Dear,
In the last posts, we’ve discussed the importance of managing Credit Risk and Capital Costs in non-financial processes.
https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-chapter-frances?trk=object-title
https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-ferran-frances?trk=object-title
The necessity of managing capital costs is nothing new; it’s the natural consequence of managing the risks associated to an economic activity. What is new is the relative importance of the capital costs in the economic analysis of a business event.
During most of the 20th Century, and particularly since the end of the Second World War (including the plans for reconstructing Europe and Japan) and the implementation of the Breton Woods Agreements, capital was abundant and inexpensive.
In this environment of capital abundance, costs of capital were easily covered by high margins and strong economic growth. Consequently there was no incentive in managing capital efficiently. For decades, the economic world chose to believe that resources were unlimited and wasting capital not an issue.
http://en.wikipedia.org/wiki/Bretton_Woods_system
With the Oil crisis of the 70’s, we discovered that natural resources were limited, challenging the economic growth.
http://en.wikipedia.org/wiki/1973_oil_crisis
At the same time that some initiatives were implemented for managing resources more efficiently, world’s leaders looked for another resource which could be wasted for feeding economic growth.
The alternative was consuming solvency by increasing debt, in other words, replacing cheap oil by solvency as a resource for feeding economic growth.
http://www.imf.org/external/pubs/ft/fandd/2011/03/picture.htm
This is the starting point in the deregulation of the financial system.
www.cepr.net/documents/publications/dereg-timeline-2009-07.pdf
Analyzing what´s the alternative for sustaining economic growth goes far beyond the objectives of this post, I just want to highlight two points.
• Sustaining economic growth on increasing debt is not possible anymore.
• Capital requirements are a percentage of Risk Weighted Assets (Percentage of Debt Weighted by the Risk of the Counterparty + Leverage Ratio); consequently as global debt is historically high, capital requirements should be historically high.
The two points above describe why the financial system is operating in a new environment of Capital Scarcity; and this is serious because Capital is the main resource of the Financial System.
In economy, when a critical resource becomes scarce we recognize it criticality and scarcity by increasing its price. These are the increasing capital costs that we’re discussing here. Higher costs of capital start in the financial system, and then they are spread by investing and lending through the whole economic system.
In the new environment, managing capital costs becomes mandatory, and particularly we must include them as part of the contribution margin of any business deal, obviously this necessity depends on the weight of capital consumption in the contribution margin.
For instance, the capital costs involved in the trade of 20.000 Barrels of Brent Oil for being delivered in 12 months, and paid in foreign currency, are not even close to the capital costs of buying 20 cans of beer in the local Walmart. But in both cases, the weight of capital costs involved in contribution margin of the deal are much higher than 30 years ago.
We have an excellent tool in the SAP Business Suite, Bank Analyzer, for determining Capital Costs (on the current releases only Credit Risk Capital Costs) and include them in the calculation of the contribution margin.
The difficulty seems to be integrating Bank Analyzer in the management of non-financial business processes; and judging by the emails I’ve received in the last weeks, this is an extended concern amongst the readers of this blog.
In my opinion, the difficulties have more to do with marketing reasons and perceptions than with technical constraints. We’ll talk about them in the next post.
Looking forward to read your opinions.
K. Regards,
Ferran.
In the last posts, we’ve discussed the importance of managing Credit Risk and Capital Costs in non-financial processes.
https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-chapter-frances?trk=object-title
https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-ferran-frances?trk=object-title
The necessity of managing capital costs is nothing new; it’s the natural consequence of managing the risks associated to an economic activity. What is new is the relative importance of the capital costs in the economic analysis of a business event.
During most of the 20th Century, and particularly since the end of the Second World War (including the plans for reconstructing Europe and Japan) and the implementation of the Breton Woods Agreements, capital was abundant and inexpensive.
In this environment of capital abundance, costs of capital were easily covered by high margins and strong economic growth. Consequently there was no incentive in managing capital efficiently. For decades, the economic world chose to believe that resources were unlimited and wasting capital not an issue.
http://en.wikipedia.org/wiki/Bretton_Woods_system
With the Oil crisis of the 70’s, we discovered that natural resources were limited, challenging the economic growth.
http://en.wikipedia.org/wiki/1973_oil_crisis
At the same time that some initiatives were implemented for managing resources more efficiently, world’s leaders looked for another resource which could be wasted for feeding economic growth.
The alternative was consuming solvency by increasing debt, in other words, replacing cheap oil by solvency as a resource for feeding economic growth.
http://www.imf.org/external/pubs/ft/fandd/2011/03/picture.htm
This is the starting point in the deregulation of the financial system.
www.cepr.net/documents/publications/dereg-timeline-2009-07.pdf
Analyzing what´s the alternative for sustaining economic growth goes far beyond the objectives of this post, I just want to highlight two points.
• Sustaining economic growth on increasing debt is not possible anymore.
• Capital requirements are a percentage of Risk Weighted Assets (Percentage of Debt Weighted by the Risk of the Counterparty + Leverage Ratio); consequently as global debt is historically high, capital requirements should be historically high.
The two points above describe why the financial system is operating in a new environment of Capital Scarcity; and this is serious because Capital is the main resource of the Financial System.
In economy, when a critical resource becomes scarce we recognize it criticality and scarcity by increasing its price. These are the increasing capital costs that we’re discussing here. Higher costs of capital start in the financial system, and then they are spread by investing and lending through the whole economic system.
In the new environment, managing capital costs becomes mandatory, and particularly we must include them as part of the contribution margin of any business deal, obviously this necessity depends on the weight of capital consumption in the contribution margin.
For instance, the capital costs involved in the trade of 20.000 Barrels of Brent Oil for being delivered in 12 months, and paid in foreign currency, are not even close to the capital costs of buying 20 cans of beer in the local Walmart. But in both cases, the weight of capital costs involved in contribution margin of the deal are much higher than 30 years ago.
We have an excellent tool in the SAP Business Suite, Bank Analyzer, for determining Capital Costs (on the current releases only Credit Risk Capital Costs) and include them in the calculation of the contribution margin.
The difficulty seems to be integrating Bank Analyzer in the management of non-financial business processes; and judging by the emails I’ve received in the last weeks, this is an extended concern amongst the readers of this blog.
In my opinion, the difficulties have more to do with marketing reasons and perceptions than with technical constraints. We’ll talk about them in the next post.
Looking forward to read your opinions.
K. Regards,
Ferran.
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