Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 55 8.6.1 Loss or Reduction of Threshold A loss or reduction of threshold would be triggered by a downgrade event to determine the contingent liquidity required because of a lower rating. Assumes that contractually specified credit thresholds will go to zero in the event of a non-investment-grade trigger event or that the threshold will be reduced to a lower amount because of a lower investment grade credit rating. Loss or reduction of threshold represents the collateral that would be required to replace the amount of thresholds that are utilized. 8.6.2 Adequate Assurance Posting of adequate assurance can be required because of a loss of confidence in financial stability or trigger events. A two-notch downgrade to below investment grade could cause a substantial increase in contingent liquidity. (Or if an organization is close to non-investment grade, a downgrade to junk or single or double agency downgrades also make a difference.) Adequate assurance usually constitutes the majority of the contingent liquidity calculation when the downgrade event puts a company below investment grade. The calculation of adequate assurance can be the most difficult because of the subjective assumptions around management intervention. Adequate assurance is contractual, but a posting of assurance could occur in order to continue doing business even if a contract did not require payment. In this case, the business mode for an organization changes when management is required to make decisions on whether to continue doing business with a counterparty or post assurance. The CCRO recommends that companies use an expected and extreme scenario in modeling adequate assurance and disclose their assumptions. The expected scenario would be contractual, and the extreme scenario would include contractual as well as assurance required to continue business. This can be an extensive exercise for an organization, as all contracts would need to be reviewed in order to evaluate exposure under the two scenarios. • Negative mark-to-market on MTM and accrual contracts – The margin required is equal to negative mark-to-market on previously non-margined positions. Even though a contract is non-marginable, counterparties may request adequate assurance to perform because they lack confidence in the company’s financial stability. In this case, management intervention is key in determining the amount of adequate assurance. Furthermore, the level of subjectivity increases in modeling impact on cash flow. Management may decide not to pay adequate assurance and discontinue future business, pay a portion of adequate assurance, or pay all. The CCRO recommends that a range of adequate assurance scenarios be estimated with an expected and extreme case. • Net A/P prepayment – A/P may be accelerated and prepayments required on physical deals not covered under master netting agreements. Given loss of confidence in financial stability or a down grade event, a company may be requested to prepay on amounts billed and not paid and for physical energy delivered but not yet billed. This can be as much as 60 days of notional value of settlements outstanding for net payables. The company most likely would not receive cash or cash equivalents for net receivables positions due it.