Fifteen years ago, you couldn’t fill a small room with energy CEOs interested in discussing how credit risk affects their companies’ bottom lines. But a recent series of contract defaults, bankruptcies, Sarbanes-Oxley controls, and merger-and-acquisition activity has placed credit-risk management squarely on the industry’s radar.
Energy and utility companies are doing business with long-time customers who have seen their credit ratings drop to the brink of junk status. Based on the huge disparity among credit scores, it’s a real case of the “credit haves” doing business with the “credit have-nots.” In other words, it’s an accident waiting to happen. According to a June 2005 study, energy firms continue to “exhibit very high risk levels,” and out of the 20 riskiest companies in the S&P 500, five were energy companies.
While credit risk is nothing new in the risk-savvy environs of banking, manufacturing, and finance, credit risk management has struggled to find a foothold in the energy industry because of a lack of dedicated focus and funding. As a result, it is commonplace to find inconsistent credit-risk methodologies, poor technology implementation processes, and a lack of integrated, robust risk systems interfacing with internal accounts receivable/payable information and timely, industry-specific external credit data.
Every classic case of a risk management blow-up (Barings Bank, Orange County, and Long-Term Capital Management, to name a few) started with strong earnings that were poorly understood and never questioned. Today, it’s clear that an integrated risk system that measures, monitors, and manages credit-related risk is no longer a Wall Street extravagance, but rather an industry essential.
Even though credit risk can, on average, comprise some 25 percent to 30 percent of a company’s overall risk portfolio, it’s often an underdeveloped and overlooked area, especially in the energy sector. But an unrecognized or hidden credit issue can be the masked disaster waiting to happen.
Case in point: according to a March 2004 survey run by the Global Association of Risk Professionals (GARP), credit risk is oftentimes managed and strung out across a hodgepodge of (sometimes more than 20) systems. In the survey, respondents were asked how many systems managed credit risk across their entire organization. More than 54 percent answered two to five, 16 percent said 5 to 10, and 15 percent used 11 to 20 or more.
Although energy companies span multiple commodity streams (crude oil, refined products, natural gas, power, coal, and others), it is rare that all commodities in a company’s portfolio adequately can be captured in a single system—hence the proliferation of systems. Surely it’s not difficult to imagine that if any of these all too numerous risk systems are not properly implemented and seamlessly integrated with one another, they easily could necessitate hundreds of hours of bad data cleanup, multiple “off-line” calculations, and manual input (i.e., human error). Given some of the low correlations of market risk across the commodities, the only time it is necessary to aggregate all of the information in these individual systems is to aggregate company exposure for credit risk purposes.
As for workflow processes used in the review of documentation and disposition of credit excesses, 42 percent surveyed reported having systems that were “mainly automated with some residual paper-based elements”; 38 percent rely on systems that are “mainly paper-based with some automation”; 9 percent indicated they had “fully automated electronic workflow with archival documentation of actions”; and 10 percent said they still ran “completely paper-based.”
Clearly, many companies still are struggling to get a real-time, enterprise-wide consolidated view of credit risk by various fundamentals, such as counterparty, location, and asset class.
This leads to the next question, in which respondents were asked, “How quickly can you get an enterprise-wide consolidated view of credit risk by counterparty/geographic location/asset class/maturity?” The vast majority, at 55 percent, answered longer than overnight; 20 percent said overnight; 17 percent answered intra-day; and a mere 7 percent could see their true credit risk in real time. Clearly, more companies need to take a closer look at all of the enterprise-wide risks and challenges involved in an increasingly difficult market environment.
Counterparty credit risk can prove to be extremely dynamic—morphing from a manageable being to a mammoth brute in an instant. But it can be tamed and assessed by the size of the exposure, the maturity of the exposure, the probability of default, and the systematic (or concentration risk) of the counterparty. Generally speaking, the four all-purpose factors that should be taken into account when establishing the amount of credit to be made available should include current exposure, potential exposure, statistical probability of default by the counterparty, and the recovery rate (amount of defaulted position that is likely to be recovered). The collapse of Enron demonstrated quite publicly the need for internal assessment of all counterparties, as the rating agencies tend to be a lagging indicator of actual default probability (a lesson further reinforced recently with General Motors’ financial woes).
Considering the ever-increasing complexity and volatility in the energy marketplace, only seamlessly integrated credit risk systems can tackle today’s highly complicated qualitative analyses and afford a truly transparent information workflow. Considering the number of new Wall Street entrants into energy, like hedge funds and investment banks, an unbalanced ratio of industry acumen to credit risk knowledge is at work in the sector.
Yet many companies today have yet to fulfill the vision of enabling their credit department with the integrated set of tools and data to effectively manage their credit risk. Savvy credit systems can automate the collection, measurement, valuation, and analyses of credit-related data, and then quickly turn around and capture substantial business & market paybacks. Vendors include the likes of Murex, Rome, Moody’s KMV, and Raft.
Through top-notch IT solutions and implementation, energy companies today can enjoy all the benefits of transparent credit risk management, including: iron-clad security with a segregation of duties and limits, immediate alerts of unfit counterparties, cross-currency capabilities, centralized database (an effective audit trail), automatic data downloads, consistent rating models, adaptable risk-weighting (for altered risk environment), and more.
In conversations with our clients, we see three pressing issues energy companies need to address: the effective capture and proper calculation of exposures; documentation (terms, conditions, policies and procedures for counterparties in all financial derivatives and physical deals); and full transparency across a front-to-back-office integrated system.
Some of the core IT functionality necessary to accomplish credit risk management tasks should include:
• Real-time or near real-time automatic download of external information. This information could include credit scores (downgrades and upgrades), company news, financial performance, stock prices, SEC filings, bond spreads, energy commodity prices, default probabilities, and external debt ratings from sources like Moody’s and Standard and Poor’s;
• Automation of external information throughout the system (without the need for manual manipulation or input);
• Allowance for in-house analytics and user-defined customization of needs, procedures, standards and limits; and
• Generation of internal ratings based on user-set parameters.
In general terms, solid credit-risk systems should address the five core arenas of credit-related risks: exposure, collateral, counterparty management, credit scoring, and contract/legal management.
The more in-depth analytics in a robust credit-risk system should include potential exposure analyses, which are based on additional exposures that could be created due to changes in market value over time, measured by potential future exposure or other calculation. For instance, incorporating potential commodity market-price volatility and current credit exposure can provide valuable insight into potential future exposure by calculating a future statistical analysis of the potential (“what-if” scenarios) for counterparty defaults. This can give credit and treasury departments information to manage overall company exposure, cash flow, and credit instruments. It is especially critical for companies with advanced credit needs, or those that deal with numerous counterparties. For state-of-the-art functionality, a credit-risk system should offer real-time or near real-time credit scoring data and run a credit check on any counterparty, providing an effective tool against radical counterparty credit shifts, bankruptcies, merger and acquisition activity, and market shakeouts.
Enterprise-wide benefits to using “ahead-of-the-curve” credit-risk IT can include, but are not limited to, the following:
• Improved, timely, meaningful, and actionable collateral, position, and reporting information and management;
• Enhanced cash flow scope in margining and forecasting, and an improved receivables collection capability;
• Corporate governance and compliance with internal and external investment and audit standards and policies. Considering the advent of the Sarbanes-Oxley Act, it is more important than ever to keep flawless internal accounting reports, as noncompliance can lead to costly criminal and civil penalties and time-consuming audits;
• Faster loan underwriting decisions and efficient monitoring of portfolio credit trends;
• Reduction in costs for borrowed funds and audit fees or fines; and
• Reduction in operational risk and an increase in productivity, and more.
Another benefit to using a real-time credit-risk IT system is the ability to scrutinize and immediately track down any breaches in book or trader credit limits.
Breaches in book or trader credit limits can create chaos in portfolios and exposures.
According to the GARP credit-risk survey, not every company has a tight rein on their sometimes bucking-bronco-like books. In the survey, risk managers and survey respondents were asked how quickly the risk staff would become aware that a book credit limit had been breached. Only 11 percent said in real time, with the rest answering intra-day (25 percent), overnight (35 percent) and longer then overnight (29 percent). As for finding breaches in trading book limits, survey respondents said about 22 percent find them in real time, 34 percent in intra-day, 29 percent overnight, and 14 percent longer than overnight.
Expensive and unwelcome breaches in user-defined roles and counterparty limits can be avoided through ironclad segregation of duties and limits, immediate threshold-based “knockout” alerts, and seamless risk management integration.
No doubt the implementation process of any risk-analysis system can be demanding. But with expert help, the journey through the process can prove richly rewarding, adding enormous fiscal value through reduced losses and improved adaptability to lightning-fast market moves. A best-of-breed system also helps reduce the internal-control difficulties inherent in manual processes, while lowering staff costs. Proper implementation of an automated solution provides both tangible and intangible benefits. Many organizations now are realizing that automated solutions are the most effective remedy for internal control challenges, but they have a limited number of internal business experts who have little or no time to focus on system integration or implementation projects.
While the benefits are compelling, the climb can be daunting. Internal red-tape, failed attempts to solve similar problems in the past, allergic reactions to multi-million-dollar/multi-year projects, poor executive sponsorship, dynamic market conditions, achieving “SOX stability,” and unprecedented volatility in the energy markets all create institutional inertia. However, there is no doubt that in this case the view is worth the climb. The difficulty today is that few companies are staffed with the right resources to work on such projects, or the key resources to make this effort a success are helping with other “hair-on-fire” issues. Selection of the right external resources and software vendors is critical to achieving success, so choose wisely.
In the end, the energy sector is rife with low-quality credit scores, counterparty contract default, and bankruptcies. The energy sector has felt enough fiscal pain in recent years to take a long, hard look at its exposures and overall risk portfolio, particularly in operations and market risk. Yet credit risk clearly is the overlooked stepchild of risk management, especially in the energy industry. Today’s ahead-of-the-curve credit risk technology is ready to take its long overdue position as an indispensable revenue-protecting risk management tool in handling energy’s challenges.