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.

I wish it were your decision Mr. Bernanke - Chapter II.

Dear,

As you could read here some weeks ago, as we move deeper into the Systemic Crisis, countries become inter-dependents. We’re entering in a post-global era in which everybody depends on everybody, and what somebody does affects the others.

http://sapbank.blogspot.co.uk/2013/06/i-wish-it-were-your-decision-mr-bernanke.html

Chinese economy has played a very significant role in the last 20 years. Once the production costs made it impossible to grow (at historical rates) by manufacturing in Western Countries, delocalization in China was the solution for keeping high growth rates.

Trade deficit was financed with debt and we enjoyed fantastic growth rates for 2 more decades. Solvency was consumed in the process, and when solvency became scarce, growth slowed down.

Now, we’re in the middle of the Systemic Crisis, but we’ve been said this summer that as US economy is in the path to recover, interest rates will be raised.

In my opinion, for understanding the event, we must analyze who is financing the American deficit and how are they doing it.

China is the main foreign holder of US debt, with approximately 8% of the cake, but Chinese institutions have their own problems, and it’s unlikely they can keep financing the US deficit as they did in the past.

http://online.wsj.com/article/SB10001424127887324906304579036592255182758.html

If financing US debt is becoming more difficult, the logical consequence is raising the Yield, and that’s exactly what’s going on. Of course, it’s nicer saying that interest rates are rising because US economy is in the path to recover than recognising US dependency in the Financial Markets and foreign investors.

And again, we’re in an interconnected economy with a globalized financial system; as a consequence, what someone does, affects the others.

Liquidity injected during QE easing cycles found their way to inflate bubbles, mainly in developing economies, that’s why their economies performed so well in the last 4 years.

As usual, with the rise of the interest rates, bubbles start to be burst, and that’s exactly what’s starting to happen.

http://blogs.marketwatch.com/capitolreport/2013/08/21/fed-plan-to-taper-slams-india-turkey-other-countries/?mod=MW_latest_news

Interest rates rise is not the problem; it’s just the symptom of a systemic crisis generated by an exhausted model based on wasting Capital. While Capital was abundant the model work, as Capital became scarce the systemic crisis started.

Let me recommend you to read the following article, by Novel Prize, Professor Paul Krugman.

http://economistsview.typepad.com/economistsview/2013/08/paul-krugman-this-age-of-bubbles.html

Professor Krugman recommends harder regulation of the Financial System and says

“In short, the main lesson of this age of bubbles ... is that when the financial industry is set loose to do its thing, it lurches from crisis to crisis”

And I cannot agree more; but he also says

“But the Fed was only doing its job. It’s supposed to push interest rates down when the economy is depressed and inflation is low”

And I don’t agree, sovereignty and supposed independency of the Fed for determining interest rates has been as responsible as deregulation for sustaining the old model, and they’re both responsible of the systemic crisis. By the way, that’s why is systemic.

As the new model will be based in Capital Optimization, regulation will be harder, and coordination amongst central banks will be higher (coordination sounds better than lost of independence, isn’t it?)

I said it once and I will say it again.

"I wish it were your decision Mr. Bernanke"

Looking forward to read your opinions.

K. Regards,

Ferran.