Capital Scarcity and Capital Optimization with the Integrated Financial and Risk Architecture of SAP Banking.

 Dear,

The Financial System is in a process of Systemic Transformation, from a model based on volume to a model based on Capital Optimization.

We are entering into a new era of Capital Scarcity for two reasons.

1) Excess of debt (the biggest in the history of capitalism) overconsumes Capital.

2) Weakening of economic growth, as a consequence of natural resources scarcity and Energy Transition of the Economic System slows down Capital generation.

If Capital is overconsumed due to excess debt and it is not generated at the same rate due to weak economic growth, Capital becomes scarce. But Capital is the most important resource of the Financial System and if it has become scarce there’s no higher priority than optimizing it.

Consequently, the Financial System has to be transformed from a model based in volume to a model based in Capital Optimization.

If Capital is scarce, a fractional reserve financial system suffers from solvency stress. Consequently, regulators increase capital requirements, forcing financial institutions to reduce their leverage.

As free capital becomes scarcer, it also becomes more expensive, driving Systemic Transformation.

Financial Assets consume Capital in three main ways:

- Credit risk.

- Market risk.

- Operational risk.

The Basel III agreement establishes the main metric to measure the Capital consumed by exposure to Credit Risk of Financial Assets, and lays the foundations for calculating the Capital requirements of a Financial Institution.

The Basel III agreement distinguishes between the Expected Loss and the Unexpected Loss produced by an exposure to Credit Risk, the first must be covered by Provisions for Impairment and the second by Capital.

A valid capital optimization model should reduce the capital consumed in credit risk exposures while limiting the Expected Loss and the Unexpected Loss.

The internal rating-based approach, both basic and advanced, gives us the opportunity to build a comprehensive credit risk optimization system, such as the credit risk model used to determine the probability of default, the loss given default, and the exposure at default (in the case of the Advanced Approach) can be used, with some adjustments, as the basis for determining the Impairment Provisions.

In this model, the Provision for Impairment is compared with the Expected Loss; if the Expected Loss is greater than the provision, the excess Expected Loss is reduced from principal.

On the other hand, if the Expected Loss is less than the provision, banks may recognize the difference in Tier 2 capital up to a maximum of 0.6% of credit risk-weighted assets.

For more information, you can refer to http://www.bis.org/publ/bcbs128.pdf

This holistic management of capital requirements and impairment provisions requires integrated accounting and risk modeling, which is exactly the foundation of Integrated Financial and Risk Architecture of SAP Banking.

SAP Banking-Credit Risk Impairment Processes offers:

- Automatic determination of the percentage of Expected Loss from the Rating and the Default Bands of the Exposures.

- Dynamic classification of Financial Assets in the Bad or Good book by processing Impairment Events.

- Determination of the Causative Status of the Impaired and Current Assets in accordance with the requirements of IFRS9.

- Determination of Expected Loss, Provision, Penalty and Penalty Amounts, and reversal of Exposures, including Off-Balance Exposures using Credit Conversion Factors.

- Accounting for Impairment Provisions in the Bank Analyzer sub-book fully integrated with the Accounting Processes.

- Transfer of Provisions for impairment to the General Ledger and full reconciliation of Provisions for impairment between the Subledger and the General Ledger.

SAP Banking's Integrated Financial and Risk Architecture offers us a holistic view of the accounting position (value-earnings), liquidity and Capital consumption (risk) of a financial exposure. But even more, it speaks the same language as SAP S/4 HANA and 70% of the World GDP managed with SAP.

This capacity allows to express the processes of the real economy in accounting terms (that is already done by SAP S/4 HANA), liquidity (only partially solved by S/4 HANA) but also Capital consumption. And that's something that only the Integrated Financial and Risk Architecture offers, and it's critical in the capital-scarce environment that we're entering.

The last 12 years our team has worked in modeling all the economic events and business flows represented in the SAP systems of the Real Economy, in terms of Capital and Liquidity consumption and generation. With this information, our systems measure how to offer Financial Instruments for covering Capital and Liquidity gaps or investing Capital and Liquidity surpluses, optimizing the Capital and Liquidity consumption of the system.

We are working on presenting our system to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting 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://lnkd.in/g3KU6DN

Visit my SAP Banking Blog at: https://lnkd.in/gXpDEdr

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

#sapbanking #capitaloptimization

Management of Internal and External costs of Financial Transactions and Capital Optimization with SAP Banking.

 Dear,

The process of Optimizing Capital begins by determining the profitability of the processes, prioritizing those that offer a greater potential return on invested Capital, and once this objective has been achieved, measure the risk weighting of these exposures to prioritize those that offer a higher return weighted by Risk.

But to determine the profitability of a process, it is necessary to measure its contribution margin, or what is the same, inventory and measure the internal and external costs and income that impact that process.

I have dedicated more than 30 years of my life to SAP consulting and, when I participated in my first Bank Analyzer project in 2004, I already had many SAP Controlling projects behind me.

From the outset, I noticed how Bank Analyzer's Credit Risk and Financial Instrument Accounting modules integrated elegantly with SAP ECC's Financial Accounting and Management Accounting areas. For this reason, they would respond to the requirements of Margin Management, Profitability Analysis and Capital Optimization.

In my opinion, this potential has not been explained enough, so I will try to shed some light on the subject in this blog.

The analysis of the contribution margin requires the detail of the costs and revenues that impact a business process. And the first task is to identify the elements of cost and income that compose it.

The costs and revenues generated by a business process are never isolated, but represented by direct and indirect costs and revenues, they are distributed throughout the organization and impact, use, support, and generate synergies with other business processes.

The integrated architecture of SAP R3, SAP ECC and S4/HANA and the analysis capacity of Financial Accounting, Cost Object Accounting, Profit Center Accounting, Activity Based Costing, etc. has led to the ability to measure these interactions. For more than 30 years, this architecture has transformed the Information Systems of 70% of the World GDP to convert its analysis into a market standard.

On the other hand, Financial institutions, with very few exceptions, have not participated in this transformation. Its Information Systems continue to be supported by obsolete technologies, built on silo-style architectures that lack the integration of SAP systems, which makes it difficult, if not impossible, to carry out an adequate cost analysis and even more so, Capital Optimization.

Let's analyze the internal and external costs and income of a Financial Transaction.

External income seems obvious; interest and commissions charged to customers.

The external costs also seem obvious; Losses due to the risk that the client does not comply with its obligations (Credit Risk) or that market conditions impact the collection rights and have less value than expected (Market Risk).

SAP's Financial Products Subledger solution determines the value of the Financial Transaction, including external costs and revenues, based on the Discounted Cash Flow of the Financial Transaction and the Credit Risk and Market Risk adjustments. It is important to note that for the accounting of the Credit and Market Risk adjustments, the FPSL solution needs to be provided externally with parameters for calculating the cost of capital, such as Loss Given Default, and that these parameters can be determined with other areas of SAP Banking as Credit Risk Analyzer, or with limitations, Market Risk Analyzer. In a future blog we will analyze this integration in more detail.

Let us now look at internal costs and revenues.

Internal costs and revenues are also easy to identify; overhead costs of financial transactions, funding costs for Assets and funding income for Liabilities.

Overhead costs are quite intuitive so I will start with them. The Management Accounting modules of SAP ECC and S/4 HANA offer us very powerful tools for analyzing, allocating, distributing and reporting the overhead costs. Cost Center Accounting, Internal Orders, Projects System, Real Estate Management, Activity Based Costing, Profitability Analysis, etc are very well known and you can find much documentation with all the necessary details for understanding the solution capacity.

The difficulty is that they provide the overhead costs at the level of the cost center/profit center and we have to distribute them to the level of the Financial Transaction. The commonly accepted approach is considering them as Standard Costs and distributing them from the Cost Center/Profit Center level to the Financial Transaction level at Period End for reconciliation purposes.

The Business Content for Profitability and Efficiency Management of SAP Performance Management for Financial Services help us on this. The Business Content for Profitability and Efficiency Management of SAP Performance Management for Financial Services comes with powerful functions for distributing standard costs (Overhead, Capital reserves, etc.) to the level of the Financial Transaction.

The above is not fully true, as the SAP S/4HANA Universal Journal integration capabilities also give us the opportunity of tracking some of the overhead costs to the level of the Financial Transaction, particularly with the help of the Controlling Modules like Activity Based Costing but this requires a level of sophistication which is not easy to find. The same applies for Capital Reserves costs.

Finally let's look at the funding costs (and income).

We will start by identifying a Profit Center as the "Funding Center" responsible for holistically managing Assets and Liabilities.

When the entity makes an investment from a Branch or Department (Loan or any other Asset) it is consuming liquidity that must be compensated by Cash or Deposits (or other equivalent Liabilities). For this reason, the funding cost of the theoretical Liability provided by the Funding Center must be allocated as an internal cost, which should provide the liquidity consumed by this Asset.

To do this, we must identify the maturity of the Asset to internally generate a Liability that compensates for the liquidity consumed and whose funding cost will give us the internal funding cost of the Asset.

Similarly, if a Profit Center captures a deposit, it will be compensated by the Funding Center with the Funding Income according to the maturity of the deposit.

The SAP Performance Management for Financial Services Business Content for Profitability and Efficiency Management provides 3 methods for calculating Funding Costs; Macaulay Duration, Fisher-Weil Duration and Modified Duration. For those of you who are familiar with the old SAP Profit Analyzer solution from Bank Analyzer, these are basically the same methods, so it will be easy for you to adapt them to the functionalities of SAP Performance Management for Financial Services.

Actually Assets and Liability Management is a critical function that goes far beyond optimizing funding costs in the Capital scarcity environment we are entering and we will discuss it in more detail in a future blog.

The integrated capabilities of SAP Financial Products Subledger, S/4 HANA and SAP Performance Management for Financial Services facilitate detailed analysis of internal and external costs and revenues of Financial Transactions, including overhead costs, capital costs and funding costs. Accurately measuring these costs and revenues is the first step in Optimizing Capital, probably the most critical activity that organizations will face in the coming decades.

We are entering into a new era of Capital Scarcity for two reasons.

1) Excess of debt (the biggest in the history of capitalism) overconsumes Capital.

2) Weakening of economic growth, as a consequence of natural resources scarcity and Energy Transition of the Economic System slows down Capital generation.

If Capital is overconsumed due to excess debt and it is not generated at the same rate due to weak economic growth, Capital becomes scarce. But Capital is the most important resource of the Financial System and if it has become scarce there’s no higher priority than optimizing it.

Consequently, the Financial System has to be transformed from a model based in volume to a model based in Capital Optimization.

The last 12 years our team has worked in modeling all the economic events and business flows represented in the SAP systems of the Real Economy, in terms of Capital and Liquidity consumption and generation. With this information, our systems measure how to offer Financial Instruments for covering Capital and Liquidity gaps or investing Capital and Liquidity surpluses, optimizing the Capital and Liquidity consumption of the system.

We are working on presenting our system to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting 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

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com