Collaterals and Underlines Accounting System - Chapter II

Dear

As we saw last week, Accounting Principles leave many opportunities for building hiding mechanisms, necessary for inflating financial bubbles.

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

As the objective is increasing transparency, the new regulatory framework should overpass the limited capacity of disclosure offered by the General Ledger and look at the foundation of the Value Generation of the Financial Assets.

While the value of an asset depends on its long-term capacity of cash-flows generation, that generation comes from two economic magnitudes of the Financial Asset; the Underline and the Collateral.

This approach is supported in some Accounting Principles, but in a limited way. For instance, in the exercise of an option, I can determine the value of the Option according to the value of the Underline.

We should go further than that, but with the flat structure/approach of the General Ledger, we have many limitations to support multi-valuation approaches of the Assets, including reconciliation techniques of these valuations. I wrote something about those limitations months ago.

http://sapbank.blogspot.co.uk/2012/09/why-de-general-ledger-is-not-enough.html

The Financial Database of Bank Analyzer permits to keep the value of collaterals and underlines in different but connected objects in the SDL and the RDL, and the multi-accounting capabilities of Bank Analyzer-AFI permit to build calculation procedures which read and combine those values with the results of the cash-flows generation engine. The opportunities of building alternative accounting systems which reconciles the expected cash-flows of an asset with the value of its Underline or Collateral are abundant.

In my opinion, this is a very important reason to consider Bank Analyzer as the central hub of Risk and Accounting magnitudes of the Bank. We expect the regulation is going to be harder, and IT investment decisions cannot be taken according to the capacity of the infrastructure for supporting current requirements, but being the foundation for covering the future regulatory framework, that will emerge as a consequence of the systemic crisis.

This humble proposal is just an idea on that direction.

Looking forward to know your opinions.

K. Regards.

Ferran.

Collaterals and Underlines Accounting System - Chapter I

Dear,

One of the main concerns after 2008 Financial Crisis is improving transparency on the Financial Markets, and some general consensus has been achieved about the necessity of building a more stringent regulatory framework for the financial system, capable of increasing transparency and stability.

The current regulation, particularly the accounting standards, gives many opportunities for hiding the real situation of a financial institution. There’re many ways of hiding information which can compromise markets opinion about the financial stability of an organization, let me name some well-known examples.

- Massive use of Off-Balance contracts for hiding debt.

http://www.investopedia.com/articles/analyst/022002.asp

- Securitization of high risk loans for hiding counterparty risk.

http://www.investopedia.com/articles/07/subprime-overview.asp

All Financial Crisis have in common that require a bubble to be inflated and burst; but while the bubble is inflated, a hiding mechanism is required to hide the bubble to potential investors. 

Obviously, if investors knew that an asset is inflated they wouldn't invest and the bubble could not be inflated. Off-balance accounting postings, assets securitization, Repo 105, OTC Derivatives, have been traditionally accepted and legal accounting practices used as bubbles hiding mechanisms.

In my opinion, the main consequence of this Financial Crisis is moving from a Financial System based in Volume to a Financial System based in efficient management of solvency and liquidity. After this systemic change, growing by inflating and bursting bubbles will not be an option.

Consequently; hiding mechanisms, necessary for inflating bubbles, will not be tolerated.

Every bubble, and the current debt one is a very good example, requires confusing solvency and liquidity. Liquidity increases temporarily the value of an asset, solvency makes the value of the asset long-term sustainable.

http://sapbank.blogspot.co.uk/2013/03/why-do-they-call-it-love-when-they-mean.html

But preventing hiding mechanisms requires more than adjusting the accounting standards, new mechanisms of financial reconciliation are going to be required.

Simplifying, every Financial Asset has a value which depends on a promise of generating future cash-flows and the probability (risk) that those “agreed” cash-flows are successfully delivered.

We work on two main families of valuations; mark to market and mark to model. The first one assumes that the market has perfect information about the value of the asset, the second is build on the hypothesis that the Financial Institution has all the information about the probability of getting successfully the promised cash-flows.

Unfortunately, as the multiple bubbles have made clear, both approaches are incomplete. Injecting or drying liquidity in the Financial System increases and reduces the value of the assets, without any real estimation of its long-term sustainable cash-flows generation capacity; and mark to model estimations have many holes for executives hiding the long-term sustainable value of their assets (Repo 105, Securitization, Off-balance accounting, etc.).

We need a new concept, capable of disclosing the long-term sustainable value of the financial assets. 

But this post has become too long, we'll talk about it next week.

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

Product Costing in Financial Services and Bank Analyzer.

Dear,

As the Financial Crisis and a harder regulation of the Financial System make capital scarce and expensive, efficient Capital Management is becoming the most critical activity for Banks.

From now on, there is not enough capital to finance/invest in every economic activity, prioritization is critical and only those business opportunities with higher expected profit, weighted by capital consumed, will get the necessary funds.

As expected growth of the global economy is going to be very limited in the next years, pressure on keeping good margins which can guarantee reasonable returns on capital is going to be usual. On the other hand, maintaining good margins in depressed markets will not come by the side of increasing revenues, but by the way of the efficiency and costing-control.

Costing management of a Financial Instrument is a complex activity as the main costs associated to the business process (funding costs, processing costs and risk costs) will be visible after signing the contract, in some cases long time after the event.

In production industries, most of the production costs are supported by the company before the product is sold, in fact they’re not considered cost till the product is sold (till then they just increase the value of the inventory). Cost of sales in Production or Retail industries is a deterministic and well known parameter; the equivalent in Financial Services is not.

Process, Funding and Risk costs of a Loan or a Deposit are supported during the whole life of the contract; considering that some contracts have very long maturity terms like mortgage loans, perpetual debt or shares, their estimation can be a very difficult exercise.

Determining Process costs of a Financial Instrument (or a Financial Transaction) is an internal management activity, the standard process costs of the Financial Instrument can be estimated from the Actual Costs determined by internal management accounting models (Cost Center Accounting, Activity Based Costing, Distributions, etc.). SAP has decades of experience in Internal Costing management, all this know-how is available for building complete and reconcilable models of Process Cost Accounting, from the Actual costs in ECC to the Standard costs in Bank Analyzer, and vice-versa.

Risk costs are even more challenging, as the costs associated to the possible counterpart default (credit risk costs) or changes in the interest rate o foreign exchange rate (market risk), are estimations based in purely probabilistic models. Probabilistic models which require extensive collection of external data (ratings, forex and interest rate estimations, historical and expected volatilities, etc.) and complex mathematical models.

The calculation of this probabilistic costs has to be based in assumptions (by definition, future events cannot be deterministic); the more correct and complete those assumptions are, the better cost estimation the Bank will make

Finally, effective costing control requires a seamless integration between all the components of the business process, from Transactional Banking to Analytical Banking, from collecting origination costs in CRM to communicate estimated funding costs from the Analytical Banking component.

We’ve mentioned many times that as a consequence of the Financial Crisis, efficient Capital Management is the most critical activity. But efficient Capital Management requires a holistic approach which includes cost and margin management, and this is the main competitive advantage of SAP Banking.

SAP has the most complete set of software components for building holistic and complete Product Costing models in many industries. All this knowledge is available and valid for building a complete model of Product Costing estimations in Financial Services.
Integration is the magic word, and for years SAP has been synonym of integration.
Looking forward to read your opinions.

K. Regards,
Ferran.

Why Capital Optimization is the priority?

Dear,

As you probably know, in my opinion, this is a Systemic Crisis. Scarcity of Natural Resources and huge debt make it impossible for the World to grow at historical rates.

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

Systemic Crisis’ force changes in the economic system foundation, according to the requirements of the new era. Priorities change in systemic crisis, it happened before and it will happen again.

This time, priorities are switching from growth to efficient management of the critical resources. Translated to the Financial System, we’re moving from a Financial System based on Volume to a Financial System based in efficient Capital Management.

Capital is the main resource of the Financial System, let’s see why.

The whole Financial System relies on trust, I deposit money in the bank and I expect the bank will give me my money back, plus some interests. But on the other side, the bank has to allocate money in other assets (investments or loans), and it also expects to recover the investments, plus some dividends or interests.

This is very important, as the Financial System is not sustained by titanium cables but by trust, trust is the main asset of the Financial System, and once broken it’s very difficult to fix it.

For protecting trust, banks have to offer a special guarantee to its lenders, that guarantee is the Regulatory Capital.

Regulatory Capital is determined according to the parameters of some international agreements called Basel agreements; Basel I, Basel II and most recently Basel III.

http://www.bis.org/bcbs/basel3.htm

Every solvency agreement is an evolution of the previous one, but they all define the Regulatory Capital as a percentage of the Bank’s Risk Weighted Assets.

Risk Weighted Assets depend on the Probability of Default of the Bank’s counterparts, and again, this is a sensitive matter.

When I run probabilistic calculations, I do it because there’s uncertainty; the information required for making the event deterministic is not available.

For Financial Assets, the missing information is in the future; I make the investment today, but only in the future I will know if my counterpart will honor his obligations.

As I don’t know what will happen in the future I use statistics for trying to find it out.

Investors can calculate the Probability of Default of the counterpart, by measuring historical default rates of counterparts similar to him, and statistical tendencies.

The whole construction depends on the economic growth. If world’s economy is not growing; Probabilities of Default, Risk Weighted assets and Capital Requirements of the Banks will grow. On the other hand, as default rates grow, Bank’s losses increase, reducing available capital.

Reducing available Capital and increasing Capital Requirements are making banks undercapitalized, even the biggest ones.

http://www.reuters.com/article/2013/06/14/us-financial-regulation-deutsche-idUSBRE95D0X620130614

That’s the foundation of the Systemic Change; Capital is the most critical resource of the Financial System (actually the whole economy) and now is very scarce. Consequently, it will have to be managed very efficiently.

Efficient Capital Management emerges as the most critical activity for the Financial System; I've worked for years in a Capital Optimization model based on SAP Software, I’ll present it to all of you in some weeks.

http://blogs.sap.com/banking/2012/02/01/capital-optimization-sap-hana/

Looking forward to read your opinions.

K. Regards,

Ferran.