The dog, the Frisbee and SAP Bank Analyzer. Chapter I.

Dear,

For years, the financial system has been driven by volume; economic growth required, and still requires, feeding the monster of debt; but the monster has become too big, making the system unsustainable, that’s why we’re in a systemic crisis.

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

Recovering the sustainability of the system requires efficient management of scarce resources, and capital is the main and most scarce resource of the financial system.

The systemic transformation requires increasing capital requirements, making visible its importance by raising its price. In other words, making capital expensive is the best way for incentivizing its efficient management.

Solvency agreements (Basel I and Basel II) should have prevented the insolvency of the financial system but history proved that they did not. As a consequence, capital requirements were increased and a tighter regulation (Basel III) was implemented after 2008 events.

Basel III increased the capital requirements in several percentage points (3%-5.5%) and required the implementation of two new ratios; Leverage Ratio and Liquidity Ratio.

http://www.bis.org/publ/bcbs251.pdf

http://www.bis.org/publ/bcbs238.pdf

The new Leverage Ratio is not “Risk Weighted” which means that does not distinguish between risky and not risky investments. It sounds estrange when we have being said that risky investments are the main threat for the stability of the financial system.

The best explanation of the necessity of a Leverage Ratio is in the speech “The dog and the Frisbee”, by Andy Haldane; Chief Economist and Executive Director, Monetary Analysis & Statistics of the Bank of England.

http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech596.pdf

Basically, Mr. Haldane is telling us that “As regulators don’t trust the complex Internal Rating and Capital Requirements calculation of the banks, they’re implementing a simpler rule for preventing over-leverage”

The proposal seems logical, if complex statistical rules of risk calculation can’t prevent over-leverage (because they can’t be verified by the auditors), let’s implement a simple rule (that can be audited). At the end, dogs don’t need to understand complex laws of physics for catching a Frisbee.

I would agree if leverage was the problem, but unfortunately it’s just a symptom. The real problem is capital scarcity and the solution requires capital optimization.

Requirements which don’t estimate capital consumption can’t incentive capital optimization, that’s why the leverage ratio will not work in the long-term.

Don’t forget that the main justification for the leverage ratio is the difficulty for auditing the bank’s models for capital requirements calculation. If auditing the bank’s internal models is difficult, transparency measures should be implemented for facilitating auditing. Unfortunately that’s much more difficult than it sounds.

Banking Information systems are built on obsolete, heterogeneous, lightly integrated databases. Determining and reporting meaningful solvency calculations in these conditions is technically impossible.

That’s why today’s alternative is a regulatory leverage ratio, if we can’t verify complex rules, let’s implement a simple one.

But as the systemic crisis evolves, the effects of capital scarcity will be more visible and painful, making necessary the implementation of capital optimization measures.

By that time, banking information systems will have to be ready to determine capital consumption properly, including the reporting capabilities for auditing the results.
Understanding the laws of physics is not necessary for catching a Frisbee, but transforming the financial system is a much more challenging endeavor.

Join the SAP Banking Group at: http://www.linkedin.com/e/gis/92860

Looking forward to read your opinions.

K. Regards,

Ferran.

Impairment in SAP Bank Analyzer, integrated scenarios and Capital Optimization.

Dear,
We mentioned in the past that Bank Analyzer represents a very robust Analytical Banking component, but it lacks on some functionalities which are available for other competitors.

For covering the gap we take advantage of the open architecture of the Financial Database and integrate the missing calculations from an external system. For instance, as previous releases of Bank Analyzer didn't have Impairment functionalities, we build interfaces to other systems, like SAP Reserves for Bad Debts, in order of including the impairment provisions in the SAP Bank Analyzer sub-ledger, achieving a complete accounting vision of the Financial Transaction (customer account).

Fortunately, new versions of SAP Bank Analyzer are coming which new functionalities, covering existing limitations. This is the case with Bank Analyzer 8 which provides a strong Impairment functionality, compliant with IFRS requirements.

Bank Analyzer 8 determines the impairment accounting entries following one of the following approaches.

- Percentage Expected Loss

- Expected Cash Flow

The first one determines the impairment postings by calculating the percentage expected loss and the percentage write-down, while the second determines the impairment postings by calculating the expected cash flow and the write-down. 

An important constrain that we must keep in mind is that expected cash-flows can’t be calculated for those products for which we’re using Source Data Aggregation. Anyway the same limitation applies for the discounting cash-flows valuation of Financial Transactions in combination with Source Data Aggregation, so customers using Source Data Aggregation will probably be familiar with the Source Data Aggregation functionality constraints.

But it’s not my intention to make a detailed description of the SAP Bank Analyzer 8 functionalities for impairment, which by the way, are very well explained in the SAP documentation. 

My intention today, is explaining the competitive advantages of the Integrated Financial Risk Architecture for the management of impaired assets.

When we’re talking about impairment, we are looking at the most risk driven accounting activity. Most of the necessary parameters for measuring the credit risk associated to a financial transaction are also required for determining their impairment accounting entries. This opens the gate for integrated scenarios between AFI and Credit Risk modules of Bank Analyzer.

Last summer, I had the opportunity of talking to a former customer who implemented Basel II on Bank Analyzer seven years ago, calculating capital requirements on contract level. But today, the same bank is calculating the impairment accounting entries in portfolio level, and distributing the results to contract level.

This is not the best approach when the customer already has most of the necessary parameters for calculating the impairment accounting entries in contract level, as they’re available as a result of their solvency calculations.

But more than that, the Integrated Financial and Risk Architecture offers others important opportunities for Capital Optimization in the management of impaired assets, which should be evaluated when defining the bank’s impairment architecture.

Keep in mind that Capital is scarce and it’s going to be scarcer in the future, and consequently capital optimization is becoming the most critical activity. The Integrated Financial and Risk Architecture of Bank Analyzer provides the foundation for optimizing capital in the management of impaired assets, by building integrated scenarios between Credit Risk and Accounting for Financial Instruments. 

I have personally worked on some of them and I’ll be happy to share with you in a future post, this one has become too long.

Looking forward to read your opinions.

Join the SAP Banking Group at: http://www.linkedin.com/e/gis/92860

K. Regards,
Ferran.