From the November 2010 issue of Treasury & Risk magazine

GOLD AHA Winner in Credit Risk Management

The economic meltdown prompted Cisco Systems to adopt a comprehensive, bank-like approach to credit risk management and to consolidate tracking of trade receivables, loans and leases, and investments--all multibillion dollar portfolios.

"For the first time, Cisco is able to quantify and segment the biggest risk contributors in terms of expected and unexpected losses," says Roger Biscay, treasurer and vice president. "This allows the corporation, as well as individual functions, to better assess, manage and mitigate credit risk and execute on cross-functional risk reduction in a timely manner. We can quickly and routinely assess the impact on capital and earnings per share under various catastrophic credit loss scenarios. This new ability helps to ensure adequate bad debt reserves and equity capital to absorb any adverse outcome without jeopardizing solvency."

Cisco formerly managed its three credit portfolios separately, even though important counterparties often showed up in all three. Total exposure was often masked by the walls between portfolios, explains assistant treasurer Greg Bromberger. Rolling up the total global credit exposure for even one counterparty was a manual task that often took up to a day, Bromberger notes.

The solution, implemented between mid-2008 and mid-2009, is anchored by Moody's KMV Portfolio Manager, which Cisco's captive financing arm, Cisco Capital, already used to monitor its loan and lease portfolio.

The project involved over 2,000 counterparties and more than 20,000 transactions that contributed to a total credit exposure of $24 billion. Implementation required a lot of scrubbing and testing. But it gave Cisco the visibility it needed to manage its risk in perilous times. The clearer view did not reveal serious mistakes or require dramatic changes, but it gave Cisco comfort that it was seeing all its risk and allowed risk managers to make selective reductions in risk by counterparty, sector or nation as the economic contagion spread in 2009. Cisco reduced the bond holdings in its investment portfolio so that it could continue to offer credit to customers while maintaining an acceptable overall risk profile, Bromberger explains.

Cisco also changed its risk analysis methods, moving away from credit scores and financial statements because they were too static to predict the defaults occurring in the rapidly sinking economy. It found the expected default frequency metrics employed by the Moody's model to be a more reliable predictive measure.

Technically, the program sets an enterprise-wide expected loss, or the average dollars likely to be lost each year due to counterparty default. Then it sets an unexpected loss possibility that one would expect to be exceeded about 5% of the time. Finally, it identifies the capital cushion it would take to absorb extreme losses defined as catastrophic (the one-in-a-thousand scenario), Biscay explains. The top 20 counterparty exposures are now flagged based on value-at-risk and catastrophic risk. The program also helps identify the optimal risk positions to hedge and how best to use credit insurance.

The software handles derivative transactions and off-balance-sheet exposures like guarantees and lender recourse arrangements, as well as loans, leases, bonds and accounts receivable.

Picking the methodology and tools were only the first steps. Much of the challenge lay in capturing all of the transactional credit data of customers in the three credit portfolios, translating them to a common format and feeding them into an integrated database. Just 12 months after launching the project, Cisco executives saw the first detailed reports and used them to adjust risk in light of the company's risk appetite, economic outlook and sales strategy.