Navigating the New Reality: Capital Optimization with SAP Banking as the Strategic Imperative for Financial Institutions

In an economic climate persistently challenged by subdued growth and an undeniable shift towards capital scarcity, financial institutions find themselves at a critical juncture. Capital, once viewed primarily as a financial buffer, has now emerged as the most vital and keenly contested resource within the financial system. The imperative of capital optimization is no longer a theoretical exercise but a strategic cornerstone for resilience and competitive advantage. Understanding how to manage and deploy capital with maximum efficiency is paramount for navigating this complex environment.

The core of effective capital optimization lies in a meticulous, multi-faceted approach, one that industry experts recognize as essential for sustainable success. This comprehensive process typically involves three interconnected pillars:

1. Precision Measurement of Capital Consumed Across Every Market Segment: True capital efficiency begins with an unsparingly accurate, granular understanding of where and how capital is being utilized throughout the organization. This goes beyond high-level allocations, demanding deep insight into the specific capital demands generated by each product, client segment, and transactional activity. Achieving this level of precision requires robust analytical frameworks and integrated data capabilities that transcend traditional silos, providing a clear, actionable view of capital footprints.
2. Intelligent and Efficient Assignment of Collateral to Exposures: In a landscape where capital is scarce, the strategic deployment of collateral becomes a powerful lever for reducing overall capital requirements. This step focuses on optimizing how collateral is allocated against various exposures. Through sophisticated mechanisms, institutions can ensure that collateral is assigned in the most efficient manner possible, thereby reducing Risk-Weighted Assets (RWAs) and freeing up capital that can be redeployed for growth initiatives or to absorb unforeseen shocks.
3. Maximizing Profit while Strategically Reducing Capital Consumption: The ultimate objective of capital optimization is not merely to hoard capital, but to deploy it in a way that maximizes profitability relative to its consumption. This involves identifying and prioritizing market segments and business lines that offer the highest expected profit for a given unit of consumed capital. It’s about making data-driven decisions that balance risk and return, ensuring that growth is capital-efficient and sustainable.

Achieving this level of sophisticated capital management often hinges on the robust capabilities of integrated financial platforms. Solutions like SAP Bank Analyzer play a pivotal role in enabling these processes. For instance, its capacity to calculate Risk-Weighted Assets with precision and facilitate the optimal distribution of collaterals is central to executing the strategies outlined above.

A key strength of advanced platforms such as SAP Bank Analyzer lies in its Integrated Financial and Risk Architecture (IFRA). This design is critical for achieving a truly integrated and reconcilable vision of both financial risk and accounting profit. By consolidating these perspectives, financial institutions gain an unparalleled holistic view of their capital position, enabling more informed strategic decisions, improved regulatory compliance, and a clearer path to sustainable profitability in an era of capital scarcity.

Mastering capital optimization is not just about compliance or cost-cutting; it's about fundamentally reshaping an organization's financial DNA for long-term success. It demands a deep understanding of financial mechanics, regulatory landscapes, and the technological tools that enable precise execution.

Weak Economic Growth, Capital Scarcity and Capital Optimization with SAP Banking.

 In recent months, as the world economy reactivated after the COVID-19 shock, we have seen rapid growth in energy prices.

During the industrial era, economic growth has been coupled with energy consumption. If this trend continues, and nothing suggests that it will break, the decrease in energy availability, either due to the depletion of natural sources, or the need to fight against climate change will weaken economic growth.

https://edition.cnn.com/2021/10/26/business/gas-prices-energy-crisis-schwarzman/index.html

As, in addition, excess debt reduces the capital available in the Financial System, we find ourselves in a new structural environment of capital shortage.

Capital is the most important resource of the Financial System, if we are in a new environment of capital scarcity the priority of the Financial System is and it will be capital optimization.

If you do a search in Google of the type "banking capital optimization" you will find many entries explaining the importance of optimizing capital, but there is not much documentation describing the steps of a capital optimization process. I will try to do it briefly in this blog.

1) The first step in a Capital Optimization process is measuring accurately the Capital consumed in every market segment that the bank is exposed to.

This is the main value proposition of the Integrated Financial and Risk Architecture of SAP Bank Analyzer.

Bank Analyzer – Credit Risk module will calculate the Risk Weighted Assets of every contract, every risk exposure of the bank’s portfolio, and consequently the Regulatory Capital consumed.

Once we know the Capital consumed by every Contract/Exposure, we can aggregate the Capital consumed according to the analytical dimensions that we have defined in the Bank Analyzer-Results Data Layer, and consequently we will know the Capital consumed in every market segment in which the bank operates.

Alternatively, the SAP Bank Analyzer Credit Portfolio also gives us the Economic Capital consumed by market segment, and all the complementary parameters to the Capital consumed.

2) The second step in a Capital Optimization process is the efficient assignment of Collaterals to exposures for reducing the Risk Weighted Assets and the Capital consumed.

The assignment of Collaterals to Exposures is not always a static assignment. The 1 to 1 assignment of a Collateral to an exposure is just the trivial case, but it’s usual that several (n) exposures are assigned to several (m) collaterals.

In case (n) exposures are assigned to (m) collaterals there’s an Optimal Distribution of the Collateral portions to the Exposures, which reduces the Risk Weighted Assets, and consequently the Capital consumption. This is the basis of the Dynamic Management of Collaterals that we discussed in a previous blog, and we will analyze again in a future one.

https://sapbank.blogspot.com/2012/09/capital-management-chapter-v-dynamic.html

The Bank Analyzer – Credit Risk Module has strong capabilities for the Optimal Distribution of Collaterals to Exposures in the Level 2 of the Calculation of the Risk Weighted Assets. These capabilities look at the Probabilities of Default and Exposures at Default of the Exposures and the Collateral Values, adjusting efficiently the assignment of Collateral portions to Exposures.

3) The third step of a Capital Optimization process is maximizing the Bank's profit reducing the Capital Consumed. Every market segment has a potential expected profit, and every market segment has a potential Expected Loss, and consequently a potential Capital Consumption.

Optimizing Capital means identifying the market segments with higher Expected Profit weighted by the Expected Capital consumed of the market segment.

This is the most difficult element of a Capital Optimization process, because it requires a double-synchronized simulation, looking for a solution which minimizes the Risk Weighted Assets maximizing the Expected Profit.

This optimization engine is still not available, but the Integrated Financial and Risk Architecture of Bank Analyzer has been designed for having an Integrated and Reconcilable vision of Risk and Accounting (Profit).

The IFRA is the technical foundation for running cycles of simulation that Capital Managers should run for achieving the Optimal Planning of the bank’s portfolio, reducing the RWA and maximizing at the same time the expected Profit.

Finally, the future will require the automatic calculation and simulation of banks investments, for proposing the Optimal Sales and Execution planning of the Bank. I’ve personally worked in some of these models, by adapting the Theory of Constraints to portfolio management.

These simulations require very strong computing capabilities, but this is the value that SAP HANA provides for solving the problem.

Looking forward to reading your opinions.

K. Regards,

Ferran.

Measuring Capital levels and Optimizing Capital with SAP Bank Analyzer

 This is not a Regulatory problem but a Technological one.

The vast majority of banks support their regulatory Capital calculations on legacy systems, disconnected in information Silos with very poor data quality.

As a consequence, the information extracted from these data is incorrect and leads supervisors to make erroneous decisions.

SAP Banking's Integrated Financial and Risk Architecture should have been the solution to this disaster, but 20 years after my first Bank Analyzer project, very few banks have faced true transformations of their Information Systems.

The situation is becoming critical with the capitalization tensions that affect the entire Financial System and that will increase as the scarcity of Capital increases.

The Financial System supports the largest debt in history, in absolute terms and as a percentage of GDP. This excess debt overconsumes Capital.

At the same time, the necessary energy transition is weakening growth and weak growth slows down the generation of Capital.

If Capital is overconsumed due to excess Debt and does not regenerate at the same rate due to weak Growth, Capital becomes scarce.

And Capital is the most important resource of the Financial System, so if it is scarce, the highest priority of the Financial System is Optimizing Capital.

But if banks cannot accurately measure their capitalization levels, how will they be able to Optimize Capital?

12 years ago I came to the same conclusion that you have just reached and since then I have led a team capable of developing the processes and technology necessary to Optimize Capital in the 70% of the World GDP managed with SAP.

We are looking for partners. Contact me with a linkedin Direct Message if you want to know more details.

#debtcrisis #capitaloptimization #oilcrisis #bankingcrisis #sapbanking #s4hana #sapjobs

Capital Optimization and Holistic Management of Basel IV and IFRS-9 with the Integrated Financial and Risk Architecture of SAP Bank Analyzer and FPSL

 Dear:

As we discussed in previous posts, we are in the midst of a systemic transformation: from a volume-based financial system to one based on efficient capital management.

In a globalized financial system, efficient capital management requires a commonly accepted regulatory framework for measuring the capital consumed by a bank's assets.

The main sources of current banking regulation are the International Accounting Standards Board (IFRS) and the Basel Committee on Banking Supervision (Basel IV).

http://www.ifrs.org/About-us/IASB/Pages/Home.aspx

https://www.bis.org/bcbs/

The BCBS's primary responsibility is to establish capital requirements to ensure the financial stability of the banking system, while the IASB's primary responsibility is to establish fair valuations of assets.

In reality, both organizations address the same problem: the measurement of capital consumption, from different perspectives.

- IFRS. The Fair Valuation of a Financial Asset determines the provisions that adjust the Nominal Value of the Asset to a Fair Value, which includes the Cost of Risk.

- Basel IV. The capital requirements of an asset determine the capital consumed when investing (or lending).

It seems reasonable to establish some level of reconciliation between the two approaches.

Basel IV requires banks to accumulate capital during the expansion phase of the business cycle to cover possible losses during the contraction phase. These countercyclical capital requirements are not tied to any particular loan, so they are generic.

On the other hand, International Financial Reporting Standards establish the provisions that banks must recognize to cover losses in their portfolio due to events that have already occurred and will affect future cash flows.

Some of these losses come from detected bad loans, but others come from bad loans that we know exist in the portfolio, but that we have not yet detected. Therefore, we must evaluate the entire portfolio and adjust its value globally, also through a Generic Provision.

But the problem remains: how to determine the Fair Provision for a hidden bad loan?

An interesting approach to determining the value of these generic provisions uses the Internal Ratings-Based Approach to Credit Risk Calculation (Basel IV).

To calculate IRB Credit Risk, we must evaluate several components: Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD), and contract maturity (M).

In addition, the IRB method allows us to calculate the expected portfolio loss (PE), which corresponds to the expected loss of each loan, calculated with the following formula:

PE=PD*LGD*EAD

For our reconciliation exercise, we use the IRB method's Expected Loss concept, which is similar to the IFRS concept of Incurred Losses, but not exactly the same.

IRB Expected Losses are the average loss stream that internal rating calculation methods predict will materialize in a year, while IFRS Incurred Losses are the balance of losses existing in the portfolio at a given time, due to past events that will generate losses in the future.

Both Incurred Losses and Expected Losses are different from the annual manifest losses (annual default stream) and, consequently, from the annual stream of specific provisions.

However, we can calculate Incurred Losses under IFRS by estimating the annual stream of expected losses and the time elapsed from the event that causes the loan to default until the moment it becomes apparent. This period between the two events is called the Loss Identification Period (LIP).

For example, if the counterparty loses their job and becomes unable to meet their payment obligations 18 months later, the Loss Identification Period would be 18 months.

Therefore, if we know both quantities (the Expected Losses and the Loss Identification Period), we can estimate the Incurred Losses by multiplying them.

For example, if the calculated Expected Losses for our portfolio (IRB method) are $45 million per year and the average Loss Identification Period is 2 years, this means that the Incurred Loss in our portfolio is $90 million.

Incurred Losses (IFRS) = Expected Losses (IRB Method) * Loss Identification Period

During the upswing of the business cycle, the Loss Identification Period is longer due to easier refinancing policies and favorable economic conditions.

According to the formula, a longer Loss Identification Period will increase Incurred Losses during the upswing.

In this way, we reconcile the calculation of IFRS Generic Provisions with the countercyclical capital buffer required by Basel IV.

The Integrated Financial and Risk Architecture holistically assesses capital consumption for Credit Risk, both from a solvency perspective (Basel IV) and from an accounting perspective (IFRS-9).

In Bank Analyzer Credit Risk, we determine the Probability of Default, the Loss Given Default, and, of course, the Expected Loss for each exposure, dynamically applying collateral and guarantees.

Secondly, SAP Financials Product Subledger uses the results of the Basel IV Credit Risk calculation as input for the calculation of IFRS-9 provisions.

Applying the above method to a real bank's portfolio management requires an integrated accounting (IFRS) and risk management (Basel IV) system within a holistic data model. This is the foundation of Bank Analyzer's Integrated Financial and Risk Architecture and makes it the best system for measuring a bank's available and consumed capital.

The results of the Basel IV and IFRS-9 calculations are holistic and reconcilable for the common dimensions of the Result Data Area of the Integrated Financial and Risk Architecture. This is why this architecture offers us a reconcilable and holistic view of capital consumption for Credit Risk.

The capital consumption for Market Risk is still missing, as it is only available in the Results DataBase. This lack of integration can be partially resolved with the open architecture of the Integrated Financial and Risk Architecture, but this would be the subject of another article.

The next level is Capital Optimization, which requires the integration of Real Economy and Financial Economics processes. For the past 12 years, our team has worked on modeling all economic events and business flows represented in Real Economy SAP systems, in terms of capital and liquidity consumption and generation. With this information, our systems measure how to offer financial instruments to cover capital and liquidity gaps or invest excess capital and liquidity, thus optimizing the system's capital consumption and liquidity.

We are working to introduce our system to the market and are looking for business partners and investors. If you are interested, please do not hesitate to contact me.

ferran.frances@gmail.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Join the SAP Banking Newsletter: Subscribe on LinkedIn https://www.linkedin.com/build-relation/newsletter-follow?entityUrn=6893665983048081409

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

If you want to connect on linkedin send me an invitation and I will accept it.

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances.  

Japanese bond market collapse, Capital scarcity and Capital Optimization with SAP Banking.

 Dear,

In recent weeks, long-term Japanese government bond rates have been rising due to investor concerns about inflation, government spending, and interest rate hikes by the Bank of Japan.

In recent years, the Bank of Japan's low interest rates, necessary to keep interest on Japan's high debt under control, created a yen carry trade, where investors borrowed in yen at low costs and purchased assets with stronger yields abroad.

This mechanism has financed investments in other markets, such as the US.

However, if Japanese debt yields rise, this carry trade mechanism will cease. Investors will have less incentive to finance assets outside of Japan, eventually liquidating US assets to obtain liquidity under the pressure of the rising interest burden on Japanese debt.

When we reach this point, and we will because the debt is growing unstoppably, the Japanese debt problem will spread to the United States and from there to the rest of the world. Let's not forget that Japan is the largest foreign holder of US debt.

As SAP consultants, none of us are in a position to stop the forces of the macroeconomic environment, and therefore our goal must be to act to guide our actions in helping our clients navigate the stormy seas of rising Capital Costs.

Ultimately, rising government debt yields will accentuate the strain on the financial system and make it difficult for companies to finance their investments.

For all of the above reasons, reducing Capital Costs, or in other words, Optimizing Capital, is becoming critical.

Let's look at what a Capital Optimization process looks like.

1) The first step in a Capital Optimization process is to accurately measure the capital consumed in each market segment to which the bank is exposed.

This is the main value proposition of SAP Bank Analyzer's Integrated Financial and Risk Architecture.

Bank Analyzer's Credit Risk module will calculate the Risk-Weighted Assets for each contract, each risk exposure in the bank's portfolio, and, consequently, the Regulatory Capital consumed.

Once the capital consumed by each contract/exposure is known, we can aggregate it according to the analytical dimensions defined in Bank Analyzer's results data layer, thus understanding the capital consumed in each market segment in which the bank operates.

Alternatively, SAP Bank Analyzer's Credit Portfolio also provides us with the economic capital consumed by market segment and all the complementary parameters to the capital consumed.

2) The second step in a Capital Optimization process is the efficient allocation of collateral to exposures to reduce Risk-Weighted Assets and capital consumption.

The allocation of collateral to exposures is not always static. A 1-to-1 allocation of one collateral to one exposure is a trivial case, but it is common for several (n) exposures to be allocated to several (m) collaterals.

If (n) exposures are allocated to (m) collaterals, an optimal distribution of collateral portions across exposures occurs, reducing Risk-Weighted Assets and, consequently, capital consumption. This is the basis of dynamic collateral management, which we discussed in a previous blog post and will discuss again in a future one.

https://www.linkedin.com/pulse/dynamic-collateral-management-capital-optimization-sap-frances-gil/

Bank Analyzer's credit risk module has robust capabilities for optimal collateral allocation to exposures in Level 2 of the risk-weighted asset calculation. These capabilities analyze Probabilities of Default and Exposures at Default, as well as Collateral Values, efficiently adjusting the allocation of collateral portions to Exposures.

3) The third step in a Capital Optimization process is to maximize the bank's profit by reducing Capital Consumption. Each market segment has a potential expected profit, and each market segment has a potential expected loss and, consequently, potential capital consumption.

Capital Optimization involves identifying the market segments with the highest Expected Profit weighted by the market segment's Expected Capital Consumption.

This is the most complex element of a Capital Optimization process, as it requires a doubly synchronized simulation to find a solution that minimizes Risk-Weighted Assets and maximizes Expected Profit.

This optimization engine is not yet available, but Bank Analyzer's Integrated Financial and Risk Architecture has been designed to provide an integrated and reconcilable view of Risk and Accounting.

The IFRA is the technical basis for running the simulation cycles that capital managers must implement to achieve optimal bank portfolio planning, reducing RWA while maximizing expected profit.

Finally, the future will require automatic calculation and simulation of bank investments to propose optimal sales and execution planning. I have personally worked on some of these models, adapting the theory of constraints to portfolio management.

These simulations require very powerful computing capabilities, but that is the value that SAP HANA brings to solving the problem.

The last 12 years our team has worked in modeling all the economic events and business flows represented in the SAP systems of the Real Economy, in terms of Capital and Liquidity consumption and generation. With this information, our systems measure how to offer Financial Instruments for covering Capital and Liquidity gaps or investing Capital and Liquidity surpluses, optimizing the Capital and Liquidity consumption of the system.

We are working on presenting our system to the market, and looking for business partners and investors, if you are interested do not hesitate in contacting me at

ferran.frances@gmail.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Join the SAP Banking Newsletter: Subscribe on LinkedIn https://www.linkedin.com/build-relation/newsletter-follow?entityUrn=6893665983048081409

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

If you want to connect on linkedin send me an invitation and I will accept it.

Looking forward to reading your opinions.

Kindest Regards,

Ferran Frances-Gil.

Industrial Decline, Capital Scarcity and Capital Optimization with SAP Banking.

The decline in industrial production in Europe is an excellent indicator of the true energy transition. An energy transition that, for geopolitical reasons, has begun in Europe but which in the medium term will spread to the rest of the industrialized world

And it is not just industrial production, unfortunately, this will be the case for most economic activities (but all of them).

All the signs point to the fact that the replacement of fossil fuels with renewable sources is being a failure. The plans for the introduction of electric vehicles are far behind the objectives. The use of green hydrogen is far behind expectations. Electricity generation from wind or photovoltaic sources is facing serious problems of intermittency. The storage devices that were supposed to solve these problems of intermittency are giving results far below those necessary to guarantee the stability of supply.

If this negative trend continues, and there is no indication that it will reverse, economic growth will weaken significantly in the coming years. Weak economic growth means weak capital generation.

At the same time, the system is supporting the largest debt in history, both in absolute terms and as a percentage of gross domestic product. Even worse, the growth of global debt, far from slowing down, continues at unsustainable rates. This excess of debt is overconsuming capital at the fastest rate in economic history.

If capital is overconsumed and not regenerated at the same rate, capital becomes scarce and capital is the most important resource of the financial system. In reality, capital is the most important resource of the socioeconomic system in which we live. That is why it is called capitalism.

If we look closely, we can already see signs of this capital shortage. Capital and commodity markets are suffering from increasingly frequent episodes of panic. The number of companies that have difficulty refinancing their debt is growing, and at the same time many others have difficulty obtaining raw materials or components necessary for manufacturing or goods to supply to the market.

The shortage of capital is not distributed evenly. And even worse, its allocation does not spontaneously adjust to the needs of business processes.

Information systems perform the fundamental function of searching for and allocating the capital required by business processes.

Among these information systems, SAP has been the most responsible for the improvement in capital management that the business sector has experienced in the last 30 years. SAP has facilitated holistic asset management models for organizations and has substantially improved the visibility of these assets for their customers and suppliers, as well as the traceability of the movement of these assets in intercompany processes.

I started my career as a SAP consultant in the early 1990s and have had the privilege of observing this transformation in many organizations. In 2006, I participated in my first analytical banking project and I was able to see how the level of efficiency that organizations in the real economy already had at that time was far ahead of that of financial institutions and motivated by being part of a transformation in the financial system similar to what was happening in the real economy, I also oriented my professional career in that direction.

Two decades later, the transformation of the real economy has even accelerated with scenarios of collaboration, analysis, artificial intelligence, asset traceability, etc., which would have been difficult to imagine when this transformation began 30 years ago.

On the contrary, the transformation of the financial system has been much more limited and given the urgency with which the growing scarcity of capital is needed, I have serious doubts that it will arrive on time.

As the scarcity of capital increases, so does the cost of capital, making it difficult to refinance debt and capitalize economic activity. Rising capital costs further slow growth and make capital optimization increasingly critical.

I came to this conclusion years ago and since then I have focused my efforts on designing and building a capital optimization model that offers a holistic view of all assets, tangible and intangible, of the financial economic system, facilitating the integration of the processes of the real economy and the financial economy.

We are looking for partners. Contact me with a linkedin Direct Message if you want to know more details.

#debtcrisis #capitaloptimization #oilcrisis #bankingcrisis #sapbanking #s4hana #sapjobs #sapbanking #saps4hana