Capital Optimization and Holistic Management of Basel IV and IFRS-9 with the Integrated Financial and Risk Architecture of SAP Bank Analyzer and FPSL

 Dear:

As we discussed in previous posts, we are in the midst of a systemic transformation: from a volume-based financial system to one based on efficient capital management.

In a globalized financial system, efficient capital management requires a commonly accepted regulatory framework for measuring the capital consumed by a bank's assets.

The main sources of current banking regulation are the International Accounting Standards Board (IFRS) and the Basel Committee on Banking Supervision (Basel IV).

http://www.ifrs.org/About-us/IASB/Pages/Home.aspx

https://www.bis.org/bcbs/

The BCBS's primary responsibility is to establish capital requirements to ensure the financial stability of the banking system, while the IASB's primary responsibility is to establish fair valuations of assets.

In reality, both organizations address the same problem: the measurement of capital consumption, from different perspectives.

- IFRS. The Fair Valuation of a Financial Asset determines the provisions that adjust the Nominal Value of the Asset to a Fair Value, which includes the Cost of Risk.

- Basel IV. The capital requirements of an asset determine the capital consumed when investing (or lending).

It seems reasonable to establish some level of reconciliation between the two approaches.

Basel IV requires banks to accumulate capital during the expansion phase of the business cycle to cover possible losses during the contraction phase. These countercyclical capital requirements are not tied to any particular loan, so they are generic.

On the other hand, International Financial Reporting Standards establish the provisions that banks must recognize to cover losses in their portfolio due to events that have already occurred and will affect future cash flows.

Some of these losses come from detected bad loans, but others come from bad loans that we know exist in the portfolio, but that we have not yet detected. Therefore, we must evaluate the entire portfolio and adjust its value globally, also through a Generic Provision.

But the problem remains: how to determine the Fair Provision for a hidden bad loan?

An interesting approach to determining the value of these generic provisions uses the Internal Ratings-Based Approach to Credit Risk Calculation (Basel IV).

To calculate IRB Credit Risk, we must evaluate several components: Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD), and contract maturity (M).

In addition, the IRB method allows us to calculate the expected portfolio loss (PE), which corresponds to the expected loss of each loan, calculated with the following formula:

PE=PD*LGD*EAD

For our reconciliation exercise, we use the IRB method's Expected Loss concept, which is similar to the IFRS concept of Incurred Losses, but not exactly the same.

IRB Expected Losses are the average loss stream that internal rating calculation methods predict will materialize in a year, while IFRS Incurred Losses are the balance of losses existing in the portfolio at a given time, due to past events that will generate losses in the future.

Both Incurred Losses and Expected Losses are different from the annual manifest losses (annual default stream) and, consequently, from the annual stream of specific provisions.

However, we can calculate Incurred Losses under IFRS by estimating the annual stream of expected losses and the time elapsed from the event that causes the loan to default until the moment it becomes apparent. This period between the two events is called the Loss Identification Period (LIP).

For example, if the counterparty loses their job and becomes unable to meet their payment obligations 18 months later, the Loss Identification Period would be 18 months.

Therefore, if we know both quantities (the Expected Losses and the Loss Identification Period), we can estimate the Incurred Losses by multiplying them.

For example, if the calculated Expected Losses for our portfolio (IRB method) are $45 million per year and the average Loss Identification Period is 2 years, this means that the Incurred Loss in our portfolio is $90 million.

Incurred Losses (IFRS) = Expected Losses (IRB Method) * Loss Identification Period

During the upswing of the business cycle, the Loss Identification Period is longer due to easier refinancing policies and favorable economic conditions.

According to the formula, a longer Loss Identification Period will increase Incurred Losses during the upswing.

In this way, we reconcile the calculation of IFRS Generic Provisions with the countercyclical capital buffer required by Basel IV.

The Integrated Financial and Risk Architecture holistically assesses capital consumption for Credit Risk, both from a solvency perspective (Basel IV) and from an accounting perspective (IFRS-9).

In Bank Analyzer Credit Risk, we determine the Probability of Default, the Loss Given Default, and, of course, the Expected Loss for each exposure, dynamically applying collateral and guarantees.

Secondly, SAP Financials Product Subledger uses the results of the Basel IV Credit Risk calculation as input for the calculation of IFRS-9 provisions.

Applying the above method to a real bank's portfolio management requires an integrated accounting (IFRS) and risk management (Basel IV) system within a holistic data model. This is the foundation of Bank Analyzer's Integrated Financial and Risk Architecture and makes it the best system for measuring a bank's available and consumed capital.

The results of the Basel IV and IFRS-9 calculations are holistic and reconcilable for the common dimensions of the Result Data Area of the Integrated Financial and Risk Architecture. This is why this architecture offers us a reconcilable and holistic view of capital consumption for Credit Risk.

The capital consumption for Market Risk is still missing, as it is only available in the Results DataBase. This lack of integration can be partially resolved with the open architecture of the Integrated Financial and Risk Architecture, but this would be the subject of another article.

The next level is Capital Optimization, which requires the integration of Real Economy and Financial Economics processes. For the past 12 years, our team has worked on modeling all economic events and business flows represented in Real Economy SAP systems, in terms of capital and liquidity consumption and generation. With this information, our systems measure how to offer financial instruments to cover capital and liquidity gaps or invest excess capital and liquidity, thus optimizing the system's capital consumption and liquidity.

We are working to introduce our system to the market and are looking for business partners and investors. If you are interested, please do not hesitate to contact me.

ferran.frances@gmail.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Join the SAP Banking Newsletter: Subscribe on LinkedIn https://www.linkedin.com/build-relation/newsletter-follow?entityUrn=6893665983048081409

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

If you want to connect on linkedin send me an invitation and I will accept it.

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances.  

Japanese bond market collapse, Capital scarcity and Capital Optimization with SAP Banking.

 Dear,

In recent weeks, long-term Japanese government bond rates have been rising due to investor concerns about inflation, government spending, and interest rate hikes by the Bank of Japan.

In recent years, the Bank of Japan's low interest rates, necessary to keep interest on Japan's high debt under control, created a yen carry trade, where investors borrowed in yen at low costs and purchased assets with stronger yields abroad.

This mechanism has financed investments in other markets, such as the US.

However, if Japanese debt yields rise, this carry trade mechanism will cease. Investors will have less incentive to finance assets outside of Japan, eventually liquidating US assets to obtain liquidity under the pressure of the rising interest burden on Japanese debt.

When we reach this point, and we will because the debt is growing unstoppably, the Japanese debt problem will spread to the United States and from there to the rest of the world. Let's not forget that Japan is the largest foreign holder of US debt.

As SAP consultants, none of us are in a position to stop the forces of the macroeconomic environment, and therefore our goal must be to act to guide our actions in helping our clients navigate the stormy seas of rising Capital Costs.

Ultimately, rising government debt yields will accentuate the strain on the financial system and make it difficult for companies to finance their investments.

For all of the above reasons, reducing Capital Costs, or in other words, Optimizing Capital, is becoming critical.

Let's look at what a Capital Optimization process looks like.

1) The first step in a Capital Optimization process is to accurately measure the capital consumed in each market segment to which the bank is exposed.

This is the main value proposition of SAP Bank Analyzer's Integrated Financial and Risk Architecture.

Bank Analyzer's Credit Risk module will calculate the Risk-Weighted Assets for each contract, each risk exposure in the bank's portfolio, and, consequently, the Regulatory Capital consumed.

Once the capital consumed by each contract/exposure is known, we can aggregate it according to the analytical dimensions defined in Bank Analyzer's results data layer, thus understanding the capital consumed in each market segment in which the bank operates.

Alternatively, SAP Bank Analyzer's Credit Portfolio also provides us with the economic capital consumed by market segment and all the complementary parameters to the capital consumed.

2) The second step in a Capital Optimization process is the efficient allocation of collateral to exposures to reduce Risk-Weighted Assets and capital consumption.

The allocation of collateral to exposures is not always static. A 1-to-1 allocation of one collateral to one exposure is a trivial case, but it is common for several (n) exposures to be allocated to several (m) collaterals.

If (n) exposures are allocated to (m) collaterals, an optimal distribution of collateral portions across exposures occurs, reducing Risk-Weighted Assets and, consequently, capital consumption. This is the basis of dynamic collateral management, which we discussed in a previous blog post and will discuss again in a future one.

https://www.linkedin.com/pulse/dynamic-collateral-management-capital-optimization-sap-frances-gil/

Bank Analyzer's credit risk module has robust capabilities for optimal collateral allocation to exposures in Level 2 of the risk-weighted asset calculation. These capabilities analyze Probabilities of Default and Exposures at Default, as well as Collateral Values, efficiently adjusting the allocation of collateral portions to Exposures.

3) The third step in a Capital Optimization process is to maximize the bank's profit by reducing Capital Consumption. Each market segment has a potential expected profit, and each market segment has a potential expected loss and, consequently, potential capital consumption.

Capital Optimization involves identifying the market segments with the highest Expected Profit weighted by the market segment's Expected Capital Consumption.

This is the most complex element of a Capital Optimization process, as it requires a doubly synchronized simulation to find a solution that minimizes Risk-Weighted Assets and maximizes Expected Profit.

This optimization engine is not yet available, but Bank Analyzer's Integrated Financial and Risk Architecture has been designed to provide an integrated and reconcilable view of Risk and Accounting.

The IFRA is the technical basis for running the simulation cycles that capital managers must implement to achieve optimal bank portfolio planning, reducing RWA while maximizing expected profit.

Finally, the future will require automatic calculation and simulation of bank investments to propose optimal sales and execution planning. I have personally worked on some of these models, adapting the theory of constraints to portfolio management.

These simulations require very powerful computing capabilities, but that is the value that SAP HANA brings to solving the problem.

The last 12 years our team has worked in modeling all the economic events and business flows represented in the SAP systems of the Real Economy, in terms of Capital and Liquidity consumption and generation. With this information, our systems measure how to offer Financial Instruments for covering Capital and Liquidity gaps or investing Capital and Liquidity surpluses, optimizing the Capital and Liquidity consumption of the system.

We are working on presenting our system to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting me at

ferran.frances@gmail.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Join the SAP Banking Newsletter: Subscribe on LinkedIn https://www.linkedin.com/build-relation/newsletter-follow?entityUrn=6893665983048081409

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

If you want to connect on linkedin send me an invitation and I will accept it.

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances-Gil.

Industrial Decline, Capital Scarcity and Capital Optimization with SAP Banking.

The decline in industrial production in Europe is an excellent indicator of the true energy transition. An energy transition that, for geopolitical reasons, has begun in Europe but which in the medium term will spread to the rest of the industrialized world

And it is not just industrial production, unfortunately, this will be the case for most economic activities (but all of them).

All the signs point to the fact that the replacement of fossil fuels with renewable sources is being a failure. The plans for the introduction of electric vehicles are far behind the objectives. The use of green hydrogen is far behind expectations. Electricity generation from wind or photovoltaic sources is facing serious problems of intermittency. The storage devices that were supposed to solve these problems of intermittency are giving results far below those necessary to guarantee the stability of supply.

If this negative trend continues, and there is no indication that it will reverse, economic growth will weaken significantly in the coming years. Weak economic growth means weak capital generation.

At the same time, the system is supporting the largest debt in history, both in absolute terms and as a percentage of gross domestic product. Even worse, the growth of global debt, far from slowing down, continues at unsustainable rates. This excess of debt is overconsuming capital at the fastest rate in economic history.

If capital is overconsumed and not regenerated at the same rate, capital becomes scarce and capital is the most important resource of the financial system. In reality, capital is the most important resource of the socioeconomic system in which we live. That is why it is called capitalism.

If we look closely, we can already see signs of this capital shortage. Capital and commodity markets are suffering from increasingly frequent episodes of panic. The number of companies that have difficulty refinancing their debt is growing, and at the same time many others have difficulty obtaining raw materials or components necessary for manufacturing or goods to supply to the market.

The shortage of capital is not distributed evenly. And even worse, its allocation does not spontaneously adjust to the needs of business processes.

Information systems perform the fundamental function of searching for and allocating the capital required by business processes.

Among these information systems, SAP has been the most responsible for the improvement in capital management that the business sector has experienced in the last 30 years. SAP has facilitated holistic asset management models for organizations and has substantially improved the visibility of these assets for their customers and suppliers, as well as the traceability of the movement of these assets in intercompany processes.

I started my career as a SAP consultant in the early 1990s and have had the privilege of observing this transformation in many organizations. In 2006, I participated in my first analytical banking project and I was able to see how the level of efficiency that organizations in the real economy already had at that time was far ahead of that of financial institutions and motivated by being part of a transformation in the financial system similar to what was happening in the real economy, I also oriented my professional career in that direction.

Two decades later, the transformation of the real economy has even accelerated with scenarios of collaboration, analysis, artificial intelligence, asset traceability, etc., which would have been difficult to imagine when this transformation began 30 years ago.

On the contrary, the transformation of the financial system has been much more limited and given the urgency with which the growing scarcity of capital is needed, I have serious doubts that it will arrive on time.

As the scarcity of capital increases, so does the cost of capital, making it difficult to refinance debt and capitalize economic activity. Rising capital costs further slow growth and make capital optimization increasingly critical.

I came to this conclusion years ago and since then I have focused my efforts on designing and building a capital optimization model that offers a holistic view of all assets, tangible and intangible, of the financial economic system, facilitating the integration of the processes of the real economy and the financial economy.

We are looking for partners. Contact me with a linkedin Direct Message if you want to know more details.

#debtcrisis #capitaloptimization #oilcrisis #bankingcrisis #sapbanking #s4hana #sapjobs #sapbanking #saps4hana

Forex Risk management and Capital Optimization in Sales Processes with SAP Banking.

 Dear all,

Capital Optimization requires synchronizing the activities of the agents participating in the value chain, reducing the Capital consumption of the system.

This process has been the basis for the development of technology and processes that have transformed the non-financial economy in the last 50 years and which has been driven by SAP's strategic vision.

When Dietmar Hopp, Hasso Platter, Claus Wellenreuther, Klaus Tschira and Hans-Werner Hector founded what is today SAP AG, they were beginning a long path of standardization and integration of business processes in the real economy. By integrating, for example, production planning with supply and demand, they established a common language that allowed the three dimensions to be synchronized, improving service levels while reducing inventory obsolescence costs.

Since then, and especially after the arrival of SAP R3 in 1992, the standardization and integration of processes has accelerated, covering 70% of the non-financial economy.

I started my career as a SAP consultant 30 years ago, at that time our goal was to integrate the processes of the companies' departments.

10 years later we were integrating processes of the subsidiaries of the groups of companies with other subsidiaries of the group.

And in the last 15 years we have massively integrated the business processes of clients, suppliers, logistics operators in a standardized language (SAP). And with this synchronizing the activities of all agents, reducing Capital consumption (transportation costs, inventory obsolescence, supply, etc.), while maintaining a high level of service.

This standardization and integration process has not been carried over to Financial Services. Banking and insurance companies, with very limited exceptions, present silo-style architectures with very limited integration that represent a brake that makes Capital Optimization difficult, if not impossible.

Following the example of the transformation experienced in the non-financial economy, the Optimization of financial capital (solvency and liquidity) requires:

1) Integrate the processes of the agents involved in the acquisition, generation and delivery of financial services.

2) The integration of the agents involved in the acquisition, generation and delivery of financial services with the processes of the real economy.

Point 1 can be covered with SAP Banking technology, rated by many experts as the most visionary in Financial Services. But while 70% of the real economy is expressed in terms of SAP processes, point 2 can only be covered with SAP technology. And this simple argument makes SAP Banking the only alternative to Optimize Capital.

If in addition, as is the case, the cost of capital is rising due to the energy crisis and excess debt, the transformation of financial services towards Capital Optimization has become a strategic urgency.

Our team detected this opportunity 12 years ago, and since then we have worked to integrate the processes of the real economy in terms of generation and consumption of Solvency and Liquidity, integrating the processes of SAP Banking, with the standardized business processes of SAP in the real economy, which as I said before, represent 70% of the non-financial World GDP.

By doing so, we change the paradigm of Financial Services, establishing financial and non-financial collaboration models. The objective is to detect capital and liquidity deficits and surpluses in business processes and cover them with debt and investment financial instruments, optimizing the system's capital consumption.

Making an analogy, it is like the Vendor Managed Inventory collaboration processes of Supply Chain Management, but in financial services. Delivering financial instruments of debt and investment instead of replenishing sales and production materials.

But in the same way that has happened in the real economy with the strategic vision of the founders of SAP, when you change the paradigm in financial services, you open a universe of capital optimization opportunities based on the synchronization of economic agents. In the next lines, I will briefly describe one of them.

One of the greatest advantages that pricing in SAP and its integration with Analytical Accounting brought was its ability to analyze the margin of purchase-sale operations. By integrating the cost of sales and transportation costs through statistical conditions in the Sales Order and the Invoice, we could analyze the margin of these operations in unimaginable detail until then.

But the buying and selling processes are also affected by capital costs that are not visible without integrating financial services with the real economy, but have a real impact on the margin. And they will have more as Capital costs increase.

For example, when we sell (or buy) a merchandise in foreign currency, we are exposing ourselves to a future loss depending on the exchange rate at the time of payment.

To eliminate this risk, companies implement hedging strategies with financial instruments (Forex Forwards and Options). These financial derivatives have a cost that is not visible at the time of confirming the purchase and sale order, limiting the ability to optimize capital in this process.

We all know that price policies are determining factors in the generation of income and the globalization process has generalized buying and selling in foreign currency.

When we negotiate a price in foreign currency, the sale price is not the conversion of that amount according to the spot rate.

A buy-sell order is a future operation, subject to foreign exchange risk, so the hedging cost must be included in the analysis. At the time of the order confirmation we know the exchange rate of the day and we can only estimate, assuming a risk, the future exchange rate. And that risk represents a cost of capital that our income statement is bearing.

Visualizing this cost in each order item, analogously to what we did with the Cost of Sales more than 30 years ago, we provide the company's managers with tools to optimize this Cost of Capital.

Determining the forex risk Cost of Capital depends on three components.

1) Current and future exchange rates and their volatilities.

2) The amount of exposure to forex risk.

3) The duration of the exposure.

The first component is information available in the capital markets (Bloomberg, Reuters, etc.)

The second component is the order amount in foreign currency that our SAP system knows perfectly.

The third is the duration of the exhibition, from the payment date to the estimated payment date of the order, easily estimable at the time of confirming the order.

With this information, and the capabilities of SAP's Pricing Determination tools, it is not difficult to define a Condition Type in the Pricing Procedure that includes the Cost of Capital per Forex risk and with this, using the standard integration with Analytical Accounting, make visible this Cost of Capital. In this way we improve the decision-making capacity of managers to determine price policies, optimizing capital.

But at the time of confirming the order, we can only estimate the capital cost for forex risk, it is a standard cost that will manifest itself at the end of the business process. Visualizing this cost in each operation, analogously to what we did with the cost of sales more than 30 years ago, we provide the company's managers with tools to optimize this Cost of Capital.

The actual foreign exchange risk Capital Costs will depend on the efficiency with which the exchange risk coverage processes are executed by the managers of the Treasury department.

By integrating actual Forex Risk Capital Costs into Analytical Accounting, with the Sales Order-Invoice granularity offered by SAP, company executives will be able to measure the deviation between actual and standard Forex Risk Capital costs. And in this way make the necessary decisions to improve the efficiency of the integrated process.

This is just one of the many examples of the opportunities to Optimize Capital by integrating the value flows of the real economy and financial services.

There are alternatives to the above proposal which provide even better estimations of the Cost of Capital, including the Market and Credit risk analyzer of SAP Banking. I will give you more details in a future blog.

In general, the SAP Banking architecture provides a data and process model that shares the integration principles of SAP systems that have transformed the real economy in the last 30 years. Transferring these principles to Financial Services is the only effective way to Optimize Solvency and Liquidity.

We are working on presenting our proposals to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting me with a private message in linkedin.

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances.

Capital Scarcity and Capital Optimization with the Integrated Financial and Risk Architecture of SAP Banking.

 Dear,

The Financial System is in a process of Systemic Transformation, from a model based on volume to a model based on Capital Optimization.

We are entering into a new era of Capital Scarcity for two reasons.

1) Excess of debt (the biggest in the history of capitalism) overconsumes Capital.

2) Weakening of economic growth, as a consequence of natural resources scarcity and Energy Transition of the Economic System slows down Capital generation.

If Capital is overconsumed due to excess debt and it is not generated at the same rate due to weak economic growth, Capital becomes scarce. But Capital is the most important resource of the Financial System and if it has become scarce there’s no higher priority than optimizing it.

Consequently, the Financial System has to be transformed from a model based in volume to a model based in Capital Optimization.

If Capital is scarce, a fractional reserve financial system suffers from solvency stress. Consequently, regulators increase capital requirements, forcing financial institutions to reduce their leverage.

As free capital becomes scarcer, it also becomes more expensive, driving Systemic Transformation.

Financial Assets consume Capital in three main ways:

- Credit risk.

- Market risk.

- Operational risk.

The Basel III agreement establishes the main metric to measure the Capital consumed by exposure to Credit Risk of Financial Assets, and lays the foundations for calculating the Capital requirements of a Financial Institution.

The Basel III agreement distinguishes between the Expected Loss and the Unexpected Loss produced by an exposure to Credit Risk, the first must be covered by Provisions for Impairment and the second by Capital.

A valid capital optimization model should reduce the capital consumed in credit risk exposures while limiting the Expected Loss and the Unexpected Loss.

The internal rating-based approach, both basic and advanced, gives us the opportunity to build a comprehensive credit risk optimization system, such as the credit risk model used to determine the probability of default, the loss given default, and the exposure at default (in the case of the Advanced Approach) can be used, with some adjustments, as the basis for determining the Impairment Provisions.

In this model, the Provision for Impairment is compared with the Expected Loss; if the Expected Loss is greater than the provision, the excess Expected Loss is reduced from principal.

On the other hand, if the Expected Loss is less than the provision, banks may recognize the difference in Tier 2 capital up to a maximum of 0.6% of credit risk-weighted assets.

For more information, you can refer to http://www.bis.org/publ/bcbs128.pdf

This holistic management of capital requirements and impairment provisions requires integrated accounting and risk modeling, which is exactly the foundation of Integrated Financial and Risk Architecture of SAP Banking.

SAP Banking-Credit Risk Impairment Processes offers:

- Automatic determination of the percentage of Expected Loss from the Rating and the Default Bands of the Exposures.

- Dynamic classification of Financial Assets in the Bad or Good book by processing Impairment Events.

- Determination of the Causative Status of the Impaired and Current Assets in accordance with the requirements of IFRS9.

- Determination of Expected Loss, Provision, Penalty and Penalty Amounts, and reversal of Exposures, including Off-Balance Exposures using Credit Conversion Factors.

- Accounting for Impairment Provisions in the Bank Analyzer sub-book fully integrated with the Accounting Processes.

- Transfer of Provisions for impairment to the General Ledger and full reconciliation of Provisions for impairment between the Subledger and the General Ledger.

SAP Banking's Integrated Financial and Risk Architecture offers us a holistic view of the accounting position (value-earnings), liquidity and Capital consumption (risk) of a financial exposure. But even more, it speaks the same language as SAP S/4 HANA and 70% of the World GDP managed with SAP.

This capacity allows to express the processes of the real economy in accounting terms (that is already done by SAP S/4 HANA), liquidity (only partially solved by S/4 HANA) but also Capital consumption. And that's something that only the Integrated Financial and Risk Architecture offers, and it's critical in the capital-scarce environment that we're entering.

The last 12 years our team has worked in modeling all the economic events and business flows represented in the SAP systems of the Real Economy, in terms of Capital and Liquidity consumption and generation. With this information, our systems measure how to offer Financial Instruments for covering Capital and Liquidity gaps or investing Capital and Liquidity surpluses, optimizing the Capital and Liquidity consumption of the system.

We are working on presenting our system to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting me at

ferran.frances@capitency.com

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances.

www.capitency.com

Join the SAP Banking Group at: https://lnkd.in/g3KU6DN

Visit my SAP Banking Blog at: https://lnkd.in/gXpDEdr

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

#sapbanking #capitaloptimization

Management of Internal and External costs of Financial Transactions and Capital Optimization with SAP Banking.

 Dear,

The process of Optimizing Capital begins by determining the profitability of the processes, prioritizing those that offer a greater potential return on invested Capital, and once this objective has been achieved, measure the risk weighting of these exposures to prioritize those that offer a higher return weighted by Risk.

But to determine the profitability of a process, it is necessary to measure its contribution margin, or what is the same, inventory and measure the internal and external costs and income that impact that process.

I have dedicated more than 30 years of my life to SAP consulting and, when I participated in my first Bank Analyzer project in 2004, I already had many SAP Controlling projects behind me.

From the outset, I noticed how Bank Analyzer's Credit Risk and Financial Instrument Accounting modules integrated elegantly with SAP ECC's Financial Accounting and Management Accounting areas. For this reason, they would respond to the requirements of Margin Management, Profitability Analysis and Capital Optimization.

In my opinion, this potential has not been explained enough, so I will try to shed some light on the subject in this blog.

The analysis of the contribution margin requires the detail of the costs and revenues that impact a business process. And the first task is to identify the elements of cost and income that compose it.

The costs and revenues generated by a business process are never isolated, but represented by direct and indirect costs and revenues, they are distributed throughout the organization and impact, use, support, and generate synergies with other business processes.

The integrated architecture of SAP R3, SAP ECC and S4/HANA and the analysis capacity of Financial Accounting, Cost Object Accounting, Profit Center Accounting, Activity Based Costing, etc. has led to the ability to measure these interactions. For more than 30 years, this architecture has transformed the Information Systems of 70% of the World GDP to convert its analysis into a market standard.

On the other hand, Financial institutions, with very few exceptions, have not participated in this transformation. Its Information Systems continue to be supported by obsolete technologies, built on silo-style architectures that lack the integration of SAP systems, which makes it difficult, if not impossible, to carry out an adequate cost analysis and even more so, Capital Optimization.

Let's analyze the internal and external costs and income of a Financial Transaction.

External income seems obvious; interest and commissions charged to customers.

The external costs also seem obvious; Losses due to the risk that the client does not comply with its obligations (Credit Risk) or that market conditions impact the collection rights and have less value than expected (Market Risk).

SAP's Financial Products Subledger solution determines the value of the Financial Transaction, including external costs and revenues, based on the Discounted Cash Flow of the Financial Transaction and the Credit Risk and Market Risk adjustments. It is important to note that for the accounting of the Credit and Market Risk adjustments, the FPSL solution needs to be provided externally with parameters for calculating the cost of capital, such as Loss Given Default, and that these parameters can be determined with other areas of SAP Banking as Credit Risk Analyzer, or with limitations, Market Risk Analyzer. In a future blog we will analyze this integration in more detail.

Let us now look at internal costs and revenues.

Internal costs and revenues are also easy to identify; overhead costs of financial transactions, funding costs for Assets and funding income for Liabilities.

Overhead costs are quite intuitive so I will start with them. The Management Accounting modules of SAP ECC and S/4 HANA offer us very powerful tools for analyzing, allocating, distributing and reporting the overhead costs. Cost Center Accounting, Internal Orders, Projects System, Real Estate Management, Activity Based Costing, Profitability Analysis, etc are very well known and you can find much documentation with all the necessary details for understanding the solution capacity.

The difficulty is that they provide the overhead costs at the level of the cost center/profit center and we have to distribute them to the level of the Financial Transaction. The commonly accepted approach is considering them as Standard Costs and distributing them from the Cost Center/Profit Center level to the Financial Transaction level at Period End for reconciliation purposes.

The Business Content for Profitability and Efficiency Management of SAP Performance Management for Financial Services help us on this. The Business Content for Profitability and Efficiency Management of SAP Performance Management for Financial Services comes with powerful functions for distributing standard costs (Overhead, Capital reserves, etc.) to the level of the Financial Transaction.

The above is not fully true, as the SAP S/4HANA Universal Journal integration capabilities also give us the opportunity of tracking some of the overhead costs to the level of the Financial Transaction, particularly with the help of the Controlling Modules like Activity Based Costing but this requires a level of sophistication which is not easy to find. The same applies for Capital Reserves costs.

Finally let's look at the funding costs (and income).

We will start by identifying a Profit Center as the "Funding Center" responsible for holistically managing Assets and Liabilities.

When the entity makes an investment from a Branch or Department (Loan or any other Asset) it is consuming liquidity that must be compensated by Cash or Deposits (or other equivalent Liabilities). For this reason, the funding cost of the theoretical Liability provided by the Funding Center must be allocated as an internal cost, which should provide the liquidity consumed by this Asset.

To do this, we must identify the maturity of the Asset to internally generate a Liability that compensates for the liquidity consumed and whose funding cost will give us the internal funding cost of the Asset.

Similarly, if a Profit Center captures a deposit, it will be compensated by the Funding Center with the Funding Income according to the maturity of the deposit.

The SAP Performance Management for Financial Services Business Content for Profitability and Efficiency Management provides 3 methods for calculating Funding Costs; Macaulay Duration, Fisher-Weil Duration and Modified Duration. For those of you who are familiar with the old SAP Profit Analyzer solution from Bank Analyzer, these are basically the same methods, so it will be easy for you to adapt them to the functionalities of SAP Performance Management for Financial Services.

Actually Assets and Liability Management is a critical function that goes far beyond optimizing funding costs in the Capital scarcity environment we are entering and we will discuss it in more detail in a future blog.

The integrated capabilities of SAP Financial Products Subledger, S/4 HANA and SAP Performance Management for Financial Services facilitate detailed analysis of internal and external costs and revenues of Financial Transactions, including overhead costs, capital costs and funding costs. Accurately measuring these costs and revenues is the first step in Optimizing Capital, probably the most critical activity that organizations will face in the coming decades.

We are entering into a new era of Capital Scarcity for two reasons.

1) Excess of debt (the biggest in the history of capitalism) overconsumes Capital.

2) Weakening of economic growth, as a consequence of natural resources scarcity and Energy Transition of the Economic System slows down Capital generation.

If Capital is overconsumed due to excess debt and it is not generated at the same rate due to weak economic growth, Capital becomes scarce. But Capital is the most important resource of the Financial System and if it has become scarce there’s no higher priority than optimizing it.

Consequently, the Financial System has to be transformed from a model based in volume to a model based in Capital Optimization.

The last 12 years our team has worked in modeling all the economic events and business flows represented in the SAP systems of the Real Economy, in terms of Capital and Liquidity consumption and generation. With this information, our systems measure how to offer Financial Instruments for covering Capital and Liquidity gaps or investing Capital and Liquidity surpluses, optimizing the Capital and Liquidity consumption of the system.

We are working on presenting our system to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting me at

ferran.frances@capitency.com

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

SAP Revenue Accounting and Reporting vs Event Based Revenue Recognition.

 Dear,

One of the most important elements of Solvency Analysis is Revenue Recognition.

Revenue Recognition has experienced a profound change since the 2008 Financial Crisis, and in particular with the implementation of the IFRS 15 in January 2018.

SAP covered the IFRS 15 requirement with the release of the SAP Revenue Accounting and Reporting solution. You can see a description of it in this blog.

https://www.linkedin.com/pulse/ifrs-9-15-business-case-sap-revenue-accounting-bank-analyzer-frances

From the architecture perspective, the Revenue Accounting and Reporting solution is built as a subledger for the IFRS 15 adjustments. It fulfills the IFRS 15 requirements but presents some opportunities for improvement.

- In case there’s an adjusted relevant item in the SD-Sales Order, the Revenue Accounting and Reporting engine creates a “replication” of the item with the format of a Revenue Accounting and Reporting Contract. The system will use this Revenue Accounting Contract for managing the IFRS 15 Performance Obligations and the IFRS 15 accounting adjustments. To some extent this Revenue Accounting and Reporting contract breaks the SAP Single Source of Truth value proposition.

- The adjustment accounting entries are generated in the Revenue Accounting and Reporting system and posted from there to the General Ledger. But the nominal accounting postings are generated by the standard SAP-SD functionality and posted from there to the General Ledger. The accounting result is correct but the tracking of the postings is split between the SD subledger and the Revenue Accounting Reporting subledger. Consistency is guaranteed because the system keeps the link between the SD-Document and the Revenue Accounting and Reporting Contract but the Revenue Accounting and Reporting documents and postings are not maintained in the SAP SD business flow. The nominal and the adjustment postings are also split in different General Ledger documents.

S/4HANA Accounting is Event-Based, meaning that the accounting postings are available on real time. On the other hand Revenue Accounting and Reporting is periodic, meaning that the IFRS 15 revenue recognition process happens at the end of the period. Having an accounting component available at the end of the period limits the S/4HANA advantages in real time financial analysis and simplification of end-of-period activities.

SAP has overcome these limitations with the release of the new Event Based Revenue Recognition functionalities of S/4HANA Accounting.

Event Based Revenue Recognition follows a different approach than the Revenue Accounting and Reporting system. It has not been built as a separated subledger but as an extension of the functionalities of S/4HANA Accounting.

Integration and reconciliation between the Financial and Management Accounting areas of the company is one of the major achievements of the SAP S/4HANA Finance Architecture. The holistic representation of the Universal Journal as a Central repository of Management and Financial Accounting provides accurate and on-time information of the Legal and Internal Financial Statements, and reducing and accelerating period end-closing activities.

You are also familiar with the multiple advantages of the Universal Journal for facilitating consolidation and planification, including heterogeneous environments with the support of the Central Finance functionalities.

The Universal Journal Architecture of SAP S/4HANA has many more advantages, but there are many other sources where you can find details of these advantages, so I will not expand on them.

The important message is that the Event Based Revenue Recognition of SAP S/4HANA accounting has been built following the principles of the Universal Journal Architecture and it comes with all its advantages.

From a more technical perspective, Event Based Revenue Recognition takes advantage of the Result Analysis Concept which was developed more than 30 years ago, as a central component for the valuation of the Work in Process and other Management Accounting requirements.

This is very logical as the valuation of the Work in Process has been an important element of a company Revenue Recognition process, including concepts like the Percentage of Completion of Performance Obligations, although these terms have taken more relevance since the issue of IFRS 15 regulation.

Event Based Revenue Recognition covers all the IFRS 15 requirements for 4 scenarios; Event-Based Revenue Recognition for Projects, Event-Based Revenue Recognition for Sales Orders, Event-Based Revenue Recognition for Service Documents and Event-Based Revenue Recognition for Provider Contracts. At the time this blog has been written the Event-Based Revenue Recognition for Provider Contracts scenario is only available in the on Cloud release of S/4 HANA but is expected to be available soon in the On Premise release.

The real time and accurate capabilities of Event Based Revenue Recognition, combined with the capabilities of the SAP S/4 HANA Universal Journal provides the strongest backbone for the representation of companies financial health, supporting the continuous improvement of business processes efficiency. Integrating these processes in the allocation of Capital and Liquidity provides the best architecture for Capital and Liquidity Optimization.

We are entering into a new era of Capital Scarcity for two reasons.

1) Excess of debt (the biggest in the history of capitalism) overconsumes Capital.

2) Weakening of economic growth, as a consequence of natural resources scarcity and Energy Transition of the Economic System slows down Capital generation.

If Capital is overconsumed due to excess debt and it is not generated at the same rate due to weak economic growth, Capital becomes scarce. But Capital is the most important resource of the Financial System and if it has become scarce there’s no higher priority than optimizing it.

Consequently, the Financial System has to be transformed from a model based in volume to a model based in Capital Optimization.

The last 12 years our team has worked in modeling all the economic events and business flows represented in the SAP systems of the Real Economy, in terms of Capital and Liquidity consumption and generation. With this information, our systems measure how to offer Financial Instruments for covering Capital and Liquidity gaps or investing Capital and Liquidity surpluses, optimizing the Capital and Liquidity consumption of the system.

We are working on presenting our system to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting me at

ferran.frances@capitency.com

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com