After ten years, now it's the time for SAP Banking

Dear,

Last week I talked to a friend who was one of the first Bank Analyzer consultants in Europe, but he moved to other businesses years ago.

He told me that SAP Banking has been just a hope for more than 10 years and he thinks that the situation is not different today.

I disagree; today we’re confronting a systemic crisis, forcing a much more stringent regulation, which is driving a profound change in the Financial System, from a business model based in Volume to a business model based in efficient Capital Management.

Today, and in the next years, SAP AG and the whole ecosystem of partners and consultants, have the opportunity to play a principal role in the systemic change,

During this month, we’ll see the strategy on the Assets Quality Review that the ECB is performing during 2014 in the European Banks. 

http://www.reuters.com/article/2014/02/03/us-ecb-banks-idUSBREA1200320140203

There have been previous audits of the solvency of the European Banking System, giving guarantees on the solvency of the Irish, Spanish, British, German, Greek banks…, and we discovered some months later that they were severely under-capitalized and had to be bailed-out.

This time is going to be different, it has to be different; today financial authorities have the protocol for shutting-down a non viable bank that has been “successfully” tested in Cyprus. They have the book and they’re going to use it.

After that, we all will be aware of what Capital means, what the consequences of its scarcity are and why it has to be managed efficiently.

For the last 7 years the center of my interests have been Capital Optimization; a wide discipline with implications in every corner of the financial system. You can find some ideas here.

http://blogs.sap.com/banking/tag/capital-optimization/

But the posts above are a very tiny description of the endeavor. From time to time I’m invited by some senior executives of Banks, (who have been reading my posts for a while, or know somebody who does) to share and exchange some ideas about Capital Optimization.

When I explained them that Capital Optimization is much more than Portfolio Management, and extend its implications to every activity, (from Loans Origination to Collateral Management, from Securitization to Payments Claim) requiring to be managed in a integrated model, they understand the size of the challenge and show their concerns about the feasibility of the objective.

I also understand the difficulties, but I’m also aware of the implications of avoiding the transformation. 

For those of you, who think I’m wrong, please remember the words of Michel Barnier (Member of the European Commission responsible for the Internal Market and Services).

 

"We need a new deal between financial regulation and society. A deal in which financial services are back at the service of the real economy. And at the service of citizens. Citizens who are also taxpayers. Those same taxpayers who are paying the bill of bailing out the banks. Citizens and taxpayers who have lost all trust in the financial system. Who don’t believe it works for them. And who won't forgive us if we don’t learn all the lessons of the crisis. And change what needs to be changed in the financial sector.This must be the starting point of any "new deal" between the world of finance and society: restoring trust"

 

 http://europa.eu/rapid/press-release_SPEECH-10-178_en.htm?locale=en

And now, tell me who can offer the technology infrastructure to put Capital at the center of the financial system, reflecting clearly the implications of the peripheral activities; from determining the Free Line of a non-fully disbursed loan in Banking Services, to reduce the rating of a counterpart, after an IRB estimation in the Historical Database of Bank Analyzer.

Explaining why SAP is the only software offering this holistic approach is the reason why I founded this community and the main objective of every post.

Looking forward to read your opinions.

K. Regards,

Ferran.

Subprime Crisis 2.0

Dear,

As the Tapering has started, instability has arrived to the Financial Markets

http://www.cnbc.com/id/101387956

This is not a surprise; as liquidity is dried from the system risky assets become less attractive.

This is just the first step in the process of normalizing the monetary policy, the key question is how deep the consequences will be at the end of it.

Maybe we can learn something from recent history.

Subprime crisis started on February 2007, as interest rates began to raise some borrowers were unable to refinance and housing prices started to drop moderately.

At the time, economy was performing well and credit kept flowing, the stock market recovered quickly and the subprime crisis was described as a Storm in a Teacup. 

One year and half later the Financial System faced the biggest crash since the Great Depression.

In my opinion, there’re similarities between February 2007 and 2014 events that deserve to be analyzed.

Last years' liquidity injections of most of the Central Banks (Bank of England, FED, Bank of Japan, etc) have reduced drastically the interest rates and carry trade has transferred the liquidity excess to the emerging economies, increasing their external debt.

For instance, Brazil external debt has grown from 200000 USD Million to 312021 USD Million in the last 6 years, with most of this capital flowing to real estate investment and consumption.

http://www.tradingeconomics.com/brazil/external-debt

As the economic activity increased, rating improved and local banking systems gave more loans increasing their leverage. Again, most of this capital flowed to real estate investment increasing property valuations.

Additionally, in some countries, like China, shadow banking has grown exponentially, making very difficult the estimation of the size of the problem. By the way, as it happened with the estimation of the size of the Collateralized Debt Obligations problem of the US Subprime Crisis.

http://blogs.wsj.com/marketbeat/2011/10/25/chinas-shadow-banking-system-the-next-subprime/

At you know, historically, this is the root cause of credit and real estate bubbles with very bad consequences. Please, spend ten minutes watching the video below.

http://www.cbs.com/shows/60_minutes/video/2340027515/china-s-real-estate-bubble/

Most of the emerging countries economies depend on the export of commodities, whose prices also rise during the monetary expansion cycle. As the cycle ends, commodities prices are dropping increasing their trade deficit.

In a globalized world capitals can flow very quickly in and out of a country; this is what we've seen in the last weeks with the logical impact in the Foreign Exchange markets. For instance Turkish Lira dropped by 10% in the last 2 weeks of January, and nearly 30% in the last 6 months.

Trying to stop capitals flight, some central banks have raised interest rates but this is likely going to slow down the economy, increasing the probability of busting the credit bubble.

http://blogs.wsj.com/moneybeat/2014/01/28/turkey-central-bank-raises-interest-rates/

Someone would say that Man is the only animal that trips twice over the same stone, but the reality is that as we’re still in a financial system oriented to volume, history repeats itself, 

But for how long?

Looking forward to read your opinions.

Kindest Regards,

Ferran.

Apples and Oranges. Bank Analyzer for Non-Financial Companies. Chapter III

Dear,

Managing means taking decisions; requires giving priority to some actions in front of others and allocating resources to the most important activities.

This is not an exception when it comes to Risk management, every investment and business activity requires taking a risk and it’s a candidate to request risk hedging actions.

But hedging a risk also has a cost that will potentially reduce the profit of the investment; at the end the profit of an investment is determined by all the revenues less all the costs.

Determining the profit of an investment without risk (arbitrage) is relatively easy, it just requires comparing homogeneous magnitudes. A typical example is the following; if we buy 3 oranges from someone for 3 $, and we sell them immediately after to someone else for 5$ we’ll make a non-risk profit of 2 $.

But if we buy the oranges for 3 $ and we exchange them for 3 apples, we can’t determine the profit immediately; we also need the value in $ of the apples to determine our profits.

That’s a typical risk management problem, if we’re storing and selling 2000 barrels of Oil; we’re taking many risks (explosion, leaks, price fluctuation, etc.) which require risk hedging activities. As risk zero does not exist, the more we invest in risk hedging activities (for instance, buying an insurance policy or installing a fire control system) the more costs we’ll support, reducing our profits.

Managing risk requires comparing the cost of the risk hedging activities with the cost of risk of the business activity, and that’s not easy.

Risk hedging activities can be measured in EUR or USD; but how I do it to compare them with the cost of risk? Again, I can’t compare apples with oranges.

This is a handicap of Integrated Information Systems, even SAP-ECC, the most successful of the Integrated ERP’s, does not offer an integrated and homogeneous vision of risk and its associated costs.

In a growing economy this is not a big issue, big margins cover inefficiencies on risk management, but we’re in a new model of limited growing economies with limited margins for the companies. In the new model, efficient management requires integrated Enterprise Risk Management systems.

But, do we have a candidate for building Enterprise Risk Management Information systems, capable of offering an integrated and homogenous vision of risk management?

In my opinion we do, and this is Bank Analyzer.

In the following lines I’ll try to give a brief description of the approach.

First we need the conversion of risk costs in USD, and we’ll look at Financial Mathematics’ for finding the function to convert risk exposures to USD, Oranges in Apples and vice-versa.

In Bank Analyzer, we can determine the NPV of a loan (Key Date Valuation), by discounting the expected cash-flows of the loan according to a yield curve, which depends on the probability of default of the counter-party. This is the probability of the expected cash-flows to become effective.

In a similar way, potential costs due to fluctuations in the Oil price, explosions, leaks, etc. represent expected Cash-Flows; by estimating the probability of those events happening, and selecting a Yield curve according to the probability of the events, we’re also estimating the Net Present Value of the Business Activity.

As you can see, from financial mathematics’ perspective there is not a big difference in calculating the Net Present Value of Lending money or the NPV of storing and selling Oil.

The challenge is modeling the business activity as SDL-Primary Objects. If we do, the risk engines of Bank Analyzer will provide us the Net Present Value, the expected losses due to counterparty risk and in future versions of BA, the Value at Risk and expected losses due to Market Risk.

We saw some weeks ago how to do it with a Sales Order of Crude Oil

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

I’m working on the modeling of many other business activities that I’ll share with you in future posts.

K. Regards.

Ferran.

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.