The Five Cs of Counterparty Credit Risk

In a punishing market for those who improperly handle risk, these tenets of credit risk management can be the difference between success and failure.

There are Many reasons why firms should take enterprise counterparty risk seriously. A perceived failure will startle investors, rating agencies and counterparties and raise questions about an organization's business processes and corporate governance procedures. The mere whiff of a rumor of default on a margin call or of overexposure 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 either real or perceived missteps and regulators demanding greater transparency. And, at a time when cash is king, it can have a very deleterious effect on liquidity.

In August 2008, for example, Constellation Energy, a firm with a previously strong reputation for sophisticated risk management, 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 appeared to be dependent on multiple lines of credit from various banks that were, at the time, wobbly, and the perception developed that Constellation 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 swirl of Lehman Brothers' death spiral. Over three days in September 2008 Constellation's stock lost nearly 60 percent 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 many companies are still depending on 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 an error-prone process that perpetuates the stovepiping of data sets.

Worryingly, a recent CommodityPoint survey sponsored by Triple Point Technology of energy and commodity executives discovered that 70 percent of companies use spreadsheets or internally assembled systems to manage counterparty credit risk. Sixty percent of the companies surveyed reported that they 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, or "The Five Cs": counterparty, contract, collateral, concentrations and credit analytics.

Counterparty

In the current climate of the financial meltdown, anti-terrorism and ratings downgrades, there are increasing internal and external pressures to understand and evaluate counterparties. Regulations such as Know Your Customer (KYC), Enhanced Due Diligence (EDD) and Anti-Money Laundering (AML) are regulatory attempts to enforce consistent, comprehensive counterparty assessments and documentation. Internal pressures such as credit policies and counterparty onboarding, scoring and credit limit-setting processes are also being revamped and extended.

In an interconnected series of markets, a firm's reputation and its financial position are only as good as those of its counterparties. And so it must have a comprehensive view of all of its relationships in order to understand its own financial and operational health. But creating a comprehensive risk profile requires the capture and management of significant data points for each counterparty.

It has become clear that organizations should not rely solely on third-party evaluations of counterparties. The credit crunch highlighted the relationship between rating agencies and the firms they were assessing. A triple-A-rated party is no longer a solid-gold guarantee. Indeed, all three major credit ratings agencies gave Lehman at least an A rating right until the day the firm filed for bankruptcy. Nor are auditors to be relied on without due diligence -- after all, Bernie Madoff was audited for years while running the world's biggest and possibly most damaging Ponzi scheme.

Collating and managing all of this information and applying custom scoring techniques are critical for any organization that wishes to protect itself from defaulting counterparties.