June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 48 of 92 Credit risk measurement methodologies have been very well defined by the financial sector and these are useful within the energy industry. These different models are available from various vendors and will produce the above distribution. For a comparative analysis of the more widely used models, refer to M. Crouhy et al. / Journal of Banking and Finance 24 (2000) pgs 59-117. In this chapter, the focus is on key aspects in determining an adequate level of capital pertaining to one’s credit risk exposures, as well as the capital necessary to implement credit risk mitigation measures. These aspects are addressed by different models in different ways, however they should be well understood in order to make both an appropriate assessment of credit risk capital and an informed judgment as to which model is appropriate to one’s individual situation. Figure 5.2 represents a credit risk measurement framework for capital adequacy that can be employed regardless of the specific credit risk model chosen. The benefit of this framework is the ability to assess the cost of risk mitigation vs. the reduction in risk, as well as providing a credit risk assessment that can be used as a to gauge appropriate level of capital adequacy. Figure 5.2 A Credit Risk Measurement Framework Whatever specific Credit risk Measurement model is utilized, each of the aspects in the graphic should be addressed, either directly or indirectly. It is important to understand how and why the model of choice is including or not including the aspects in the graphic, and what assumptions are underpinning the foundation of the model. 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 -12 -13 -14 -15 Loss from Credit Defaults ($MM) Probability 0 0.05 0.1 0.15 0.2 0.25 0.3 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 -12 -13 -14 -15 Loss from Credit Defaults ($MM) Probability Credit Loss Distribution Before Mitigation Measures Credit Loss Distribution After Mitigation Measures 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 -12 -13 -14 -15 Loss from Credit Defaults ($MM) Probability 0 0.05 0.1 0.15 0.2 0.25 0.3 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 -12 -13 -14 -15 Loss from Credit Defaults ($MM) Probability Credit Loss Distribution Before Mitigation Measures Credit Loss Distribution After Mitigation Measures Expected Default Probability (EDP) Credit Risk Measurement Model Default Volatility & Correlations Recovery Rate & Volatility Credit Migration Current Exposure Potential Future Exposure (PFE) Credit Risk Mitigation Tools Compare Cost of Mitigation vs. Reduction in Risk Econometric Factors