Volume 4— Credit Risk Management
VI MITIGATION One of the primary intents of the CCRO’s effort is to ensure that mitigation opportunities are more widely understood and accepted. The importance of wider acceptance of mitigation techniques is driven by the power of these tools as well as by the current industry environment. Indeed, some of the underutilized tools have the ability to drive credit exposures down to a small fraction of current levels and will result in improved liquidity – especially important as the industry faces today’s liquidity crisis combined with stronger capital adequacy standards demanded by the credit rating agencies. This section defines and addresses all methods of mitigation. We compare and contrast the methods in terms of their effect on credit exposure, their costs, and their ability to be used as common business practice.
1.0 Types of Risk Mitigation There are two general categories of credit risk mitigation: (1) reduction and (2) transfer. The goal for each is to lower the overall credit exposure from an energy merchant’s trading and marketing activities. Reduction techniques are integral to a company’s credit risk management processes and include familiar techniques such as collateralization, financial/performance guarantees, exposure reducing trades, and less familiar methods such as master-netting agreements. Transfer methods move the credit exposure to another entity. These methods are less familiar and include credit derivatives, credit insurance, and an insurance financial guarantee. Multilateral clearing will have features of both reducing and transferring credit risk, depending on the type of clearing implemented. The rule of thumb in mitigating credit risk is to first reduce exposure to the maximum extent possible, then transfer any remaining credit exposure that cannot be tolerated by the firm’s overall financial risk profile. Table 2 provides a summary of methods for mitigating (or managing) credit exposure.
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