Risk Management Techniques & Tools

Transcription

1 Risk Management Techniques & Tools Ron Wells Credit Executive URL: BarrettWells.com Resources: BarrettWells.co.uk Singapore 1

2 CONTENT Understanding price and market risks Managing operational and credit risk Performance and payment as key types of credit risk Protecting your company s solvency and profitability 2

3 PEOPLE 3

4 Incompetent or Dishonest MANAGEMENT 4

5 FAILED STRATEGY. a set of analytical techniques for understanding better, and so influencing, a company s position in its actual and potential market place.* * Financial Times Mastering Strategy Pearson Education Limited

6 MANAGING THE FUTURE 6

7 RISK MANAGEMENT ( MANAGING THE FUTURE ) Managing the risk of not being paid in the future for cargoes delivered, or not being compensated for transactions repudiated in the future. 7

8 8

9 There can be no vision of the future, but there can and must be a vision for the future: a new barbarian vision. A future that isn't there yet can't be discovered. FUTURE It is created by men and women of vision, who are faced with the simple choice: to create their own future, or fall into somebody else's (and) be at the mercy of another's whim. The New Barbarian Manifesto - How to survive the Information Age 2000 Ian Angell 9

10 AGENDA The Black Swan or Fat Tail Concept The Risk Universe Physical Commodity Coal Trading Risk Risk Assessment in the 21 st Century 10

11 AGENDA The Black Swan or Fat Tail Concept The Risk Universe Physical Commodity Coal Trading Risk Risk Assessment in the 21 st Century 11

12 12

13 The Impact of the Highly Improbable - The Black Swan - Nassim Nicholas Taleb (NNT) draws together a large number of references and anecdotes to illustrate his points. He repeatedly attacks the received wisdom of those who model the future and who, being lulled into a false sense of security by the elegant mathematics of their models, are repeatedly surprised when the future does not adhere to their script. In essence NNT persuades the reader that the most impactful social and technological changes the changes that will drastically alter the course of future history - cannot be predicted since they are unknown unknowns. Such events which he calls Black Swans will happen for the first time so cannot be imagined in advance, and cannot be predicted by models that extrapolate forward the past. The past cannot be a basis on which to predict the future; ask any turkey just before the butcher s cleaver falls if he thought his today would be any different from the preceding 1000 days when he ate heartily and potted around a garden or dozed in the sunshine. 13

14 The most impactful social and technological changes the changes that will drastically alter the course of future history - cannot be predicted since they are unknown unknowns. Such events which Taleb calls Black Swans will happen for the first time so cannot be imagined in advance, and cannot be predicted by models that extrapolate forward the past. 14

15 UNKNOWN UNKNOWNS 15

16 The Fat Tail Concept NORMAL PROBABILITY DISTRIBUTION CURVE 3 STANDARD DEVIATIONS = 99% CONFIDENCE LEVEL I.E. ONLY 1% CHANCE OR RISK THAT PRICE WILL BE EXCEEDED MEAN TAIL RISK

17 The Fat Tail Concept NORMAL PROBABILITY DISTRIBUTION CURVE ACTUAL DISTRIBUTION MEAN ACTUAL TAIL RISK

18 IT IS THE 1% ACTUAL TAIL RISK THAT COULD KILL A BUSINESS > 3 STD DEVIATION SPIKE IN A 6 WEEK PERIOD 18

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20 AGENDA The Black Swan or Fat Tail Concept The Risk Universe Physical Commodity Coal Trading Risk Risk Assessment in the 21 st Century 20

21 Counterparty Risk cannot be eliminated it can only be either retained or changed into another type of risk; a class of risk judged to be easier to bear safely. 21

22 RISK TRANSFER COLLATERAL RISK PRICE OR MARKET RISK REPUTATION RISK CREDIT RISK RISK TRANSFER OPERATIONAL RISK 22

23 RISK TRANSFER COLLATERAL RISK PRICE OR MARKET RISK REPUTATION RISK CREDIT RISK RISK TRANSFER OPERATIONAL RISK 23

24 RISK TRANSFER COLLATERAL RISK PRICE OR MARKET RISK REPUTATION RISK CREDIT RISK RISK TRANSFER OPERATIONAL RISK 24

25 RISK TRANSFER COUNTERPARTY CREDIT RISK RISK TRANSFER 25

26 Counterparty Risk consists of two main elements; namely Performance Risk and Payment Risk. 26

27 POST-DELIVERY RISK Payment Risk 27

28 Performance Risk PRE-DELIVERY RISK 28

29 Other FRANCHISE SUPERMARKET INDEPENDENT NATIONAL GROUP NICHE Risks Concentration Risk 29

30 Concentration Risk Construction 30% Other 12% EXAMPLE Automotive 16% Packaging 15% Mechanical Engineering 14% Metal Goods 13% Source: 2004 AR EXAMPLE 30

31 Other BELARUS UKRAINE POLAND HUNGARY BULGARIA Risks Country Risk 31

32 AGENDA The Black Swan or Fat Tail Concept The Risk Universe Physical Commodity Coal Trading Risk Risk Assessment in the 21 st Century 32

33 Physical Performance Risk Performance (Pre-Delivery) Risk is the risk that a counterparty will not deliver or will not accept delivery of a physical product or service, at the agreed price, on the agreed future date or series of dates. Payment Risk is the risk that a buyer will not pay an invoice in full, on the due date; it is post-delivery risk. This is sometimes referred to as Delivery Risk or Deferred Settlement Risk. 33

34 Assertion It is evident that the risk that a buyer will not pay an invoice on due date, a date after physical delivery of a commodity, is fundamentally not equivalent to the risk that the same counterparty will refuse to receive the same commodity at a previously agreed fixed price. Likewise the risk that a supplier of a physical commodity will fail to deliver the commodity, at a previously agreed fixed price in the future, is fundamentally not the same as the risk that that supplier would fail to repay a loan at some future date. 34

35 Basel II Credit Risk PD Probability of Default (PD) THIS SINGLE DEFINITION DESIGNED TO COVER PAYMENT RISK IS INCORRECTLY USED TO COVER PERFORMANCE RISK X EAD Exposure at Default (PFE) = EL X LGD Loss Given Default (LGD) Expected Loss 35

36 This Credit Risk related formula has been adopted by Banks to quantify Performance Risk related to Financial Derivatives. It is not appropriate to use it to measure Physical Performance Risk 36

37 Physical Performance Risk Today The Probability of Default (PD) or the likelihood of failure to take or deliver a Physical Commodity per contract in future is erroneously based on a Credit Risk assessment THIS IS OFTEN IMPUTED BASED ON S&P TABLES USING AN EQUIVALENCE MAPPING OF INTERNAL CREDIT RATINGS TO S&P RATINGS 37

38 Physical Performance Risk Today Potential Future Exposure (PFE) is based on Value at Risk (VaR) calculations, a methodology that has repeatedly proven to be seriously flawed THIS IS THE AMOUNT USED TO CALCULATE REQUIRED INITIAL MARGIN (COLLATERAL) AND/OR THE AMOUNT NECESSARY TO PROVIDE ADEQUATE ASSURANCE, IF INVOKED, AND TO ESTIMATE THE EXPOSURE AT DEFAULT 38

39 The Impact of the Highly Improbable Nassim Nicholas Taleb (NNT) draws together a large number of references and anecdotes to illustrate his points. He repeatedly attacks the received wisdom of those who model the future and who, being lulled into a false sense of security by the elegant mathematics of their models, are repeatedly surprised when the future does not adhere to their script. In essence NNT persuades the reader that the most impactful social and technological changes the changes that will drastically alter the course of future history - cannot be predicted since they are unknown unknowns. Such events which he calls Black Swans will happen for the first time so cannot be imagined in advance, and cannot be predicted by models that extrapolate forward the past. The past cannot be a basis on which to predict the future; ask any turkey just before the butcher s cleaver falls if he thought his today would be any different from the preceding 1000 days when he ate heartily and potted around a garden or dozed in the sunshine. Read the article at: 39

40 Produced by: IBC an informa business 40

41 Physical Performance Risk Today Loss Given Default (LGD) or loss given failure is assessed on the basis of Credit Collection experience, not actual cases of performance default LGD IS USUALLY ASSIGNED BASED ON COLLECTION DATA GATHERED IN RELATION TO DEFAULTED ASSETS IN THE SAME ASSET CLASS AND JURISDICTION 41

42 Who are the majority of risky Suppliers and Buyers for physical commodities? Growing Country Based Producers Marginal Producers (Peak or Eco-friendly) Small & Medium Size Industrial and Commercial Consumers Energy Retailers New Businesses 42

43 THE DILEMMA The result of using these inappropriate tools is often the exaggeration of the physical performance risk and failure to complete otherwise profitable business transactions. When a counterparty risk management function repeatedly declines potentially profitable business it fails in its primary objective, which is to actively manage performance and payment risk, not to avoid or eliminate such risk. 43

44 AGENDA The Black Swan or Fat Tail Concept The Risk Universe Physical Commodity Coal Trading Risk Risk Assessment in the 21 st Century 44

45 Possible Alternative Method: Scenario Planning as a basis to estimate the Potential Future Exposure and the probable impact on the CP s business (Opportunity) A Performance Risk ScoreCard to produce a Probability of Performance Default (Motive) A Recovery Rate Model to estimate the Loss Given Default (Means) 45

46 Opportunity Motive & Means Is the Counterparty (CP) sufficiently hedged to tolerate any foreseeable Potential Future Exposure? Opportunity Is the CP motivated to meet its commitments? Motive Will the CP have the financial means to pay? Means 46

47 Opportunity to Perform Create an Appropriate Scenario Decide how far in the future the risk extends; for example 3 months, 6 months, one year, two, five, seven, ten or twenty years. Then consider the CP s business model and what relevant factors may change during that period. Devise a method to determine the maximum Potential Future Price (PFP) factor for the related product-market combination category, in each future time period. Apply these factors to the current values of the relevant volumes daily. Revise the factors periodically. 47

48 Scenario planning derives from the observation that, given the impossibility of knowing precisely how the future will play out, a good decision or strategy to adopt is one that plays out well across several possible futures. To find that robust strategy, scenarios are created in plural, such that each scenario diverges markedly from the others. These sets of scenarios are, essentially, specially constructed stories about the future, each one modelling a distinct, plausible world in which we might someday have to live and work.* * How to Build Scenarios Lawrence Wilkinson Wired Digital Inc. 48

49 Scenarios are learning stories... the process of working through them (and) experiencing them, is as important as the conclusions. Quotation from Russia 2010 and what it means for the World by Daniel Yergin & Thane Gustafson 1993, 1995 Cambridge Energy Research Associates. 49

50 Motive to Perform Create a Performance Risk ScoreCard Consider what are the imperatives of the senior Executives of the Counterparty (CP), what is in their interest given those imperatives, and on what basis they will likely decide whether to perform or not when the time for performance arrives. Include country risk related issues when imports or exports are involved. 50

51 Risk ScoreCard Objectives To make credit limit decisions in a standardised and systematic way, based on facts. To make credit decisions which align with and support the company strategy. To speed up credit decisions and enable the use of technology to a greater extent. 51

52 HYPOTHESIS Credit Analysts generally make subjective decisions based on a mix of; financial information (which is not always available and is often subject to manipulation), a different set of facts and feelings in each case (depending on what is available) and an intuitive weighting system based on personal experience. It is submitted that it is possible to distill all of these factors into a manageable generic list of questions which require factual answers, to weight these answers and thus to produce consistent credit decisions by effectively mimicking the usual activity of an experienced credit analyst. 52

53 Means to Perform Create a Recovery Rate Model Design a Recovery Rate Model that includes scoring a number of significant factors, such as: The existence in helpful jurisdictions of assets of value belonging to the Counterparty. The existence or otherwise of a liquid market for the product in question at the place of failure to perform Is Right-way Risk a factor? 53

54 Summary Methods that were invented for credit risk assessment, and are suitable for cash settled derivatives trading (futures) have been migrated into the physical (forward) world, where they produce unhelpful results. In the micro sense, when examining physical performance risk counterparty by counterparty, more appropriate and useful tools need to be invented. That is the challenge 54

55 The Art of Assessing, Quantifying and Managing Buyer or Supplier Future Physical Performance Risk Read more on this subject in English at: FALKIRK WHEEL Or in Chinese (Mandarin - Simplified Characters) at: 55

56 Disclaimer Just to emphasise that the opinions, ideas and suggestions expressed throughout this presentation are mine alone. In making this presentation I do not represent any other organisation, my employer, or any other person. This presentation is simply a sharing of ideas with a view to stimulating a debate, which may lead to the widespread adoption of a holistic, future-oriented approach to counterparty risk management. Ron Wells 56

57 Ron Wells is the author of Global Credit Management, an Executive Summary published by John Wiley & Sons. This concise work describes the essence of effective credit management, which too often is a passive and reactive discipline within a company. It includes practical guidance to equip a reader with the basic tools necessary to establish a holistic credit management discipline within a business. The Mandarin Chinese (simplified characters) version of Global Credit Management was published in July 2007, titled Huan Xin Ping Heng Biao Shang De Shui Shi Awaken the Sleeping Lion on the Balance Sheet. See (Chinese version: for details. Ron maintains a free access, credit management resources web site at: He has delivered numerous presentations relating to credit and performance risk management, and taught several classes in related subjects; see for details. Ron is a Certified Credit Executive (CCE), a Chartered Management Accountant (ACMA), a qualified International Banker (ACIB) and a Chartered Corporate Secretary (FCIS). He participated in the NACM Graduate School for Credit and Financial Management in 1996/97, passed with distinction and was elected Best Student. Ron joined Cargill International Trading in Singapore as Asia Credit Manager for Energy, Transportation and Metals from February to December He was Vice President - Credit Risk Management of RBS Sempra Commodities in London from October 2007, and became Executive Director of Counterparty Risk Analysis and Portfolio Management EMEA, when J.P. Morgan s Global Commodities Group purchased RBS Sempra on July 1, Previously Ron was Credit Manager for Global Supply & Trading with Chevron Corporation for 16 years. Ron earlier worked for various companies and commercial banks becoming a specialist in financial analysis, corporate credit management, trade operations management and trade finance-related marketing. 57