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Credit departments manage billions of dollars of capital and provide a system of checks and balances on company risk, but are chronically under funded and lack regulatory support to provide proper oversight. In the rush to make a quick buck, organizations often fail to invest the time and energy they should to constantly re-evaluate the strength of their policies and procedures and ultimately conduct business in a way that ensures long-term prudence and prosperity. Even with recent financial reform regulatory actions under the Dodd-Frank act, no person, department or governmental compliance effort can totally prevent all errors, misrepresentations, or deceptions. It is essential that organizations have their own enterprise credit risk management policies in place to provide transparency and to help ensure compliance. This market perspective presents a number of timely approaches for potential improvements to the regulation and administration of credit risk management issues.
Automated Collateralization / Margining
The International Swaps and Derivatives Association, Inc. (ISDA) recently conducted its 2010 ISDA Margin Survey. Over the last ten years, the number of executed collateral agreements has grown from 12,000 to over 170,000, with the estimated amount of collateral in circulation growing from $200 billion to over $3.2 trillion, and 83% are bilateral. Much of the tracking and application of collateral (and its expiration) is still conducted in spreadsheets, with the potential for manual error and/or incorrect calculation. This can lead to the belief that credit reserves are adequate when they’re not, or increased trading that is not supported by accurate and enforceable risk-mitigation provisions. Automation and audit-ability of the recording, maintenance, and calculation of collateral and margining is critical to meet the growing demand. Under Dodd-Frank, evolving requirements for minimums, timeliness, and collateral type will likely increase. Investments in this area support the business and help to avoid the next company going down because it couldn’t meet liquidity demands.
Credit Rating Agency Independence
Similar to auditing, paying a company to review your own business and provide a rating can represent a potential conflict of interest. And yet, critical decisions on billions of dollars of investments and contingent collateral requirements are based on those same ratings. If you look to the consumer sector, where credit bureaus like TransUnion, Equifax, and Experian provide FICO credit scores, revenue comes from the requestor of the score—individuals do not pay for their own evaluation. Even with the 2006 Credit Rating Agency Reform Act and the SEC implementation in 2007 of the Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organization, NRSRO’s still rely on an “issuer-pays” business model. These ratings are too important to take a chance– a subscription-based model would provide significant independence. Recent reforms mandated by the Dodd-Frank act (Title IX, Subtitle C) look to address the oversight and regulation of rating agencies, but it is still unclear how far and deep the changes will go. Market leading organizations will pay close attention and provide comments to the rule making process to ensure reform delivers comprehensive, sustained results.
Many companies today are moving from reliance on any 3rd party rating to calculation of their own scores. This allows for smart companies with knowledgeable people to gain competitive advantage through effective evaluation of the creditworthiness of their counterparties, and appropriate and profitable risk taking in their dealings. In the current environment where financial filings are vastly different between each company, analysis is costly, time consuming, prone to manual error, and may allow significant information to be “buried” in the mass of information produced. Mandated adoption of a common, standardized electronic format for financial reporting, such as Extensible Business Reporting Language (XBRL), would immediately provide quality data for analysis to make sound business decisions. A standardized electronic format would allow more companies to increase the confidence level of their counterparty risk by evaluating their own counterparties. This quantitative data could then be effectively combined with judgmental (qualitative) information for accurate, proactive measures of creditworthiness.
In today’s Energy sector, a good credit department is vital to ensure efficient and effective risk management. When credit best practices are properly implemented, the Credit Department can effectively control risk and complement the corporate drive to maximize profits. While most everyone would agree that education is a key factor in implementing best practices in Enterprise Credit Risk Management, there are still many opposing forces that deter organizations from embracing formal credit risk training. Some of these forces include economic pressures, resource shortages, and lack of relevant training courses combined with the absence of industry certification requirements and minimal financial incentives from parent companies. Existing certification and training sources, such as PRMIA and FRM, offer minimal programs focused on credit risk in the energy industry. Many other disciplines (traders, CPAs, doctors, lawyers, etc.) have formal testing and certification bodies, requirements for accreditation by position, and continuing education requirements, as well. It’s about time credit professionals get the recognition they deserve for their knowledge and experience, while being held to a high standard of knowledge and performance based on objective assessment and certification. Like other disciplines, credit risk professionals should also be provided the time, the tools, and the financial investment to improve where necessary, especially given the changing market conditions we are experiencing today.
Another issue is the question of audit independence. Paying the same firm every year to audit your own financial records can represent a potential conflict of interest. How well served were employees, investors, and markets in the case of Enron, or with Bernard Madoff? Audit firms are retained to provide independent and objective assessments, but the auditor is chosen at will and, as long as positive opinions are written, the audit choice typically becomes a long-standing relationship, representing significant financial cash flows to the audit firm. Can any audit firm be truly objective, when a negative opinion could mean the loss of one of their highest paying clients? Supporters of the current audit system argue that audit firms have significant institutional knowledge about client companies and that there would be a high cost to redevelop that knowledge when switching audit firms. But, that argument just illustrates the point that annually renewed audit firms are not fully independent and objective —they should be digging in and asking the questions fresh every year, and not basing evaluations on previous work that may no longer be valid or current. One idea to address this issue is to establish a common fund, paid into by audited companies based on their size, to reimburse audit firms for some or all of their services. Another idea is creation of regulations to mandate annual change of auditors or an annual lottery system to assign auditors. Reforms such as these could strengthen objectivity and quality, while encouraging competition and new entrants.
Many trading organizations concentrate on “cost/benefit” vs. “risk/reward.” Incentives are often tied to the greatest profit without consideration of the associated risk and cash flows—today, in the future, and in potential stress scenarios or statistical simulations. Organizations are starting to be rated on their adoption and execution of risk management standards, as with Standard and Poor’s Policies, Infrastructure, and Methodology (PIM) approach and Enterprise Risk Management (ERM) benchmarking. Counterparties should invest in and be evaluated based on adoption of clearly defined risk and credit policies, metrics and systems for analytics, and incentives from the board through the trade floor to conduct business based on the risk of the activity, not just today’s profit.
Greater Independence, Transparency, and Incentivization
Financial reform and regulation should be combined with internal controls and policies to provide proper enterprise credit risk management. Companies can begin to rebuild confidence and maximize risk-adjusted returns by developing an enterprise credit risk management strategy that delivers greater independence, transparency, and incentivization.