November 2014 and milestones on the systemic change.

Dear,

In every process of change every day is different than the day before, but when change is completed historians mark in the calendar those special days which explain the change.

For instance, if we look at the history of modern economy, we will find special days like the Black Tuesday, when the markets decided to believe that the Roaring Twenties were over, triggering the most devastating stock market crash in the history of the United States and starting the Great Depression.

http://en.wikipedia.org/wiki/Black_tuesday

September 15, 2008 is also an interesting day, when the US authorities decided to let Lehman Brothers fall.

On the previous weekend several alternatives were put in the table; merging Lehman with Bank of America as they did with Merrill Lynch, bailing out the bank as they did with Bear Stearns or AIG, or mixed solutions like bailing out the bank and selling the good assets to Barclays.

But the decision was letting fall the fourth-largest investment bank in the US; changing the rules of the game for the first time in 80 years.

November 2014 will be another milestone; by then, the new Single Supervisory Mechanism of the European Central Bank will issue the results of the stress tests that will make public what is the “real” situation of the European Banking System.

Since the starting of the financial crisis in 2007/2008 we have seen several audits of the financial system, telling us that the financial system was solvent, and acknowledging some months later that more capital was needed.

http://en.wikipedia.org/wiki/List_of_bank_stress_tests

This time is going to be different as it has to be different, rumors say that 9 European banks are going to fail and 51 billion Euros are going to be needed for recapitalizing the system. Other rumours are more pessimistic and predict that 100 billion euros will be required.

http://www.reuters.com/article/2014/09/03/banks-goldman-survey-idUKL1N0R32IL20140903

Whatever the final figure is, the important consequence will be that the banking European system is undercapitalized.

But, only the European banks have solvency difficulties?

Of, course not.

In a global financial system everybody is connected and affected by the others; and what happens to one, it happens to the system.

Once again, look at the global debt clock.

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

According to it, every Belgian carries a public debt of $45,405.40, every Briton $40,456.90, every French $37,989.90, every Spaniard $23,093.85, every Greek $27,189.68, etc.

And don't forget that on top of this mountain of public debt, the financial system is full of private debt, carried by corporations and individuals.

Are capital markets naive enough for believing that this debt can be paid?

Assuming that European banks, main holders of European public debt, need 51 billion Euros of Capital, with very low public debt interest rates; how much capital are they going to need, when capital markets decide to become anxious and raise the spreads?

I asked the same question to a reader of my blog, with management responsibilities in a European bank, who contacted me some months ago. He acknowledged that more capital is going to be needed and capital optimization is going to be a critical activity.

Unfortunately, he was not able of describing any concrete action for optimizing capital management on his bank.

Intriguing, isn't it?

By the way, in my opinion issuing shares or subordinated debt means increasing capitalization levels, not optimizing capital management.

Looking forward to read your opinions.

K. Regards,
Ferran.

Market Risk, Value at Risk and SAP Bank Analyzer.

Dear,

As we commented in previous posts, SAP Bank Analyzer does not have an strong Market Risk engine yet, particularly if we compare Bank Analyzer functionalities with other competitors like Sunguard.

Anyway, SAP Bank Analyzer is being designed with the holistic purpose of measuring and managing the main risks a financial institution is exposed to.

Credit Risk is very well covered with the correspondent Bank Analyzer risk engine, Liquidity Risk is very well covered by Bank Analyzer in combination with the SAP HANA-Liquidity Risk Management solution, and it’s a matter of time that SAP enhances the Strategy Analyzer sub-module of Bank Analyzer for covering the requirements of an strong Market Risk solution.

Strategy Analyzer sub-module of Bank Analyzer supports GAP Analysis and Net Present Value Analysis of the bank’s portfolio, examining the cash-flows at Financial Transaction or Financial Instrument level (contract level).

Strategy Analyzer requires to be provided with alternative, scenario based, market data sets and the contract Financial Conditions of the Financial Transactions and Financial Instruments. With this information, the Source Data Layer cash-flow generator will provide the scenario based cash-flows, and the risk engine calculator will give us the scenario based valuation of the portfolio, according to the correspondent market data set.

The complete modelization of the Financial Position Objects in the Bank Analyzer Results Data Layer supports the alternative scenario-based valuations of the portfolio.

Selecting properly the granularity of the characteristics contained in the Financial Database will guarantee a seamless transformation of the Results Data Layer positions on an analytical risk hierarchy.

All the above can be very useful to banks which have already implemented the Accounting for Financial Instruments module of Bank Analyzer.

After AFI has been fully implemented, enhancing the capabilities of Bank Analyzer for supporting GAP and Net Present Value analysis of the bank’s portfolio requires a relatively low effort.

But as I mentioned before, this is not enough to be considered a best of breed Market Risk technology, and I thought it would be a good idea to look at what functionalities should be included in SAP Bank Analyzer from Market Risk perspective.

GAP Analysis and Net Present Value Analysis represent the foundation of Market Risk Analysis as they told us the expected value and the cost of opportunity of our portfolio, in alternative or even stressed scenarios, but they don’t tell us what’s the statistical probability and the confidence level of the analysis.

In order of including this relevant information on the results of our analysis SAP Bank Analyzer should include an strong Value at Risk calculator, and this is precisely what SAP Bank Analyzer does not have today.

For those of you who are not familiar with the Value at Risk concept, Value at Risk is a statistical technique used to measure and quantify the level of financial risk in an investment portfolio over a specific time frame.

Value at Risk calculation is measured in three dimensions; the amount of potential loss (already provided by Net Present Value and GAP Analysis, but also the probability of that calculated loss, and the time frame in which the Market Risk event should occur.

This information is extremely useful to bank’s executives and risk managers, as it provides an statistical measure of the level of market risk the bank is exposed to, in every portfolio and by all risk hierarchy dimensions.

Additionally, detailed control of the evolution on the value at risk parameters will provide the basis for triggering alerts in case actual valuations are suffering deviations from the expected results, as Basel III agreement requires.

Looking forward to read your opinions.

Kindest Regards,

Ferran

Systemic crisis and capital scarcity. How did we arrive here?

Dear,
Since 2008 Financial Crisis, we decided to believe, conscious or unconsciously, that the crisis was just an accident; the sad consequence of the actions of a bunch of selfish, reckless banks’ executives, who blinded by greed, had converted the Capital Markets in a global casino of Credit Default Swaps, Mortgage Backed Securities and other exotic and incomprehensible financial instruments.
https://www.youtube.com/watch?v=iszwuX1AK6A
We can blame the bankers if that’s going to make us feel better; but if we really want to understand the magnitude of the problem, we need a little bit more than watching a great film.
If this was just a Banking crisis, it could be fixed by reshaping the banking system, but this is a systemic crisis which requires a systemic change. Obviously, in a capitalist model, the Financial System plays a protagonist role. Reshaping the financial System, it is a very important part of the solution, but it can’t be “the solution”.
For understanding this crisis it will help to have a look at the graphs below.
http://en.wikipedia.org/wiki/File:Oil_Prices_1861_2007.svghttp://upload.wikimedia.org/wikipedia/commons/e/e0/Components-of-total-US-debt.jpg
In the first graph, we see the historical evolution of the oil prices; as we can see, since the end of the Second World War till 1970’s decade, Oil prices had been kept relatively stable. And then as a consequence of the USA peak oil production and market cartelization, prices started to rise abruptly.
http://en.wikipedia.org/wiki/1973_oil_crisis
Oil is the most critical natural resource, and main responsible of the amazing period of growth the humanity has enjoyed since the starting of the Second Industrial Revolution.
http://en.wikipedia.org/wiki/Second_Industrial_Revolution
As higher prices of the resource responsible of feeding world’s economic engine made it less affordable, world’s economic growth should have slowed down, but it’s never easy to accept that unemployment rises, poverty increases and tomorrow we’re living worse than today.
Consequently, world’s leaders looked for an alternative source of growth that could maintain the economic engine running.
After some years of crisis, they found the alternative; global debt have been kept stable since the end of the Second World War, and it showed up as the alternative to finance economic growth, that could not be supported by cheap oil prices anymore.
The brilliant idea was replacing cheap oil by solvency, as the main resource to maintain economic growth.
Some constrains had to be eliminated; financial regulation, implemented after the 1930’s Great Depression limited the transformation; consequently a new era of financial deregulation started.
After that, maintaining economic growth by consuming financial solvency was possible. We started the new era of a Financial System driven by volume, starting a new phase of economic growth which was going to last during the following 30 years.
By 2008 financial solvency was consumed and became scarce, triggering the current systemic crisis, which started in the financial system, and spread on the following years, to the whole economy and society.
Six years later, we’re close to learn that we don’t have an alternative resource for maintaining historical rates of economic growth. Once again, our main problem is maintaining economic growth.
http://blogs.sap.com/banking/2011/12/07/its-growth-stupid/
As we’re in a capitalist system, banks are at the center of problem again, becoming protagonists of the transformation. When next November, European Central Bank audits make visible the financial system undercapitalization, we will start the new era of a financial system driven by efficient capital management, with multiple ramifications in the economy and society.
Looking forward to read your opinions.
K. Regards.
Ferran.

US General Attorney and SAP Banking.

Dear,

An interesting point, when we look at the transition to the new Financial System, it is the role played by the US General Attorney office. As Mr. Eric Holder made very clear some months ago, we've moved in six years, from a Financial System in which some corporates were too big to fail, to a new model in which no banks are too big to jail.

http://www.theguardian.com/world/2014/may/05/eric-holder-banks-criminal-investigation-jail

Since the starting of the Financial Crisis in 2008, Wall Street has been fined with more than 100 billion dollars.

http://www.foxbusiness.com/economy-policy/2014/06/13/huge-wall-street-fines-raise-calls-for-more-transparency-1287760936/

Bank of America, Wells Fargo, JP Morgan, BNP Paribas, Citigroup, Goldman Sachs and Morgan Stanley have received severe fines, impacting their results and reputation.

This week, we read in the media, that the New York Federal Reserve send last December, a letter to the executives of Deutsche Bank, accusing some of its US arms of releasing low quality, inaccurate and unreliable financial reports, and supporting its processes with inadequate auditing and oversight and weak technology.

http://www.reuters.com/article/2014/07/22/us-deutsche-bank-usregulators-idUSKBN0FR2BU20140722

What’s going on here?

Was everything perfect before, or the regulator has just discovered how to audit a Bank’s processes?

Not really, this is just a sign of the Systemic Change; for the last 30 years, the financial system has been deregulated and oriented to grow in volume, without looking at the capital consumed in the process. The objective was growth, no matter the resources, including solvency (main Financial System resource), consumed in the process.

http://en.wikipedia.org/wiki/Financial_deregulation#Finance

But today, global debt and natural resources scarcity are limiting global growth, making the Financial System severely under-capitalized.

We’re in a highly leveraged, fractional reserve, Financial System; which multiplies growth when growth is robust, but becomes insolvent with limited growth rates.

In the new scenario, we need a technology oriented to control; and new paradigms like Risk Adjusted Performance Management become the drivers.

Organizations, and particularly banks, objective cant't be selling and growing, but offering the best financial performance, weighted by risk (or what’s the same, capital consumption).

Regulators fines, which are going to be more frequent in the oncoming years, will be one of the incentives used, for “convincing” bank’s executives that they must align with the systemic change.

SAP Banking has the answer in terms of technology to the requirements of the new paradigm; it has been built with the objective of capital control and efficient management of resources, particularly with the Integrated Financial and Risk Architecture of Bank Analyzer.

But implementing SAP Banking is not an easy task; SAP Banking has a holistic data model, which makes it challenging to integrate with the current obsolete and over-simplified, Financial Information Systems.

Anyway, what’s the alternative for a bank’s executive; suffering fine after fine, till he aligns with the new paradigm?

Remember this; from now on, no Bank is too big to jail.

Looking forward to read your opinions.

K. Regards,
Ferran.

Basel IV and SAP Bank Analyzer.

Dear.
No, the title is not a mistake.

If you look at the dates of publication of the three first international solvency agreements, you will see that Basel I was published on 1988 and enforced by law on 1992. Basel II agreement was published on 2004 and Basel III on 2011.
Following that progression, we should have a new international solvency agreement for banks very soon.

But beyond that, there're a number of signals that make me think that Basel 4 is closer than expected.

Several countries, including the US and the Eurozone are implementing higher capital requirements for banks than Basel 3 requirements.

There’s a growing feeling amongst regulators against giving bank’s risk executives liberty for implementing Internal Rating methods for calculating the bank’s Risk Weighted Assets, and consequently the regulatory capital, advocating for more simple, easier to audit models.

A new simple, leverage ratio, it is been implemented for compensating the difficulties on auditing the bank’s internal models.

In general, the tendency is increasing the capital requirements of banks and disclosure capabilities of their risk management information systems. This is just a consequence of the systemic crisis; remember that natural resources scarcity and global debt are limiting global economic growth.

Limited growth means scarce capital; in a fractional reserve banking system (like today’s), lack of capital produces financial instability. As a consequence regulators increase the bank’s capital requirements for recognizing the critical value of this growth generating resource.

I understand that some of you don’t share my opinion; for those of you who think that the new regulation is just a temporary fashion, let me remind you that some authorized voices, like Eugene Fama, 2013 Nobel Prize in Economics, is advocating for capital requirements for banks which should be around 40 or 50% of the bank’s assets; 4 times what currently Basel 3 agreement requires.

http://baselinescenario.com/2010/06/02/eugene-fama-too-big-to-fail-perverts-activities-and-incentives/

This scenario, which represents a threat for the old banking model, is a great opportunity for those who understand the driver of the new model.

If efficient capital management is the priority in the new model, capital optimization must be at the center of the bank’s strategic decisions.

Capital optimization requires first, an integrated vision of all capital consumption activities of a bank, offering an accurate measure of the capital consumed in each of them. In a second step it requires optimizing the capital consumed in every activity, and prioritizing those activities which offer a better return weighted by consumed capital.

Capital consumption is embedded in every banking activity; from maintaining dynamically the free-line of a revolving loan, to measuring accurately the probability of default of a counterpart, and taking pre-emptive actions before the default event happens.

An integrated vision of all the capital consuming activities of the bank requires an integrated information system, and the most holistic integrated information system for banks is SAP.

SAP does not have a capital optimizer yet, but it has the Bank Analyzer system which is capable of collecting, storing and managing the capital consumed in every banking activity.

The Integrated Financial and Risk Architecture of Bank Analyzer offers those capabilities and I’m explaining them to my customers in my daily work; and in these internet activities for the last 6 years.

In my opinion, it’s a matter of time that SAP sees the opportunity and develops a capital optimizer on top of the Integrated Financial and Risk Architecture, the systemic change is bringing the requirement and developing a market eager to implement it.

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

Profit Centre Accounting, Business Segments Accounting and SAP Bank Analyzer.

Dear,
I’ve worked as SAP consultant for 18 years, in many areas like Finance, Controlling, Transactional and Analytical Banking, Data-warehousing, etc.; and one of the first lessons I learned is that SAP is about integrated processes that must be modelled from an End to End perspective.

There’re many ways of modelling a process, but there’s always an optimal modelization, and finding it requires looking at all its implications from an End to End perspective.

Some time ago, I was requested by a customer to make a proposal for covering IFRS-8 reporting regulatory requirements.
http://www.ifrs.org/IFRSs/Documents/IFRS8en.pdf

Simplifying, IFRS-8 main requirement for a corporate is disclosing financial information about their operating segments, products and services, the geographical areas in which they operate, and their major customers. Typically, an operating (or business) segment must involve around 10% of the company income, assets, etc.

We have two functional elements in SAP (including Bank Analyzer) that potentially support the IFRS-8 financial regulatory reporting requirements.

The first option is the profit centre; SAP Bank Analyzer and SAP Enterprise Core Components, support the complete disclosure of the accounting position of a Profit Centre (Balance Sheet and Profit/Losses). This makes Profit Centre Accounting a suitable candidate for building IFRS-8 reporting requirements.

On the other hand, SAP also offers another functional element for covering IFRS-8 regulatory requirements; the Business Segment. Business Segments Accounting is also available in Bank Analyzer and in SAP-ECC, and it also provides with the capacity of disclosing the Financial Statements of the Business Segments.

If both Profit Centre and Business Segments Accounting provide the functionalities of IFRS-8, can we use indistinctly one or the other?

Not really, a more detailed analysis can help on detecting the advantages of one approach in front of the other.

Profit Centre Accounting is an Internal Management Accounting functionality, which gives the answer of how well or bad, the company’s areas of responsibility are performing. The final objective is taking corrective measures for improving the performance, and incentivating with bonuses the managers with better performance.

On the other hand, Business Segments Accounting is oriented to provide external financial disclosure (typically IFRS-8), but as IFRS-8 requirements literally refer to “internal management reports”, the overlapping with Profit Centre Accounting can become confusing.
Some hints for helping on the decision of implementing Profit Centre Accounting, Business Segments Accounting or both.

Bank Analyzer standard delivery of Internal costs calculation is done on Profit Centre level; Funding Costs, Standard Process costs, Standard Capital costs, etc. are initially calculated in Profit Centre level.

Profit Centre Accounting provides a full valuation approach of the company performance, including Transfer Prices for representing the internal valuation of intra-group transactions. The Transfer Prices of these intra-group transactions can differ of the market invoicing prices. It can be sensitive to report this information in the audited IFRS-8 financial statements.

Additionally, as Business Segments are required for reporting those operations involving more than 10% of the company income, the number of business segments is typically around (or less) than 10.

And as Profit Centres represent areas of responsibility whose performance must be estimated, their typical number can be hundreds, or even thousands in big Financial Institutions.

We can discuss about the effort of building the double reporting framework of Profit Centre Accounting and Business Segments accounting, but SAP gives some tools to reduce the necessary customizing activities. We’ll talk about them in a future post.

K. Regards,
Ferran.
 

Attention CIOs, SAP Banking is the answer to the question you´re about to be asked.

Dear,
This week, Mr. Mohamed El-Erian, Chief Economic Advisor at Allianz http://www.allianz.com/, former chief executive officer at Pimco http://www.pimco.com/ and chairman of Barack Obama's Global Development Council published the following article in Bloomberg.

http://www.bloombergview.com/articles/2014-05-30/the-new-paradigm-for-banks

Just the title is clear enough; "The New Paradigm for Banks".

A paradigm change is a big thing, what are the root causes?

Mr. El-Erian names three; weak economy, central bank policies and regulation.
I
can´t agree more. Those of you who have read this community posts in the last 6 years already know what´s my opinion about it.

We´re in the middle of a Systemic Crisis which is driving a major change on the Financial System, from a model based in volume to a model based in efficient Capital Management.

Natural resources scarcity and global debt have reduced the world's potential growth, and this has deep implications for the Financial System.

Three years ago, you could read it here.

http://blogs.sap.com/banking/2011/12/07/its-growth-stupid/

We're in a Fractional Reserve Banking System; a Financial System which only requires a limited amount of capital (around 8-10% of Risk Weighted Assets); or in other words, a highly leveraged Financial System.

Leverage produces a multiplying effect in a growing economy but it´s unsustainable in a non-growing or limited-growing economy.

Governments know this, and as Mr. El-Erian mentions, they come with a two steps proposal:

- Regulation to drive capital management efficiency.

- Central Banks policies to borrow the necessary time to implement the new regulatory framework.

This is not new information, Mr. Jaime Caruana, General Manager of the Bank for International Settlements (Central Bank of the Central Banks) made it very clear one year ago.

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

Paradigm change of the Financial System is going to happen and it's going to be challenging.

Let´s imagine for a minute that we're sitting at the executive board of a Tier 1 or Tier 2 Bank; as the bank can´t fulfill the increasing capital requirements, the chairman brings a critical request to his team.

What can you offer to improve the bank's capital ratio?

Barclay´s example that we discussed some weeks ago is giving us some answers.

http://sapbank.blogspot.com/2014/05/why-barclays-is-good-example-of.html

- The Chief Financial officer will propose a plan for toxic assets liquidation.

- The Chief human resources officer will come with a headcount reduction.

And the Chief Information Offer will have to bring a proposal for efficient capital management; let´s help him with it.

Efficient Capital Management requires:

- Determining the long term sustainable value of the bank´s portfolio.

- Matching accurately bank´s assets and liabilities by maturity bands.

- Proactive and effective implementation of hedging risk strategies.

- Integrated and multidimensional portfolio stress testing.

And overall, an Integrated and Financial Risk Architecture which offers a holistic vision of all the banks rights and obligations; assets, liabilities and collaterals.

These are the shapes that capital takes; modeling them in an integrated architecture is the basic requirement for building the IT proposal to the paradigm change.

After the crisis, financial institutions will have to live in a very different world of scarce and expensive capital which will make efficient capital management the main priority.

Combining Bank Analyzer Integrated Financial and Risk Architecture with the in-memory capabilities of SAP HANA, makes the foundation of a Capital Optimization model in which I have been working for the last six years, as I described briefly in the post below.

http://blogs.sap.com/banking/2012/02/01/capital-optimization-sap-hana/

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