Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 34 5.5 Alternative Measure as Interim Step The CCRO recognizes that firms may not have the ability, due to system limitations, to calculate credit economic capital along the lines described in the preceding sections. For this reason, an interim solution for calculating stress factors in measuring credit economic capital is discussed below. The recommendation is not considered a replacement of methodologies discussed in the credit section, and is presented only as an interim solution for companies that may not otherwise be able to calculate economic capital. Having borrowed this solution from banking, the accuracy of these calculations relative to sophisticated credit models when applied to energy credit portfolios is not well established in the energy industry. Companies with more sophisticated credit capabilities are therefore encouraged to benchmark this interim solution against more robust credit models so that the CCRO can provide more guidance on this issue in the future. The interim approach is based on a methodology discussed in the Basel Credit Risk Pillar published within the Third Consultative Paper of the new Basel Capital Accord in April 2003. This methodology has its roots in the one-factor Merton model. It consists on 3 straightforward steps. The economic capital set aside for credit risk is defined as: ECCR = sum (K * Estimated Exposure) over all counterparties 5.5.1 Computation of capital, given known exposure The first step is to calculate the capital requirement percentage14, K, which depends on the loss given default and the probability of default of each counterparty. )] R (1− ))/ Mkt G( * R ) PD N[(G( LGD* K + = In the above formula, LGD is the loss given default, PD is the default probability, Mkt is the probability of a market downside event, and R is the pairwise asset correlation so that the square root of R is the correlation of the firm’s assets with the market. N [.] corresponds to the standard normal cumulative distribution. G (.) denotes the inverse cumulative distribution function for a standard normal random variable. The Excel add-in functions normsinv and normsdist can be used to evaluate N[.] and G[.]. The terms in brackets represent the normalized distance between the expected default distance (based on the counterparty unconditional default probability) and the market downside event (based on a desired confidence level – Basel uses 99.9%). In probability term, this distance becomes the unexpected loss probability. A firm may choose to use a different solvency standard as a confidence interval depending on their target debt rating. 14 Appendix B provides a detailed example of this calculation.