Dodd-Frank vs. EMIR and Bank Analyzer.

Dear,

Some months ago, we were required to prepare an analysis of the implications of using Bank Analyzer as a central repository, for fulfilling the reporting requirements of the European Market and Infrastructure Regulation and Dodd-Frank Act for a Bank subject to both regulations.

Dodd-Frank in the US and EMIR in Europe are the result of the G20 summit mandate on September 2009, requesting the Over the Counter Derivatives Market to be regulated, in order of enhancing transparency and reducing systemic risk in the Financial System.

They have similarities; both EMIR and Dodd-Frank include clearing transaction, and risk mitigation provisions reporting requirements, that apply to financial and non-financial firms trading derivative contracts.

But EMIR and Dodd-Frank have also some differences that must be considered when it comes to evaluate the SAP Bank Analyzer capabilities to help a Bank to be compliant with them.

The first difference is in the scope; EMIR only applies to derivatives not cleared in Central Counterparty Clearing Houses, while Dodd-Frank is also applicable to swaps cleared in designated clearing organizations.

Dodd-Frank and EMIR definitions of Swaps and Derivatives are not fully coincident; consequently the reporting requirements for them are different under Dodd-Frank and EMIR.

Intra-group transactions are in scope for Dodd-Frank while EMIR establishes some exceptions to the reporting of transactions with affiliates.

EMIR is only applicable to transactions with counterparties legally established in the EU while Dodd-Frank has broader cross-border application.

The second important difference is reconciliation; US Commodity Futures Trading Commission requires exchange of valuation in all cases while EMIR establishes some exceptions to it.

Other important differences are the requirements for documenting the relationship with the client which are much more detailed for the US-Commodity Futures Trading Commission than for the European Union regulation.

Finally the US-Commodity Futures Trading Commission includes specific and detailed record keeping requirements while the European regulation does not.

From a technical perspective, the multilayer architecture of Bank Analyzer (Source Data Layer, Process and Methods Layer, Results Data Layer and Analytical Layer) offers us strong functionalities for covering the reporting requirements of multiple regulations as in this case.

As in many other consultancy analyses, there is more than one approach for looking at the problem, in this particular case our proposal was the following.

Regulation is dynamic and it can change, particularly in very new regulation like Dodd-Frank and EMIR. Consequently selection functions of the transactions in scope for EMIR or Dodd-Frank shouldn’t be contained in the SDL. The SDL is a representation of the facts represented in the Transactional System, while regulations (EMIR, Dodd-Frank or others) are just an interpretation of the facts.

Consequently our advice was to build the selection function as part of a PML process that could be run separately for preparing the EMIR or Dodd-frank regulatory requirements according to the particular selection criteria (index function) of the contracts in scope for them.

Additionally, this approach gives us the flexibility of enhancing the transaction data according to the different requirements of EMIR and Dodd-Frank Act.

Finally the proposal included building two separated Results Data Areas on the Results Data Layer for storing the data before is extracted to SAP Business Intelligence; improving the performance of the system and containing the full set of data required by every regulation.

Finally the data is extracted to SAP Netweaver-Business Intelligence. Finally, it can be exported to external systems using the functionalities of the Open Hub Service.

Looking forward to read your opinions.

K. Regards.
Ferran.

Securitizating Countries - SAP Real Estate and Bank Analyzer.

Dear,

As you could read here, the world is facing an unsustainable, un-payable debt.

http://www.economist.com/content/global_debt_clock

This debt is spread as Financial Assets, amongst the balance sheets of corporations, investment funds, etc

In my opinion, the Fair Value of these assets is far below their current book value, and the recognition of their real value will be a huge bubble burst that will drag the value of many other assets down.

On the other hand, crisis are also opportunities, and I’d like to talk today about an economic activity which is going to experience a significant growth with the Financial Crisis, and it’s also an opportunity for SAP Banking.

I mentioned in a previous post that securitization activities are going to grow, but it’s going to be different than the securitization business we saw before the starting of the Financial Crisis.

At the time, we were in a booming economy, and securitization was mainly a commercial driven activity. For instance, remember the “toxic” synthetic securitizations, purely financial bets, not supported by any real economic asset.

http://sapbank.blogspot.com/2013/06/toxic-assets-strike-back.html

But, let’s come back to the problem of the global debt. Paying the debt will require making this very toxic asset attractive to investors (of course after suffering a necessary hair-cut), and securitization is going to play a very important role on it.

This is going to be a very different securitization, not commercially, but capital management driven, with new requirements of control and disclosure. In the new model Capital will be recognized as scarce; and managing it efficiently, the priority.

The proposal of securitizating assets is not new for poor (capital scarce) economies, look what the International Monetary Fund said about it 12 years ago.

http://www.imf.org/external/pubs/ft/fandd/2001/03/ketkar.htm

And look what the International Monetary Fund, European Central Band and European Commission (main lenders of Greece), are requesting to the extremely indebted country, in exchange of a new package of financial assistance.

http://www.reuters.com/article/2013/08/29/us-eurozone-greece-privatisation-idUSBRE97S0EJ20130829

Please, read carefully the articles above, you will find the key words there; Risk Mitigation, Management, Control...

Nothing to do with the old securitization model, represented by the example of the subprime CDOs., massively traded with no control on the risk or the fair value of their underline, in liquidity flooded markets.

Once again, the Financial Crisis is driven the systemic change, from a business model based in volume to a business model based in efficient capital management.

Greece is a very good example, it help us to understand the new paradigm. Detailed control of the assets performance, in this scenario Information management and control is the key.

What the troika is proposing is the securitization of Greek Real Estate assets under the control of an external institution (controlled by the lenders). 

Those lenders are also going to face financial difficulties after the crash, and they will need investors allocating capital; and in a scenario of scarcity, investors will require guarantees of the efficient management of the acquired assets.

We discussed here some months ago how to manage efficiently this process with SAP Banking components. (ECC-GL Real Estate, Treasury and Risk and Bank Analyzer) 

http://sapbank.blogspot.com/2013/08/real-estate-rentals-securitization-and.html

SAP has proved for decades to be the leader in detailed control and performance measurement of assets in many industries. Now it’s the time of leveraging those functionalities to the new requirements of the Financial System.

I have no doubt that it has the capacity of making it happen.

Looking forward to read your opinions.

K. Regards,

Ferran. 

European Market Infrastructure Regulation, Collateral Highway and Bank Analyzer.

Dear,

As you know, we’re in the middle of a transition period of the Financial System, from a business model based in Volume to a business model based in Efficient Capital Management.

Some weeks ago, we introduced the concept of Collateral mobilization, and today we’re going to elaborate it a bit more.

http://sapbank.blogspot.com/2013/11/collateral-mobilisation-and-bank.html

As Capital is scarce the main priority is managing it efficiently, wasting capital is not acceptable and the regulation will drive the change by increasing the Banks’ Capital Requirements.

One of the most important sources of regulation towards the new model are; the Market Infrastructure Regulation in Europe and the Dodd–Frank Wall Street Reform and Consumer Protection Act in the US.

http://www.esma.europa.eu/page/European-Market-Infrastructure-Regulation-EMIR

http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf

They have some differences but are coincident in the general objectives.

- Reporting obligation for OTC derivatives

- Clearing obligation for eligible OTC derivatives

- Measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives

- Common rules for central counterparties (CCPs) and for trade repositories

- Rules on the establishment of interoperability between CCPs

And the consequence in both of them is the same, making collateral squeeze visible.

http://video.ft.com/2674562697001/Collateral-squeeze-worries-traders/Markets

As collateral becomes scarce, financial agents demand new sources of this critical resource.

The market has seen the opportunity, and new services oriented to cover the collateral shortage and improve the inefficiencies in collateral management are being developed.

A very interesting example is the Collateral Highway, a joint initiative by Euroclear and The Depository Trust & Clearing Corporation (DTCC).

https://www.euroclear.com/en/services/managing-collateral/collhighwayportal.html 

The Collateral Highway is an electronic marketplace which connects financial agents providing lending and borrowing collateral functionalities. 

This way the market can unlock collateral pools that otherwise would be infra-utilized, increasing liquidity in the financial system and mitigating the effects of the collateral scarcity.

But as in any other marketplace, offering eligible collateral is critical for successful trade, and there’s no better way of making financial assets eligible than disclosing its value, and we don’t have a better tool to disclose the value of financial instruments than Bank Analyzer.

But successful collateral mobilization confronts Banks with other challenges.

Communication is key, SWIFT is a real time network, but the communication flow can be very complex, involving the investor, the global custodian, the central securities depository , the International central securities depository and a third party.

Remember that Banking systems have been built in silo-style architectures with point to point connections in multiple flows like the example above, and even including manual steps. Efficient capital management is also about re-engineering and reducing complexity in the communication flow; we need a single, homogeneous and centralized repository of the Bank’s assets, another core value of SAP Bank Analyzer.

This central vision of the Bank’s collaterals brings the foundation of the Enterprise Collateral Management, another critical activity in Collateral Optimization.

There’re other techniques, like securitization, which are going to play a very important role in the new model for increasing capital mobilization; we’ll talk about them in a future post.

Looking forward to read your opinions.

K. Regards,

Ferran.

Understanding the Bank Analyzer - Results Data Layer. Chapter II.

Dear,
Last week, we look at the open architecture of the Results Data Layer, in terms of the opportunity it represents for integrating non-Bank Analyzer data which is required for Accounting or Capital Requirements purposes.

On the current stage of the transitionary period, this is a very important feature. There’re many reasons (economic, strategic, technical ...) why we’re having heterogeneous landscapes in the Banking Systems, with SAP and non-SAP components coexisting in the same technological infrastructure. On this environment, open architectures facilitating the integration between former silo-style components are a necessary requirement.

But on the other hand, and in the middle of the systemic change, the open architecture of the Bank Analyzer-RDL is an opportunity for implementing new integrated scenarios that were not feasible some years ago.

This year I've been collaborating part-time in an advisory role for a European client who implemented AFI some years ago and now it’s considering a Profit Analyzer implementation.

In this particular case, we analyzed the possibilities of calculating the process costs of impaired loans.
Simplifying; in addition to the process costs of a performing loan, impaired loans also generate additional process costs for the bank (dunning and collection costs, collateral liquidation costs, etc.).

The probability of Loan becoming impaired is represented by the probability of default of the counterpart. This means that the standard process costs are related to the probability of default of the counterpart, the higher the probability of default the higher the potential process costs.

Collecting the historical real process costs in the Controlling modules (Activity Based Costing, Cost Center Accounting, Profitability Analysis, etc.) is well known functionality of SAP-ECC.

The Bank has a very detailed analysis of its process costs, including Activity Based Costing models, supported with data collected by their CRM System and leveraged to the SAP-ECC Controlling Components. Amongst other parameters, the Bank is capable of capturing most of the process costs by client type.

By including the Rating of the Counterpart as a reporting dimension in Profitability Analysis we will get an accurate tracking of the real costs of the process costs according the rating of the counterparts, including dunning costs, collection costs, etc.

In the proposed model we would transfer the historical real costs to SAP Business Planning and Consolidation. From there we will build planning models for estimating the evolution of future process costs by counterparty ratings.

Finally, the calculated plan costs and the estimated standard costs will be transferred to the RDL for two purposes.

- Making the basis of the standard costs, escalated by counterpart rating, in the AFI sub-ledger.

- Tracking the dispersion between estimated planned process-costs, estimated standard costs and real costs, and consequently the accuracy of the standard costs.

This is just an example of the integration capabilities of the SAP Banking business suite, I’m sure that as the market comes with new requests we’ll find new opportunities to show them.

K. Regards,
Ferran.

Understanding the Bank Analyzer - Results Data Layer. Chapter I.

Dear,

One of the last components in joining the Layers architecture of Bank Analyzer has been the Results Data Layer (RDL), which is available since the Version 5.

When 7 years ago I was working in my first Bank Analyzer project, the system didn't have a Results Data Layer. The functions of storing results data coming from the Process and Methods Layer, was performed by the Results Data Base, which was an evolution of the component with the same name in SEM Banking.

At the time, we heard that with the new Bank Analyzer 5.0, the RDB was going to be replaced by a new component called RDL, whose main difference with the RDB is that the RDL supports the storage of non-Bank Analyzer originated data.

My first Bank Analyzer project was a Credit Risk/Basel II implementation in Bank Analyzer 4.2. When the project team heard about the RDL we saw it could be very useful for storing risk parameters (Loss Given Default, Exposure at Default, etc.) of risk exposures not-included in the scope of the project, and whose risk parameters, were not calculated by Bank Analyzer.

As the RDL was not available at the time we follow the work around of storing the data directly in the Operational Data Stores and Infocubes for the Basel II regulatory reporting of BIW; obviously with a much weaker level of integration.

The main priority for the Bank’s executives at the time was to get the approval by the audit authorities of the central bank. For the audit authorities there was no much difference in using the RDL or not, as they did not have the capacity of checking the source of the data provided in the reporting results.

Integrated systems, capable of offering reconciling functionalities between the Transactional and Analytical Banking systems, were not available at the time, and the capacity of the auditors for requesting these reconcilable reports was very limited.

This is one of the reasons while the Financial Situation is what it is, reconciliation capabilities between Analytical and Transactional Banking information are “control oriented” functionalities. We come from a Banking system driven by volume, in which capital consumption control was not the priority, with the catastrophic consequences we witnessed in 2008 and we’re still suffering 5 years later.

By the way, if we want make SAP Banking a successful business, we should educate the audit authorities about its reconciliation and reporting capabilities.

Remember; solvency is not only what it is, it is also what it looks like.

http://sapbank.blogspot.com.es/2010/07/stress-testing-what-solvency-is-and.html

After this first Bank Analyzer project I always have had the Results Data Layer available for the integration of accounting or credit risk data that for some reasons (project scope, technical limitations, etc.) could not be managed by the standard Bank Analyzer flow (Source Data Layer -> Process and Methods Layer -> Results Data Layer).

A typical example is the uploading Provision postings for Impaired Loans in the Bank Analyzer RDL. As previous versions of Bank Analyzer couldn't calculate provisions for impaired loans, we would calculate those provisions in the Reserves for Bad Debts module of IS-Banking, and upload the accounting postings of those provisions directly in the RDL. Consequently, the Bank enjoyed in the AFI sub-ledger the full vision of the Loans valuation, including impairment provisions.

Another example is the calculation of Hedge Accounting adjustments; valuation of Derivatives products and Hedge Accounting adjustments are initially calculated outside of Bank Analyzer and uploaded to the RDL; from there they enjoy the standard integration with the Financial Statements and the General Ledger.

But the open architecture of the RDL opens the gate for more challenging integration scenarios; we’ll talk about some of them next week.

K. Regards,
Ferran.

Collateral Mobilisation and Bank Analyzer Value Proposition.

Dear,

In a new era of Capital Scarcity, efficient management of any form of Capital is the most critical activity.

Collateral is a form of Capital, over-collateralized assets means having non-allocated capital. The new model comes with very limited growth potential and bringing any contribution to GDP growth, reducing the capital consumption will be the priority.

Bankers will be incentived to manage efficiently any form of Capital, including collateral, by the constantly higher capital requirements and limited growth and revenues potential.

We already can see this tendency, but it will grow as we cross the systemic crisis towards the new model.

A very interesting example of this tendency is a new discipline called Collateral Mobilisation

http://www.youtube.com/watch?v=mVcgRLqBOsM

We’ll look in detail at the Collateral Mobilization and its characteristics in a future post, but today, I’d like to focus in the important role SAP Bank Analyzer must play in this critical activity of Collateral Management efficiency.

As you probably remember we’ve commented in the past that we’re in a transitionary period of the Systemic Crisis.

Since Hank Paulson’s rescue package of 2008, followed by the unconventional monetary policies of the Central Banks, Financial markets have been flooded with Massive Liquidity Injections.

http://en.wikipedia.org/wiki/Emergency_Economic_Stabilization_Act_of_2008

http://en.wikipedia.org/wiki/Quantitative_easing

Apparently, those liquidity injections have prevented the world to fall in a Depression, maintaining some level of stability in the Capital Markets.

But some authorized voices are warning that those measures have inflated another huge bubble whose burst can bring catastrophic consequences.

http://www.huffingtonpost.com/2013/10/14/nobel-prize-bubble-housing_n_4098409.html

We’ve already mentioned here last June speech of Mr Jaime Caruana, General Manager of the Bank for International Settlements; “Making the most of borrowed time”.

https://www.bis.org/speeches/sp130623.htm

Quantitative Easing of the U.S. Federal Reserve, bond-buying programmes of the European Central Bank and the Bank of Japan have only one purpose, maintaining some level of stability in the Capital Markets, giving time to the construction of the new Financial System. In Mr. Jaime Caruana’s words, they are just borrowing time.

But those measures have also accelerated the un-sustainability of the debt bubble bringing the unconventional monetary policies close to the end.

http://www.economist.com/content/global_debt_clock

Either the end of the unconventional monetary policies bring the burst of the Capital Markets bubbles or the authorities succeed in deflating them; in both cases, we’ll see at the time how the lack of solvency in the Financial System becomes visible, drying massive amounts of liquidity from it.

On this scenario, it will be necessary enjoying a system for mobilising any form Capital in order of allocating it efficiently.

The key word is eligibility; mobilising capital (or collateral) means transporting it from where it lies to where is needed; meaning, trading collateral for cash or another underline.

But solvency also means confidence; and consequently, capital scarcity will come with lack of confidence.

In an environment of distrust, making collateral eligible for mobilisation will require proving its core value, and here comes the value proposition of Bank Analyzer, certifying and improving the eligibility of the Bank’s collateral.

Once again, Bank Analyzer is not only about providing regulatory reporting, its competitive advantage comes from its disclosure capabilities and they are going to be very valuable in the new model.

Looking forward to read your opinions.

K. Regards,

Ferran.

Margin Calls - Collaterals Management and Bank Analyzer Part III

Dear,

As you probably know, SAP Bank Analyzer does not have yet, the recognition it deserves in the Investment Banking industry.

Ironically, it could be a very powerful element of an Investment Bank IT landscape, particularly in combination with other SAP Banking components.

A very interesting example is the management of Margin Calls.

Margin Calls are a very critical requirement in Investment Banking and Capital Markets trading.

Simplifying, the business scenario is as it follows.

Brokers demand investors collateralize their exposures in order to open a position. For keeping the position opened, the broker will require a specific level of collateralization ratio to be maintained (this is a regulatory requirement in most of the jurisdictions).

During normal operations the fair value of the position and the collateral fluctuate every day (actually, every second). If the fair value of the position or the collateral drops, reducing the collateralization ratio below a determined level (called maintenance requirement), a “margin call” will be triggered, requesting additional guarantees to the investor.

If the investor fails to provide the additional guarantees, the broker will close the position.

The question is; does Bank Analyzer have strong functionalities for covering the "margin call" requirements of an Investment Bank?

If we check the Bank Analyzer menu, we will not find any “margin call” transaction (actually we can find it in SAP-TRM).

On the other hand, if we look at the detailed requirements of a margin call scenario, we’ll see that we can handle it by combining the functionalities of several SAP Banking components, even more efficiently than what best of breed trading products can offer today.

We saw some weeks ago, how Bank Analyzer can make an accurate calculation of Financial Collaterals.

sapbank.blogspot.com/2013/10/collaterals-management-and-bank.html 

Let’s see how to run an enhanced calculation of the collateralization ratio.

Most of Trading Systems determine the minimum collateralization ratio as a quotient between the collaterals fair value and the exposures at risk.

This is an incomplete model because it does not include the Probability of Default of the counterpart, and it does not seem logical to request the same level of collateralization to a risky and a very reliable investor.

Basel II/Basel III agreements give us the foundation for and enhanced calculation of the Collateralization level, which should estimate the Loss Given Default and Probability of Default of the exposure, which depend on the Rating of the Counterparty (Advanced IRB).

The main advantage of this “enhanced” calculation of the collateralization ratio is efficient Capital Management; remember that Collateral is a form of Capital.

Once again, we’re in the middle of a Systemic Crisis which is transforming the Financial System from a business model based in Volume to a business model based in Efficient Capital Management.

Bank Analyzer-Credit Risk Analyzer supports the calculation of LGD and PD parameters according to the Advanced IRB approach, which is the foundation for the enhanced calculation of the collateralization ratio.

Once we’ve calculated the LGD and PD with Bank Analyzer-CRA, determining the enhanced collateralization ratio, and triggering margin call alerts are just reporting requirements, is supported by the reporting functionalities of Netweaver.

I’m aware that the enhanced calculation of the collateralization ratio with Bank Analyzer-CRA presents some performance challenges for big portfolios in very dynamic trading markets, but this is the added value of including SAP-HANA into the landscape.

At the end, we’re talking about Efficient Capital Management, the driver of the new Financial System.

Looking forward to read your opinions.

K. Regards.

Ferran.

I wish it were your decision Mr. Bernanke – Chapter IV

Dear,

While I’m writing this post, the main concern of the economic world is a political agreement; will politicians raise the US debt ceiling or will they force the government default?

http://www.bbc.co.uk/news/business-24511283

I don’t think we’re going to see a US default this week, because nobody is interested in bursting the US debt bubble yet. But that’s not the question. The question is; can US politicians prevent the default, just by increasing the leverage?

Of course not, according to www.usdebtclock.org, the US national debt is approximately 17 trillion USD (148.000 USD per taxpayer), and more important, US interest payments in 2013 will be 2.8 trillion USD (24.000 USD per taxpayer).

What the debt levels are showing us is the exhaustion of an economic model based in wasting capital, and increasing the debt ceiling means buying time while we build the new model based on efficient capital management.  At this point, it’s very recommendable to read last June's speech of Mr. Jaime Caruana, General Manager of the Bank for International Settlements.

http://www.bis.org/speeches/sp130623.htm?ql=1

But are the economic elites actually making the most of borrowed time?; what concrete actions are being taken towards the new paradigm?

Just an example; while everybody is looking at Washington, hoping for an agreement between democrats and republicans, much more important decisions are taken at the other side of the world.

http://www.reuters.com/article/2013/10/10/us-ecb-china-swap-idUSBRE9990A220131010

US dollar has been a key player on the economic model that western world has enjoyed since the Great Depression and the end of the Second World War, and since then, it has become the international trade and reserve currency.

But the end of the model comes in parallel with the fall of the preponderance of the US currency; as investors become concern about the solvency of the FED, a new multilateral model shows up.

Since the starting of the Financial Crisis on 2008, FED balance sheet has grown from 1 to 3.5 trillion USD (1 trillion in MBS’s). What’s the risk and capital consumption associated to this exposure?

http://blogs.wsj.com/economics/2013/09/17/a-look-inside-the-feds-balance-sheet-16/tab/interactive/

While the European Central Bank and the People's Bank of China make movements, addressed to replace the USD in their trade relationships, they’re also building the foundation of a new international currency system.

European and Chinese central banks are building a stability framework for Forex risk limitation on their bilateral trade (by the way, reducing capital consumption), and implicitly, limiting trade unbalances to sustainable levels.

Once again, we’re moving from a financial system based in volume, to a financial system based in efficient capital management.

The new currency system was already recommended by the International Monetary Fund in 2010 in order of assuring world’s financial stability.

http://www.imf.org/external/np/pp/eng/2010/041310.pdf

Financial stability is the key; growing by wasting capital and injecting liquidity, with no collateral support, will be visibly unsustainable very soon, and it will painfully give birth to the new model.

Signs are already there, but we prefer to believe that everything is a political game, and the agreement between the Tea Party and the Obama administration will solve our problems.

Sometimes reality is so hard that we prefer dreaming, till somebody else wakes us up.

Looking forward to read your opinions.

Kindest Regards,
Ferran.

Over the Counter Derivatives, Capital scarcity and Collateral Management.

Dear

As you probably know, one of the major exponents of the current debt bubble and responsible of the 2008 Financial Crash are the Over the Counter Derivatives.

These Financial Contracts are just bets on the fluctuation of a Financial Parameter, called underline (Stock Market Indexes, Foreign Exchange Rates, Interest rates, Commodities Prices, etc.).

Over the Counter Derivatives were responsible of one of the worst moments of the 2008 Financial Crisis when on September the United States Federal Reserve Bank injected 85 billion USD to prevent the AIG’s collapse. This is the largest government bailout of a private company in U.S. history.

Just for giving you an idea of the size of the OTC Derivatives bubble, according to the estimations of the Bank for International Settlements (Central Bank of the Central Banks), the OTC derivatives market has a nominal size of more than 600 trillion USD, approximately 10 times the world’s GDP.

The danger of this bubble is very well known; for instance, on 2002 Warren Buffett called them “Financial Weapons of mass destruction”.

On the 2009 summit in Pittsburgh, G20 leaders agreed the regulation of the OTC derivatives market.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=auIe3UTJncpY

Unfortunately, today's situation is not much better than in 2008, the destructive capacity of the derivatives market is even bigger than it was at the time, and the everyday closer rising of the interest rates has the capacity of bursting the bubble.

On a recent speech, Mr. Stephen G Cecchetti, Head of the Monetary and Economic Department of the Bank for International Settlements advocated for the regulation of the OTC derivatives market.

http://www.bis.org/speeches/sp130912.pdf

He also mentions the concerns among the banking community about the collateral restrictions generated by the implementation of the regulation.

This is a wrong perception, collateral scarcity is not a consequence of the regulation; it just makes it visible. The chain of events is as it follows.

1)      Growth rates are going to be lower due to natural resources scarcity and global debt.

2)      Low growth rates produce capital scarcity.

3)      Capital scarcity requires managing it efficiently.

4)      Stringent regulation and higher collateral requirements reduce free capital available to invest, and drives efficient Capital Management.

Don’t forget that collateral is just a form of capital, and efficient capital management requires efficient collateral management.

In the meantime, the most urgent concern is deflating the derivatives bubble before it bursts. As you could see in the last weeks, keeping the interest rates low is more difficult every day, and rising interest rates are one of the most dangerous scenarios for debt bubbles, including derivatives bubbles (which are just another form of debt).

For giving some hints of the magnitude of the problem, consider this.

On 1929 Financial Crisis which triggered the great depression there was no such thing as derivatives, just debt and stocks.

The total value of the United States stock market is estimated at 23 trillion USD, while US banks have exposures in derivatives markets by 223 trillion USD

http://www.forbes.com/sites/halahtouryalai/2013/03/28/risk-is-back-americas-big-banks-are-knee-deep-in-derivatives/

When the new deal bailed out the US economy, the national debt was only 16% of the annual GDP while today is over 100% of annual GDP.

The only option is Efficient Capital management and efficient collateral management is one of its components.

During this month I’m going to focus on the SAP Banking capabilities for efficient collateral management, I hope this post gives an idea of the necessity of making it happen.

Looking forward to read your opinions.

K. Regards,

Ferran.

Collaterals management and Bank Analyzer - Chapter II.

Dear,

Last week we discussed the importance of a centralized and integrated management of the Bank’s collaterals.

http://sapbank.blogspot.com/2013/09/collaterals-management-and-bank.html

Today, I’d like to look specifically at the issues and requirements on the valuation of Collaterals, particularly Financial Collaterals.

Valuation of collaterals is a critical issue in Collaterals Management; any hair-cut damaging the value of the collateral will penalize its capacity as a risk mitigator, and it will increase the potential losses of the Bank, and its Capital consumption.

We have two types of Assets that can be used as Collaterals, Physical and Financial (Non-Physical).

SAP Collaterals Management has powerful functionalities for determining market and lending values of the collateral from external valuations. ,

But for the valuation of Financial Collaterals, SAP-CMS offers us another excellent opportunity of integration with other SAP Banking components.

Bank Analyzer is a very detailed and sophisticated tool for valuating Financial Transactions and Financial Instruments. Additionally, valuations are always opinions; even regulatory valuations can be different (IFRS, US-GAAP, etc.).

Integrating Financial Collaterals objects with the multi-accounting valuation functionalities of Bank Analyzer will give us a detailed and complete tool for valuating them.

More importantly, integrating Collaterals Management with the risk management tools of Bank Analyzer (Strategy Analyzer) and future Analyzers (ALM) will leverage those functionalities for valuating Financial Collaterals on stressed and simulated scenarios, and estimate potential hair-cuts.

You’re probably aware already of the advantages in terms of Total Cost of Ownership and Single Truth DataSources for the Bank, of the integrated architecture proposed above.

But this is just the beginning, as we move deeper into the Financial Crisis and the Financial System feels the scarcity of Capital, we will discover new advantages on having a holistic vision of Collaterals Management, integrating the Transactional and Analytical Banking scopes.

For instance, as the Basel II and Basel III agreements recognize, there’s an optimal distribution of Collateral bundles to exposures which minimizes the Capital Requirements for the portfolio of assets.

Actually, the Credit Risk Analyzer of Bank Analyzer supports this functionality on the Level 2 of the Capital Requirements Calculation; this is the foundation of a Capital Optimization technique called “Dynamic Collateral Management”.

Reducing Capital requirements the Bank achieves better Capitalization ratios, and consequently lower Cost of Capital (the less risky investment, the lower the capital cost) and new investment opportunities, as better capitalization also means the opportunity of allocate the free capital in new exposures.

This is just an example, the new Financial System, driven by the new paradigm of Capital Management efficiency, will require holistic information systems which assure the optimal utilization of the banks’ capital.

As I mentioned in the past; Capital Optimization is not just a portfolio management activity, it involves the whole Bank, and requires a seamless integration between the Transactional and Analytical Banking information systems,

With these premises, I don’t think any software company is in the position of competing with SAP for offering the required holistic vision and seamless integration between the Banking Information System components that the new Financial System is going to demand.

Looking forward to read your opinions.

Kindest Regards,

Ferran.

Collaterals Management and Bank Analyzer - Chapter I.

Dear,

In a Financial System of limited Capital, efficient Capital Management is the priority.

Efficient Capital Management depends on two magnitudes, Assets Value generation and Risk management (Market, Credit or Operational).

As you can see, we can optimize Capital Management from both sides of the equation; either we increase Value generation or we reduce the Risk of the investment; or even better, we increase Value generation minimizing at the same time the Risk of the investment.

We’ll look at Capital Optimization from the Value generation perspective, and SAP competitive advantages for this in another post, but today we’ll analyze Capital Optimization from the perspective of Risk Optimization.

Reducing the Risk of the investment requires analyzing the expected behavior of Exposures and Counterparts, or utilizing Risk Mitigation Techniques.

Determine effectively the performance of the Bank’s exposures and behavior of the counterparts is a difficult activity, in which statistics calculation, historical patterns and capital markets information can be very useful.

We discussed about SAP Banking components for a holistic Rating and Credit Risk analysis in previous posts

http://sapbank.blogspot.com/2013/05/rating-scoring-and-sap-banking-chapter-i.htmlhttp://sapbank.blogspot.com/2013/06/rating-scoring-and-sap-banking-chapter.htmlhttp://sapbank.blogspot.com/2013/08/implicit-ratings-uncertainty-efficiency.html

We will look at this topic in the future again, but today, we’re going to look at Capital Optimization from the perspective of the Risk mitigation techniques; typically Collaterals and Guarantees.

SAP Banking has an excellent Collaterals Management System, integrated with the SAP Banking Components; Loans Management, Treasury and Risk (for Corporate Banking trade), Reserve for Bad Debts (for Impairment Provisions Calculation) and Bank Analyzer (for Capital Consumption).

The main advantage of SAP-CMS is its integration capacity.

In many Banking legacy systems, their legacy “Collaterals Management System” has been built as a sub-component of the Loans management system. This approach represents a serious limitation from an Architecture Perspective.

In reality, the right or asset which is going to be used in a collateral agreement can collateralize to more than one Loan (or any other exposure), it can exist before the exposure, and in fact, its lifecycle is not dependent on the exposures it’s covering.

A central vision of the value of the Collateral (including potential haircuts) and its charges is mandatory, for assuring that the collateral will fulfill its functions as Risk mitigator.

Take into account that in Banking Legacy systems, we normally find more than one Loans system, with limited integration among them, and minimal (if some) integration with the Corporate and Derivative products’ Banking System.

With this niche architecture, managing centrally the charges supported by the collaterals, and measuring potential hair-cuts on the value of the guarantees, and the subsequent impact on the Bank’s regulatory capital, is “Science Fiction”.

Seven years ago I was working on one of the biggest Bank Analyzer-Basel II implementations for a European Bank. The Bank was performing very well at the time (in the middle of a huge Real Estate bubble I must say),but I still remember how shocked I was when I understood the lack of control on the management of the Bank’s Real Estate Collaterals, which were supposed to mitigate the Credit Risk of the Bank’s exposures.

Actually, when just some months ago, I saw in the news that the Bank had to be bailed out, I was not surprised.

This is the past and we cannot change the past, we have wasted Capital for decades and now the situation is what it is.

Now it's the time to implement the new paradigm and SAP has the technology which makes it possible.

Looking forward to read your opinions.

K. Regards,

Ferran.

I wish it were you decision Mr. Bernanke - Chapter III

Dear,

This week the Federal Reserve decided to keep injecting liquidity in the Financial System by not changing its $85 billion a month bond-buying strategy.

http://www.reuters.com/article/2013/09/19/us-usa-fed-idUSBRE98G1D620130919

And the stock markets went up

http://www.reuters.com/article/2013/09/17/us-markets-stocks-idUSBRE9890IQ20130917

If the stock market prices were a fair representation of the economic health of the world, this would be great news.

Unfortunately, this is a purely speculative movement; injecting liquidity will never fix a solvency problem.

A Fractional Reserve banking system requires growth for being solvent, and we’re not going to grow, because scarcity of natural resources and global debt is making it impossible to grow at historical rates.

http://blogs.sap.com/banking/2011/12/07/its-growth-stupid/

And this is the real problem, lack of solvency in the Financial System. Federal Reserve is giving Red Bull bottles to a Financial System with a metastatic cancer. Maybe it looks like healthier, but at the same time the tumour is spreading.

The reality is that with limited growth, Capital becomes scarce, and no liquidity program can fix that.

As Mr. Jaime Caruana, General Manager of the Bank for International Settlements (Central Bank of the Central Banks) explained clearly some months ago, these stimulus programs are just borrowing time.

http://www.bis.org/speeches/sp130623.pdf

And we’re all going to pay a very high price for it; we are wasting funds that we’ll need in the future.

One month ago, William White, BIS’s former chief economist, gave another clear warning; “This looks like to me like 2007 all over again, but even worse,”

http://www.telegraph.co.uk/finance/10310598/BIS-veteran-says-global-credit-excess-worse-than-pre-Lehman.html

In fact, debt volume in the developed world is 30% higher today than on 2007.

http://www.economist.com/content/global_debt_clock

These debt levels are unsustainable, un-payable, and recognizing the fact will be the biggest bubble burst in the recent economic history.

Remember; financially, recognizing un-payable debts means writing them off. Trillions of dollars in assets will disappear, reducing dramatically the world’s Gross Domestic Product.

Abruptly, the global economic system will accept that we’re much poorer than we think we are.

But this was not meant to be a scary post, the day after the crash, sun will rise again, and we’ll wake up to live in a different world. At the time, it will be so clear that Capital is scarce that we’ll be ready to accept the only alternative; Efficient Capital Management.

The question is, what are we doing to be prepared for the systemic change?

Regulation is just part of the story, deregulation brought Capital waste, but a more stringent regulation is not enough for making the change happen.

Let me give you a simple example, governments can issue a law penalizing speeding, but if they don’t give radar speed guns to the police, speeding will not be prevented.

We’re not talking about plastic surgery here; we’re talking about changing the foundation of the financial system, from a business model based in volume to a business model based in efficient Capital management, a huge challenge indeed.

A holistic and integrated vision of Banks’ activities is mandatory, and in my opinion, SAP is the only software company with the vision and resources, for building the required technologic infrastructure.

But this capacity is useless if we don’t make it effective.

Some weeks ago, I talked to a friend who has had SAP Banking sales responsibilities for more than 10 years; he literally told me “Bank Analyzer is difficult to sell because we don’t have many people who really knows how it works”

This cannot be an excuse, we’re in the middle of a Systemic Change and we have to make it happen; whatever it takes.

Looking forward to read your opinions.

K. Regards,

Ferran.

Assets Protection Schemes. Efficient Management of Public Funds and Bank Analyzer.

Dear,
Capital Scarcity is the main threat for the financial system, and it is driving it from a Business Model based on Volume to a Business Model based on Efficient Capital Management.

Efficient management has some requirements; the main one is providing the Banks’ managers and auditors with a holistic vision of all Bank’s rights (Assets) and obligations (Liabilities).

Unfortunately, in the traditional accounting systems, some of the Banks’ rights don’t have full recognition, when they have the same capacity of value generation than other, fully recognized assets.

A quite interesting case is the representation of the Assets Protection Schemes (APS’s), commonly used since the starting of the Financial Crisis on 2008.

Simplifying, the basic idea under APS’s is the following; Banks on financial difficulties were recapitalized by receiving special guarantees from the government. Those guarantees protected them from potential losses in damaged assets.

APS’s directly improved the solvency of rescued banks, giving them access to the capital markets where they would get liquidity, and provided them with free-capital, that they were able of allocating, according to the strategy defined by Bank’s executives.

Of course, the transfer of solvency came with a price; as Banks improved their solvency, public finances suffered the losses, represented by reductions in their solvency ratings.

Rescued packages have offered some stability to the Financial System, but there’re some doubts about the long term effectiveness of the program; particularly, when it comes to the good utilization of those public funds. At least partially, the reason has to do with the capabilities of the Bank’s information systems, for tracking the allocation of the public funds transferred to them, and the way those rights were represented.

APS’s have been modeled in most of Bank’s Information Systems as collaterals of the damaged assets. As the risky assets are now highly collateralized, the banks have been able of using them in securitization processes or repo-style transactions, in exchange for liquidity.

On the other hand APS’s can also be modeled as Over-the-Counter Credit Derivatives (Options), capable of hedging the Default Risk of the Banks’ damaged Assets.

While improvement of the solvency position is recognized by both approaches, the value of the transferred funds is not equally represented in the balance sheet. With the first approach; the impact of an over-collateralized asset in the balance sheet could be minimal, as the collateral value is represented in books when the collateralized asset becomes impaired.

On the other hand; with the second approach, the Over-the-Counter Credit Derivatives Fair Value have full recognition from the time it is acquired, including any potential Hedge-Accounting adjustment.

As mentioned at the beginning of this post, the objective should be achieving a holistic representation of all Bank’s rights and obligations; supported by functionalities, capable of tracking capital consumption, and actual return of the allocated capital.

Giving visibility to capital and its utilization, is the first step for building a system which supports its efficient management. In my opinion, Accounting standards and the flat structure of the General Ledger don’t provide the best info-structure for offering that visibility.

On the contrary, the Integrated Financial and Risk Architecture of the Bank Analyzer offers the required holistic approach, representing the underlines, risk of assets, and their expected and actual return. Additionally, their multi-accounting system functionalities, provides the capacity of reporting the bank’s position according to multiple approaches.

Looking forward to read your opinions.
K. Regards,
Ferran.

"Mergers and Acquisitions" - Leveraged Buyout and Bank Analyzer.

Dear,
Two weeks ago I was in London for presenting the GAP Analysis of a Bank Analyzer implementation in an Investment Bank.

By the way, I love the City, even when I have to spend two hours for crossing the passport control at the Gatwick Airport.

I have mentioned here that, in my opinion, Bank Analyzer is probably the finest piece of software ever developed by SAP, but for finding its real advantages we have to look at specific, non-trivial scenarios.

In this particular case, we found a real challenge in the management of mergers and acquisitions. In this business is very usual a finance process called “Leveraged buyout”. 

Simplifying, it is the acquisition of a company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition.

On this model, the company being acquired is used as collateral for the loan. Borrowing the money, the investors can make large acquisitions reducing Capital commitment. The necessary Capital is mainly provided by the investment Bank, which is effectively becoming a very significant stakeholder in the deal.

From a classic perspective, the investment bank is giving a loan and receiving as collateral the assets of the acquired company, but we are going to see that the reality is a little bit more complicated, but also more interesting.

The value of the collateral is the value of the acquired company, but the value of the company fluctuates every day. Every P/L relevant transaction will produce a change on the value of the company, and consequently, in the collateral value, and the Investment Bank Capital Consumption.

Some weeks ago, I described in this forum some proposals for alternative Accounting representation, enhancing the classic approach; I called them “Underlines and Collaterals Accounting System”.

sapbank.blogspot.com/2013/07/collaterals-and-underlines-accounting.html

sapbank.blogspot.com/2013/07/collaterals-and-underlines-accounting_27.html

The basic idea behind this proposal is looking at the value generation of the business process, and not limiting it to the classic accounting value. The Leveraged buyout process is a good example of the utility of this approach.

Take into account that from the Investment Bank perspective, managing the company is managing the collateral of its exposure.

In this process, all the risk relies in the management of the acquired company. If the company performs well, the borrowers will be able of paying back their obligations to the investment bank with the profits of the acquired company.

If not, the investment bank will have to use its rights on the collateral, but remember, the collateral is the acquired company. If it’s not performing well, the borrowers will not fulfill their obligations, but the collateral will also suffer a significant hair-cut.

As you see, the critical factor is controlling the performance of the acquired company, and controlling the performance requires integration. Again, the main competitive advantage of the SAP Banking business suite.

A seamless integration of this process would require integrating the net value (Capital, Reserves and P/L) of the acquired company with the Collateral Primary object of Bank Analyzer. With this integration, the investment bank has an updated value of its assets collateral, and a clear estimation of the investors’ capacity of paying their obligations.

The opportunities of detailed management of this process in Bank Analyzer are abundant. For instance, in case of a very critical deal, we could integrate the whole Balance Sheet and P/L of the acquired company in the AFI Sub-ledger, and transferring its net value as value of the collateral in the Primary Object.

The more we move deeper into the Financial Crisis, the more important efficient Capital management will be. It’s in this environment where the holistic vision of SAP Banking can prove its competitive advantages.

Looking forward to read your opinions.
K. Regards,
Ferran.