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Credit Risks on the Rise

The US Federal Reserve hiked interest rates again by 0.75% this week saying it was “”very premature” to think about pausing and that the peak for rates would likely be higher than previously expected” according to Reuters. The UK is expected to raise interest rates by a record amount and the ECB will be looking at its policies too, amongst others. This had the expected knock on effect on currencies as the USD rallied and the GBP fell. It also had an impact on commodity prices as a result of many being priced in USD and also as demand forecasts were revisited and downgraded. Inflation appears to be out of control in some places as it hit 75% in Turkey, for example. All of this of course has an impact on the cost of capital, price volatility in commodities and treasury operations to ensure adequate cash where it is needed. It will also heighten awareness of credit issues and credit risks in general.

The recent Risk Technology Trends report, sponsored by Amphora, Commodities People and NASDAQ Risk Platform, commented that,

Though credit risk is often referred to a singular capability, it in fact comprises multiple aspects: credit scoring, exposure calculation and limit monitoring, credit instrument management and credit analytics. There is specific vendor supplied credit applications on the market and many CTRM solutions incorporate sometimes rudimentary credit functionality as well. Around a third of the respondents said that they used a credit application to manage this exposure yet less than 20% felt this to be an area where tools were lacking and almost 60% felt that this was an area requiring greater focus. Around a third used specific credit risk tools and applications to help manage exposures.

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In our experience, despite there being several credit solutions on the market, many firms still appear to use home grown tools to manage credit exposures along with the use of some limited CTRM functionality. Mostly, these tools appear to be spreadsheets-based.  Despite this, we do anticipate continuing adoption of dedicated, vendor-provided credit solutions driven by several current needs, including the ability to better forecast margin and improved monitoring of counterparty exposures. Managing and predicting cash needs is a key aspect of risk management and knowing what margin calls may be anticipated, what cash is tied up in collateral and counterparty exposures is key. Additionally, though perhaps longer term, the increased focus on ESG which will require increased focus on KYC (Know Your Customer) capabilities and counterparty selection.

Key issues in this risk area identified in this study are,

  • Credit is identified as an underserved area requiring greater focus,

  • It is an area that can also be impacted by ESG regulations going forward.

In a recent white paper sponsored by Enuit, we also looked in more detail at credit risk functionality in CTRM solutions versus stand alone Credit solutions. There we stated that,

Many firms, especially smaller ones, instead rely on a combination of manual business processes, home grown solutions, spreadsheets and rudimentary ETRM / CTRM system functionality to manage counterparty and credit risk. As a result, operations like KYC and credit scoring are performed by reference to third party credit ratings and analysis of financial statements. And the resulting credit limit is maintained in the ETRM / CTRM solution. It is also in that system that much of the exposure management is performed and compared against the limits. Other areas like collateral management may be performed in other solutions along with more advanced risk metrics, if utilized.

We noted that although dedicated credit solutions are likely the best way to go, many firms either simply cannot afford to go that route and rely on their ETRM as a cheaper option despite the risk. Under these circumstances ensuring the ETRM solution has reasonable credit risk functionality becomes a key consideration and we discussed this in that free white paper.

Whatever strategy is adopted, it is clear that credit risk and liquidity risks are an area of increasing focus and risk. Both the report and the white paper are tools that can potentially aid in ensuring that these are covered as effectively as possible and setting up the optimal strategy.