Risk Policy & Procedures

Past failures show that companies without adequate risk policies can experience significant losses. Clear, concise and well documented policies and controls are essential and help minimise the risk of significant failures regardless of organisation size.

Compliance Reporting

In most cases a risk management committee should be set up with the following responsibilities:

• Review effectiveness of business plan
• Monitor breakdown in segregation of duties
• Monitor & assess competency, integrity and effectiveness of systems and personnel
• Recommend policy changes and prospective commercial controls
• Review and approve new credit, market and liquidity methodologies
• Verify compliance with limits
• Review and approve new transactions in alignment with company business strategy

Commercial Authorisation & Limits

Major losses have occurred largely becuse commercial personnel were marketing and trading in instruments, tenors, commoditities and quantaties for which they were not authorised. Limits to these activities are essential controls for this type of risk.

Daily P&L and Position Attribution, Analysis and Reporting

Analyse components of P&L and Position factors that change portfolio evaluations on a daily basis. Errors or incomplete analysis of any component may cause material mis-statement of earnings if not caught in a timely manner.

MTM vs. Accrual Accounting Treatment

There have been several well publicised companies in the energy industry that were forced to re-state their financials due to the improper classification of contracts under accrual or MTM acounting. Failure to properly classify could lead to reputation risk, fines and regulatory scrutiny with ultimate distress on shareholder value.

It is important for risk personnel to understand the accounting treatmnt of contracts and properly record in systems which are ultimately recored in accounting records and financial statements. Furthermore, Sarbanes Oxley requires certification by management as to the integrity of the financial disclosures.

Position Reporting

Positions from all physical and financial systems should be analysed and summarised to reflect correct position and risk exposure in support of commercial personnel. There is a significant chance of execution and market risk if the information needed to make quick decisions is not accurate or timely.

System Administration

Significant control breakdowns and earnings mis-representation can occur if system administration is not put in place. This is the fundamental control to ensure data integrity and sound data authorisation.

Market Reporting & Analysis

Senior management, trading management and the risk management committee should be informed of risk exposures, P&L, invested capital and positions.

Ad Hoc Reporting & Analysis

Without the ability to respond quickly to decision-making needs and investigations, companies are hard-pressed to reassure ratings agencies. investors and other inquirers that they have robust controls and could calculate cash flow and credit exposure in a accurate and timely manner.

Ad hoc reporting allows for quick turn-around of information by business users in making key decisions when IT production reports do not provide all necessary information.

Prudence Analysis

Correlation, liquidity, model, credit and specific deal risks should be quantified and analysed quarterly in order to properly value a portfolio. Inability to quantify risks could result in a mis-staement of earnings.

Value at Risk (VaR)

Var provides a single summary of the market risk in a portfolio by estimating unexpected earnings volatility.

Model Validation

Best practices are that models should be validated by an independent group before they are used for valuation in order to ensure accurate financial results.

Risk-Adjusted Performance Measurements

Risk-adjusted performance measurements give an objective view of the performance of the portfolio relative to other companies, relative to other parts of the portfolio and relative to safer, risk-mitigated investments.

Absolute Dollar returns can be deceiving if the risk required to attain them is not reasonable. Returns to VaR, credit risk and economic capital required are more useful than a simple Dollar measure. Furthermore, management will make more informed decisions on capital allocation and the cost of capital use.

Stress Testing

Stress testing shows how the book may perform under specific circumstances such as interest rate rises. This allows us to look for weaknesses in the portfolio that may require action. Furthermore, stress testing affords a glimpse of how earnings might suffer under extreme scenarios that VaR cannot measure.

Scenario Analysis

Scenario analysis is similar to stress testing but allows a company to test the portfolio under specific circumstances for catastrophic or abnormal events.

Credit Risk Analysis & Reporting

Given the systematic deterioration of credit quality, it is imperative that a firm measures credit exposure to reduce risk of unexpected loss and evaluates capital adequacy and exposure in the event of default, credit event or crisis situation.

Systems should have the capability to quantify credit risk and to analyse incremental risk of counter-parties if they continue to transact. Current exposure and potential exposure should be used in quantifying and reporting on credit exposure.

Credit Limit Allocation and Financial Risk Analysis

A company establishes credit limits based on risk tolerance of organisation given current economic environments and trends. Qualitative and quantative scoring systems should be used to rate portfolios and counter-parties to enable allocation of credit lines to counter-parties and the setting of monetary, tenor and commodity credit limits.

Credit Contact Administration and Mitigation

The credit group should negotiate and administer credit provisions of contracts in order to manage credit ridk and collateral exposure. Furthermore, credit mitigation techniques, such as Reduction and Transfer, are used to lower credit exposure.

Pro-active, knowledgeable and responsive administration and mitigation will minimise unexpected earnings and collateral losses due to default or adverse credit events.

Margin Management

Inefficient use of capital and increased credit exposure can occur without timely and accurate margining of counter-parties. Additionally, a large disparity between marginable and non-marginable contracts may cause severe streses on liquidity. A firm should perform daily margin management of all in-the-money and out-of-money contracts to minimise significant swings in cash.

Cash Flow at Risk (CFaR)

Rating agencies, investors and financial stakeholders currently view liquidity as the most important factor in measuring capital adequacy of a firm. It has been the largest factor in ratings migration to below investment-grade status for a majority of large industry players

It is vital that a company has the knowledge, tools and systems in place to measure Cash Flow at Risk and cash flow sensitivity to market price movements. Additionally, it is important for a company to utilise these systems to optimise market risk vs. liquidity risk to make decisions on new and existing transactions.

Contingent Liquidity Risk

Contingent liquidity capital is ordinarily the largest use of liquidity for a firm. A company must be able to interpret the contingent capital requirements for new and existing contracts to efficiently and accurately monitor liquidity needs.

Contingent capital is normally required due to ratings triggers and adequate assurance. An extensive review of terms of contracts will enable a company to estimate contingent capital on an on-going basis.

Cash Forecasting and Budgeting

Given the heightened sensitivity to liquidity, the ability to accurately forecast cash will assist Treasury in efficiently managing working capital over the short-term. It will also demonstrate capital adequacies over the long-term. This facilitates planning and budgeting or management intervention due to potential financial liquidity distress.

Deal Checkout & Modified Trades Checkout

This ensures that all new deals are recorded and adjustments to existing deals in the portfolio are completed in a timely and accurate manner. Potential material valuation or data errors can occur if deals are missed or incorrectly entered or modified.

OTC and NYMEX Checkout and Reconciliation

This ensures that all OTC brokered and exchange deals recorded in the portfolio are complete and valuation is accurate. Potential material valuation errors can occur if deals are missed or corrections are not timely.

Curve Validation

Forward curves should be independently validated against market quotes to ensure accurate valuation of portfolio to prevent material mis-statement of earnings. There is potential for rogue trading, mis-representation of financials, reputation risk and cash-flow & credit errors if this control is not followed.

Operations and Operational Risk Management

Operational risks arise through owning or controlling assets. These risks are difficult to measure. Risk controls can be put in place to minimise sytems and human errors.

Business Risk Management

Business risks are due to uncertainties regarding changes to business environments including, but not limited to, regulations, macro-economy, reputation damage etc.

Index Reporting

Mid-office employees are required to submit data to index publishers for price index calculation.