Example of Consulting Scope for Credit Risk Management Implementation

1. Credit Risk Management Policy


A credit risk management policy document will articulate the objectives of counterparty credit risk management, along with functional responsibilities and essential elements of a credit risk management program.
2. Credit Risk Management Procedures
• Creditworthiness Review & Evaluation
• Information Management
• Credit Enhancements
• Extension of Credit
• Credit Approval Process
• Credit Limits
• Credit Reserves
• Creditworthiness Monitoring
• Reports
• Credit Forms
• Process diagram
A credit risk management procedures document will articulate the processes and flow of information involved in managing counterparty credit risk, and will describe step by step actions involved in credit risk management activities. After completing the document, everyone must work to ensure that the procedures are being followed as proscribed.
3. Credit Analysis
• Improve the ability to analyze counterparty financial data


• Assist Compliance staff in conducting quantitative financial analysis of specific counterparties, and in benchmarking evaluation results relative to rating agency evaluations


• Work with Compliance staff to implement financial analysis using external benchmark data such as that from Robert Morris Associates


• Provide a credit scoring model

Each company needs to gain experience in evaluating counterparty creditworthiness, and needs to refine and optimize its evaluation process. The focus of this effort will be on analyzing specific quantitative factors that will give greater insight into the creditworthiness of a counterparty, compared to relying solely on unsecured bond ratings, and on incorporating qualitative information to adjust, as necessary, the result of the quantification of creditworthiness.
4. Potential Exposure
• Research methodology to calculate potential credit exposure (a modified market value at risk measurement applied to each specific counterparty). This will involve an exploration of ZAI*NET's (or any other position tracking software in place) value at risk capabilities along with an exploration of off the shelf VaR systems.
  Potential exposure is a probabilistic measure of how far a credit exposure could move against you, representing the potential amount of credit risk that could result in case of a counterparty bankruptcy. It is a measure of potential credit risk due to potential forward market price movement only – not due to potential changes in counterparty creditworthiness. Potential exposure is calculated in the same manner as market value at risk, except that potential exposure is calculated for the life of the exposure as opposed to market value at risk which is calculated for a defined time period.

• Assist in the incorporation of potential exposure in credit risk management reports.
  Potential exposure is a critical measure of credit risk. The sum of potential exposure and current exposure (mark-to-market value of open contracts) will be debited against each counterparty's credit limit to determine remaining available credit capacity.
5. Operationalize Reports
• Incorporate reporting within ZAI*NET (or other position tracking software) to enable security of counterparty data and flexibility of information sharing and decision making
• Develop and implement "flags" and analytics for new transactions; establish an efficient and reliable process for avoiding problematic transactions and counterparty relationships
• Work with Compliance staff to resolve business issues that emerge as credit reports are developed.
6. Creditworthiness Monitoring
• Assist in developing counterparty creditworthiness monitoring, including changes in counterparty creditworthiness and the measurement of credit exposure
• Provide advice on obtaining and applying market data to monitor and measure creditworthiness (such as data from the stock market)
• Assist in the development of credit monitoring procedures
Beyond the ability to perform an initial evaluation of counterparty creditworthiness, a company must develop the ability to gather and process information in a rapid fashion regarding the potential deterioration of a counterparty's creditworthiness. The company must also develop the ability to calculate mark-to-market credit exposure on a daily basis, and to disseminate that information in a usable form to all necessary personnel.
7. Credit Reserves
• Assist in the development and application of probabilities of default and recovery
• Choose and adjust default probabilities
• Calculate counterparty and portfolio credit reserve amounts

Treasury should maintain a credit reserve for potential losses due to counterparty credit risk. Appropriate default probabilities must be researched and selected, and the application of recovery probabilities should be considered.
8. Credit Value at Risk
• Assist in further defining and developing a credit value at risk methodology
• Develop plans for implementing credit value at risk
The science of credit risk management is continually evolving. A developing area is the calculation of credit value at risk. As opposed to potential exposure, for which credit value at risk is often confused, even by leading accounting and consulting firms, credit value at risk is a measure of the potential risk of a counterparty, or portfolio, suffering a change in credit quality. It is a measure of potential credit risk due to potential changes in counterparty creditworthiness. This measure would enable a more accurate and dynamic calculation of credit reserve requirements, and would enable a more systematic diversification of credit risk. This method of risk measurement is still developing, and should continue to learn about it, consider how to apply it, and develop a plan for its eventual implementation.
9. Counterparty Relationships
• Assist in structuring credit policy exceptions, including the implementation of credit waiver authorities
• Assist and advise Compliance staff in developing secured credit relationships with problematic counterparties such as uncreditworthy leading energy marketing companies
10. Concentration Limits
• Assist in the development and implementation of concentration limits
An important element in managing credit risk is the application of concentration limits. Concentration limits are one effective means of imposing a balance between business risk and credit risk. Sufficient credit to execute all of one's transaction volume requirements may exist with only a few counterparties. However, the concentration of transaction volume with just a few counterparties may inappropriately expose to business risks such as suboptimal transaction pricing and undiversified operational risk.