With J.P. Morgan’s recent $2 billion loss, financial risk is once again making headlines. It doesn’t look like this loss is going to cause systemic failure, but it serves as a prudent reminder that strong credit risk management systems and practices are vital to surviving today’s risky waters.
In a recent article in We Know Commodities, Dana Docherty and Amanda Lohec, Directors at Opportune, warn that “All too often, spreadsheets that are intended to be a stopgap measure become comfortable and are accepted as a long-term solution. Replacing those spreadsheets with Credit Management and Reporting (CMR) systems is critical to developing strong credit risk management capabilities.” In the article, they also share some important lessons learned from credit risk and reporting system implementations. The following are some lessons learned to ease the transition:
1. Understand your data environment
2. Review and document your current credit processes
3. Consider a modular approach
4. Carefully consider product enhancements
5. Manage your common data
6. Enforce good business processes
Beyond protecting you from losses, credit risk systems can help you better understand traders’ profitability – neither of which you can do with spreadsheets. Read more about Triple Point’s award-winning credit risk solution, Commodity XL for Credit Risk™.
Research and consultancy firm, Finadium, published an interesting report last week on the challenges that new regulations (MiFID and Dodd-Frank) are set to bring collateral management for OTC trading. The report highlights how dramatic the changes are going to be, and according to the market participants they interviewed, how technology is the only viable solution to effectively manage collateral in a post regulation world.
MiFID and Dodd-Frank central clearing mandates are going to change OTC trading forever. The increase in cash collateral requirements and daily margin calls will have a large impact. According to a recent Bloomberg article the cost of central clearing could setback Europe’s electricity market by up to $93bn.
While decreasing counterparty credit risk, central clearing will bring huge operational risk. Daily margin calls will make position and liquidity management impossible on a manual basis. Additionally, firms with non-standard trades that cannot be centrally cleared, or who are exempt from clearing, need to manage a ‘mixed’ collateral environment which only adds to the complexity and need for automation.
Effective collateral management needs to become a key feature in pre-trade decision making, where costs of collateral may affect where, whether and how to engage in a trade. So, not only is effective collateral management required from an operational point of view but it will be vital to drive the best trading decisions.
In its conclusion the report highlights that the majority of participants have started to look for collateral management solutions now, rather than wait until the regulations have taken effect. Have you started to think about this? With changes this far reaching can you afford not to?
The full report can be downloaded from here: www.omgeo.com/reportswhitepapers
There has been a lot of discussion recently about how the credit function will undergo revolutionary changes in the next few years. This highlights what Triple Point has been saying for the last 12 months, “Uncertain regulations in both the US and Europe will significantly increase the cost of trading and require the credit department to take a strategic position in optimizing portfolios.”
Rather than a revolution, we talk about the ‘New Rules for Credit Risk’. By following these rules organizations can be ready today for whatever regulatory or economic changes occur in the future (revolution or not), safe in the knowledge that they don’t have to overhaul their IT systems.
‘New Rules for Credit Risk’
- Margining: The impact of clearing OTC swap transactions is huge. According to Richard McMahon, Vice-President, Energy Supply and Finance at the Edison Electric Institute, the annual cashflow impact could be between $250 million and $400 million per company. A credit department’s primary focus will need to shift from counterparty assessment to margining and collateral. This can only be achieved with robust collateral management.
- Reporting: Enterprise-wide analysis and reporting to both the company and regulator will need to be a key priority, and with the ability to be performed within minutes of a transaction. Flexible reporting will prepare for today’s uncertain fiscal and regulatory environment.
- Exposure Monitoring & Management: Monitoring cash flow risk and exposure is critical. Increasing capital requirements make it more important than ever to mitigate risk and seize opportunity. Rather than monitoring positive exposures (amounts owed to the company by counterparties), the credit function will need to monitor negative exposures (what the company owes exchanges and clearing houses).
- Analytics: Changing and uncertain times have proved that many of the basic risk analysis and measurement techniques are not adequate and companies need access to more forward looking information. Credit analytics does just that. It provides a consistent framework to forecast, evaluate, and respond to future credit events.
- Internal Scoring Don’t rely solely on credit rating agencies. Collating and managing counterparty information, and applying custom scoring techniques, is critical for any organization that wishes to protect itself from defaulting counterparties.
Don’t just cross your fingers and hope catastrophe won’t happen. Start following the rules today and safeguard your organization against credit risk failure.
There are any number of reasons why firms should take enterprise counterparty risk seriously, and manage it appropriately. A perceived failure will start investors, rating agencies and counterparties questioning an organization’s business processes and corporate governance procedures. The merest whiff of a rumor of default on a margin call, or over-exposure to a downgraded counterparty will start the wolf pack circling.
Failure to manage credit risk across the entire company can put organizations on a collision course with a market, that has shown little forgiveness for both real and perceived mis-steps, and regulators demanding greater transparency. It means that business decisions are being made on incomplete or inaccurate data. It severely blinkers a firm’s vision of the future, and hampers its ability to move forward. And, at a time when cash is king, it can have a very deleterious effect on liquidity.
Constellation – a firm with a previously strong reputation for sophisticated risk management – knows all about credit risk failure. In August 2008, the power producer shocked investors when it revealed that it had made an accounting error and underestimated its potential liabilities in case of a ratings downgrade. Both Standard & Poor’s and Fitch Ratings swiftly downgraded Constellation’s credit. Constellation was so large and appeared to be dependent on multiple lines of credit from various banks that were, at the time, either wobbly or are going under, that the perception developed that it was at risk.
Despite Constellation’s efforts to reassure investors of its excess liquidity, good balance sheet and solid commodities trading business, it got caught up in the spokes of Lehman Brothers’ death spiral.
Over three days in September 2008, Constellation’s stock lost nearly 60 per cent of its value as it was dragged into a world of plummeting share prices and eventual sell-offs.
And yet, post-Constellation, post-credit crunch, even post-Enron, when we know that the wrong numbers can do untold damage, many companies are still using a simple spreadsheet to stand between them and potential ruin. Instead of managing credit risk in a holistic fashion, based on consolidated, auditable data from across the organization, businesses rely on error-prone processes that perpetuate the stove-piping of data sets.
Worryingly, a CommodityPoint survey, sponsored by Triple Point Technology, of energy and commodity executives discovered that 70 per cent of companies are using spreadsheets or internally assembled systems to manage counterparty credit risk. While 60 per cent of the companies surveyed felt the need to upgrade their credit risk systems to manage counterparty risk effectively in the current business environment.
If companies do not wish to follow in the footsteps of Constellation, Lehman and Enron, they must grasp the central tenets of credit risk management which we call the five Cs: counterparty, contract, collateral, concentrations and credit analytics.
George Carlin once told a great story about how he “put a dollar in one of those change machines and nothing changed.” Wouldn’t it be nice if we could control change. In today’s volatile world we never know when to expect it, where it will come from or what it will bring - we just know it’s coming.
The Dodd-Frank Act, the most sweeping financial reform since the 1930’s, is coming and it will bring dramatic changes to the face of energy and commodity credit risk. New rules on central clearing, position limits and margining have the potential to significantly increase the cost of hedging and reduce the availability of credit. Many of the details are still uncertain, but the 5 simple rules below will help you prepare for the Dodd-Frank Act and other inevitable changes.
- Internal Scoring. Don’t rely solely on credit rating agencies. Your own internal model can be more accurate.
- Monitoring. Monitor your cash flow risk and exposure. Increasing capital requirements make it more important than ever to mitigate risk and seize opportunity.
- Margining. Do not use spreadsheets for collateral management. Robust collateral management is now a necessity. If you have a significant number of counterparties, it is time to eliminate spreadsheets. With the proliferation of margining they are no longer adequate and cannot provide active and accurate cash management.
- Reporting. Build flexible reporting infrastructure that prepares for today’s uncertain fiscal and regulatory environment.
- Analytics. Perform liquidity analysis with analytics. Companies who understand the impact of capital and margin requirements on their liquidity will have a competitive advantage.
We can’t control change, but proactive companies with a flexible trading and risk infrastructure will be best prepared to avoid the pitfalls and take advantage of the new opportunities that come with change. Is reporting cash exposure a piece of cake? Do you know without a doubt your IT systems will meet new regulations? Is your margining process working great for you? If not, maybe now is the time for change.
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.