Measuring and Managing Utility Credit Risk: Taking a Page from Wall Street

Adopting a portfolio approach to credit risk is the answer.

How times have changed from the "good old days" of credit risk management. No longer can credit managers hide behind the false comfort that they only approve transactions with companies that pay their bills.

Now, what is needed for appropriately functioning credit risk quantification is a portfolio perspective and a long time horizon. The portfolio perspective accounts for the realization of an average low level of losses most of the time, punctuated with an occasional large loss, and an even more infrequent period of several correlated losses. The long time horizon is necessary to capture the risk associated with that period of correlated losses. This is highlighted by the graphic that depicts annual portfolio losses right ().

The key here is a long time horizon-something like a year. Credit managers cannot afford to set limits and manage credit risk based only on accounts receivables balances plus current mark-to-market exposures. A view of potential future exposure (PFE) is critical.¹