Collaterals and Underlines Accounting System - Chapter II

Dear

As we saw last week, Accounting Principles leave many opportunities for building hiding mechanisms, necessary for inflating financial bubbles.

http://sapbank.blogspot.com.es/2013/07/collaterals-and-underlines-accounting.html

As the objective is increasing transparency, the new regulatory framework should overpass the limited capacity of disclosure offered by the General Ledger and look at the foundation of the Value Generation of the Financial Assets.

While the value of an asset depends on its long-term capacity of cash-flows generation, that generation comes from two economic magnitudes of the Financial Asset; the Underline and the Collateral.

This approach is supported in some Accounting Principles, but in a limited way. For instance, in the exercise of an option, I can determine the value of the Option according to the value of the Underline.

We should go further than that, but with the flat structure/approach of the General Ledger, we have many limitations to support multi-valuation approaches of the Assets, including reconciliation techniques of these valuations. I wrote something about those limitations months ago.

http://sapbank.blogspot.co.uk/2012/09/why-de-general-ledger-is-not-enough.html

The Financial Database of Bank Analyzer permits to keep the value of collaterals and underlines in different but connected objects in the SDL and the RDL, and the multi-accounting capabilities of Bank Analyzer-AFI permit to build calculation procedures which read and combine those values with the results of the cash-flows generation engine. The opportunities of building alternative accounting systems which reconciles the expected cash-flows of an asset with the value of its Underline or Collateral are abundant.

In my opinion, this is a very important reason to consider Bank Analyzer as the central hub of Risk and Accounting magnitudes of the Bank. We expect the regulation is going to be harder, and IT investment decisions cannot be taken according to the capacity of the infrastructure for supporting current requirements, but being the foundation for covering the future regulatory framework, that will emerge as a consequence of the systemic crisis.

This humble proposal is just an idea on that direction.

Looking forward to know your opinions.

K. Regards.

Ferran.

Collaterals and Underlines Accounting System - Chapter I

Dear,

One of the main concerns after 2008 Financial Crisis is improving transparency on the Financial Markets, and some general consensus has been achieved about the necessity of building a more stringent regulatory framework for the financial system, capable of increasing transparency and stability.

The current regulation, particularly the accounting standards, gives many opportunities for hiding the real situation of a financial institution. There’re many ways of hiding information which can compromise markets opinion about the financial stability of an organization, let me name some well-known examples.

- Massive use of Off-Balance contracts for hiding debt.

http://www.investopedia.com/articles/analyst/022002.asp

- Securitization of high risk loans for hiding counterparty risk.

http://www.investopedia.com/articles/07/subprime-overview.asp

All Financial Crisis have in common that require a bubble to be inflated and burst; but while the bubble is inflated, a hiding mechanism is required to hide the bubble to potential investors. 

Obviously, if investors knew that an asset is inflated they wouldn't invest and the bubble could not be inflated. Off-balance accounting postings, assets securitization, Repo 105, OTC Derivatives, have been traditionally accepted and legal accounting practices used as bubbles hiding mechanisms.

In my opinion, the main consequence of this Financial Crisis is moving from a Financial System based in Volume to a Financial System based in efficient management of solvency and liquidity. After this systemic change, growing by inflating and bursting bubbles will not be an option.

Consequently; hiding mechanisms, necessary for inflating bubbles, will not be tolerated.

Every bubble, and the current debt one is a very good example, requires confusing solvency and liquidity. Liquidity increases temporarily the value of an asset, solvency makes the value of the asset long-term sustainable.

http://sapbank.blogspot.co.uk/2013/03/why-do-they-call-it-love-when-they-mean.html

But preventing hiding mechanisms requires more than adjusting the accounting standards, new mechanisms of financial reconciliation are going to be required.

Simplifying, every Financial Asset has a value which depends on a promise of generating future cash-flows and the probability (risk) that those “agreed” cash-flows are successfully delivered.

We work on two main families of valuations; mark to market and mark to model. The first one assumes that the market has perfect information about the value of the asset, the second is build on the hypothesis that the Financial Institution has all the information about the probability of getting successfully the promised cash-flows.

Unfortunately, as the multiple bubbles have made clear, both approaches are incomplete. Injecting or drying liquidity in the Financial System increases and reduces the value of the assets, without any real estimation of its long-term sustainable cash-flows generation capacity; and mark to model estimations have many holes for executives hiding the long-term sustainable value of their assets (Repo 105, Securitization, Off-balance accounting, etc.).

We need a new concept, capable of disclosing the long-term sustainable value of the financial assets. 

But this post has become too long, we'll talk about it next week.

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

Product Costing in Financial Services and Bank Analyzer.

Dear,

As the Financial Crisis and a harder regulation of the Financial System make capital scarce and expensive, efficient Capital Management is becoming the most critical activity for Banks.

From now on, there is not enough capital to finance/invest in every economic activity, prioritization is critical and only those business opportunities with higher expected profit, weighted by capital consumed, will get the necessary funds.

As expected growth of the global economy is going to be very limited in the next years, pressure on keeping good margins which can guarantee reasonable returns on capital is going to be usual. On the other hand, maintaining good margins in depressed markets will not come by the side of increasing revenues, but by the way of the efficiency and costing-control.

Costing management of a Financial Instrument is a complex activity as the main costs associated to the business process (funding costs, processing costs and risk costs) will be visible after signing the contract, in some cases long time after the event.

In production industries, most of the production costs are supported by the company before the product is sold, in fact they’re not considered cost till the product is sold (till then they just increase the value of the inventory). Cost of sales in Production or Retail industries is a deterministic and well known parameter; the equivalent in Financial Services is not.

Process, Funding and Risk costs of a Loan or a Deposit are supported during the whole life of the contract; considering that some contracts have very long maturity terms like mortgage loans, perpetual debt or shares, their estimation can be a very difficult exercise.

Determining Process costs of a Financial Instrument (or a Financial Transaction) is an internal management activity, the standard process costs of the Financial Instrument can be estimated from the Actual Costs determined by internal management accounting models (Cost Center Accounting, Activity Based Costing, Distributions, etc.). SAP has decades of experience in Internal Costing management, all this know-how is available for building complete and reconcilable models of Process Cost Accounting, from the Actual costs in ECC to the Standard costs in Bank Analyzer, and vice-versa.

Risk costs are even more challenging, as the costs associated to the possible counterpart default (credit risk costs) or changes in the interest rate o foreign exchange rate (market risk), are estimations based in purely probabilistic models. Probabilistic models which require extensive collection of external data (ratings, forex and interest rate estimations, historical and expected volatilities, etc.) and complex mathematical models.

The calculation of this probabilistic costs has to be based in assumptions (by definition, future events cannot be deterministic); the more correct and complete those assumptions are, the better cost estimation the Bank will make

Finally, effective costing control requires a seamless integration between all the components of the business process, from Transactional Banking to Analytical Banking, from collecting origination costs in CRM to communicate estimated funding costs from the Analytical Banking component.

We’ve mentioned many times that as a consequence of the Financial Crisis, efficient Capital Management is the most critical activity. But efficient Capital Management requires a holistic approach which includes cost and margin management, and this is the main competitive advantage of SAP Banking.

SAP has the most complete set of software components for building holistic and complete Product Costing models in many industries. All this knowledge is available and valid for building a complete model of Product Costing estimations in Financial Services.
Integration is the magic word, and for years SAP has been synonym of integration.
Looking forward to read your opinions.

K. Regards,
Ferran.

Why Capital Optimization is the priority?

Dear,

As you probably know, in my opinion, this is a Systemic Crisis. Scarcity of Natural Resources and huge debt make it impossible for the World to grow at historical rates.

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

Systemic Crisis’ force changes in the economic system foundation, according to the requirements of the new era. Priorities change in systemic crisis, it happened before and it will happen again.

This time, priorities are switching from growth to efficient management of the critical resources. Translated to the Financial System, we’re moving from a Financial System based on Volume to a Financial System based in efficient Capital Management.

Capital is the main resource of the Financial System, let’s see why.

The whole Financial System relies on trust, I deposit money in the bank and I expect the bank will give me my money back, plus some interests. But on the other side, the bank has to allocate money in other assets (investments or loans), and it also expects to recover the investments, plus some dividends or interests.

This is very important, as the Financial System is not sustained by titanium cables but by trust, trust is the main asset of the Financial System, and once broken it’s very difficult to fix it.

For protecting trust, banks have to offer a special guarantee to its lenders, that guarantee is the Regulatory Capital.

Regulatory Capital is determined according to the parameters of some international agreements called Basel agreements; Basel I, Basel II and most recently Basel III.

http://www.bis.org/bcbs/basel3.htm

Every solvency agreement is an evolution of the previous one, but they all define the Regulatory Capital as a percentage of the Bank’s Risk Weighted Assets.

Risk Weighted Assets depend on the Probability of Default of the Bank’s counterparts, and again, this is a sensitive matter.

When I run probabilistic calculations, I do it because there’s uncertainty; the information required for making the event deterministic is not available.

For Financial Assets, the missing information is in the future; I make the investment today, but only in the future I will know if my counterpart will honor his obligations.

As I don’t know what will happen in the future I use statistics for trying to find it out.

Investors can calculate the Probability of Default of the counterpart, by measuring historical default rates of counterparts similar to him, and statistical tendencies.

The whole construction depends on the economic growth. If world’s economy is not growing; Probabilities of Default, Risk Weighted assets and Capital Requirements of the Banks will grow. On the other hand, as default rates grow, Bank’s losses increase, reducing available capital.

Reducing available Capital and increasing Capital Requirements are making banks undercapitalized, even the biggest ones.

http://www.reuters.com/article/2013/06/14/us-financial-regulation-deutsche-idUSBRE95D0X620130614

That’s the foundation of the Systemic Change; Capital is the most critical resource of the Financial System (actually the whole economy) and now is very scarce. Consequently, it will have to be managed very efficiently.

Efficient Capital Management emerges as the most critical activity for the Financial System; I've worked for years in a Capital Optimization model based on SAP Software, I’ll present it to all of you in some weeks.

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

Looking forward to read your opinions.

K. Regards,

Ferran.

I wish it were your decision Mr. Bernanke.

Dear,

Last Thursday, world’s Financial Markets listened carefully the speech of Mr. Ben Bernanke, chairman of the Federal Reserve, as one of the most important events of the quarter.

http://www.youtube.com/watch?v=KRiRX1dR12U

Since 2008 Financial Crisis, the main response of the FED, under Mr. Bernanke’s mandate, has been injecting liquidity in the US economy, by keeping interest rates in historically low levels and buying debt in Quantity Easing cycles.

But this measures, which have proved to be successful on Keeping high levels valuation of the Capital Markets and maintaining economic activity on the US, have also increased the vulnerability of the US economy by rising US debt to unsustainable levels.

As a difference to the European Union, when the painful austerity measures have started to reduce the bubble of Financial and Economic overcapacity, US economy has continued “growing” by wasting solvency.

http://www.usdebtclock.org/

By listening Mr. Bernanke’s speech, one could get the idea that US FED has been able of keeping their monetary stimulus because is a sovereign decision, and those stimulus will dissapear at the end of this year because US economy is in the path to recovery.

Unfortunately, the reality is that US economy was already very vulnerable on September 2008 and the FED has been capable of injecting liquidity with the massive QE programs, because the capital markets have let them to do it.

Remember, inflating bubbles is a very good business till they explode.

China’s economy has played a significant role in this game. China’s banks are some of the majors US debt holders and while Chinese’s investors have been willing to buy and hold US debt, FED reserve has been able of issuing paper without raising their Yield.

The question is, what will happen if Chinese economy has their own liquidity problems, big enough to have to concentrate on them, and not using their funds on supporting US debt?

If Capital markets and Chinese banks cannot buy US debt, or even worse, become net sellers of US bonds, the FED will be unable of keeping low interest rates.

But that’s exactly what’s started to be visible this week.

http://www.nytimes.com/2013/06/21/business/global/china-manufacturing-contracts-to-lowest-level-in-9-months.html?pagewanted=all&_r=0

In my opinion, US economy will not be in better shape at the end of the year than what’s today.

But interest rates will be higher by then, not because the FED is willing to, but because in a global economy countries carrying high levels of debt become dependent on the interests and capacities of their debt holders.

At the beginning of this crisis we were said that the growth of Brasil, India, China and Russia will compensate the lack of growth on developed economies.

Five years later India’s debt is close to junk level, Brazil economy is slowing down and China is facing a liquidity crisis.

http://online.wsj.com/article/SB10001424127887324767004578488872271273296.htmlhttp://www.bloomberg.com/news/2013-05-29/brazil-s-economic-growth-disappoints-for-fifth-quarter.html

The truth is the exit strategy of this crisis is efficient Capital Management and the BRIC’s have been wasting capital because they still had some solvency to waste on 2008. US economy has also been wasting capital, but in this case with Capital Markets permission.

Now, we’re facing the burst of a huge debt bubble with hard consequences for the economy and the financial system, but that’s the lesson we have to learn before we’re ready to accept the change.

http://www.reuters.com/article/2013/06/21/markets-usa-bonds-idUSL2N0EX0ZV20130621

Looking forward to read your opinions.

K. Regards,

Ferran.

Toxic Assets strike back.

Dear,

As I explained here some weeks ago, speculation is one of the causes of the current Financial and Economic crisis, but not the main one.

http://sapbank.blogspot.fr/2013/05/why-bankers-play-casino-dear-common.html

The root cause is Capital scarcity which has generated a systemic problem, and the solution requires a Systemic Change; from a Financial System based in Volume to a Financial System based in Efficient Capital Management.

In fact, 5 years after the official start of the Great Recession some of the toxic and risky assets, publically condemned at the time, are back in the Capital Markets.

http://www.ft.com/cms/s/0/76778796-cebe-11e2-ae25-00144feab7de.html#axzz2WAS0jtrr

One of the most criticized products after 2008 crash were the Synthetic CDO’s; let’s see why.

A Synthetic CDO is a form of Collateralized Debt Obligation in which the investor takes long positions betting some referenced securities will perform. In a standard CDO the investor is paid with the interests of borrowers paying their mortgages loans, while in a Synthetic CDO, the investor is paid with the fees of Credit Default Swap insuring financial assets from a default event.

Simplifying, if the asset protected by the Credit Default Swap performs well, the investor in the Synthetic CDO will receive a portion of the fees paid by the client who has bought the CDS. In case the issuer of the insured asset defaults, the investor will have to pay his portion of the insured asset to the buyer of the Credit Default Swap.

For investment banks, synthetic CDO’s are like a securitization of Credit Default Swaps, which helps them to reduce their exposures and Capital consumption. On the other hand, for the investors, Synthetic CDO’s are a financial instrument which lets them participate in the derivatives business by selling Credit Default Swaps and receive a portion of the fees paid for the insurance.

The main advantage for an investor taking a long position in a synthetic CDO, instead of directly selling the CDS, is risk diversification. The seller of a Credit Default Swap takes all the default risk on a specific security, while investing in a Synthetic CDO the investor will be able of diversifying the risk with a portfolio of securities, with even different tranches of ratings (Probabilities of Default).

Synthetic CDO’s were severely criticized after the Financial Crisis of 2008; the main reason was their capacity for multiplying losses, with standard CDO’s the limit of the exposures is determined by the total volume of the securitized mortgage loans. This limit does not exist for synthetic CDO’s, as the investing banks can issue an infinite numbers on Credit Default Swaps on the existing securities, as long as investors agree to take the other part of the bet.

While economy is performing well, Synthetic CDO’s are generating liquidity which feeds the economic engine and helps to maintain high valuations in the Capital Markets.

But as it happened in 2007, when the economy slows down the probability of default of the insured securities will rise. If a default event activates the Credit Default Swaps, a payment obligation will be triggered for the Synthetic CDO’s, generating enormous losses for their holders.

After the event, we will probably blame Bankers for not learning the lesson; but Banks are private companies whose objective is generating dividends for their shareholders and bonus for their executives. On the other side investors are moved by greed and the low interest rates are incentives for them to invest in more risky, purely speculative, assets.

Once again, the exit strategy of this Financial Crisis is Efficient Capital Management. Growing by inflating bubbles (Real Estate, Gold, Public Debt, Derivatives, etc.) is a waste of Capital that we could afford when Capital was abundant, but this is not the case anymore.

Looking forward to read your opinions.

K. Regards,

Ferran.

Rating, Scoring and SAP Banking - Chapter II.

Dear, 

A complete scoring system also requires combining internal rating determination, like described in the Chapter I of this post, with evaluations from external sources.

These external sources include Credit Rating and Scoring Agencies and analysis of the Capital Markets behavior.

Credit Risk managers use two main approaches for credit risk modelling based on Capital Markets data analysis; Structural and Reduced models.

- Structural models, like Merton, are used for calculating probabilities of default focusing on equity prices.

- Reduced models, like Jarrow-Turnbull, focus on debt values, and perform the analysis looking at evolution of interest rates.

Obviously they also use combinations or evolutions of the above on their internal models. For instance, some months ago I had a conversation with the VP responsible of Risk Management in an investment bank in Singapore. He explained me some interesting details of their rating models and particularly, how they included the current, future and volatility prices of some Financial Instruments in their model for estimating the solvency of governments and corporate
counterparties.

Those models are not directly supported by SAP tools, but it could be done by complementing SAP Components (Bank Analyzer, Market Risk Analyzer, etc) with external statistical analysis tools (SPSS). It’s not a standard construction, but in my opinion it’s worth exploring it during the project preparation.

Finally, managing ratings requires more than effective determination of the Business Partner Risk, it also requires centralized management of the scoring data and seamless integration with the Operational Systems. Not having centralized controls is a big weakness in a Credit Risk System, as it can be the root cause of erroneous decisions and consequently wasting Capital.

For instance; without a centralized credit control, a Business Partner, considered insolvent in one country or by a business line, would be able of over-passing his credit limit by borrowing funds in another. A well known example is how the Greek government could hide part of its deficit, getting funds by using derivatives contracts with Goldman Sachs support.

http://www.spiegel.de/international/europe/greek-debt-crisis-how-goldman-sachs-helped-greece-to-mask-its-true-debt-a-676634.html

The Credit Risk component of SAP combines the capacity of acting as central repository of counterparty risk data, with the flexibility of adapting the risk data to different business scenarios, by storing it in separated credit segment data. This segment data could be tailored to the requirements of specific business lines or jurisdictions, and then be delivered this way to separated business areas or legal entities of the Financial Group (Insurance, Leasing, Retail and Private Banking, etc.).

As it happens with other SAP Banking solutions, some of the components described in this post are not very well known in the market; the Historical Database of Basel II has been implemented in several banks in Asia Pacific and Africa and a good number of European Banks, but I’m not aware of any implementation in the America region and it’s even more difficult to find references of the described integrated scenarios.

On the other hand, the advantages of using an integrated platform for the management of credit risk are abundant, rating calculation and risk management require effective calculation and centralized control, but also common semantics that helps Banks’ executives to understand
the root cause of their risk exposures, from the operational to the analytical level and vice-versa.

That’s SAP value proposition; common semantics and seamless integration of software components. From this perspective I don’t have doubts that as soon as we improve the on field knowledge of SAP Banking capabilities on Credit Risk management, it will become the market leader.

K. Regards,
Ferran.