The Next Evolution of the Basel Agreement: Harnessing Forecasted Losses to Enable Dynamic Counter-Cyclical Capital

Basels Next Evolution: Harnessing Forecasted Losses for Dynamic Counter-Cyclical Capital The global financial crisis of 2008 fundamentally reshaped banking regulation, giving rise to Basel III's enhanced capital requirements and macro-prudential tools like the Counter-Cyclical Capital Buffer (CCyB). Simultaneously, accounting standards like IFRS 9 ushered in a new era of forward-looking Expected Credit Loss (ECL) provisioning.1 As the regulatory landscape continues to evolve beyond the "Basel III Endgame" reforms, a powerful, albeit ambitious, proposal emerges: integrating estimated losses from banks' forecasted lending and existing commitments directly into the determination of counter-cyclical capital requirements. This approach offers a compelling vision for a truly dynamic and economically responsive capital framework. The Current Divide: Capital, Commitments, and Forecasts Under the present Basel framework, Pillar 1 minimum capital requirements are primarily based on existing, verifiable exposures – both on-balance sheet assets and legally binding off-balance sheet commitments (which are converted to credit equivalent amounts using Credit Conversion Factors - CCFs). However, a significant portion of a bank's future risk profile stems not just from what's currently on the books or firmly committed, but from its pipeline and forecasts of future lending and business growth. These "forecasted" exposures are typically managed within Pillar 2 (the Supervisory Review and Evaluation Process - SREP) and through stress testing, but they don't directly feed into Pillar 1 minimum capital requirements. Meanwhile, IFRS 9 demands that banks provision for expected credit losses over the lifetime of an exposure, explicitly incorporating forward-looking economic information.3 This creates a disconnect: accounting principles require a forward view of losses, while prudential capital requirements for "new" or "future" business remain largely tethered to current and past events. A Proposal for Basels Future: Integrating Foresight into Capital The core of this proposal suggests that future iterations of the Basel Agreement could introduce a mechanism where: Estimated Losses on Forecasts and Commitments Inform Capital: Banks would be required to estimate the Expected Credit Losses (ECL) on their significant uncommitted lending pipelines and undrawn commitments, drawing on methodologies similar to those used for IFRS 9, but perhaps with a prudential overlay. This would involve projecting potential drawdowns and subsequent losses on these future exposures under various economic scenarios. Dynamic Capital Adjustment: These estimated future losses would then directly influence the bank's counter-cyclical capital requirements. During periods of strong economic growth and potentially excessive credit expansion, higher forecasted lending volumes would lead to larger estimated future losses, which in turn would trigger an increase in the bank's counter-cyclical capital buffer or an additional capital add-on. This would proactively "lean against the wind" of the credit cycle, forcing banks to build capital when credit risk is accumulating. Capital Release in Downturns: Conversely, in an economic downturn, banks' forecasted lending might naturally decline, and new commitments would slow. This reduction in estimated future losses from new business could contribute to a release of counter-cyclical capital, encouraging banks to lend into the downturn when the economy needs it most. This mechanism would provide a more precise and data-driven trigger for capital buffer adjustments than currently possible. Enhanced IFRS 9 Reconciliation: By formally incorporating IFRS 9-like estimated losses from forecasts and commitments into prudential capital, a more robust reconciliation between accounting and regulatory frameworks could be achieved. This would lead to greater methodological consistency in risk modeling (PD, LGD, EAD), data management, and scenario analysis across both financial reporting and capital management. The Economic Imperative: Preventing Future Credit Crunches The current system, while improved, still faces the risk of procyclicality, where capital requirements tighten in downturns just when lending is needed, and are relatively lighter in booms when risks are building. This can exacerbate credit crunches. By linking capital requirements directly to forecasted losses from future lending, the proposed framework offers several benefits: Proactive Capital Build-up: It incentivizes banks to internalize the future capital cost of their growth ambitions during good times, preventing a sudden capital shortfall when those forecasts materialize into loans during a stress event. Smoother Credit Cycles: The dynamic adjustment based on estimated future losses acts as an automatic stabilizer, curbing excessive credit growth during booms and potentially supporting credit supply during busts. Increased Transparency: It provides a clearer, forward-looking view of a bank's capital adequacy that reflects its true risk exposure, not just its historical book. Stronger Link Between Risk Management and Strategy: Banks would be compelled to integrate their business forecasting, risk modeling, and capital planning more seamlessly, leading to more disciplined growth strategies. Navigating the Challenges Ahead While the vision is compelling, implementing such a framework would face significant hurdles: Defining and Measuring "Forecasts": Establishing clear, auditable, and globally consistent definitions for which "forecasts" warrant a capital charge is paramount. The spectrum from an aspirational business plan to a highly probable deal pipeline is vast. Model Validation and Comparability: Requiring banks to estimate losses on future exposures for Pillar 1 would necessitate robust new modeling techniques and a sophisticated supervisory validation framework. Ensuring comparability across diverse banks and their varied forecasting methodologies would be a major challenge. Calibration Complexity: Calibrating the precise relationship between estimated future losses, forecasted lending, and the counter-cyclical capital buffer would be immensely complex, requiring extensive data and economic modeling to avoid unintended procyclical or anti-competitive effects. Regulatory Consensus: Achieving international consensus among Basel Committee members for such a profound shift in Pillar 1 would be a long and arduous process, given the inherent complexities and potential impacts on national banking systems. Conclusion: A More Resilient Future? The proposal to derive counter-cyclical capital requirements from estimated losses on forecasted lending and commitments represents a bold conceptual leap for global banking regulation. It moves beyond a purely reactive or current-exposure-based framework towards one that is intrinsically forward-looking, economically sensitive, and more deeply integrated with modern accounting standards. While the practical challenges are significant, the potential for building a truly resilient financial system – one that proactively prevents credit crunches by anticipating and capitalizing future risks – makes this an avenue worthy of serious consideration in the ongoing evolution of the Basel Agreement. The future of financial stability may well lie in our ability to more accurately capitalize not just what is, but also what is yet to come. Connect and Stay Informed: Join the Conversation: Connect with fellow professionals in the SAP Banking Group on LinkedIn. https://www.linkedin.com/groups/92860/ Stay Updated: Subscribe to the SAP Banking Newsletter for the latest insights. https://www.linkedin.com/newsletters/sap-banking-6893665983048081409/ Explore More: Visit the SAP Banking Blog for in-depth articles and analyses. https://sapbank.blogspot.com/ Connect Personally: Feel free to send a LinkedIn invitation; I'm always open to connecting with like-minded individuals. ferran.frances@gmail.com I look forward to hearing your perspectives. Kindest Regards, Ferran Frances-Gil

Optimizing Capital Through Real-Time Risk Management in Transportation: Leveraging SAP SCM for In-Transit Stock Visibility

The Evolving Landscape of Collateralized Finance In today's interconnected global economy, the movement of goods is the lifeblood of commerce. From raw materials to finished products, vast quantities of valuable assets are constantly in transit across continents and oceans. For businesses, this "stock in transit" often represents significant capital investment, and increasingly, it serves as crucial collateral for financial contracts. However, the very nature of this dynamic collateral introduces a unique set of challenges for lenders and borrowers alike. Traditional financial instruments and risk assessment models, while robust for static assets, often struggle to adequately account for the fluidity and inherent uncertainties of goods on the move. When a financial contract is guaranteed by stock that is physically traversing supply chains, the collateral's value isn't just subject to market price fluctuations but also to the highly variable factors of logistics, transportation, and unforeseen delays. This gap in real-time risk management presents a significant hurdle for capital optimization within the financial system. The Proposal: A Proactive Stance on In-Transit Collateral This article champions a critical enhancement to financial contracts guaranteed by stock in transit: the implementation of a transportation delay-triggered margin call clause. This seemingly straightforward addition holds profound implications, serving as a powerful mechanism to bridge the divide between the "real economy" (the physical movement and value of goods) and the "financial economy" (the capital allocated and risks assumed). What does it entail? Simply put, if the stock serving as collateral for a loan experiences a predefined delay in its transportation, it will automatically trigger a margin call. This requires the borrower to either provide additional collateral or reduce the outstanding loan amount, thereby restoring the agreed-upon loan-to-value (LTV) ratio. Beyond Risk Mitigation: The Path to Capital Optimization While the immediate benefit of this proposal is undeniable risk mitigation for lenders, its deeper impact lies in its potential for significant capital optimization. Currently, financial institutions often factor in a conservative "buffer" or higher interest rates for loans backed by in-transit collateral due to the elevated and less quantifiable risk. This conservative approach, while prudent, leads to capital inefficiency. By introducing a mechanism that dynamically adjusts for risk as it materializes (i.e., when delays occur), lenders can: Reduce Capital at Risk (CAR): With a clearer and more immediate response to deteriorating collateral situations, lenders can potentially reduce the amount of regulatory capital they need to set aside against these exposures. This frees up capital for other investments or lending opportunities. Improve Risk-Adjusted Returns (RAROC): By more precisely matching capital allocation to the actual risk profile, financial institutions can enhance their risk-adjusted returns, making these types of transactions more attractive and profitable. Increase Lending Capacity: A more efficient use of capital translates directly into a greater capacity for lending. As the risk associated with in-transit collateral becomes more manageable and transparent, financial institutions can confidently expand their portfolios in this growing area of trade finance. Refined Pricing Mechanisms: The ability to react in real-time to transportation risks allows for more granular and accurate pricing of loans. This moves away from broad, often over-cautious pricing, towards a system that better reflects the actual risk premium. This benefits both lenders (fairer compensation for risk) and borrowers (potentially lower costs for well-managed supply chains). In essence, by making the invisible risks of goods in motion visible and actionable, this proposal transforms a static, high-risk capital allocation into a dynamic, adaptable, and ultimately more efficient one. It's about optimizing the deployment of financial capital by tying it directly to the fluctuating realities of the physical world. The Disconnect: Why Integration is Key The traditional separation between the "real economy" (where goods are produced, traded, and consumed) and the "financial economy" (where capital is raised, invested, and managed) has long been a feature of global commerce. However, in an era of just-in-time inventory, global supply chains, and increasing demand for efficiency, this disconnect is becoming a significant impediment to progress and innovation. The proposed margin call mechanism for in-transit collateral is a prime example of how this integration can be achieved. It necessitates a deeper and more continuous flow of information between the physical world of logistics and the digital world of finance. Requirements for Integrating Business Flows and the Role of SAP SCM Successfully implementing a transportation delay-triggered margin call isn't merely a contractual tweak; it demands a fundamental integration of business flows across both the real and financial economies. This integration requires several key components, where SAP SCM (Supply Chain Management) plays a crucial role: Real-Time Data Visibility: To effectively trigger margin calls, financial institutions need real-time visibility into the location, status, and estimated arrival times of in-transit goods. SAP SCM, particularly SAP SAP Transportation Management (TM) and SAP Global Track and Trace (GTT), are designed to provide this granular visibility. SAP TM, for example, can track shipments from origin to destination, integrating with carrier systems and providing live updates on delays, re-routes, or other disruptions. This allows businesses to monitor their in-transit stock with unparalleled precision. Standardized Communication Protocols: For seamless information exchange between logistics and financial systems, standardized communication protocols are essential. SAP SCM solutions facilitate this by offering robust integration capabilities, enabling the flow of critical logistics data, such as shipment status, estimated time of arrival (ETA) changes, and event management updates, to external financial systems. Defined Operational Procedures: Clear operational procedures are needed to define what constitutes a "delay" and how a margin call is initiated and processed. SAP SCM can support the establishment of these procedures by providing event management capabilities that automatically flag deviations from planned transportation schedules. This data can then be configured to trigger alerts or workflows that feed directly into financial risk management systems. Technological Infrastructure: A robust technological infrastructure is fundamental for handling the volume and velocity of data required for real-time risk management. SAP SCM offers a comprehensive platform that not only manages complex supply chain operations but also provides the necessary data backbone for integrating with financial systems. Its capacity to monitor and report on the exact situation of in-transit stock — from its current location to any anticipated delays — makes it an indispensable tool for managing dynamic collateral. The Vision: A Smarter, More Resilient Financial Ecosystem By demanding and facilitating the integration of real-time logistics data with financial risk management systems, this proposal moves beyond a mere contractual clause. It pushes the boundaries towards a more intelligent, responsive, and ultimately, more resilient financial ecosystem. In this integrated future, where SAP SCM provides the critical insights into the movement of goods, financial capital can flow more freely and efficiently, precisely guided by the real-world conditions of the assets it supports. Lenders can make more informed decisions, borrowers can manage their supply chains with greater financial accountability, and the overall system becomes less susceptible to the opaque risks of physical movement. This isn't just about mitigating a specific risk; it's about laying the groundwork for a more dynamic and capital-optimized interaction between the physical and financial worlds. The journey of a shipment will no longer be merely a logistical concern but a live data stream, enhanced by the tracking capabilities of solutions like SAP SCM, that actively informs and shapes financial obligations, fostering a new era of transparency and efficiency in global trade finance. Connect and Stay Informed: Join the Conversation: Connect with fellow professionals in the SAP Banking Group on LinkedIn. Stay Updated: Subscribe to the SAP Banking Newsletter for the latest insights. Explore More: Visit the SAP Banking Blog for in-depth articles and analyses. Connect Personally: Feel free to send a LinkedIn invitation; I'm always open to connecting with like-minded individuals. I look forward to hearing your perspectives. Kindest Regards, Ferran Frances-Gil.

The Imperative of Capital Optimization with SAP Banking

In today's dynamic financial landscape, capital optimization isn't just a buzzword; it's a strategic imperative. As capital becomes an increasingly scarce resource, financial institutions must shift their focus from mere volume to intelligently optimizing their capital allocation. This comprehensive approach is significantly bolstered by the powerful capabilities of SAP Banking's integrated financial and risk architecture, offering a robust framework for achieving this crucial goal. The Imperative of Capital Optimization The prevailing economic climate demands a re-evaluation of traditional banking models. A volume-based approach, once sufficient, now falls short in an environment where capital efficiency directly translates to sustainable growth and competitive advantage. The ability to precisely measure, strategically allocate, and ultimately reduce capital consumption is no longer a luxury but a necessity for maximizing profitability and ensuring long-term viability. This shift necessitates sophisticated tools and a deep understanding of financial flows and their impact on capital. A Three-Pillar Approach to Capital Efficiency Achieving true capital optimization can be broken down into a strategic, three-pillar framework: 1. Accurate Capital Measurement The foundational step involves gaining an unflinching clarity on capital consumption across every facet of the business. This means accurately quantifying the capital utilized in each individual market segment. SAP Banking's integrated financial and risk architecture proves invaluable here, providing the granular data and analytical tools required to precisely map where capital is being deployed and at what cost. Without this foundational understanding, efforts to optimize are largely speculative. 2. Efficient Margin Allocation Once capital consumption is precisely measured, the next crucial step is to strategically allocate margins to exposures. This isn't just about covering costs; it's about actively reducing Risk Weighted Assets (RWA) and, consequently, the capital consumed. By intelligently assigning margins, institutions can mitigate risk more effectively, leading to a leaner capital footprint. This proactive approach minimizes the capital held against potential losses, freeing it up for more productive and profitable ventures. 3. Profit Maximization Through Capital Reduction The ultimate objective of capital optimization is to maximize the bank's profit by strategically reducing consumed capital. This isn't about simply cutting corners; it's about smart capital deployment. By efficiently measuring and allocating, banks can unlock capital that would otherwise be tied up, making it available for investment in growth initiatives, new technologies, or enhanced customer offerings. This leads to a higher return on equity and a stronger financial position. Driving Innovation in Financial Risk Management The insights discussed here are a testament to the ongoing work in applying advanced analytical capabilities to complex financial challenges. The team behind this analysis possesses extensive experience in modeling intricate economic events and detailed business flows within SAP systems. This specialized knowledge enables them to go beyond theoretical concepts, providing practical solutions for measuring and optimizing both capital and liquidity consumption. Their dedication to understanding the nuances of financial data within SAP's robust architecture helps institutions not only navigate current regulatory landscapes but also strategically position themselves for future success in an increasingly capital-constrained world. Expanding the Horizon: Network-Wide Capital Optimization Let's take this concept even further. By incorporating the financial processes of your subsidiaries, partners, and even key suppliers, you can achieve a truly holistic view of your entire network's capital and liquidity. This expanded perspective unlocks powerful collaboration scenarios. Imagine a network where certain processes or entities can proactively provide capital, liquidity, or investment opportunities to others within the same ecosystem. This isn't just about internal efficiency; it's about transforming your entire business network into a more agile and financially interconnected entity, where every part contributes to the collective capital optimization. We're excited to be bringing this innovative system to market and are actively seeking business partners and investors who share our vision for transforming financial operations. If you're interested in exploring this opportunity further, please feel free to reach out directly to ferran.frances@gmail.com. Connect and Stay Informed: Join the Conversation: Connect with fellow professionals in the SAP Banking Group on LinkedIn. https://www.linkedin.com/groups/92860/ Stay Updated: Subscribe to the SAP Banking Newsletter for the latest insights. https://www.linkedin.com/newsletters/sap-banking-6893665983048081409/ Explore More: Visit the SAP Banking Blog for in-depth articles and analyses. http://sapbank.blogspot.com/ Connect Personally: Feel free to send a LinkedIn invitation; I'm always open to connecting with like-minded individuals. I look forward to hearing your perspectives. Kindest Regards, Ferran Frances-Gil.

Get Ready for IFRS 9 and IFRS 15 and Capital Optimization with Revenue Accounting and Reporting and Bank Analyzer

It's been a while now since January 1, 2018, when IFRS 9 and IFRS 15 became mandatory accounting standards for banks and corporations. In my experience, a surprising number of organizations are still far from ready to fully comply with these critical legal requirements. We're going to see the consequences of this unpreparedness unfold over the coming months.

There's also a good deal of confusion surrounding what IFRS 9 and IFRS 15 actually mean for businesses. Let's break it down with a practical example to make it clearer.

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Understanding IFRS 15: Revenue from Customer Contracts

IFRS 15 focuses on revenue from contracts with customers, with a particularly noticeable impact on agreements that bundle both services and goods.

Let's imagine a telecommunications company. They sign a contract with a customer for 12 months of internet access at €35/month and a subsidized Wi-Fi router for €50.

Before IFRS 15, the accounting for this was straightforward: the company would recognize €35 in revenue each month for the internet service and a one-time €50 revenue for the router sale. Simple, right?

With IFRS 15, things get more nuanced. Companies now must adjust revenue recognition based on the fair price of each sold component (router and internet access) and the completion of their commitment to the client (delivering the router and providing internet access). Since the router was subsidized because the customer committed to a 12-month internet contract, it makes sense that a portion of the router's revenue should be distributed over those 12 months of internet service.

The International Accounting Standards Board (IASB) provides a five-step process to meet IFRS 15 requirements:

1. Identify the contract with the customer: This is about clearly defining the agreement where the company promises to deliver a bundle of services and goods, like our telecom example.
2. Identify separate performance obligations: These are the distinct promises made to the client to transfer goods or services. In our example, the two performance obligations are providing the internet service and delivering the router. Crucially, the company must also determine the "Stand-Alone Selling Price" for each obligation – this is the fair price if each was sold separately.
   • A note on technology: While SAP Revenue Accounting and Reporting (current version 1.3) doesn't automatically determine Stand-Alone Selling Prices, companies can use historical average prices to figure them out.
   • For our example, let's assume the Stand-Alone Selling Price for internet access is €40/month and for the router is €55.
3. Determine the transaction price: This is the actual price the company is charging the client for each performance obligation. In our case, it's €35/month for internet and €50 for the router.
4. Allocate the transaction price to each performance obligation: This step ensures the revenue recognized reflects the value delivered for each good/service. Here's how it breaks down for our example:

Performance Obligation	Transaction Price	Standalone Selling Price	Allocated Amount	Calculation of the Allocated Amount
Router	€50	€55	€48	(€470 total transaction price) * (€55 router Standalone Price) / (€535 total Standalone Price)
12-month Internet Service	€420 (€35*12)	€480 (€40*12)	€422	(€470 total transaction price) * (€480 internet Standalone Price) / (€535 total Standalone Price)
Total	€470	€535	€470

5. Recognize revenue when each performance obligation is satisfied: This is where the actual accounting takes place over time.

   • Month 1: The router (Performance Obligation 1) is fully delivered, and 8.33% of the internet service (Performance Obligation 2) is provided. Revenue recognized: €48 (router) + €35.17 (internet) = €83.17.
   • Months 2-10: 8.33% of the internet service is provided each month. Revenue recognized: €35.17.
   • Months 11-12: 8.33% of the internet service is provided each month. Revenue recognized: €35.16.

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Understanding IFRS 9: Expected Credit Loss

Now, let's switch gears to IFRS 9. When a company issues invoices, it takes on credit risk – the risk that the customer won't pay. IFRS 9 outlines the process for measuring the Expected Loss from this credit risk.

This process begins by determining the Probability of Default (PD) for the client. This is typically based on a credit risk model that categorizes clients according to the payment behavior of similar risk segments. This "historization" process is often supported by systems like SAP Bank Analyzer.

The second step involves determining a Fair Value provision. This provision will reduce the recognized revenue until the client actually makes the payment. The amount of this provision is calculated through a Key Date Valuation within modules like AFI-Bank Analyzer. It involves discounting the cash flow (the amount due) using a yield curve with the same maturity as the cash flow, along with the corresponding spread for the client's Probability of Default.

Naturally, if the client fails to pay on time and the account receivable becomes impaired, this provision will increase.

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The Implementation Challenge

SAP offers a comprehensive business suite designed to help companies meet these new accounting standards. However, there's a significant bottleneck: scarce technical and functional skills needed to implement them. This scarcity makes these implementation projects incredibly challenging.

What are your thoughts on these new standards and the challenges they pose? I'm eager to read your opinions.

Kindest Regards,

Ferran.