In the most recent edition of our Newsletter (no. 116 dated 25 November 2021), we reported in detail on increased energy price risks in industry and trade and their consequences. In this article we want to look at how these price developments affect credit risk and to show what risk management can do to address these risks as effectively and rapidly as possible.
The latest increase in electricity and gas prices on the European energy markets is keeping buyers and risk managers on tenterhooks across all energy-intensive sectors. Due to the spike in prices, companies that planned in recent years for the long term through (for example) structured energy procurement and who fixed their purchase prices, especially for electricity and gas, are facing considerable delivery and replacement risk and higher utilisation of their credit limits, or of their own credit limits concluded with their contract partners. In the worst case, therefore, companies risk being unable to act if it is not possible to adjust these limits and increase risk capital. Companies finding themselves in such a position have several means to ensure the required flexibility to maintain commercial activities. We will here comment on these options in more detail and highlight potential for optimisation in handling credit risks.
Review of risk capital aggregation
First, there should be a review of whether the aggregation of risk capital is appropriate. In aggregating individual risks, a risk correlation of 1 is often assumed (additive). This represents a conservative approach, as the simultaneous occurrence of all risk types is assumed. In general, the risks in this approach are overestimated, resulting in "too much" risk capital being provided for risk types. Credit risk management needs to consider the fact that all trading partners will never realistically default at the same time. This means that the sum of granted credit lines can be larger than the allocated credit risk capital.
Reallocation of risk capital
A similarly effective method for the commitment of risk capital for credit risks is to reallocate (already allocated) risk capital. In this regard, it is necessary to regularly review the actual utilisation of risk capital due to individual risks (market, credit and liquidity risks as well as operational risk) and to perform regular backtesting to challenge the appropriateness of the methodology and modelling used to measure these risks. If the testing shows that less risk capital for market and liquidity risks and operational risks is required in aggregate, this can justify an increase in the risk capital committed for credit risks without it being necessary to provide additional risk capital. If required, additional flexible risk capital can be reallocated to credit risk to cover transitory peaks in credit limit utilisation, and this can be agreed for a fixed time, for example by resolution of management or the risk committee. The necessary frameworks need to be created in advance and laid down in the current risk policies.
Revision of measure of risk
Companies often consider credit risks at the individual level, meaning they assume the default of a single trading partner. For greater precision, a company must determine the expected default for the given credit lines granted and the probability of default at the level of the trading portfolio. This can be addressed by the credit VaR model. The default of a trading partner can be modelled as a binary random variable. The default amount is then the sum of correlated binary random variables. This results in a skewed distribution typical for credit risks. In a trading portfolio, there is high probability of no credit risk losses occurring at all and low probability of very high losses. To obtain an even more precise result, it is possible to use other correlation factors gained from the analysis of historical data. By using a CVaR and relevant correlations, the accuracy of risk measurement rises and, in general, overestimation of credit risk is avoided. Nevertheless, the informational value of the CVaR depends heavily on the size of the trading portfolio under review and the quality of the data used.
Take the opportunity to review your current methods and models for determining risk capital and credit limit utilisation and, where necessary, to revise these in consideration of increased market price volatility.
Please do not hesitate to contact us if you have any queries.
Source: KPMG Corporate Treasury New, Edition 117, December 2021
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Mangement, KPMG AG
Moritz zu Putlitz, Manager, Finance and Treasury Mangement, KPMG AG