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Confronted with a new paradigm, energy firms centralize the management process.
The recent exponential growth in the energy commodity markets—with record risks and record returns—has changed the rules of credit risk management across energy markets and for their participants.
Credit risk management is becoming increasingly complex, driven by various sources ranging from counterparty financial health, covenants in contracts, market price volatility and others, requiring energy firms to have data, systems and procedures that enable them to account more effectively for their exposure to counterparty default and collateral management across business activities.
However, many energy market participants still have weak credit risk management tools and processes. These data and tools, when they exist, have been mostly deployed in isolation at various business units or related to only a sub-set of trading activities. The tools are disparate across many areas of the credit, treasury and accounting functions and often have disparate sources of data. As a result, energy market participants are exposing themselves to unforeseen risks of large unexpected losses and inefficient use of scarce risk capital.
What’s confronting energy firms is the new paradigm of credit risk management. Implementing a proactive approach to centralize the credit risk management process is a good response.
A centralized approach will deliver three key benefits: a single view of credit risk exposure made possible by centralizing the risk function, aggregating all data and identifying all contract terms and conditions by counterparty and their parent company to affiliate relationships; reliable credit risk metrics through the implementation of advanced analytics, enterprise-wide credit risk management systems and processes; and optimized use of collateral through proactive management of collateral requirements led by more reliable, insightful and regular information.
Provide single view of credit exposure
In the past, the most common misstep by energy firms was managing credit risk in silos. They often managed credit assets on a transaction-by-transaction basis without an integrated view of the overall portfolio exposure across the enterprise. Most energy firms were unlikely either to fully understand their exposure to extreme credit loss or to react quickly to potential adverse credit events (uncertainty around Enron or Amaranth, for example).
A centralized approach to credit risk enables energy firms to fulfill this missing integrated view of the portfolio.
First, by centralizing the credit risk function, usually accompanied by the creation of a credit risk manager position, top management gives a clear signal to the rest of the organization of the importance of credit risk management. Credit now has a seat at the decision table. This step empowers credit risk managers and enables them to have their influence on shaping the terms and conditions of new transactions. Credit risk managers are actively involved with traders in the origination, structuring and collateralization of new transactions. Counterparties are fully monitored beforehand and new transactions are concluded taking into account their marginal contribution to the overall credit portfolio through metrics such as Potential Future Exposure (PFE) or Credit Value-at-Risk (CVaR).
Second, by centralizing all counterparty information and aggregating all contract credit terms and conditions in an integrated database, a single view of credit exposure is made possible. This ability to measure, monitor and forecast current and potential credit exposures across the entire firm on both the counterparty level and the portfolio level is vital. The centralization of all credit terms and conditions has become more imperative because energy contracts are increasingly complex, despite standardization efforts made by the industry through the use of ISDA, EEI or NAESB templates. Contract netting arrangements, collateral triggers and margin calls can be optimized better. This single view of exposure allows the credit risk manager to react quickly to any deterioration in counterparty risk and request additional collateral if necessary.
Implement reliable credit risk metrics
Implementing enterprise-wide tools is essential in order to obtain the single view of counterparty exposure described above and produce meaningful and reliable credit risk metrics such as current and potential future exposure, expected credit losses or CVaR. However, implementing a scalable and consistent enterprise risk management framework is a challenging task for many energy firms.
To manage credit risk effectively at the enterprise level, energy firms have to integrate substantial quantities of data on exposure, netting agreement, collateral, and payment in addition to a variety of other relevant credit information. Generally, enterprise-wide tools use both vendor solutions and bespoke builds to fill out a target application architecture that delivers the required capabilities by the credit risk function.
Therefore, there are four steps that inevitably will take place in order to build a robust enterprise-wide credit risk system: - Strategic design of system architecture
- Custom-built components
- Vendor solutions
- Bringing it all together
First, building a robust enterprise-wide credit risk system starts with a strategic design of sound system architecture. Exposure calculation methodologies, workflow processes or credit analytics will most certainly continue to advance; the design of an integrated credit risk architecture needs to be flexible to embrace these changes.
The challenge faced by energy credit risk managers when managing credit risk at the enterprise-wide level is one of three-order elements: Obtain high quality input data from disparate sources from external rating vendors, market risk systems for mark-to-market position to accounting systems for receivable and payable; accurately quantify credit risk exposure; and produce high-level as well as detailed portfolio analytics and reporting for strategic credit manage-ment decisions.
Therefore, a vital ingredient to enable credit systems to deliver value is to create a well-crafted architecture along these three elements.
Second, software providers will have to unbundle the component functionality contained in packaged applications. One firm may want to purchase the exposure management from an exposure and limit system, the workflow component from a collateral package and the PFE calculator and the scoring models from an analytics engine.
Third, once the “off-the-shelf” system components are identified and required internal models built, the next step is to reassemble the different pieces of the puzzle to get a enterprise-wide picture of credit risk. Historically, bringing all the parts together as an integrated system has been the most challenging for energy firms. Therefore, the key for a successful enterprise-wide credit risk system is not only the technology, but the implementation strategy.
A good implementation strategy requires careful consideration of the organization, its roles, the supporting protocols and accompanying procedures. It should address two key fronts: how to break the silos and bridge together in a modular approach components that have been isolated in disparate credit systems and processes, and how to manage the complex changes in processes, structures and roles introduced by the new credit risk architecture.
Adopting these implementation steps and strategy will enable energy firms to achieve higher accuracy in their data collection, credit risk exposure quantification and effectiveness of credit risk management, while avoiding future large incremental systems investment.
Optimize use of collateral
Given the rapid increase of the use of collateralization in the energy markets, the need to pro-actively manage use of scarce capital is growing imperative to company health. In fact, the International Swaps and Derivatives Association estimates that the percentage of collateralized energy transactions has risen from 16 percent in 2003 to more than 50 percent in 2006 (ISDA Margin Survey, 2006).
Credit risk management strategy and systems are useless if collateral is not properly managed, but when it comes to collateral, many energy firms still have their collateral management group separated from the credit risk group.
A centralized and proactive credit risk approach breaks this mold and calls for an integration of collateral management within the credit risk group. This integration will deliver benefits in two ways, by optimizing the risk-return equation of collateral use and proactively managing liquidity problems.
A key benefit of integrating collateral management within the credit risk management group or with tight dotted-line accountability is the possibility for both groups to work together in the negotiations of the contract terms for the collateral agreements.
With collateral function closely aligned with credit, credit risk managers can leverage collateral as a trade enabler rather than viewing it simply as a post-trade operations function. Credit risk managers are in a position to help identify the right assets to use or receive for collateral, given credit concentration and liquidity constraints, as well as determine the risk-return characteristics of the asset serving as collateral. They can also optimize the use of collateral through cross-product margining. In doing so, credit risk managers transform collateral management into a value driver for the firm.
Proactive management of liquidity problems
Another key benefit of centralized collateral management is the proactive management of financial liquidity. With the integration of collateral management in the risk management team comes the centralization of the responsibility for monitoring changes in the counterparty risk exposures, as well as the evaluation of the impact in the credit and liquidity risk profile of the firm when counterparties are approaching their rating triggers. Credit risk managers can take their existing collateral agreement and run “what-if” scenarios to determine the counterparties that need changes in their collateral terms as market and credit conditions change. If the credit risk group has a Potential Future Exposure (PFE) engine for counterparty risk analysis, adding collateral and netting terms in the simulation framework can provide early warning signals of potential problems as well as a full liquidity analysis in the event of rating downgrades.
Today, the focus for many energy firms is to adopt an enterprise-wide centralized credit risk management approach as it gives an integrated view of risk. Best practices in credit risk management should demonstrate centralization, standardization, proactive management of collateral and efficient tools for managing exposures.
The next (new) generation of credit risk systems will be found inside each energy trading firm as a customized solution that optimizes existing and vendor systems with business specific models. Energy firms should recognize that they will not need to invest heavily in new credit risk systems to achieve this enterprise-wide view of credit risk. They need to invest in a careful architecture design that builds up on vendor systems and selectively develops in-house models to supplement any identified gap. They also need to invest in managing the changes in terms of the roles and responsibilities of the credit function as well as procedures and processes to ensure a successful implementation. Finally, energy firms should similarly recognize the need for a centralized and integrated collateral management within the credit risk function.
Rahim Inoussa is a principal consultant in PA Consulting’s global energy practice in New York. His areas of expertise are risk management, risk system implementation, structured finance lending, and financial analysis techniques. He has led or worked in a variety of strategy and risk management assignments in the energy and capital markets sectors. Inoussa would like to thank Sid Jacobson, a managing consultant in energy trading and risk management at PA Consulting Group, for his contributions to this article.
Electric Light & Power January, 2008
Author(s) :
Rahim Inoussa
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