Comprehensive Capital Assessment Review and Bank Analyzer – Chapter I

Dear,
A former colleague asked me last week if Bank Analyzer would be useful for the current Comprehensive Capital Assessment Review and Stress Tests that US Banks have passed recently.

You can find some information here
http://www.federalreserve.gov/newsevents/press/bcreg/ccar_20140326.pdf

This is, and it’s going to be, a very hot topic for all the Banks, and it’s important we all know the Bank Analyzer capabilities in this area.

Since 2008 Financial Crisis impacted the entire U.S. economy (actually the world’s economy), banks’ capital requirements have been the top’s priority for the regulators

Basel III, Dodd-Frank and EMIR, amongst other regulations, have increased significantly the Capital Requirements of the Financial System players; with the intention, at least theoretical, of preventing another collapse.

Determining the Capital Requirements of a Bank is a quite sensitive matter, low capital requirements incentive banks executives to take risks and increase the short term banks results, and too high capital requirements would reduce available capital to invest, impacting the bank’s results and economic growth.

The main objective on the determination of the Capital Requirements of a Bank is the calculation of its Risk Weighted Assets; remember that the Capital Requirements are defined as a percentage of the Risk Weighted Assets.

Determining the risk weighted assets is a challenging activity; there’re several accepted approaches (standardized, Foundation IRB, Advanced IRB) and the banks also have some flexibility in their implementation.

Determining the Risk Weighted Assets also require determining the Probability of Default and Rating of the counterpart.

And for making it a little bit more complicated; we also have to consider that the rating of a counterpart is a dynamic magnitude, which depends on the economic environment, and how it affects the business segment that the counterpart belongs to.

Determining the evolution of the rating of the counterpart means looking at the future, and as we don’t know the future, we have to create simulated “stressed” scenarios, and estimating the rating of the counterparts on those stressed scenarios.

Bank Analyzer has very powerful tools for calculating the rating of the counterparts on basis and stressed scenarios.

Typically, we have the Historical Database in which we can model the bank’s internal statistic models for estimating the current and future Probability of Default of the counterparts, by classifying them in business segments and looking at the past performance of those business segments.

Building integrated scenarios also requires a holistic vision of the risks and risk hedging strategies of our portfolio, and this is a very important value proposition of SAP Bank Analyzer.

In general, Banks are far from having a centralized and holistic repository of their risk exposures; on the contrary, their information systems have been built as a collection of silo-style systems with very poor, if any, integration.

Typically Banks have several repositories of risk; for retail banking, consumer loans, home loans, corporate banking, derivatives, etc.; all of them sustained by different technologies, with non-consolidated and non-homogenous master and transactional data.

Expecting an accurate determination of the Bank’s Risk Weighted Assets on these conditions requires a big deal of optimism.

On the contrary, Bank Analyzer has been built on the Integrated Financial and Risk Architecture, which is capable of managing holistically, all the Credit Risk Exposures of a Bank, and it’s meant to be capable of managing all the Bank’s risk and its accounting implications.

But I run out of space with this post, I’ll continue next week.

Looking forward to read your opinions.

K. Regards,
Ferran.

Single Euro Payments Area. Market concentration and SAP Banking opportunities.

Dear,

By August the 1st, 2014 all the Banking payments in Europe should be processed with the unified format of the Single Euro Payments Area.

The Single Euro Payments Area is an initiative of the European Union with the objective of simplifying the process of cross-border bank transfers denominated in euro, by creating common payment instruments in its area of application.

http://ec.europa.eu/internal_market/payments/sepa/index_en.htm

The final objective is turning the fragmented national banking markets of the Euro-zone into a single domestic one.

Most of the European credit institutions have successfully enhanced their payment systems on time.

http://www.bankingtech.com/210552/eba-clearing-reports-uptick-in-sepa-payments/

But SEPA's full implementation is just the beginning of this unification process; European authorities are already planning additional regulations on credit cards, risk management, etc.

By the autumn of this year the European Central Bank will become the principal supervisor of the credit institutions of the area.

http://www.ecb.europa.eu/ssm/html/index.en.html

The homogenization of processes and regulatory framework is reducing cross-border barriers and bringing new competitors into the domestic markets.

At the same time we’ll see how limited growth is driving margins down and increasing pressure for costs reduction.

In this scenario, a critical competitive advantage is developing economies of scale, standardizing processes and technology.

That’s the idea, efficiency, costs reduction. Once again, the driver of the new financial system emerging of this Financial Crisis will not be driven by volume, but by efficient management of the resources.

Additionally, capital scarcity due to the higher Capital requirements of Basel III, collateral requirements in the derivatives market, and limited growth of the developed economies will bring higher competition on the Capital Markets; and ultimately, new waves of concentration amongst financial institutions.

Does SAP Banking have the answer to these challenges?

Of course it does; SAP has demonstrated in the last 40 years to have the know-how for becoming the world’s leader on deploying integrated, cross-border, multi-language, multi-currency and consolidated information systems.

The consolidated approach is embedded in the SAP Banking architecture from many perspectives.

ECC system deployed multi-company, multi-currency functionalities many years ago, supporting smoothly integrated cross-border business process.

This approach is also incorporated to the SAP Banking business suite; for instance, Banking Services has no restrictions for supporting multi-company, multi-currency and cross-border functionalities; and Bank Analyzer, in combination with Business Planning and Consolidation, and the reporting capabilities of Business Information Warehouse has the capabilities for offering the consolidated vision of the Capital/Risk and Accounting position of a globalized Financial Group.

Keep the word in mind, Assets Consolidation.

Since 2008 crisis, and in spite of the bad reputation of the “Too Big to Fail”, we see that the number of players is being reduced, consolidating assets in bigger and bigger financial conglomerates, reducing operational costs and increasing their systemic influence.

Is there any difference between the old “Too Big to Fail” and the new “Consolidated” model?

Yes there is, the old model was driven by volume and the new one will be driven by efficient Capital Management. Size matters, but it’s not the key point here.

But this post has become too long, we’ll discuss about it another week.

Looking forward to read your opinions.

K. Regards,

Ferran.

Margin Debt. Subprime Crisis 2.0 - Chapter II

Dear,
Expansionary cycles of low interest rates and liquidity injections have the tendency of inflating economic bubbles. As the bubble inflates, positive perception of the investors keeps interest rates low, increasing leverage and rising markets valuation. 

Even when the spreads rise, ending the expansionary cycle, we don’t know how big the bubble is, we only will when the correction is complete, and the process can take months, even years.

It happened before and it will happen again. 

Remember that the subprime crisis started on February 2007 and we were not aware of its severity till September 2008.

We saw a couple of weeks ago, that some emerging economies have started the correction, as a consequence of the different perception on the interest rates evolution, triggered by US FED tapering.

http://sapbank.blogspot.com/2014/02/subprime-crisis-20.html

As in 2007, the general perception is that this is not that serious, US economy is performing well, and the Chinese real estate crisis is far from here.
Be careful with that feeling, don´t forget we’re in a globalized economy, in the middle of a systemic crisis; consequently what happens to one affects the system. 

Different economies make the crisis take different shapes, but the root cause is common, Capital Scarcity; and the solution has to be also global and coordinated.

Let’s look now at the symptoms in the developed economies.

A very interesting one is the total Margin debt level, which hit a historical record of $451B last January

http://video.foxbusiness.com/v/3323760203001/margin-debt-levels-hit-record-451b-in-january/#sp=show-clips

For those of you who are not familiar with the term, Margin Debt is the dollar value of securities purchased on margin within an account, and it’s a clear indicator of leverage levels and investors feelings. As the investors have positive feelings about the market evolution, they increase their leverage, buying securities at margin.

If the market perception changes, for instance, triggered by a rise of the interest rates, this huge margin debt will become a very large number of margin calls coming due, increasing the selling pressure and bursting the bubble. 

2008 subprime crisis was inflated by a long period of low interest rates; when the bubble burst, and with the intention of avoiding a global depression, Central Banks reduced interest rates, and injected huge amounts of liquidity in the Financial System.

Injecting liquidity for avoiding a depression is an old solution which worked in the past, when capital was abundant. 

Unfortunately, today we are in a new era of capital scarcity; a new era coming with new challenges, which require new strategies. In a capital scarce environment, injecting liquidity for preventing a depression, triggered by a debt crisis, it just makes the debt crisis bigger.

Someday we´ll see, that what Central Banks have done during the last five years, is trying to avoid a global fire with gasoline.

Last five years liquidity injections have delayed the depression and inflated a new bubble. 

When the new bubble bursts, it will be visible that capital is very scarce, even more scarce than five years ago.

The only alternative is building a new Financial System, with the priority of making efficient use of Capital, but transforming the Financial System is a herculean effort, and that´s why we are in a systemic crisis.

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

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.