I wish it were your decision Mr. Bernanke – Chapter V

Dear,
Some months ago, we saw the US economy confronting a real possibility of default as the US representatives disagreed on the terms of raising the nation's debt limit, with a number of economic consequences, like the US debt rating or rating perspective being downgraded by several rating agencies.

http://sapbank.blogspot.com/2013/10/i-wish-it-were-your-decision-mr.html

On October 16, the Senate passed the Continuing Appropriations Act, 2014, suspending the debt ceiling until February 7, 2014 which “apparently” solved the problem.

From this perspective, it seems we’re confronting a political issue, impacting the biggest world’s economy.

Unfortunately not, we’re going to see that politics have nothing to do with this and the problem is purely economic.

The below graph shows that US Federal debt has risen from 35% to nearly 75% of the US GDP in the last 10 years, and particularly since the starting of the Financial Crisis in 2008.

http://en.wikipedia.org/wiki/File:FederalDebt1940to2012.svg

And if we look at the evolution of the total debt of the US economy, we see how it has reached 350% of the US GDP with a very significant contribution of the Financial Sector, whose debt has speeded up since 1980’s deregulation.

http://upload.wikimedia.org/wikipedia/commons/e/e0/Components-of-total-US-debt.jpg

Today US economy presents an uncontrollable deficit and an unsustainable debt, growing independently of the government party, republican or democrat. Once again, this is not a political problem but an economic one.

This growing debt has fueled economic growth; this is logical as the current economic model requires wasting capital for generating economic growth.

As debt is a Financial Asset (Liability for the counterpart), growing debt means oversizing the Financial System. The U.S. finance industry comprised 10% of total non-farm business profits in 1947, but it grew to 50% by 2010. Over the same period, finance industry income as a proportion of GDP rose from 2.5% to 7.5%, and the finance industry's proportion of all corporate income rose from 10% to 20%.

This wouldn't be a problem if debt could grow indefinitely, but the question is; is that even possible?

Since the starting of the financial crisis, the FED has injected 2.3 Trillion Dollars in the economy.  This month, as “Tapering” has reduced the liquidity injections from 85 to 75 billion dollars a month, a storm has been triggered in the Forex, Stock and Commodity markets.

http://www.telegraph.co.uk/finance/business-news-markets-live/10603717/Business-news-and-markets-as-it-happened-January-29-2014.html

What will be the impact in the Financial System when the Financial Markets decide to open their eyes and burst this huge debt bubble, raising the interest rates?

We saw it already in 2008, as the Financial Markets decided to not believe that real estate prices could grow indefinitely, interest rates of the CDO’s raise, and the world’s financial system was put on the edge of collapse.

The alternative at the time was bailing out the Financial System with public funds, collateralizing their debt and giving new and fresh guarantees to the debt holders.

At the time US Public debt was 5 trillion USD (36% of the GDP) and today it is more than 12 trillion USD (73% of the GDP). What’s the alternative now, who is going to rescue the Financial System if the interest rates start to rise?

When in the great movie “Too Big to Fail” http://www.imdb.com/title/tt1742683/ Hank Paulson asks Ben Bernanke for reducing the capital requirements of Bank of America so they can merge with Lehmann Brothers, Ben Bernanke replies.

“You want me to allow them to raise their leverage so they can buy a bank that's about to fail because it was overleveraged?”

Ok, now we have the US Central Bank overleveraged, what are we going to do about it?

Looking forward to read your opinions.

Kindest Regards,
Ferran.

Banking and Trading. Bank Analyzer for Non-Financial Companies - Chapter II

Dear,
Last week I received the feed-back of some readers to the post “Bank Analyzer for Non-Financial Companies - Chapter I.”; thanks for that, I really appreciate.

http://sapbank.blogspot.com/2014/01/bank-analyzer-for-non-financial.html

In their emails, most of them expressed doubts about the incentives for a Non-Financial Company implementing Bank Analyzer.

As I commented in my answers, there’re two reasons for a company, Financial or Non-Financial to implement Bank Analyzer.

- Capital Optimization/Risk Management.

- Regulatory Compliance.

I’ll focus today in the Regulatory Compliance.

It’s true that the regulatory framework for Banks is harder than for non-financial companies, but as you probably know, the new Dodd-Frank regulation on Over-The-Counter derivatives trading also applies to Non-Financial companies. For instance, Oil & Gas companies, in which derivatives’ trading is an intrinsic part of their business, are subject to this regulation.

http://www.ey.com/US/en/Industries/Oil---Gas/Dodd-Frank--what-oil-and-gas-companies-need-to-know

But we’re just at the beginning of the Systemic Change, and regulation will change to drive the economy towards the new Capital efficiency paradigm.

A good example is the US Congress “concern” about the involvement of investment banks, like Goldman Sachs or Morgan Stanley, in the commodity trading, which are posing at risk the stability of the financial system.

http://www.reuters.com/article/2014/01/15/us-commodities-banks-senate-idUSBREA0E07Q20140115

http://www.bloomberg.com/news/2014-01-13/fed-said-to-release-plan-to-limit-banks-commodities-activities.html

http://www.nytimes.com/2014/01/16/business/lawmakers-to-press-for-tighter-rules-on-physical-commodities.html?_r=0

Commodity trading is a core activity of investment banks, limiting their involvement in the commodity trading business means two things.

- Reducing their opportunities to do business.

- Eliminating risky (capital consuming) assets from their balance sheet.

Is this not a symptom of the systemic change of the financial system I’ve been describing you for the last 5 years, from a Business model based in volume to a business model based in efficient Capital management?

Additionally, “Lawmakers are saying that dealing in commodities could create conflicts of interest and lead to market manipulation by deposit-taking institutions”, and this is bad.

And the question is, why this was good 20 years ago, when Glass–Steagall Act, which assured the separation between commercial and investing banking, was repealed?

At the time, we were said that regulation limited the growth potential of the economy. Is it ok limiting the growth potential of the economy today?

You know my opinion, speculation is not good or bad, it’s just the consequence of an economic model based in capital consumption.

http://blogs.sap.com/banking/2011/11/16/the-financial-system-speculators-and-the-recession-dream/

In the old model, wasting capital was not an issue as it was abundant, not anymore.

The legislator is telling us today that in the new model is not convenient that banks are involved in commodity trading, and they prefer this activity to be performed by the natural market agent; Oil, Gas, Mining, Companies, etc.

If so, shouldn't we, as SAP consultants, look at those companies and analyzing integrated scenarios for managing their “banking” business processes?

I’m doing it already and I’ll share my findings with you in future posts, I hope you enjoy them.

Looking forward to read your opinions.
K. Regards,
Ferran.

Bank Analyzer for Non-Financial Companies - Chapter I.

Dear,

When we say that in the new model Capital Optimization is the priority we don’t mean only for Banks, but for all economic activities. Many companies, especially big corporations, are aware of this Systemic Change, and they are developing In-House Banking programs to be aligned with the new paradigm.

We talked about it in a previous post.
http://blogs.sap.com/banking/2012/01/18/in-house-banking-its-not-what-it-looks-like/

Some years ago, SAP released the In-House Cash module, as a component of the Financial Supply Chain Management area.  The solution has many advantages over other competitors, especially in integrated scenarios with other SAP ECC components (Purchasing, Sales, Treasury and Risk, Cash-Management, etc.). 
  
Unfortunately, this is not sufficient for covering the requirements of an In-House Banking solution in the new environment of Capital scarcity. As I mentioned in the post above, in the new model, in-house banking is not only about cash-concentration or wire transfer costs reduction, it’s mainly about capital optimization. 

For instance; two affiliates of the same multinational group can clear their Foreign Exchange exposures by signing Intra-group Forex contracts, reducing their capital consumption due to currency exchange volatility.

Fortunately, with Bank Analyzer, SAP has also developed the best piece of software for Capital Optimization, the question is, how to leverage its advantages in non-financial companies? 

I’ll answer the question with one example of the Oil industry.
Some could think that a confirmed Sales Order of Crude Oil is just a logistics contract, but technically is also a Financial Transaction with the following characteristics.

- Financial Transaction Type: Over-The-Counter Forward Contract.
- Underline: Crude Oil
- Forward Price: Confirmed Sales Price.
- Settlement Type: Physical Delivery.
- Forward Date: Invoice Date.

From a Market Risk perspective, the above forward contract represents an off-balance exposure, and consequently a capital consumption determined by the Value at Risk of the exposure, which depends on the underline price and volatility.

From a Credit Risk perspective, the confirmed sales order represents a Credit Risk exposure which also consumes capital. If the sales order is modelled as a Financial Transaction, the Credit Risk engine of Bank Analyzer can calculate the Credit Equivalent Amount of the Forward Contract. With the CEA and the Rating of the counterpart it will also calculate the Expected Loss, the Loss Given Default and the Capital consumed.
  
The Historical Database of Bank Analyzer and the Credit Risk module of SAP ECC offer powerful functionalities for determining the Rating of the Counterparty according to Internal and External models. We talked about it in previous posts.

http://sapbank.blogspot.co.uk/2013/05/rating-scoring-and-sap-banking-chapter-i.html

http://sapbank.blogspot.com/2013/06/rating-scoring-and-sap-banking-chapter.html

As you can see, representing the logistics process in Bank Analyzer gives the company executives’ visibility of the expected losses and consumed capital due to Financial Risk.

Having visibility of the Capital consumed is the first step of an efficient management of this critical resource; we’ll discuss in detail how to do it in a future post.

Looking forward to read your opinions.
K. Regards,
Ferran.

Bank Analyzer and the Systemic Change.

Dear,

In my opinion, one of the key documents for understanding the current financial crisis is the paper “Has Financial Development Made the World Riskier?”, by the current Governor of the Reserve Bank of India and former Chief Economist at the International Monetary Fund; Mr. Raghuram Rajan.

http://www.nber.org/papers/w11728.pdf?new_window=1

In his paper, Mr. Rajan warned that Bank's executives were encouraged to take risks which could have catastrophic consequences for the financial system.

Mr. Rajan published his paper in 2005 receiving a negative response. Just two years later, his vision was proved to be prophetic, with the explosion of the financial crisis.

Capital consumption is a consequence of Risk, when we determine the Capital consumed by an Investment; it comes from its Counterparty Risk (Risk Weighted Assets) and its Market Risk (Value at Risk).  Saying that bank’s executives are encouraged to take risk, means that the Financial System is oriented to consume capital.

Some of the most critical dangers described by Mr. Rajan’s paper are still present in the current Financial System; some decisions towards a more stringent regulation have been taken, but we’re at the very beginning of the process.

For instance, the current liquidity injections of the Central Banks are feeding the next financial crisis, or more exactly, they are just delaying the systemic consequences of maintaining an exhausted Financial System based in volume and oriented to capital consumption.

Read carefully last June's speech of the General Manager of the Bank for International Settlements, Mr Jaime Caruana; “Making the most of borrowed time”

https://www.bis.org/speeches/sp130623.htm

When the borrowed time is over, we’ll see the real consequences of the current systemic crisis as the Financial System moves from a model based in Volume to a model based in Efficient Capital Management.

The new regulation, Basel III, IFRS, Dodd-Frank, European Market Infrastructure Regulation and others that will come are just the driver of the Systemic Change.

Managing this community for more than 5 years has given me the opportunity of contacting and exchanging opinions with many people; some of them are Bankers, or IT Managers of Banks. In general, they’re concerned by the new regulation and the capacity of their IT infrastructure for providing the regulatory reports.

Some weeks ago, I had the opportunity of discussing about Bank Analyzer with an executive of a medium size Bank which is considering the implementation of Bank Analyzer, or some of its competitors, Oracle, Sunguard, etc.

He asked me a very intriguing, but also interesting question.

Why should my Bank implement Bank Analyzer, when other competitors offer less complex systems that also support IFRS and Basel III?

My answer; Bank Analyzer is complex because is the most complete modelization of the reality, and as the reality is complex, Bank Analyzer has to be complex.

If you believe that the new regulation is just a temporary fashion you will not understand the competitive advantages of Bank Analyzer. But if you think that the Financial System is in the middle of a Systemic Change, you will appreciate an IT infrastructure which can help your Bank in the biggest challenge it has confronted in decades.

Happy 2014 to everybody, it's going to be interesting.

Looking forward to read your opinions.
K. Regards,
Ferran.

Dodd-Frank vs. EMIR and Bank Analyzer.

Dear,

Some months ago, we were required to prepare an analysis of the implications of using Bank Analyzer as a central repository, for fulfilling the reporting requirements of the European Market and Infrastructure Regulation and Dodd-Frank Act for a Bank subject to both regulations.

Dodd-Frank in the US and EMIR in Europe are the result of the G20 summit mandate on September 2009, requesting the Over the Counter Derivatives Market to be regulated, in order of enhancing transparency and reducing systemic risk in the Financial System.

They have similarities; both EMIR and Dodd-Frank include clearing transaction, and risk mitigation provisions reporting requirements, that apply to financial and non-financial firms trading derivative contracts.

But EMIR and Dodd-Frank have also some differences that must be considered when it comes to evaluate the SAP Bank Analyzer capabilities to help a Bank to be compliant with them.

The first difference is in the scope; EMIR only applies to derivatives not cleared in Central Counterparty Clearing Houses, while Dodd-Frank is also applicable to swaps cleared in designated clearing organizations.

Dodd-Frank and EMIR definitions of Swaps and Derivatives are not fully coincident; consequently the reporting requirements for them are different under Dodd-Frank and EMIR.

Intra-group transactions are in scope for Dodd-Frank while EMIR establishes some exceptions to the reporting of transactions with affiliates.

EMIR is only applicable to transactions with counterparties legally established in the EU while Dodd-Frank has broader cross-border application.

The second important difference is reconciliation; US Commodity Futures Trading Commission requires exchange of valuation in all cases while EMIR establishes some exceptions to it.

Other important differences are the requirements for documenting the relationship with the client which are much more detailed for the US-Commodity Futures Trading Commission than for the European Union regulation.

Finally the US-Commodity Futures Trading Commission includes specific and detailed record keeping requirements while the European regulation does not.

From a technical perspective, the multilayer architecture of Bank Analyzer (Source Data Layer, Process and Methods Layer, Results Data Layer and Analytical Layer) offers us strong functionalities for covering the reporting requirements of multiple regulations as in this case.

As in many other consultancy analyses, there is more than one approach for looking at the problem, in this particular case our proposal was the following.

Regulation is dynamic and it can change, particularly in very new regulation like Dodd-Frank and EMIR. Consequently selection functions of the transactions in scope for EMIR or Dodd-Frank shouldn’t be contained in the SDL. The SDL is a representation of the facts represented in the Transactional System, while regulations (EMIR, Dodd-Frank or others) are just an interpretation of the facts.

Consequently our advice was to build the selection function as part of a PML process that could be run separately for preparing the EMIR or Dodd-frank regulatory requirements according to the particular selection criteria (index function) of the contracts in scope for them.

Additionally, this approach gives us the flexibility of enhancing the transaction data according to the different requirements of EMIR and Dodd-Frank Act.

Finally the proposal included building two separated Results Data Areas on the Results Data Layer for storing the data before is extracted to SAP Business Intelligence; improving the performance of the system and containing the full set of data required by every regulation.

Finally the data is extracted to SAP Netweaver-Business Intelligence. Finally, it can be exported to external systems using the functionalities of the Open Hub Service.

Looking forward to read your opinions.

K. Regards.
Ferran.

Securitizating Countries - SAP Real Estate and Bank Analyzer.

Dear,

As you could read here, the world is facing an unsustainable, un-payable debt.

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

This debt is spread as Financial Assets, amongst the balance sheets of corporations, investment funds, etc

In my opinion, the Fair Value of these assets is far below their current book value, and the recognition of their real value will be a huge bubble burst that will drag the value of many other assets down.

On the other hand, crisis are also opportunities, and I’d like to talk today about an economic activity which is going to experience a significant growth with the Financial Crisis, and it’s also an opportunity for SAP Banking.

I mentioned in a previous post that securitization activities are going to grow, but it’s going to be different than the securitization business we saw before the starting of the Financial Crisis.

At the time, we were in a booming economy, and securitization was mainly a commercial driven activity. For instance, remember the “toxic” synthetic securitizations, purely financial bets, not supported by any real economic asset.

http://sapbank.blogspot.com/2013/06/toxic-assets-strike-back.html

But, let’s come back to the problem of the global debt. Paying the debt will require making this very toxic asset attractive to investors (of course after suffering a necessary hair-cut), and securitization is going to play a very important role on it.

This is going to be a very different securitization, not commercially, but capital management driven, with new requirements of control and disclosure. In the new model Capital will be recognized as scarce; and managing it efficiently, the priority.

The proposal of securitizating assets is not new for poor (capital scarce) economies, look what the International Monetary Fund said about it 12 years ago.

http://www.imf.org/external/pubs/ft/fandd/2001/03/ketkar.htm

And look what the International Monetary Fund, European Central Band and European Commission (main lenders of Greece), are requesting to the extremely indebted country, in exchange of a new package of financial assistance.

http://www.reuters.com/article/2013/08/29/us-eurozone-greece-privatisation-idUSBRE97S0EJ20130829

Please, read carefully the articles above, you will find the key words there; Risk Mitigation, Management, Control...

Nothing to do with the old securitization model, represented by the example of the subprime CDOs., massively traded with no control on the risk or the fair value of their underline, in liquidity flooded markets.

Once again, the Financial Crisis is driven the systemic change, from a business model based in volume to a business model based in efficient capital management.

Greece is a very good example, it help us to understand the new paradigm. Detailed control of the assets performance, in this scenario Information management and control is the key.

What the troika is proposing is the securitization of Greek Real Estate assets under the control of an external institution (controlled by the lenders). 

Those lenders are also going to face financial difficulties after the crash, and they will need investors allocating capital; and in a scenario of scarcity, investors will require guarantees of the efficient management of the acquired assets.

We discussed here some months ago how to manage efficiently this process with SAP Banking components. (ECC-GL Real Estate, Treasury and Risk and Bank Analyzer) 

http://sapbank.blogspot.com/2013/08/real-estate-rentals-securitization-and.html

SAP has proved for decades to be the leader in detailed control and performance measurement of assets in many industries. Now it’s the time of leveraging those functionalities to the new requirements of the Financial System.

I have no doubt that it has the capacity of making it happen.

Looking forward to read your opinions.

K. Regards,

Ferran. 

European Market Infrastructure Regulation, Collateral Highway and Bank Analyzer.

Dear,

As you know, we’re in the middle of a transition period of the Financial System, from a business model based in Volume to a business model based in Efficient Capital Management.

Some weeks ago, we introduced the concept of Collateral mobilization, and today we’re going to elaborate it a bit more.

http://sapbank.blogspot.com/2013/11/collateral-mobilisation-and-bank.html

As Capital is scarce the main priority is managing it efficiently, wasting capital is not acceptable and the regulation will drive the change by increasing the Banks’ Capital Requirements.

One of the most important sources of regulation towards the new model are; the Market Infrastructure Regulation in Europe and the Dodd–Frank Wall Street Reform and Consumer Protection Act in the US.

http://www.esma.europa.eu/page/European-Market-Infrastructure-Regulation-EMIR

http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf

They have some differences but are coincident in the general objectives.

- Reporting obligation for OTC derivatives

- Clearing obligation for eligible OTC derivatives

- Measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives

- Common rules for central counterparties (CCPs) and for trade repositories

- Rules on the establishment of interoperability between CCPs

And the consequence in both of them is the same, making collateral squeeze visible.

http://video.ft.com/2674562697001/Collateral-squeeze-worries-traders/Markets

As collateral becomes scarce, financial agents demand new sources of this critical resource.

The market has seen the opportunity, and new services oriented to cover the collateral shortage and improve the inefficiencies in collateral management are being developed.

A very interesting example is the Collateral Highway, a joint initiative by Euroclear and The Depository Trust & Clearing Corporation (DTCC).

https://www.euroclear.com/en/services/managing-collateral/collhighwayportal.html 

The Collateral Highway is an electronic marketplace which connects financial agents providing lending and borrowing collateral functionalities. 

This way the market can unlock collateral pools that otherwise would be infra-utilized, increasing liquidity in the financial system and mitigating the effects of the collateral scarcity.

But as in any other marketplace, offering eligible collateral is critical for successful trade, and there’s no better way of making financial assets eligible than disclosing its value, and we don’t have a better tool to disclose the value of financial instruments than Bank Analyzer.

But successful collateral mobilization confronts Banks with other challenges.

Communication is key, SWIFT is a real time network, but the communication flow can be very complex, involving the investor, the global custodian, the central securities depository , the International central securities depository and a third party.

Remember that Banking systems have been built in silo-style architectures with point to point connections in multiple flows like the example above, and even including manual steps. Efficient capital management is also about re-engineering and reducing complexity in the communication flow; we need a single, homogeneous and centralized repository of the Bank’s assets, another core value of SAP Bank Analyzer.

This central vision of the Bank’s collaterals brings the foundation of the Enterprise Collateral Management, another critical activity in Collateral Optimization.

There’re other techniques, like securitization, which are going to play a very important role in the new model for increasing capital mobilization; we’ll talk about them in a future post.

Looking forward to read your opinions.

K. Regards,

Ferran.