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

Silicon Valley Bank is just the beginning and Capital Optimization with SAP Banking.

Dear readers,

As you know, the Silicon Valley Bank bankruptcy last Friday has triggered tension in the financial system, bringing back memories of the worst moments of the 2008 financial crisis.

https://www.cnbc.com/2023/03/11/silicon-valley-bank-failure-has-investors-calling-for-government-aid.html

Analysis of its bankruptcy tells us that the bank's problem was its exposure to bonds acquired in previous years, with a lower interest rate because interest rates were lower then. As interest rates rise, new bonds issued have higher yields and old ones are less attractive and lose value. By increasing the differential between the new and old bonds, the problem is accentuated and the losses generate tension, depositors withdraw their funds from the bank and bankruptcy arrives.

This description, being true, is incomplete and could lead us to think that the problem is localized when in fact it is systemic.

The financial system is not a static entity that acquires assets and holds them until maturity, like a calm pool of dammed water. On the contrary, it is a continuous flow like a torrent, which is continuously capturing and allocating capital and liquidity.

The speed with which capital flows is the interest rate, when the interest rate is low or negative, capital flows very quickly, but when the interest rate is high the torrent dries up.

From this perspective, the solution should be easy, if central banks reduce the interest rates the problem would be solved. Unfortunately the reality is more complex.

The interest rate is the price of capital, and as Adam Smith taught us, prices are constructed by the intersection of the supply and demand curves. If, as John Forbes Nash demonstrated, the supply and demand curves are also affected by the different bargaining power of economic agents influencing the price determination.

Thus, when the capital in circulation is abundant, its price falls, and when it is scarce, its price rises, and there is nothing that can prevent it. Economic agents, including Central Banks, can delay or speed up the process but not prevent it. 

And the effects of capital scarcity are serious because Capital is the most important resource of our social-economic system, this is why it is called capitalism.

Curiously, despite the fact that the word capitalism haunts us all day, it would be difficult for all of us to define capital (I kindly suggest that you try to do it). For the moment we will approach the concept of capital remembering that it is generated with economic growth and is consumed with risky assets (mainly debt).

Economic growth presents a causal relationship with the availability of energy. The improvement in living conditions that the industrial revolution has brought comes from the greater availability of energy in the history of mankind. To give us an idea, in a first world developed country, energy consumption per inhabitant provides work equivalent to that produced by 100 human slaves in Ancient Rome. No Roman Patrician had so many slaves.

This huge availability of energy has represented the greatest economic growth, capital generation and improvement of living conditions in the history of mankind. 

In the 1970s, with the first Oil Crisis, the growth in energy availability slowed, the Oil market became cartelized (OPEC), and economic growth slowed, and with it the generation of capital. The capital scarcity brought the increase in interest rates during Paul Volcker's term as Secretary of the Treasury. Inflation is not the problem, it is just the symptom, like temperature in an infection.

Access to the sources of economic growth can be obtained by paying in cash or with debt, and as the sources of growth were drying up, the system began to push them with debt. From this point of view, debt is the current consumption of future growth (capital consumption)

We have reached the moment in which the scarcity of energy resources (Peak Oil) is weakening growth and the generation of capital. But at the same time, the system supports the largest debt in history by overconsuming capital.

If capital is consumed by excess debt and is not regenerated at the same rate because growth is weak, capital becomes scarce. And don't forget that capital is the most important resource of the social-economic system in which we live.

We can look for somebody to blame but we will not solve the problem. Solving the problem means focusing on optimizing that critical resource that has become scarce. In other words, from now on, the highest priority of the economic system will be Capital Optimization.

The Second Law of Thermodynamics teaches us that to optimize a resource in a system it is necessary to reduce its entropy and that entropy is reduced with information.

And information theory teaches us that the exchange of information requires a common language between sender and receiver.

The highest level of information exchange to reduce entropy is process integration, when the sender and receiver collaborate on the process and share the information needed to plan and execute it efficiently.

SAP has been since its foundation the leader in process integration. First integrating the processes of the departments of a company, then the information of the companies within a group and finally integrating processes between groups of companies until reaching 70% of the World’s GDP.

Financial services have remained isolated from this integration process, very few banks have transformed their processes to SAP and none have integrated their processes with those of their clients.

Optimizing Capital requires integrating the business processes of the real economy with the processes of the Financial System, and if 70% of the real economy is in SAP, the integration of the real economy with the financial economy must be done with SAP Banking.

Our team has dedicated the last 14 years to this objective, until developing the Technology that integrates the business processes of the real economy (Sales, Production, Purchasing, etc.) managed on SAP Systems of Chemical, Pharmaceutical, Telco companies, etc. (70% of World GDP) in terms of generation and consumption of Capital and Liquidity.

With this information and supported by SAP Banking technology, the system proposes financial instruments that cover the capital and liquidity deficits of some agents with the capital and liquidity surpluses of others, adjusting the spread and optimizing the consumption of capital of the participants in the integrated collaboration environment.

We are working on presenting our system to the market and looking for business partners and investors.

If you are interested, do not hesitate to contact me at ferran.frances@capitency.com

I look forward to reading your comments.

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

Capital Optimization and Collateral Mobilization with SAP Banking

 Dear colleagues,

The energy crisis that is manifested in the increase in prices is weakening growth and the generation of capital. Additionally, excess debt, the largest in history, is overconsuming capital.

If capital is overconsumed and not regenerated at the same rate due to weak growth, capital becomes scarce. And capital is the most important resource of the Financial System.

As capital becomes scarce, the efficient management of all forms of capital is becoming increasingly important.

A valuable form of capital is collateral; collateralization of exposures is one of the main risk mitigation techniques as it reduces capital consumption and provisions amounts for counterparty and market risk exposures.

But collateral management is an activity poorly executed by the majority of banks, which represents an opportunity to generate a competitive advantage for those who improve the management of their collaterals.

There are multiple reasons why collateral management is inefficient. The most visible one is that collateralization agreements are potential assets of the bank that only become effective in the case of default of the counterparty and the implementation of the guarantees. In the meantime, it is only shown in the Financial Statements by reducing the amount of provisions, and in some cases, although rare, as off-balance sheet entries.

As the vast majority of the bank's Information Systems position the General Ledger at the main source of their analytical information. And as I said before, the Financial Statements do not allow a precise representation of the collateralization agreements, all collateral management activities end up being improvable.

The SAP Integrated Financial and Risk Architecture is a much more robust architecture for representing a bank's rights, obligations, assets, liabilities, and solvency statements, including collateralization agreements. But describing the SAP Integrated Financial and Risk Architecture is not the objective of this article. If you are interested, you can find some references to it in previous articles of my blog and it is a topic that I will return to in the future.

Any inventory of best practices for efficient collateral management and capital optimization should include collateral mobilization. And what is collateral mobilization?

Collateral mobilization is a two-step activity.

1) Identification of the eligible collateral.

2) Efficient allocation of collateral to exposures.

Identification of eligible collateral requires deep integration of the bank's collateral management system and the customer information system. The technical attributes of the assets that can be used in collateralization agreements will determine their fair value, foreseeable evolution, potential haircuts and behavior in stressed scenarios.

Once identified the eligible collateral with an accurate description of its main attributes, the second step of collateral mobilization describes how to efficiently allocate the collateral portions to the exposures.

Collateralization of exposures reduces capital consumption up to a maximum level at which the exposure is overcollateralized and allocating more portions of collateral does not produce a further reduction in capital consumed.

This collateral surplus could be utilized more efficiently by allocating it to other undercollateralized exposures, reducing the bank's total capital consumption. This is a functionality that, if properly implemented, is provided by the SAP Bank Analyzer Credit Risk System. It is also known as dynamic collateral management, and I wrote about it in previous articles that you also can find in my blog.

As capital requirements become increasingly stringent and growth and income potential remain limited, return on assets weighted by capital consumption becomes very challenging. This trend is already becoming visible and will continue to grow as the systemic crisis evolves.

In this challenging environment of capital scarcity, bankers will be incentivized to manage efficiently all forms of capital, including collateral. Collateral mobilization reduces provisions and capital consumption, and also releases bank’s resources for further investment, improving return of assets weighted by capital consumption. A very good reason to be in the strategic agenda of the bank’s executives. 

We are at the last steps of a transition period from a model of strong growth and limited debt to a model of limited growth and excess of debt. Massive injections of liquidity following 2008 bailouts and unconventional monetary policies by central banks have helped maintain some level of stability in capital markets.

Unfortunately these actions have just delayed the effects of the capital crisis paying the price of even higher levels of debt over consuming capital and natural resources scarcity weakening the economic growth and capital generation.

As financial stress grows up, the ability to efficiently manage capital, including collateral, is becoming increasingly important. SAP Banking value proposition lies in its ability to certify and improve the eligibility of a bank's collateral and the efficient distribution of collateral portions to exposures providing the necessary process and technology for collateral mobilization.

Finally, SAP Banking competitive advantage comes not only from its ability to meet regulatory reporting requirements, but also from its disclosure capabilities. These capabilities will be invaluable in the new environment of capital scarcity that will emerge from this systemic crisis. 

You are not as solvent as you are but also as your counterparties recognize you are.

This is just an example of the competitive advantage of SAP Banking for the management of collaterals and a brief description of its potentialities.

These potentialities are the guidelines followed by our team in the construction of our Capital Optimization system, built on top of the SAP Integrated Financial and Risk Architecture.

Our Capital Optimization system “speaks” with the business processes of our clients' SAP Systems (70% of the world’s GDP) translating them in terms of Capital and Liquidity generation and consumption. With this information the Capital Optimization system measures the deficits and surpluses of capital and liquidity of the business processes and proposes financial instruments to offset these deficits and surpluses, optimizing the consumption of capital and liquidity 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 to contact me at ferran.frances@capitency.com

I look forward to reading your comments.

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

Capital Optimization with SAP Banking by Integrating Logistics and Foreign Risk Hedging processes.

Dear colleagues,

As we have commented in previous articles, we are entering a phase of systemic change, characterized by the scarcity of capital.

On the one hand, the economic system bears the largest debt in history. Debt consumes capital and excess debt over-consumes capital

On the other hand, the scarcity of resources (fundamentally energy but not only energy) is weakening growth and slowing down the generation of capital.

If capital is overconsumed by excess debt and not regenerated at the same rate by weak growth, capital becomes scarce. And capital is the most important resource of the financial system. It is not by chance that the current socio-economic system is called capitalism.

When the most critical resource becomes scarce, the priority is to optimize it. Thus, if capital is the most critical resource of the economic system and it has become scarce, the priority that drives the systemic transformation that we are experiencing is Capital Optimization.

We already observed symptoms of the overconsumption of capital and its future scarcity during the Financial Crisis of 2008. But for better or for worse, the ultra-expansionary monetary policies of central banks in the last decade have flattened the yield curve, delaying the problem. But in doing so, they have stimulated the consumption of capital, exacerbating the problem.

The disruptions to supply chains that followed the COVID-19 pandemic lockdowns and the military standoff in Ukraine have triggered volatility in energy prices, which have been transmitted throughout the economy, as an indicator of the capital shortage of the system.

As an example of this volatility, you can check the freight price in the Freightos Baltic Index (FBX) - Global Container Freight Index between September 2020 and December 2022.

http://fbx.freightos.com/

Optimizing a critical resource in a system requires synchronizing its constituent elements by exchanging information between them. In physical terms, reducing the entropy of the system. This is a well-known principle in Physics, from classical thermodynamics to the most recent proposals in quantum information theory.

But since I imagine that most of the readers are not familiar with the Laws of Physics, I will try to explain it with an example of a process managed with an SAP system.

Suppose that a US company is selling personal computers to a French company and the order is valued in EUR.

As we know, the USA company will be subject to an exchange rate risk due to the volatility of the EUR and the USD.

But let's look at the process in more detail; The exposure to exchange rate risk will begin at the time of order confirmation (t=0) and it will end at the time of payment (t=Tpayment).

If at that time the company signed a purchase-sale contract with a broker, through which it sells the EUR that it will receive from its French client at a fixed exchange rate, receiving USD, with the date of purchase of the currency t=Tpayment (date of payment of the computers order), the company would have hedged against the risk of volatility between the exchange rate of the EUR and the USD.

Contractually the Payment Date (t=Tpayment) is always referenced to the Invoice Date (Tpayment = Invoice Date + Payment Term) and the Invoice Date is referenced by contract to the Delivery Date (Delivery Date +/- Billing Calendars, etc.)

The difficulty for the selling company is that it cannot know the exact Delivery Date because it is subject to logistical constraints and transportation capacities and disruptions. And without a deterministic Delivery date, the selling company does not have a deterministic Payment Date of the French customer.

In summary, the problem of optimizing capital in exchange rate risk exposures and hedges is limited to accurately estimating the Delivery Date of the order. As you can see, and contrary to what the initial perception tells us, this is not a banking or financial problem, it is a fundamentally logistical problem.

SAP Sales and Distribution consultants know that system integration provides us with powerful tools to estimate the Delivery Date.

The first of these is the Available to Promise availability check. If the vendor has this functionality configured, the system will validate the company's ability to meet the Requested Delivery Date based on confirmed stock entries and exits, safety stock, etc.

The Delivery Date also depends on the transportation time and this can be estimated by the route that links the shipping point with the ship-to party. The handling time which can be estimated with the parameters of the shipping point, etc.

As we can see, the more logistical constraints our SAP shipping system considers, the more precise the estimate of the Delivery Date will be and, therefore, the more precise the estimate of the exchange rate risk exposure will be and consequently the more precise the hedging will be. This synchronization between the logistic and financial processes reduces the entropy of the system and makes it possible to optimize capital.

As we know, the logistics reality is even more complex. From the moment of confirming the order until the execution of the expedition, we will find that other clients will cancel orders with the same materials, production or supply will be delayed or accelerated on the planned dates, etc. To manage these disturbances, we will execute the back-order processes that will adapt to the new supply and demand situation, providing new expected Delivery Dates, with new order confirmations that will be converted into new expected Payment Dates and reestimation of forex risk exposures and risk hedging instruments.

Once again, it will be the management of logistical constraints and the precise estimation of the Delivery Date that will allow us to optimize capital effectively.

And although it is not my intention to make this blog much longer, I am going to mention that logistics have come a long way in the last 30 years. For example, with S4 HANA we have the New Product allocation (PAL) features in Advanced ATP, the integration of Product Allocations with the consensus forecast in IBP-Demand Planning, the management of supply restrictions, supply, transportation in Integrated Business Planning Time Series and Order Based, Transportation Planning with SAP Transportation Management, geolocation and many other features that offer us more precise estimates of the Delivery Date, and therefore more accurate estimations of the Payment Date.

By integrating the logistic processes with the hedging processes of exchange rate risk exposures, we are synchronizing the logistic and financial processes, reducing the entropy of the system and the consumption of capital.

And as I said at the beginning, in a scenario of scarcity of capital, the priority is to optimize it and that is the structural environment in which the world economy finds itself.

This article only showed one example, selected for being more intuitive, but the principle of synchronizing the financial and logistics arm of the value chain for reducing the entropy of the system is also the basis for optimizing capital in more complex capital and liquidity allocation processes.

These are the guidelines followed by our team in the construction of our Capital Optimization system, built on top of the SAP Integrated Financial and Risk Architecture.

Our Capital Optimization system “speaks” with the business processes of our clients' SAP Systems (70% of the world’s GDP) translating them in terms of Capital and Liquidity generation and consumption. With this information the Capital Optimization system measures the deficits and surpluses of capital and liquidity of the business processes and proposes financial instruments to offset these deficits and surpluses, optimizing the consumption of capital and liquidity 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 to contact me at ferran.frances@capitency.com

I look forward to reading your comments.

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

#saplogistics #saps4hana #sapbanking #forex #capitaloptimization