Volume 4 — Credit Risk Management © Copyright 2002, CCRO. All rights reserved. 4 II CREDIT ALLOCATION AND FINANCIAL RISK ANALYSIS 1.0 Credit Policy A company establishes credit limits for a counterparty based on its “risk tolerance” as determined and approved by its board of directors and as set out in its credit policy. Thus, the initial step in deciding how to allocate credit is to establish a credit policy. Such a policy should include the following: • Guidelines for establishing credit limits and allocating credit to counterparties (These guidelines are described at length in Sections III-2.0 and III-3.0.) • Guidelines regarding when and how to request credit • Guidelines for monitoring trading lines • Guidelines on specific types and tenor of transactions allowed • Guidelines on segregation of duties between commercial teams and credit teams, up to the chief executive officer (CEO) or board level (See the Governance and Controls White Paper) • Guidelines on the levels and allocation of authority, from the credit analyst to the CEO (See the Governance and Controls White Paper) • Guidelines for approving exceptions. 2.0 Establishing Credit Limits The establishment of monetary credit limits and tenor limits should weigh the creditworthiness and size of the counterparty along with the strength and type of contract used to document the transaction. Credit lines should be defined in dollars and should consider the accounts receivable and MTM portions as well as tenor. To assist in establishing credit lines, the use of financial ratios or metrics (for examples, see Table 1) will facilitate new counterparty setups and provide guidance for real-time situations where existing counterparty lines have to be adjusted. When establishing credit limits, the credit manager should account for and factor in a counterparty’s specific characteristics. Also, these financial metrics should be considered and adjusted to reflect the current economic environment and trends within given business segments. While neutral to any industry or business segment, Table 1 below is meant to provide an example of key metrics to be used and their variation by credit quality.