Dear,
Capital is the most critical resource of the Financial System, and it has become very scarce as a result of excessive indebtedness and weak economic growth.
https://edition.cnn.com/2022/05/05/investing/double-dip-recession-economy-inflation/index.html
https://blogs.imf.org/2022/04/11/dangerous-global-debt-burden-requires-decisive-cooperation/
If Capital is scarce, the most critical activity of the Financial System is Capital Optimization that drives and will drive its transformation from the current model based on Volume to a new model based on Efficient Capital Management.
One of the most effective techniques in Capital Optimization is Dynamic Collateral Management which I will try to describe in this article.
A classic method for Risk Mitigation (Reduction of capital consumption), recognized by all the Basel agreements and solvency regulations, is the management of guarantees or collateralization.
In collateral management we can follow two approaches.
• Static collateral management. The Bank has an exposure (account receivable or asset) and requests guarantees to cover the Default Risk of the exposure. The greater the exposure, the greater the collateral required. The degree of collateralization is determined by the difference between the amount of the exposure and the value of the guarantee.
• Dynamic collateral management. On the other hand, according to the Basel agreement, Capital consumption does not depend directly on the Bank's exposure to Risk, but rather on Risk exposures “weighted” by the risk level of the exposures. Consequently, the requested level of collateralization depends on the amount and risk of the exposure, and the value and risk of the collateral, and it changes (dynamically) with them.
If we analyze in detail the two previous approaches, we will see that the decision to follow one or the other has significant consequences in the management of capital.
In the first case, the collateralization does not depend on the risk of the exposure and the collateral (rating), but only on the Degree of Collateralization with respect to the Exposure Amount. On the contrary, in the second case, the risk of the collateral and the exposure are included in the Calculation of Risk-Weighted Assets and, consequently, in the degree of collateralization.
The second approach is more risk sensitive allowing more efficient collateral management, and it is particularly useful when a pool of collaterals covers multiple exposures. Determining the most efficient allocation of collateral to exposures reduces the capital consumed. This reduction in Capital consumption is the basis of Dynamic Collateral Management, one of the main Capital Optimization techniques.
Balancing collateral and exposures to optimize return on risk-adjusted capital (RAROC) is no easy task. The Loss Given Default depends on the amount of the exposure and counterparty's rating (or its Probability of Default), and the value and rating of the collateral. All these magnitudes are continuously fluctuating. Consequently, the allocation of Collateral portions from a Collateral Pool to the bank's exposures must be a dynamic activity that must be adjusted as the market and counterparty’s conditions change.
For example, as the counterparty's rating improves, or the value of the collateral increases, the Loss Given Default will be reduced until it reaches a limit, in which a better rating or greater collateralization does not reduce the risk-weighted assets. This collateral excess can be released and used in another risk exposure, improving the performance of the portfolio, without penalizing the bank’s capital consumption.
On the other hand, if the value of the collateral declines or the counterparty's rating worsens, higher portions of the collateral pool will be required to reduce capital consumption, triggering, if needed, a margin call.
This technique is very useful in environments of scarcity of Capital but requires an accurate calculation of the collateralization levels of the bank's exposures.
At this point we should ask ourselves; how to obtain the information required for the dynamic calculation of the collateralization levels?
The answer has been provided by SAP for the last 30 years; “Process Integration”.
The business processes of companies in the real economy generate and consume capital and liquidity, but with a maturity mismatch that comes from the business maturation cycle. Simplifying, the business process consumes resources at the beginning of the business cycle and generates revenue at the end. If this maturity mismatch is not covered with internal resources, it will be covered by the financial system, obtaining a yield that remunerates the investor for the cost of Capital.
Detailed modeling of the capital consumption of the process, including the exposures and their risk weighting, provides the capacity of dynamique and efficient allocation of collaterals, reducing the capital consumption of the system.
Approximately 70% of the world's GDP is managed with SAP systems, offering an accurate measure of resource consumption and revenue generation, as well as its planning and deviations from planned values. Just the information we need to calculate capital consumption and generation and efficiently allocate available collateral.
Our system, built on SAP technology, integrates with the processes of the real economy (managed with SAP), and determines its capital and liquidity consumption. With this information, it proposes financial instruments that cover deficits or excesses of capital and liquidity, adjusting the price to the risk of the operation.
We are working on presenting our system to the market and looking for business partners and investors. If you are interested, do not hesitate to contact me at ferran.frances@capitency.com
Looking forward to reading your opinions.
Kindest Regards,
Ferran Frances.
www.capitency.com
Join the SAP Banking Group at: https://www.linkedin.com/groups/92860
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Let's connect on Twitter: @FerranFrancesGi
Ferran.frances@capitency.com
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