Managing non-evident Capital Costs with SAP Bank Analyzer. Chapter IV

Dear,
As we commented in the previous post, the difficulties of integrating Bank Analyzer as a sub-ledger of non-financial processes are more related to marketing reasons and perceptions than real technical constrains.

I will try to make a simple description on this post.
The main objects for modelling a business deal in the Accounting for Financial Instruments module (sub-ledger scenario) of Bank Analyzer are the following.

- Business Partner. It’s the Physical or Legal Person with whom our company is having a business relationship.

- Financial Transaction (or Financial Instrument). It’s the representation of the financial contract that our company has with the business partner.

- Business Transaction. It’s an event of the real world, relevant for accounting which can potentially trigger a flow in a GL Account.

The objects above are not specific of a financial deal, but in fact to most, if not all, business deals.

All business deals have a counterparty with which our company is having the business relationship, the business agreement is represented by a contract (Financial Transaction), and a number of events happen in the real world, in relation to the contract, and can trigger flows in GL Accounts (Business Transactions).

For instance, let’s look at typical sales business deal, represented in SAP by a Sales Order, a Delivery (with Post Goods Issue) and an Invoice.

Every Item of the Sales Order represents the commitment of delivering a number of goods (or services), at a delivery date for an agreed price.

The Item of the Sales Order also represents the conclusion of a forward contract for delivering an underline (goods or services) at an agreed date (forward date) and price, with a Payment Date which is determined by the Delivery Date and the Payment Term.

On forward date we will create a logistics delivery (actually some days in advance as for fulfilling the delivery date we also must consider the picking, packing, transportation times, etc.) and the correspondent accounting entry as the forward contract has been settled. 

At that moment our Sales Order Item (Forward Contract) has become an Account Receivable that will be cleared (if the counterparty fulfils his obligations) at Payment Date.
As you can see, there’s a parallelism in the business flow of a standard Sales and Distribution process with the events of a Derivatives Trading business flow.

The main difference between these two modelizations of the business deal is that the Sales and Distribution modelization puts the focus in the logistics process, while the derivatives trading modelization puts the focus in the Capital consumption (Market and Credit Risk).

Modeling the Sales and Distributions Process as a Forward Contract in Bank Analyzer gives us the opportunity of determining:

- The Capital Consumption due to Credit Risk, by determining the Exposure at Default from the Credit equivalent amount of the derivative and the Probability of Default of the counterparty (business partner on the deal). 

- The Capital Consumption due to Market Risk by running a Value at Risk calculation (in future Bank Analyzer releases). 

For years, capital was abundant and it was not necessary to estimate the Capital consumption due to Credit and Market Risk of most of business deals; that’s why we could afford modelling the business processes neglecting its importance. 

But today, we’re in the middle of a systemic crisis generated by the new environment of capital scarcity. In this new environment, we can’t afford neglecting the cost of the capital that we consume in a business deal. 

Consequently we’ll have to build information systems which include accurate measurements of the cost of capital of the business deal, and include them in the calculation of its contribution margin.

In my opinion, SAP Bank Analyzer technology is the answer to this requirement.

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

Managing non-evident Capital Costs with SAP Bank Analyzer. Chapter III

Dear,
In the last posts, we’ve discussed the importance of managing Credit Risk and Capital Costs in non-financial processes.

https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-chapter-frances?trk=object-title

https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-ferran-frances?trk=object-title

The necessity of managing capital costs is nothing new; it’s the natural consequence of managing the risks associated to an economic activity. What is new is the relative importance of the capital costs in the economic analysis of a business event.

During most of the 20th Century, and particularly since the end of the Second World War (including the plans for reconstructing Europe and Japan) and the implementation of the Breton Woods Agreements, capital was abundant and inexpensive.

In this environment of capital abundance, costs of capital were easily covered by high margins and strong economic growth. Consequently there was no incentive in managing capital efficiently. For decades, the economic world chose to believe that resources were unlimited and wasting capital not an issue.

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

With the Oil crisis of the 70’s, we discovered that natural resources were limited, challenging the economic growth.

http://en.wikipedia.org/wiki/1973_oil_crisis

At the same time that some initiatives were implemented for managing resources more efficiently, world’s leaders looked for another resource which could be wasted for feeding economic growth.

The alternative was consuming solvency by increasing debt, in other words, replacing cheap oil by solvency as a resource for feeding economic growth.

http://www.imf.org/external/pubs/ft/fandd/2011/03/picture.htm

This is the starting point in the deregulation of the financial system.

www.cepr.net/documents/publications/dereg-timeline-2009-07.pdf

Analyzing what´s the alternative for sustaining economic growth goes far beyond the objectives of this post, I just want to highlight two points.

• Sustaining economic growth on increasing debt is not possible anymore.

• Capital requirements are a percentage of Risk Weighted Assets (Percentage of Debt Weighted by the Risk of the Counterparty + Leverage Ratio); consequently as global debt is historically high, capital requirements should be historically high.

The two points above describe why the financial system is operating in a new environment of Capital Scarcity; and this is serious because Capital is the main resource of the Financial System.

In economy, when a critical resource becomes scarce we recognize it criticality and scarcity by increasing its price. These are the increasing capital costs that we’re discussing here. Higher costs of capital start in the financial system, and then they are spread by investing and lending through the whole economic system.

In the new environment, managing capital costs becomes mandatory, and particularly we must include them as part of the contribution margin of any business deal, obviously this necessity depends on the weight of capital consumption in the contribution margin.

For instance, the capital costs involved in the trade of 20.000 Barrels of Brent Oil for being delivered in 12 months, and paid in foreign currency, are not even close to the capital costs of buying 20 cans of beer in the local Walmart. But in both cases, the weight of capital costs involved in contribution margin of the deal are much higher than 30 years ago.

We have an excellent tool in the SAP Business Suite, Bank Analyzer, for determining Capital Costs (on the current releases only Credit Risk Capital Costs) and include them in the calculation of the contribution margin.

The difficulty seems to be integrating Bank Analyzer in the management of non-financial business processes; and judging by the emails I’ve received in the last weeks, this is an extended concern amongst the readers of this blog.

In my opinion, the difficulties have more to do with marketing reasons and perceptions than with technical constraints. We’ll talk about them in the next post.

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

Managing non-evident Capital Costs with SAP Bank Analyzer - Chapter II

Dear,

In the previous post we introduced the relevance of Capital Costs in non-financial business processes.

https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-chapter-frances?trk=object-title

The basic rule for analyzing the profitability a business deal is determining its contribution margin. Historically, contribution margin calculation models, in non-financial business, have not included capital costs.

ERP systems in general and SAP in particular, are the result of modeling business processes in an era of capital abundance. As a consequence, capital costs of the business deals were not relevant enough to compensate the effort of including them in the calculation of its contribution margin.

Auditors would say that in an environment of capital abundance, the effect of the capital costs in most of the business deals was immaterial.

But this is the main difference of the new environment; we’re in the middle of a systemic crisis whose main characteristic is capital scarcity. The main symptoms of this capital scarcity are growing credit and market risk.

Those of you, who disagree, just look at the impact on international trade between the Eurozone and Switzerland, of this week’s revaluation of the Swiss Franc. In other words, how many European customers will have difficulties to honor their payment obligations in Swiss Francs, considering that those obligations have increased 20% in one week?

I don’t have a proper estimation of the magnitude of the issue, but by looking at the impact of this week events in the solvency of some Banks and Forex brokers, we can infer that the losses are going to be considerable.

http://www.reuters.com/article/2015/01/16/us-swiss-snb-brokers-idUSKBN0KP1EH20150116

Anyway, let’s come back to our initial example, we know that SAP ECC offers a very powerful integration between the Sales and Distribution and the Profitability Analysis modules (CO-PA) which offers a complete analysis of the margin of the business deal.

Not exactly, introducing capital costs in this (CO-PA) analysis represents a challenge, which is normally confronted with simplifications.

In fact, CO-PA has not been designed to deal with this kind of analysis, CO-PA is a multidimensional Profit and Loss structure, but it does not include balance sheet positions.

On the other hand, balance sheet positions are mandatory for a proper analysis of the capital costs of a business processes. This is the main limitation of SAP ECC for managing accurate margin analysis in an economic environment of capital scarcity.

We still can build simplified models for estimating the capital costs of the business deal, but they’re just simplifications.

For instance, some years ago we worked for a customer who required this kind of analysis.

We fulfilled his requirement by building an enhancement of the sales pricing procedure, including a statistical condition type which determined the expected loss as a percentage of the invoice net value. Additionally, the Probability of Default is maintained in a table depending of the customer rating.

The statistical condition type is mapped to a CO-PA key figure, providing the expected capital costs (due to credit risk) as an input in the contribution margin calculation.

This approximation is valid for those cases of moderate capital cost for credit risk, but is insufficient in those cases of business deals with higher risk exposures.

When the capital costs due to credit risk are significant, or we’re modeling more complex business processes, for instance including securitization of account receivables, the above approximation is insufficient.

For those cases, integrating the SAP logistics modules with the Risk engines of Bank Analyzer is an excellent option.

We’ll talk about it in the next post.

Looking forward to read your opinions.

K. Regards,

Ferran.

Managing non-evident Capital Costs with SAP Bank Analyzer – Chapter I.

Dear,

I mentioned in previous posts that I’ve been doing Bank Analyzer consultancy for the last 9 years, but before that I worked in other SAP areas, particularly Supply Chain Management.

In fact, years ago I took part in one of the first SCM implementations of SAP APO by a Japanese Industrial Company in its European branch.

In that project I learned for the first time that managing Capital Costs have a direct impact in the non-financial areas of the company, including Supply Chain Management.

For instance, in some deals, the company requests to the customer opening a letter of credit for reducing credit risk, and then the Sales Orders insured by the letter of credit receive more priority in the Production and Distribution process.

Actually we implemented a rule in the Supply Chain Management System (SAP-APO) for giving more priority to them.The reason is that these are very reliable deals in which the company wanted to offer the best service.

The above sounds reasonable, but the question is, is this logic properly modeled in the current Information Systems?

When a customer is opening a letter of credit, it’s actually reducing the Credit Risk of the deal by including collateral.On the other hand, the vendor receiving the letter of credit is reducing its capital costs, as the expected loss of the deal, due to credit risk, has been mitigated.

The letter of credit is effectively a vehicle for transferring capital from the customer to the vendor.Let’s come back now to the requirement of giving more priority to the “very reliable”, collateralized with letters of credit, sales orders.

Giving priority to those sales orders means allocating capital for serving the order; increasing production costs, inventory costs, storing costs and/or distribution costs, even commercial costs as the service to other customer will be lower, because they have less priority.

From an accounting perspective, the vendor is receiving capital from the customer (highly collateralized deal), and it’s allocating logistic capital (production costs, inventory costs, etc.) by giving more priority to these highly reliable deals.

But what happens if a very solvent customer places an order without including a letter of credit, which he does not need as his rating is good enough.

Should his orders have more priority than others?

If so, how can we model the rule?

Efficient management would require that the executives compare the value of the financial capital they’re receiving with the cost of “logistic” capital they’re allocating.

If the value of the capital you’re receiving is higher than the costs you’re suffering it looks like a good deal, if not you probably should reconsider the deal.

Before the financial crisis, Capital was abundant, and companies could live without this kind of analysis; but today it is scarce and expensive, and estimating all capital costs of economic activities has become very important.

But we don’t have tools for running this kind of analysis. Even the most sophisticated accounting systems, like the Financial and Management Accounting modules of SAP-ECC, can’t provide the Capital costs of the sales deals.

Fortunately, SAP has developed Bank Analyzer, which is perfectly capable of providing answers to the challenges of this new environment of Capital scarcity; we just have to model the business process properly.

But this post has become too long, we’ll discuss about it in a future one.

Looking forward to read your opinions.

Happy New Year and all the best for 2015.

Ferran.

Join the SAP Banking Group at: http://www.linkedin.com/e/gis/92860

The dog, the Frisbee and SAP Bank Analyzer. Chapter II.

Dear,
We saw in the previous post that, as regulators have concerns about the accuracy and auditability of complex Internal Rating and Risk Weighted Assets calculations, they have decided the implementation of a simple Leverage Ratio in the Basel III agreement, for preventing over-leverage.

http://sapbank.blogspot.com/2014/11/the-dog-frisbee-and-sap-bank-analyzer.html

I also commented that a "Not Risk-Weighted” ratio, which does not estimate capital consumption, it is not the best approach for fixing the issues of the Financial System, as the main problem is not only over-leverage, but capital scarcity.

With strong economic growth, an over-leveraged Financial System could be sustainable, without economic growth an over-leveraged Financial System is in serious risk of insolvency.

A common mistake is thinking that capital optimization is a centralized function, which happens in the headquarters of the bank. On the contrary, capital management is spread all over the bank, but we need an integrated system to make it visible.

Rating methods are based on estimating the probability of a counterpart not fulfilling his obligations, and they’re based on the following logic.

1) Analyzing the characteristics that will drive the counterpart behavior, and classify the counterpart in a group or segment, with the same characteristics.

2) Measure the number of default events in the group and determine a statistical pattern.

3) Determine the probability of default of the members of the group, according to the statistical pattern.

But let’s not forget that the validity of any statistical analysis relies in the validity of the collected data, and collecting and processing valid data is more challenging than what it looks like.

Let me give you an example.
Let’s imagine that an account manager decides to capitalize the due amounts and extend the loan term of a customer, this event can represent two different realities. 

1) The customer has a growing and successful business and it requires additional capital to finance the growth. 

2) The customer is insolvent and can’t fulfill his obligations.

In the first case, the account manager is allocating the bank’s capital efficiently; in the second one he is hiding a default event and wasting the bank’s capital.

In both cases we’ll see exactly the same transaction, capitalization of due amounts and extension of the payment term; the difference is not the transaction but the “Transaction Reason”.

The account manager normally should have the information for deciding if the customer is solvent or not. But still, some questions rise up.

- Are account managers decisions, always driven by capital efficiency?

- If yes, are the banking information systems capable of proving it to the regulatory authorities?

- If not, are the risk models including the statistical bias?

Efficient Capital management requests, that the operational banking system stores the risk analysis of the loan extension, and the argumentation of the decision. And then, transfer this information to the analytical banking system, so it can be reviewed audited and controlled.

I have been implementing SAP systems for 20 years and SAP Banking for the last 9. I don’t see legacy systems capable of providing the integrated vision, necessary for disclosing all the relevant risk information. That’s why regulators have to implement simple, leverage and “not risk-weighted” ratios.

Remember, capital scarcity requires capital efficiency, and capital efficiency requires an integrated and holistic vision of the banking processes.

This post is just an example; we will see others in future posts.

Join the SAP Banking Group at: http://www.linkedin.com/e/gis/92860

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

The dog, the Frisbee and SAP Bank Analyzer. Chapter I.

Dear,

For years, the financial system has been driven by volume; economic growth required, and still requires, feeding the monster of debt; but the monster has become too big, making the system unsustainable, that’s why we’re in a systemic crisis.

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

Recovering the sustainability of the system requires efficient management of scarce resources, and capital is the main and most scarce resource of the financial system.

The systemic transformation requires increasing capital requirements, making visible its importance by raising its price. In other words, making capital expensive is the best way for incentivizing its efficient management.

Solvency agreements (Basel I and Basel II) should have prevented the insolvency of the financial system but history proved that they did not. As a consequence, capital requirements were increased and a tighter regulation (Basel III) was implemented after 2008 events.

Basel III increased the capital requirements in several percentage points (3%-5.5%) and required the implementation of two new ratios; Leverage Ratio and Liquidity Ratio.

http://www.bis.org/publ/bcbs251.pdf

http://www.bis.org/publ/bcbs238.pdf

The new Leverage Ratio is not “Risk Weighted” which means that does not distinguish between risky and not risky investments. It sounds estrange when we have being said that risky investments are the main threat for the stability of the financial system.

The best explanation of the necessity of a Leverage Ratio is in the speech “The dog and the Frisbee”, by Andy Haldane; Chief Economist and Executive Director, Monetary Analysis & Statistics of the Bank of England.

http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech596.pdf

Basically, Mr. Haldane is telling us that “As regulators don’t trust the complex Internal Rating and Capital Requirements calculation of the banks, they’re implementing a simpler rule for preventing over-leverage”

The proposal seems logical, if complex statistical rules of risk calculation can’t prevent over-leverage (because they can’t be verified by the auditors), let’s implement a simple rule (that can be audited). At the end, dogs don’t need to understand complex laws of physics for catching a Frisbee.

I would agree if leverage was the problem, but unfortunately it’s just a symptom. The real problem is capital scarcity and the solution requires capital optimization.

Requirements which don’t estimate capital consumption can’t incentive capital optimization, that’s why the leverage ratio will not work in the long-term.

Don’t forget that the main justification for the leverage ratio is the difficulty for auditing the bank’s models for capital requirements calculation. If auditing the bank’s internal models is difficult, transparency measures should be implemented for facilitating auditing. Unfortunately that’s much more difficult than it sounds.

Banking Information systems are built on obsolete, heterogeneous, lightly integrated databases. Determining and reporting meaningful solvency calculations in these conditions is technically impossible.

That’s why today’s alternative is a regulatory leverage ratio, if we can’t verify complex rules, let’s implement a simple one.

But as the systemic crisis evolves, the effects of capital scarcity will be more visible and painful, making necessary the implementation of capital optimization measures.

By that time, banking information systems will have to be ready to determine capital consumption properly, including the reporting capabilities for auditing the results.
Understanding the laws of physics is not necessary for catching a Frisbee, but transforming the financial system is a much more challenging endeavor.

Join the SAP Banking Group at: http://www.linkedin.com/e/gis/92860

Looking forward to read your opinions.

K. Regards,

Ferran.

Impairment in SAP Bank Analyzer, integrated scenarios and Capital Optimization.

Dear,
We mentioned in the past that Bank Analyzer represents a very robust Analytical Banking component, but it lacks on some functionalities which are available for other competitors.

For covering the gap we take advantage of the open architecture of the Financial Database and integrate the missing calculations from an external system. For instance, as previous releases of Bank Analyzer didn't have Impairment functionalities, we build interfaces to other systems, like SAP Reserves for Bad Debts, in order of including the impairment provisions in the SAP Bank Analyzer sub-ledger, achieving a complete accounting vision of the Financial Transaction (customer account).

Fortunately, new versions of SAP Bank Analyzer are coming which new functionalities, covering existing limitations. This is the case with Bank Analyzer 8 which provides a strong Impairment functionality, compliant with IFRS requirements.

Bank Analyzer 8 determines the impairment accounting entries following one of the following approaches.

- Percentage Expected Loss

- Expected Cash Flow

The first one determines the impairment postings by calculating the percentage expected loss and the percentage write-down, while the second determines the impairment postings by calculating the expected cash flow and the write-down. 

An important constrain that we must keep in mind is that expected cash-flows can’t be calculated for those products for which we’re using Source Data Aggregation. Anyway the same limitation applies for the discounting cash-flows valuation of Financial Transactions in combination with Source Data Aggregation, so customers using Source Data Aggregation will probably be familiar with the Source Data Aggregation functionality constraints.

But it’s not my intention to make a detailed description of the SAP Bank Analyzer 8 functionalities for impairment, which by the way, are very well explained in the SAP documentation. 

My intention today, is explaining the competitive advantages of the Integrated Financial Risk Architecture for the management of impaired assets.

When we’re talking about impairment, we are looking at the most risk driven accounting activity. Most of the necessary parameters for measuring the credit risk associated to a financial transaction are also required for determining their impairment accounting entries. This opens the gate for integrated scenarios between AFI and Credit Risk modules of Bank Analyzer.

Last summer, I had the opportunity of talking to a former customer who implemented Basel II on Bank Analyzer seven years ago, calculating capital requirements on contract level. But today, the same bank is calculating the impairment accounting entries in portfolio level, and distributing the results to contract level.

This is not the best approach when the customer already has most of the necessary parameters for calculating the impairment accounting entries in contract level, as they’re available as a result of their solvency calculations.

But more than that, the Integrated Financial and Risk Architecture offers others important opportunities for Capital Optimization in the management of impaired assets, which should be evaluated when defining the bank’s impairment architecture.

Keep in mind that Capital is scarce and it’s going to be scarcer in the future, and consequently capital optimization is becoming the most critical activity. The Integrated Financial and Risk Architecture of Bank Analyzer provides the foundation for optimizing capital in the management of impaired assets, by building integrated scenarios between Credit Risk and Accounting for Financial Instruments. 

I have personally worked on some of them and I’ll be happy to share with you in a future post, this one has become too long.

Looking forward to read your opinions.

Join the SAP Banking Group at: http://www.linkedin.com/e/gis/92860

K. Regards,
Ferran.