Shane Mathis
Risk Management Inc.
Many events in recent months have led to a heightened awareness among board members, CEOs, CFOs, risk managers and shareholders of the amount of potential exposure arising from counterpaty default. To assist companies in managing credit risk exposure in today's uncertain economic climate, RMI has put together the following guidelines.
Step 1: Develop policies and procedures
The last thing any board member or officer wants is to be surprised about the amount of risk, be it credit or market, the company is incurring. One of the first steps that should be taken is the establishment of a risk management program policies and procedures document which addresses:
- The amount of exposure the company is willing to undertake;
- The method by which exposure is to be tracked;
- The action steps required when exposure limits are breeched;
- The personnel responsible for various functions;
- A schedule of authorizations;
- A means of communicating exposure to all involved parties.
The policies and procedures document typically establishes a risk management oversight committee (RMOC) which sets and amends policy. The risk manager has more of an enforcement role revolving around those policies.
Guidelines for counterparty credit risk evaluation and tracking can be included in the policies and procedures document or can be written into a separate credit policy.
Step 2: Determine credit analysis methodology
As a result of the intricacies of accounting rules in addition to the sheer complexity of most company infrastructures, counterparty evaluation has become more of an art than a science. One method is to create a factor model which looks at both quantitative as well as qualitative measures. Quantitative measures would most likely be those gathered from annual and quarterly financial statements. Qualitative measures should include ratings from outside sources along with timely information gathered verbally from the marketplace.
One of the lessons that Enron taught us is that once you find the credit rating from an outside source your work is far from complete. Often overlooked is information that can be gathered by direct contact with the counterparty or from within the industry. Many times an outside credit rating is used in conjunction with financial ratios to set the initial score. Data gathered from direct contact or the marketplace is only used to decrease the score and not to increase it. The reason for this is that companies should want their scoring model to have the least amount of positive bias as possible. By only allowing a score to decline based on supplemental information, the methodology can only become more conservative and therefore minimize any positive bias.
Step 3: Establish credit limits
Companies may establish identical scoring methodologies but have markedly different credit limits established for the same counterparties because every organization is going to have a different tolerance for risk based on its individual business models. A top-down method is one approach that may be used when looking to establish limits. Essentially the highest scored counterparty is taken first and assigned a desired amount of credit. This initial figure could be considered to be the credit maximum. From there, every other counterparty should fall somewhere between the credit maximum and zero. It is not uncommon for a credit limit to contain a tenure component or other variables instead of using only dollar amounts.
Step 4: Monitor exposure
There are at least four main exposures that should be monitored and a good risk management system with accounting interface capability should be able to capture these evaluations.
•Current exposure: Exposure that is made up of not only accounts receivable but also replacement costs, if any, on transactions that have yet to settle (taking into account if a netting agreement has been executed).
•Future expected exposure: Exposure calculated by taking the positions in existence today and assuming everything remains static except for the delivery schedule of the physical transactions. Assume for example that you have sold a physical product to your counterparty for delivery next month. The market price may increase above your sales price before delivery to where you might be indifferent if your counterparty were to become insolvent because you could now replace the sale at a higher price. Your current exposure would be zero or negative in this case. However, as you begin to deliver your product, you have probably yet to be paid and therefore would be incurring accounts receivable exposure. This exposure can add up quickly and leave you in a position far exceeding your original credit limit.
•Potential exposure: Exposure calculated through scenario analysis. Essentially, you take the positions that are in existence and begin performing what-if analysis. As we all know prices do not remain static and often times move in amounts far greater than what has been observed in the past or what might be expected into the future.
•Collateral exposure: Your counterparties exposure to you. This type of exposure was often overlooked until recent events. The reason why this has become vital is that many companies have bi-lateral agreements in place that require certain types of collateral to be posted due to triggering actions. The most common event is a decline in credit rating by one of the major rating agencies. It can happen and has happened in some cases that everyone exposed to you begins to demand collateral. A liquidity problem can arise because a triggering event has not occurred with the counterparties that owe you money. Therefore, you are not able to take in enough cash in order to satisfy others' contractual demands. In essence it becomes a run on the bank.
Step 5: Mitigate exposure as needed
Exchange clearing has provided the most proven credit mitigation method to date. Provided that your account is properly margined, it allows for any profits that have accrued on your positions to be withdrawn immediately. This process is in contrast to the over-the-counter (OTC) market which, in most cases, you must wait until the settlement and billing process is complete to receive profits. If futures contracts are closed prior to delivery there is no book out process or scheduling requirements such as in the OTC market. Also, if positions have been closed there is no future expected exposure to worry about and no physical settlement process. The position is off the books.
One of the previous constraints of clearing through an exchange has been that the only products allowed to be cleared were listed futures contracts. As we all know in the ordinary course of business most companies can not completely hedge their risks using futures because of the delivery location or other product specifications. However, a change in the law occurred last year which would allow exchange clearinghouses to clear transactions that take place in the OTC market. The NYMEX has been the first to offer this service.
NYMEX OTC clearing first requires that two companies agree to do a trade in the OTC market. Upon consummation of the transaction it is agreed by both parties that they would like it to clear via the exchange rather than assuming one another's credit. They would then enter their respective buy and sells into the clearing system, the two sides would match, and from that point forward, for all intents and purposes, an OTC position has been converted into a futures position. In our opinion, this alternative is one of the most exciting credit mitigation services offered.
An additional technique for mitigating exposure is netting and close-out. Netting provides a contractual agreement to allow each counterparty in a transaction to owe the net rather than gross amounts involved for both settled transactions and replacement costs on positions that have not yet settled in the event of a bankruptcy.
Collateral is another avenue for mitigating exposure. It can take many forms, with cash, parental guarantees, letters of credit and surety bonds being some of the more common forms. Each alternative has its own set of unique characteristics and should be examined closely to make sure that it is appropriate for your needs.
Step 6: Communicate continually
Continual communication to senior management is critical in maintaining any risk management program. It can and should take several forms. Weekly, if not daily, reports should be generated to provide a snapshot of the risks that are being faced within the organization. Meetings of the RMOC should be conducted periodically. In addition, communication with the board of directors or equivalent entity should occur at least once a year.
The organization should make it clear that an open and direct line of communication exists for all employees to give information to a risk manager or an equivalent position. The timeliest information can often come from someone working in field operations that interacts with one of your counterparties on a more informal basis.
 Shane Mathis, Risk Management Inc. |
Mathis is a principal with Risk Management Inc. They can be contacted at info@riskmgmt.net or 312-341-5849.
Over the past 10 years, RMI has developed programs for over 40 utilities, drafting policies and procedures, designing hedge strategies, structuring price plans, supplying price models and executing NYMEX transactions.
