Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 27 V. CREDIT RISK 5.1 Definition of Credit Risk This section describes the economic capital associated with the credit risk of an organization. The discussion is consistent with the general approach for measuring credit risk described in the CCRO “Credit Risk Management” white paper. Where appropriate, more detailed specifications and clarifications of the approach are introduced here. On a high level, credit risk is the risk that a loss will be incurred if a counterparty does not fulfill its contractual obligation. Economic capital for credit risk is the difference between the expected loss of a portfolio and the maximum tolerable loss implied by a desired confidence level. Economic capital for credit risk is derived by calculating the amount of capital required to support the unexpected credit loss of an organization, using a distribution of credit losses generated by a credit risk model. The framework sets the probability of losses exceeding the maximum tolerable loss equal to the probability of default implied by target credit rating (Figure 14). Credit risk has two major components: expected loss (EL) and unexpected loss (UL). Expected loss represents the average loss that a company could expect to incur over a given horizon. It is typically used in setting loss provisions. Unexpected loss measures the uncertainty of losses around the expected loss. Losses that deviate from expectations threaten the health of an organization, and the purpose of credit economic capital is to protect against unexpected loss. Energy companies currently use a variety of proprietary and third-party credit models. Credit models should typically account for the impact of commodity price volatility on the organization’s credit exposure coupled with the occurrence of counterparty default. More general models, however, would also consider the impact of ratings migration and other factors on credit exposure and default probabilities. Depending on a company’s credit risk profile, it may choose to use models that do not explicitly account for credit migration and focus only on outright default as a credit event. An organization should review which credit risk model best suits its risk profile. Note that the credit economic capital framework described here is general enough to accommodate whatever credit model a company ultimately uses. As an alternative interim solution, Section 5.5 describes a measurement of credit risk for companies that have simple portfolios or lack the ability to calculate credit economic capital because of system limitations.