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.