SAP Account Origination and Bank Analyzer.

Dear,

We all know that SAP Banking is about integration, and most likely you have seen and read that main advantages of integration are lower Total Cost of Ownership, improved Data Management and Governance, Best Practices in Process Management, etc.

All the above is true and all those facts have made SAP the market leader in Enterprise Management Software for the last 40 years.

On the other hand, an SAP Banking implementation is a huge investment, an investment which is going to determine the strategy of the organization for decades.

If I was the President of a Bank and had to take a decision like this, I would expect to hear stronger, non trivial arguments, which helped me to take the decision.

We’re crossing a systemic crisis which is driving the Financial System from a business model based in volume to a business model based in efficient Capital Management. For taking a strategic decision I expect strategic arguments, if the Financial System is in the middle of a systemic change, I want to know that my decision will position my bank into the new model.

If the answer is Capital Optimization, the question should be what SAP Banking will offer me to drive my Bank towards the new paradigm?

Capital Optimization is not just about Portfolio Management, it’s embedded in the Bank’s business processes, from the Account Origination till the Corporate decisions.

Let me give you an example.

Tracking the consumption of a critical resource is the main priority if we want to optimize it. Does SAP Banking help me to track the Capital Consumption on my Bank?

Capital Consumption does not start with accounting relevant transactions. For instance, the commitment of a Loan does not have any accounting impact (only disbursement has). But a committed, not disbursed loan represents a Free-Line which consumes capital.

A committed, non disbursed Loan starts in the Origination process, and the integration of Account Origination and Bank Analyzer is more than an interface; it’s a seamless integration based in common semantics. With this approach is easier to support bi-directional communications, and sometimes, they can be very useful.

I worked for a client sometime ago in an efficiency and business process analysis; during the assignment, we discovered that the branches did not reduce the free-line of non-fully disbursed loans, even when by contract the client was not allowed to further disbursements.

This means that the free-line did not exist anymore but that was not represented in the Information System. From the Bank’s perspective, that “virtual” free-line meant increasing wrongly the Capital Requirements of the Bank. As the free-line does not have accounting relevance, nobody noticed. Or more exactly, the Bank’s executives knew that it was happening, but they could not measure the impact and correct the problem. This is serious when Capital is the more scarce and critical resource for a Bank nowadays. Giving visibility to this type of shortcomings is what the integrated proposal of SAP Banking is about.

There’re other examples, and I hope we have the chance of discussing about them in the next weeks, but I promised to a friend that I was going to write about SAP Account Origination this week, so here you have it.

By the way, this is what the Fed said this week about Capital Planning.

http://ca.reuters.com/article/businessNews/idCABRE97I0S920130819

Capital Optimization is the answer to this Systemic Crisis, and the closer we're to the crash the more visible will be.

Looking forward to read your opinions.

Kindest Regards,

Ferran.

Implicit Ratings; Uncertainty, Efficiency and Capital Waste.

Dear,
As we discussed last week, we have two main families of assets valuation.
- Historical Value Accounting.
- Fair Value Accounting.

http://sapbank.blogspot.com.es/

The second includes risk and capital consumption, the first doesn’t as there’s no uncertainty in past events.

In a world of limited Capital, estimating risk is a critical activity; incorrect risk estimations will driver wrong valuations and capital waste.

In Corporate Finance we identify three types of Risk (this is just a classification; there’re others).

- Credit Risk.- The Risk that our counterpart don’t fulfill his obligations.
- Market Risk.- The Risk that the value of an asset fluctuates due to market events.
- Operational Risk.- The Risk that of making an operational mistake.

In Credit Risk estimation, we measure the Rating, which is an estimation of the statistical probability that our counterpart is not willing or able of fulfilling his obligations.

Again, we have two methods of estimating the rating.

- We look at the past.
- We look at the future.

We also can ask for an expert opinion (Rating Agency), but whatever methods they use, they will look at the past, at the future or both (mixed methods).

Looking at the past means measuring the past credit events of the counterpart, or other counterparts similar to him (Historization). Looking at the future means “making a bet”.
We’re in the middle of a Systemic Crisis, we’ve enjoyed high growth rates on the last 70 years, but Capital scarcity is making very challenging to keep those rates in the future.

Can we estimate the uncertainty of the future, just by looking at the past events, when we assume that the environment will be radically different?

An alternative is “making a bet” or even better, measuring the bets of many experts. For doing that we can use a Financial Derivative called Credit Default Swap.

Finance Mathematics provide us with a function which determines the value of a CDS according the Rating of its counterpart, the inverse function will determine the Rating according to the value of the CDS. We call it "Implicit Rating".

But the question remains, what is the Value of the CDS?

Let’s assume for a second that Capital Markets are Perfectly Competitive Markets (we know they’re not), under this assumption trade price would be very close (ideally identical) to the value of the asset, and consequently trade price of CDS’s would disclose the Rating of the counterpart.

But we know we’re far from being in a Perfectly Competitive Capital Markets; the real power is concentrated in a small number of Investment Funds, Hedge Funds and Shadow Banking agents. They have the ability of determining the price of the assets and consequently the Rating of the counterparts. On the process, they drive Capital allocation activities, inflating and bursting bubbles according to their interests.

In a world of limited Capital, growing by inflating and bursting bubbles is a big issue. Can we move to the new model if we don’t improve the transparency and efficiency of the Capital Markets?

I don’t think so.

Looking forward to read your opinions.

K. Regards,

Ferran.

Fair Value Accounting, Historical Value Accounting and Bank Analyzer.

Dear,

One of the most sensitive topics in the Capitalist System is the recognition of the Assets Value.

As a difference of many other economic events, payment, debts, terms of payment, interest calculation, etc. Assets Valuation is a controversial matter. The first belong to the group of economic facts, the second are just opinions.

For instance; once defined the Financial Conditions of a Loan, there’s only one result of the Interests Calculation.

But there’s not a unique valuation of the value of a house (or any other asset). We can request expert appraisals, and we’ll get as many valuations as expert opinions.

Assets valuation is a critical activity. In every economic transfer, both agents (buyer and seller) need to make an agreement about the value of the transferred asset, without an agreement on the value of an asset there’s no trade and without trading there’s no modern economy.

By the way, the infamous “Toxic Assets”, responsible of the 2008 Financial Crisis are just the consequence of an abrupt disagreement in the value of some Financial Assets. As the market agents cannot agree in the trade price, the asset becomes illiquid and the market freezes. If the volume of illiquid assets and the disagreement in its value is big enough, they’re capable of triggering a huge financial crisis.

Additionally, assets valuation plays a very significant role in Capital Allocation. If the economic agents expect a revaluation of an asset or family of assets, they will see them as an investment opportunity and capital will be allocated in them. If the expected valuation is not finally translated into real Profits, the investor will have wasted Capital, the most critical resource.

Traditionally, we have worked with two families of Assets Valuation/Accounting methods; Cost Accounting and Fair Value Accounting. The first one looks at the past transactions of the asset, the second looks at the current/future realizable value of the asset.

Obviously, Historical Valuation does not estimate risk, as there’s no uncertainty in past events.

On the other hand, Risk is a very relevant Capital consumer. Historical accounting is easier to implement, but as it does not estimate Risk, it’s not accurate enough in a world of limited Capital.

Fair Value Accounting does estimate risk, but it also requires much more reliable information, confidence, transparency and disclosure; without them Fair Value Accounting is useless.

In my opinion Assets Valuation rules are going to experience a very deep transformation in the oncoming years. IFRS is just one step in the transformation that will get speed with the Systemic Change driven by the current Systemic crisis. Personally I’m an advocate of an Accounting System which looks at the value generation foundation of the Assets, as the fundamental component of the Value recognition.

http://sapbank.blogspot.co.uk/2013/07/collaterals-and-underlines-accounting.html

http://sapbank.blogspot.co.uk/2013/07/collaterals-and-underlines-accounting_27.html

We’re going to see deep changes in the next years; it sounds logic that during the transition period, multiple valuation models are going to be required. Consequently, Accounting Information Systems need to be prepared for supporting parallel accounting models, something that Bank Analyzer is ready to offer.

Looking forward to read your comments.

K. Regards,

Ferran.

Real Estate Rentals Securitization and Bank Analyzer.

Dear,

This week, several Financial Institutions announced that they are offering a new securitization program of Real Estate Rental contracts.

http://online.wsj.com/article/SB10001424127887324170004578638093802889384.html

Securitization is a very promising business for the next years; the Financial System is suffering huge capitalization difficulties, and removing Risk from their Balance Sheets, by securitizing Assets, is an excellent way of improving the Banks’ Capital Ratios.

The market opportunities are abundant, and as the above article shows, include new concepts in securitization.

Last months I've been collaborating with the Architects of TXS, responsible of the development of Funding Management, a critical component of the End to End Securitization and Syndication processes in SAP http://www.txs.de/txs-en.aspx

The outcome of this collaboration is very promising, as offering an End to End Integrated solutions for Securitization in SAP is a very significant competitive advantage (increased visibility, lower Total Cost of Ownership, etc.).

Today, I’d like to share with you how to manage an End to End Securitization process of Real Estate Rental contracts with SAP, just as the example described in the above article.

Managing a Securitization process of Real Estate Renting contracts in SAP is quite natural; let me give you a brief description of the process.

SAP has a great solution for Real Estate renting management, as part of the ECC Financial Accounting components (Real Estate Management & Flexible Real Estate Management). The main object is the Real Estate Contract which contains the conditions for generating the expected cash-flows of the Asset.

Replicating the Real Estate contract as a Financial Transaction of the Bank Analyzer SDL is supported by the Bank Analyzer architecture, either by using the ETL or developing specific services.

The postings (payments, renewals, etc.) in the Renting Contract will have to be transferred as Business Transactions; once we include the other Primary Objects (Business Partners, Collaterals, etc.) will have the complete scenario modeled in Bank Analyzer.

Funding Management 2.0 has also a quite open architecture, and it’s feasible to develop the necessary interfaces with ECC- Real Estate and Bank Analyzer for supporting the payment distribution functionalities (including waterfall processes, provisions generation, etc.) from the Renting Contracts Pool to the Especial Purpose Vehicle.

Finally; Issuing, Trading and managing the Payment obligations of the Securities is very well supported by the Treasury and Risk Management Component of SAP-ECC.

Additionally managing Real Estate contracts is a mature industry for SAP with a very significant market share, those are business facts that should help to position SAP Banking components for securitizing those contracts.

In addition to all the above, there’s a very important concern on the development of the Securitization Industry. As the article highlights, after the Financial Crisis there’s a relevant lack of trust on the transparency of the Securitization Processes. And for offering transparency and control, there’s no better value proposition than the integrated architecture of SAP.

By the way, Securitization will play a very important Role in the new Financial System driven by Efficient Capital Management. But it will a new model of Securitization, we’ll talk about it in a future post.

Once again, Disclosure is the word.

Looking forward to read your opinions.

K. Regards,

Ferran.

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.