Why Your Exposure to a Supplier Default May Be Higher than You Think

When companies estimate their exposure to the potential default of a supplier, they often only evaluate how the loss of the supplier will directly affect their business. To understand the full potential impact of a bankruptcy, companies need to consider how a default will impact the remaining market participants as well.

For example, one energy market maker currently estimates that the direct and follow-on impacts of bankruptcies of the suppliers in its sector are only a fraction of its total exposure. At first, this firm only examined the replacement cost of the energy that would no longer be directly provided by the failed supplier. That replacement cost is based on a significant increase in spot prices, driven by a short-term shortage.

But many of these large suppliers use bilateral contracts, in addition to the market maker, to sell energy. If the supplier defaults, those bilateral customers will immediately begin sourcing energy from the spot market, using the market maker. As a result, the volume of energy to be replaced could be 20 times more than the direct volume.

Worse, the combination of the increased volumes moving through the spot market and higher prices from reduced supply creates potential credit exposures in excess of $100 million for this firm.

More robust diagnostics are crucial in developing a more realistic picture of what could actually happen if a supplier defaults – and in enabling a company to avoid that outcome.

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