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.