United States: Credit Risk Du Jour

Charles Andrews has Worked for a Number of Blue Chips and major merchant banks from Europe to Asia, and most places in between for the past 25 years or so, both before and after joining PwC's financial risk management practice in 1998. When it comes to credit risk-management processes and procedures in more mature competitive industries we reckon he's seen it all.

So, being that credit risk is still a big, ugly moving target in the competitive energy game, we asked that he offer up a few slivers of wisdom from the financial markets that could be appropriately modified for better managing such risk in our industry.

His first point: Despite what you hear about adapting best practices from the "financial markets," realize that such a sweeping generalization is almost a misnomer. "Financial markets," on the whole are about as varied and unique as industries come. Just like the energy industry. Credit risk management is going to be different for a bank, a fund manager, finance company, or for that matter a power marketer or utility. His conclusion: Know thyself and know thy customer before you try to take on a new enterprise-wide credit risk management program. Not all best practices will necessarily apply to every scenario or represent a cost-effective solution.

"It's been a tough transition for many energy companies. For a long time the notion of credit risk usually referred to accounts receivable, but even there the amounts were always fairly certain, short duration exposures, a known customer base and so on. Now of course you have a situation where customers are less well known to you, and credit losses are no longer subsidized."

Andrews views the energy industry's fast and furious adoption rate of new, sophisticated technology and procedures to better manage credit risk as a generally positive sign.

"But that's not to say you should discard your old credit skills and people skills to prevent credit losses over the long term. Far from it. The saying that "credit is an art, and not a science," still holds true here. Despite the firepower that technology can bring to bear on a subject, people still have to make decisions."

He says the banking industry has been grappling with the same issues for years: Determining the right mix of technology, sophisticated scoring models, complex exposure algorithms and the like, with expert human judgment. These days he says it's easy to get caught up in the technology alone. What with the pace of technology advances, and access to real-time, unlimited quantities and varieties of market data, it can be a strong elixir indeed to spend all your time trying to create the "silver bullet" technology solution to managing credit risk. A good exercise to be sure, but it will never completely replace the need for developing a closer relationship and a more in-depth knowledge of major customers and counterparties.

"Technology or not, you should never forget the old 80/ 20 rule. Lets try to get 80 percent of it right and we can manage our major risks on that basis."

Judging from the level of defaults and other credit "issues" in the market over the past couple years, Andrews and company have been busy. He says that regardless of the industry, the risk-assessment framework he performs is similar - you need to take a step back to try to understand how credit risk-management is being used to support the business, and understand its goals and objectives from a marketing perspective. Try to better understand who your customers are, what are you selling, your risk profile and what is your tolerance for loss.

In terms of credit-risk management procedures, he says that among the major players there is a certain degree of consistency. As for the rest, well, his answer conjured up images of scatter diagrams.

"A lot of the confusion in the risk-management area comes down to having a clear view of what sort of risks are you trying to manage? Are you trying to manage a tolerable level of loss coming out of your normal business activities? Or are you trying to ensure there won't be any catastrophic loss that will sink the firm? These strategic issues are not always clearly defined, which can cause big problems down the line."

A bigger question perhaps than whether or not the industry as a whole has truly wised up in the credit risk- management arena over the past five years, is whether or not more people will recognize the need to continue to develop their credit risk-management techniques, Andrews says.

"Whether they will more rigorously assess the creditworthiness of the people they're dealing with or more rigorously track the products and services they sell to counterparties. Will they continue to develop more advanced approaches to calculating potential exposure to these counterparties and a more robust methodology for looking at portfolio risk? In any industry in transition, it takes a while to get it right. There is a need for a continued emphasis on developing better tools and procedures in the energy markets."