Rating, Scoring and SAP Banking – Chapter I

Dear, 

As we’ve discussed here before, we’re in a Systemic Financial Crisis which is driving a major transformation in the Financial System, from a business model based on Volume to a business model based in efficient Capital Management.

One of the most critical activities in Capital Management is the rating and scoring of Business Partners, Financial Instruments and Financial Transactions. Rating has a direct impact in the Valuation of the Portfolio (Fair Value) and the calculation of the Capital
Requirements (Risk Weighted Assets).

But Rating managements is becoming a very challenging activity; globalization makes very difficult tracking the risk of corporate counterparts operating in multiple countries, financial instability and unexpected credit events in some European countries have dried the credit markets impacting the solvency of governments and corporations; complex legal structures, including constructions in offshore jurisdictions have been used by insolvent counterparties for hiding unsustainable debts, by-passing solvency regulations.

On the other hand, efficient Rating management is a key activity for avoiding risky investments and taking corrective measures in case credit events damage the bank’s portfolio (Credit Default Swaps, Collateralization, Assets Protection Schemes, etc).
Fast response is critical; as detecting those damages and risks once they’re publicly known in the Capital Markets, makes the corrective measures much more expensive.

SAP Banking has a very complete set of components for offering a holistic management of the rating of the Banks assets; we’ll have a look at them in the next posts.

The Historical Database component of Bank Analyzer (included in the Credit Risk Analyzer/Basel II module) and its integration with Banking Services; which was initially developed for the calculation of some of the most important parameters of the Internal Rating Based Approach of the Basel II agreement, is in fact a very powerful tool for determining counterparty risk ratings, not only for the Capital Requirements calculation of the solvency regulation, but as a basis of other scoring activities.

A typical example is the calculation of the Probability of Default by selecting combination of characteristics defining micro-portfolios with analog risk dimensions. Measuring the historical number of defaulted and not-defaulted Financial Transactions in each micro-portfolio, and using logistic regression, the bank’s risk managers can make a statistical estimation of the Probability of Default, and consequently the rating of the Financial Transactions belonging to that micro-portfolio. The accuracy of rating estimation will depend on the risk dimensions selection and the statistical significance of the example.

Obviously there’re more complex models for Rating determination, including not only internal estimations, but external measures and combinations of external and internal models. We’ll talk about them in the next post.

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

Securitization process with SAP Banking.

Dear,


In this post, we’re going to see how to manage a securitization process with SAP Banking. This process is very well supported by SAP components; but unfortunately, with limited market recognition.

For those who are not familiar with the process; Securitization is the financial practice by financial institutions, like banks or leasing companies, of pooling various types of assets (mortgages, leases, credit card debt obligations, etc.) and selling said consolidated debt as securities to the investors. The asset pool serves as collateral of the securities sold to investors.

The investors strongly demands full transparency of the asset pool, because the value of the security depends only on the value of the asset pool. Therefore a very complex so called investor reporting is needed periodically. The principal and interest on the debt, underlying the security, is paid back to the investors regularly according the calculations in the investor reporting, esp. the payment report.

The issue of the securities is normally done by a separated legal entity called Special Purpose Vehicle (SPV). The purpose of the SPV is to separate the underlying asset pool from the other assets on the balance sheet of the financial institution (Originator) and to issue the asset-backed securities, which are assigned to tranches with different ratings.

The first step of the process is the selection of qualified assets for example Loans which are going to be securitized and building the pool of Loans. This process is managed by the Funding Management Solution of SAP. On this solution we have tools for adding eligible Loans to the pool, structure the pool according concentration limits within the pool, calculating the Net Present Value of candidates Loans to be securitized, building the pools, even with different ratings and preparing the transfer of the ownership of the pools to the SPV. Challenge for example is to optimize the pool in that way the financial institution is able to sell as much as possible without violation of the investor requirements on the underlying asset pool.

The second step of the securitization process is the issue and trade of the securities. The Special Purpose Vehicle can use the Transaction Manager module of ECC-Treasury and Risk Management for covering this step.

The third steps is the distribution of the borrowers’ payments to the pool of loans and transfer them to the Special Purpose Vehicle. This step is fully covered by the Funding Management solution of SAP Banking, including special cases of pool Loans with different ratings and priorities like cash waterfall.

The fourth step is the payment of interests by the securities according the payment distribution information provided by Funding Management in the third point. This is not a standard SAP integration but we’re working with TXS on developing this integrated scenario.

The last step is the periodically reporting to the investors. SAP Funding Management provides a reporting engine including prepared templates to build up such an investor reporting. During the whole process there’s a cross requirement of providing the Financial Statements of the loans pools (including Probability of Defaults, Liquidity Analysis, Market Value, etc.). The Credit Risk Analyzer, Accounting for Financial Instruments and Profit Analyzer module of Bank Analyzer are very useful at this stage. The integration of these modules with Funding Management is not out-of-the-box but we’re also working with TXS on it.

Finally, let me take this opportunity to thank Frank Zeidler and Benjamin Schneidereit from TXS GmbH for their support in the preparation of this post and their detailed technical explanations about Funding Management 2.0

Looking forward to read your opinions.

K. Regards,

Ferran.

Why Bankers play Casino?

Dear,

Common opinion says that we’re in this recession because Bankers have become insane and play Casino instead of giving credit.

I wish it was that easy, if that was the case fixing the problem would be as easy as implementing stronger regulation penalizing speculative investments. That will happen and it will be part of the solution, but it’s not “the solution”.

This is a Depression triggered by a crisis of Solvency; without economic growth the world’s debt is unpayable and economic growth is not possible due to the scarcity of resources (oil, gas, financial solvency, etc).

Since October 2008 the proposal has been injecting liquidity financed with more debt (Quantitative Easing cycles and Bail-Outs).

Has anybody thought how can we fix a crisis of debt with more debt? For me this is like putting out a fire with gasoline.

Bankers claim that lending is impossible if there’s no solvent demand, and there’s no solvent demand because there’s no economic growth.

But on the other hand central banks are injecting a huge amount of liquidity on the system, and the banks use this liquidity for buying public debt.
The question is; are banks buying that debt expecting future cash-flows? Not really, they’re buying bonds because they’re a quite liquid asset and they expect to make profit by selling the asset to new buyers.

It’s a purely speculative/casino game, I buy an asset because I expect an increase on its price in the short term.

Actually, as Warren Buffet pointed out brilliantly last week, the current interest rates are artificially low which makes the bonds price artificially high (remember the price of the bonds has an inverse relationship to their yield). As a consequence, any future increase on the interest rates will make the bubble burst.

http://bonds.about.com/b/2013/05/07/warren-buffett-bonds-are-a-terrible-investment-right-now.htm

Don’t forget that Banks are private companies, and their executives are supposed to generate profit for paying dividends to shareholders and get their bonus. If the most profitable business is short-term speculative investment, it’s common sense to take part on it.

The alternative is tackling the solvency issue and there’re only three ways to do it.

- Economic Growth. Not expected soon.
- Recapitalization. Somebody has to provide the funds.
- Bail-In. That’s the Cyprus alternative we discussed some weeks ago. But, are you ready to accept it?

In the meantime, enjoy the game.

Looking forward to read your opinions.

K. Regards,

Ferran.

CAMELS Rating System and Bank Analyzer.

Dear,
Recently I talked to an executive of a US Bank who wanted to discuss about Bank Analyzer capabilities.

Apparently he tried to get some information about the potential of SAP Bank Analyzer for fulfilling the requirements of the CAMELS Rating System, but he found some challenges for getting an answer.

CAMELS Rating System is a supervisory rating system for providing a holistic analysis of a bank’s condition. It was initially developed in the US but it’s been accepted in many other countries.

Actually, SAP Bank Analyzer covers quite well most of CAMELS requirements; let’s see those requirements in detail.

- Capital Adequacy
- Assets
- Management Capability
- Earnings
- Liquidity
- Sensitivity

Capital Adequacy is very well covered by SAP Components; Capital Requirements for Credit Risk are fully covered by the CRA module of Bank Analyzer, including Advanced IRB approach with full Historization capabilities in BA-Historical Database and integration with BS-Loans.

Lately, Basel committee in Banking Supervision has made some proposals for new requirements in counter-cycle provisions. Those requirements have been locally regulated in some European countries for years and we developed some enhancements to cover them 7 years ago (quite well supported by the Financial Database).

Capital Adequacy for market risk is an opportunity for improvement in Bank Analyzer; Value at Risk calculations are fully covered by Market Risk Analyzer of SEM Banking, and hopefully they will be supported by BA-Strategy Analyzer in future releases.

Operational Risk Calculations for Capital Adequacy are covered by SAP GRC.

Assets quality analysis is one of the strongest points of Bank Analyzer. Stress Testing, External and Internal Cost Analysis on Financial Transaction/Financial Instrument Level are fully covered.

Management Capability.- Bank Analyzer integration with other Netweaver components offers very good foundation for working on this requirement. I’ve personally worked in integration scenarios between Bank Analyzer and Balanced Scorecards; I’ll give you details in a future post.

Earnings.- This is very well covered by BA AFI, Profit Analyzer and its integration with the New General Ledger, and SAP Controlling modules.

Financial Planning and Financial Consolidation is very well supported by the integration between BA-AFI and SAP-BPC.

Liquidity.- Fully covered by SAP Liquidity Risk Management, including new Basel III liquidity requirements.

Sensitivity to Market Risk.- We have an opportunity for improvement here. We have some functionality available in BA-Strategy Analyzer, but we miss Market Data Generation and Simulation capabilities. Hopefully we’ll enjoy them in future releases.

In my opinion, with some limitations, Bank Analyzer is in a very good position for providing structured and good quality data for covering CAMELS analysis, and it’s the best option to build the foundation of regulatory reporting.

Lesson learned; developing great software is not enough, we need to improve the market recognition of its true value.

Looking forward to read your opinions.

K. Regards,
Ferran.

Technology, Financial Regulation, Transformation and Culture.

Dear,

Some weeks ago I had a very interesting conversation with a colleague about Information Systems Architecture for Analytical Banking. We've being working together in the planning of an Accounting for Financial Instruments project for a while, but he wanted to discuss about enlarging the scope of the project.

Apparently, there's a growing concern in the IT department of his bank due to the difficulties on reducing TCO and comply with the new regulatory requirements.

He knows the Financial Data Base of Bank Analyzer is the reporting hub for providing the Single Source of Truth in Analytical Banking. This is the foundation of an Information System ready to fulfill the Credit Risk, Market Risk, Liquidity Risk and Accounting regulatory requirements, without having to replicate the banking data on silo-style systems.

But building a centralized architecture, capable of supporting current and future regulatory reporting is a difficult challenge.

Historically, Market Risk, Credit Risk, Liquidity Risk, Capital management and Accounting departments of Banks have worked as silos, with limited capacity of reconciling data and independent objectives.

It's clear that Dodd–Frank and European Market Infrastructure Regulation are increasing pressure on forcing Financial Services system agents to provide reconcilable and detailed data about their Investments, Risk Exposures and Financial positions, but it's also true that those efforts have not been proved to be fully successful till now.

On the other hand, most Banks, even those in which governments took position after 2008 turmoil, work as private organizations, driven by yearly departmental budgets and objectives, and they have their results scrutinized every quarter by market analysts. Planning long term and strategic changes with those constrains and in the current market conditions is not easy.

Building a centralized single source of truth for regulatory reporting is not just a technical decision; it's a strategic one that requires executive management support and long term budget.

The advantages are clear and include the following, better reconciling capabilities, reducing TCO and enhanced visibility.

But the challenges are also big; amongst others, the main is the necessary change on Bank's culture; this is not another crisis and the new tendency of increasing regulatory requirements is not just a temporary fashion, it's the driver of a major transformation in the Financial System from a business model based in Volume to a business model based on efficient management of Capital.

Technology is available or close of being available, but changing organizations' culture will take longer.

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