthy an institution wants to be, the more willing it needs to be to cover an increasingly worsening "worst case" scenario. In other words, an "A" rated institution has to be able to weather a worse "worst case" loss than does a "B" rated institution.
A properly developed EC framework incorporates these drivers in such a way to quantify the credit risk of an entire portfolio and (more usefully) attribute the credit risk back to the individual counterparties or business activities within the portfolio. A framework that is capable of doing this facilitates several useful credit risk management applications. These applications are highlighted in the next section.
A framework for quantifying credit risk is useful in and of itself, but is enhanced greatly by the applications it supports. The EC framework, with its single metric for quantifying credit risk, stands out as particularly useful due to its ease of application in various risk management situations. These include:
- Capital adequacy-One of the first useful questions that a quantitative credit risk measurement framework addresses is whether or not the firm has sufficient resources (i.e., equity) to be able to cover credit losses resulting from its operations. Comparing the actual amount of capital (i.e., shareholders equity) to the calculated amount of EC provides an analysis of capital adequacy.
- Credit approval and limit monitoring-A credit measurement framework that is capable of attributing EC back to an individual counterparty or business opportunity facilitates limit management. Unlike a limit management system that is based on exposures, an EC framework focuses on the risk from a given counterparty.
- Business opportunity analysis-For asset deals that generate credit risk (e.g., acquiring a generation asset with a long-term PPA from a customer that may default), building in a quantification of credit risk from the transaction may decide the financial attractiveness of the deal.
- Prudence reserve management-A quantitative method for measuring credit risk can assist in setting the appropriate amount of prudence reserves. The reserves are often set at some level above EL, but well below EC, depending on corporate policy.
- Portfolio management-A versatile credit portfolio model assists in the management of counterparty exposures by highlighting diversification opportunities, and preventing excessive concentrations of exposures to a single counterparty or industry.
Striking a Balance
In addition to the many useful applications of an economic capital framework for quantifying credit risk, one of its strongest attributes is its ability to resonate with two key stakeholder groups: shareholders and debtholders. Figure 5 provides a representation of the conflicting interests of both groups, and highlights how economic capital "bridges the gap" as the common metric to serve the differing interests of the two groups.
In the case of shareholders, whose interest is that of maximizing return on invested capital, economic capital provides the framework to evaluate business opportunities on a common footing. Likewise in the case of debtholders, who are more interested in making sure the company pays its bills; EC provides a measure of the appropriate capitalization of the organization. Economic capital provides the single measure that allows the competing views to strike an appropriate balance between profits and prudence.
While economic capital will not solve all the problems currently gripping the energy industry, it certainly provides credit managers with a powerful tool for measuring credit risk and facilitates several credit risk management applications. In addition, it gives corporate managers a communication device that resonates well with the competing interests of shareholders and debtholders.
- For a more complete discussion of PFE, see our recent article, "Potential Exposure: The Long View On Credit Risk," Public Utilities Fortnightly, May 15, 2002, p. 42.
- "Companies' Enron exposure estimated at $6.3 BLN", Reuters News Service, December 7, 2001.
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