Margin Calls - Collaterals Management and Bank Analyzer Part III

Dear,

As you probably know, SAP Bank Analyzer does not have yet, the recognition it deserves in the Investment Banking industry.

Ironically, it could be a very powerful element of an Investment Bank IT landscape, particularly in combination with other SAP Banking components.

A very interesting example is the management of Margin Calls.

Margin Calls are a very critical requirement in Investment Banking and Capital Markets trading.

Simplifying, the business scenario is as it follows.

Brokers demand investors collateralize their exposures in order to open a position. For keeping the position opened, the broker will require a specific level of collateralization ratio to be maintained (this is a regulatory requirement in most of the jurisdictions).

During normal operations the fair value of the position and the collateral fluctuate every day (actually, every second). If the fair value of the position or the collateral drops, reducing the collateralization ratio below a determined level (called maintenance requirement), a “margin call” will be triggered, requesting additional guarantees to the investor.

If the investor fails to provide the additional guarantees, the broker will close the position.

The question is; does Bank Analyzer have strong functionalities for covering the "margin call" requirements of an Investment Bank?

If we check the Bank Analyzer menu, we will not find any “margin call” transaction (actually we can find it in SAP-TRM).

On the other hand, if we look at the detailed requirements of a margin call scenario, we’ll see that we can handle it by combining the functionalities of several SAP Banking components, even more efficiently than what best of breed trading products can offer today.

We saw some weeks ago, how Bank Analyzer can make an accurate calculation of Financial Collaterals.

sapbank.blogspot.com/2013/10/collaterals-management-and-bank.html 

Let’s see how to run an enhanced calculation of the collateralization ratio.

Most of Trading Systems determine the minimum collateralization ratio as a quotient between the collaterals fair value and the exposures at risk.

This is an incomplete model because it does not include the Probability of Default of the counterpart, and it does not seem logical to request the same level of collateralization to a risky and a very reliable investor.

Basel II/Basel III agreements give us the foundation for and enhanced calculation of the Collateralization level, which should estimate the Loss Given Default and Probability of Default of the exposure, which depend on the Rating of the Counterparty (Advanced IRB).

The main advantage of this “enhanced” calculation of the collateralization ratio is efficient Capital Management; remember that Collateral is a form of Capital.

Once again, we’re in the middle of a Systemic Crisis which is transforming the Financial System from a business model based in Volume to a business model based in Efficient Capital Management.

Bank Analyzer-Credit Risk Analyzer supports the calculation of LGD and PD parameters according to the Advanced IRB approach, which is the foundation for the enhanced calculation of the collateralization ratio.

Once we’ve calculated the LGD and PD with Bank Analyzer-CRA, determining the enhanced collateralization ratio, and triggering margin call alerts are just reporting requirements, is supported by the reporting functionalities of Netweaver.

I’m aware that the enhanced calculation of the collateralization ratio with Bank Analyzer-CRA presents some performance challenges for big portfolios in very dynamic trading markets, but this is the added value of including SAP-HANA into the landscape.

At the end, we’re talking about Efficient Capital Management, the driver of the new Financial System.

Looking forward to read your opinions.

K. Regards.

Ferran.

I wish it were your decision Mr. Bernanke – Chapter IV

Dear,

While I’m writing this post, the main concern of the economic world is a political agreement; will politicians raise the US debt ceiling or will they force the government default?

http://www.bbc.co.uk/news/business-24511283

I don’t think we’re going to see a US default this week, because nobody is interested in bursting the US debt bubble yet. But that’s not the question. The question is; can US politicians prevent the default, just by increasing the leverage?

Of course not, according to www.usdebtclock.org, the US national debt is approximately 17 trillion USD (148.000 USD per taxpayer), and more important, US interest payments in 2013 will be 2.8 trillion USD (24.000 USD per taxpayer).

What the debt levels are showing us is the exhaustion of an economic model based in wasting capital, and increasing the debt ceiling means buying time while we build the new model based on efficient capital management.  At this point, it’s very recommendable to read last June's speech of Mr. Jaime Caruana, General Manager of the Bank for International Settlements.

http://www.bis.org/speeches/sp130623.htm?ql=1

But are the economic elites actually making the most of borrowed time?; what concrete actions are being taken towards the new paradigm?

Just an example; while everybody is looking at Washington, hoping for an agreement between democrats and republicans, much more important decisions are taken at the other side of the world.

http://www.reuters.com/article/2013/10/10/us-ecb-china-swap-idUSBRE9990A220131010

US dollar has been a key player on the economic model that western world has enjoyed since the Great Depression and the end of the Second World War, and since then, it has become the international trade and reserve currency.

But the end of the model comes in parallel with the fall of the preponderance of the US currency; as investors become concern about the solvency of the FED, a new multilateral model shows up.

Since the starting of the Financial Crisis on 2008, FED balance sheet has grown from 1 to 3.5 trillion USD (1 trillion in MBS’s). What’s the risk and capital consumption associated to this exposure?

http://blogs.wsj.com/economics/2013/09/17/a-look-inside-the-feds-balance-sheet-16/tab/interactive/

While the European Central Bank and the People's Bank of China make movements, addressed to replace the USD in their trade relationships, they’re also building the foundation of a new international currency system.

European and Chinese central banks are building a stability framework for Forex risk limitation on their bilateral trade (by the way, reducing capital consumption), and implicitly, limiting trade unbalances to sustainable levels.

Once again, we’re moving from a financial system based in volume, to a financial system based in efficient capital management.

The new currency system was already recommended by the International Monetary Fund in 2010 in order of assuring world’s financial stability.

http://www.imf.org/external/np/pp/eng/2010/041310.pdf

Financial stability is the key; growing by wasting capital and injecting liquidity, with no collateral support, will be visibly unsustainable very soon, and it will painfully give birth to the new model.

Signs are already there, but we prefer to believe that everything is a political game, and the agreement between the Tea Party and the Obama administration will solve our problems.

Sometimes reality is so hard that we prefer dreaming, till somebody else wakes us up.

Looking forward to read your opinions.

Kindest Regards,
Ferran.

Over the Counter Derivatives, Capital scarcity and Collateral Management.

Dear

As you probably know, one of the major exponents of the current debt bubble and responsible of the 2008 Financial Crash are the Over the Counter Derivatives.

These Financial Contracts are just bets on the fluctuation of a Financial Parameter, called underline (Stock Market Indexes, Foreign Exchange Rates, Interest rates, Commodities Prices, etc.).

Over the Counter Derivatives were responsible of one of the worst moments of the 2008 Financial Crisis when on September the United States Federal Reserve Bank injected 85 billion USD to prevent the AIG’s collapse. This is the largest government bailout of a private company in U.S. history.

Just for giving you an idea of the size of the OTC Derivatives bubble, according to the estimations of the Bank for International Settlements (Central Bank of the Central Banks), the OTC derivatives market has a nominal size of more than 600 trillion USD, approximately 10 times the world’s GDP.

The danger of this bubble is very well known; for instance, on 2002 Warren Buffett called them “Financial Weapons of mass destruction”.

On the 2009 summit in Pittsburgh, G20 leaders agreed the regulation of the OTC derivatives market.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=auIe3UTJncpY

Unfortunately, today's situation is not much better than in 2008, the destructive capacity of the derivatives market is even bigger than it was at the time, and the everyday closer rising of the interest rates has the capacity of bursting the bubble.

On a recent speech, Mr. Stephen G Cecchetti, Head of the Monetary and Economic Department of the Bank for International Settlements advocated for the regulation of the OTC derivatives market.

http://www.bis.org/speeches/sp130912.pdf

He also mentions the concerns among the banking community about the collateral restrictions generated by the implementation of the regulation.

This is a wrong perception, collateral scarcity is not a consequence of the regulation; it just makes it visible. The chain of events is as it follows.

1)      Growth rates are going to be lower due to natural resources scarcity and global debt.

2)      Low growth rates produce capital scarcity.

3)      Capital scarcity requires managing it efficiently.

4)      Stringent regulation and higher collateral requirements reduce free capital available to invest, and drives efficient Capital Management.

Don’t forget that collateral is just a form of capital, and efficient capital management requires efficient collateral management.

In the meantime, the most urgent concern is deflating the derivatives bubble before it bursts. As you could see in the last weeks, keeping the interest rates low is more difficult every day, and rising interest rates are one of the most dangerous scenarios for debt bubbles, including derivatives bubbles (which are just another form of debt).

For giving some hints of the magnitude of the problem, consider this.

On 1929 Financial Crisis which triggered the great depression there was no such thing as derivatives, just debt and stocks.

The total value of the United States stock market is estimated at 23 trillion USD, while US banks have exposures in derivatives markets by 223 trillion USD

http://www.forbes.com/sites/halahtouryalai/2013/03/28/risk-is-back-americas-big-banks-are-knee-deep-in-derivatives/

When the new deal bailed out the US economy, the national debt was only 16% of the annual GDP while today is over 100% of annual GDP.

The only option is Efficient Capital management and efficient collateral management is one of its components.

During this month I’m going to focus on the SAP Banking capabilities for efficient collateral management, I hope this post gives an idea of the necessity of making it happen.

Looking forward to read your opinions.

K. Regards,

Ferran.

Collaterals management and Bank Analyzer - Chapter II.

Dear,

Last week we discussed the importance of a centralized and integrated management of the Bank’s collaterals.

http://sapbank.blogspot.com/2013/09/collaterals-management-and-bank.html

Today, I’d like to look specifically at the issues and requirements on the valuation of Collaterals, particularly Financial Collaterals.

Valuation of collaterals is a critical issue in Collaterals Management; any hair-cut damaging the value of the collateral will penalize its capacity as a risk mitigator, and it will increase the potential losses of the Bank, and its Capital consumption.

We have two types of Assets that can be used as Collaterals, Physical and Financial (Non-Physical).

SAP Collaterals Management has powerful functionalities for determining market and lending values of the collateral from external valuations. ,

But for the valuation of Financial Collaterals, SAP-CMS offers us another excellent opportunity of integration with other SAP Banking components.

Bank Analyzer is a very detailed and sophisticated tool for valuating Financial Transactions and Financial Instruments. Additionally, valuations are always opinions; even regulatory valuations can be different (IFRS, US-GAAP, etc.).

Integrating Financial Collaterals objects with the multi-accounting valuation functionalities of Bank Analyzer will give us a detailed and complete tool for valuating them.

More importantly, integrating Collaterals Management with the risk management tools of Bank Analyzer (Strategy Analyzer) and future Analyzers (ALM) will leverage those functionalities for valuating Financial Collaterals on stressed and simulated scenarios, and estimate potential hair-cuts.

You’re probably aware already of the advantages in terms of Total Cost of Ownership and Single Truth DataSources for the Bank, of the integrated architecture proposed above.

But this is just the beginning, as we move deeper into the Financial Crisis and the Financial System feels the scarcity of Capital, we will discover new advantages on having a holistic vision of Collaterals Management, integrating the Transactional and Analytical Banking scopes.

For instance, as the Basel II and Basel III agreements recognize, there’s an optimal distribution of Collateral bundles to exposures which minimizes the Capital Requirements for the portfolio of assets.

Actually, the Credit Risk Analyzer of Bank Analyzer supports this functionality on the Level 2 of the Capital Requirements Calculation; this is the foundation of a Capital Optimization technique called “Dynamic Collateral Management”.

Reducing Capital requirements the Bank achieves better Capitalization ratios, and consequently lower Cost of Capital (the less risky investment, the lower the capital cost) and new investment opportunities, as better capitalization also means the opportunity of allocate the free capital in new exposures.

This is just an example, the new Financial System, driven by the new paradigm of Capital Management efficiency, will require holistic information systems which assure the optimal utilization of the banks’ capital.

As I mentioned in the past; Capital Optimization is not just a portfolio management activity, it involves the whole Bank, and requires a seamless integration between the Transactional and Analytical Banking information systems,

With these premises, I don’t think any software company is in the position of competing with SAP for offering the required holistic vision and seamless integration between the Banking Information System components that the new Financial System is going to demand.

Looking forward to read your opinions.

Kindest Regards,

Ferran.

Collaterals Management and Bank Analyzer - Chapter I.

Dear,

In a Financial System of limited Capital, efficient Capital Management is the priority.

Efficient Capital Management depends on two magnitudes, Assets Value generation and Risk management (Market, Credit or Operational).

As you can see, we can optimize Capital Management from both sides of the equation; either we increase Value generation or we reduce the Risk of the investment; or even better, we increase Value generation minimizing at the same time the Risk of the investment.

We’ll look at Capital Optimization from the Value generation perspective, and SAP competitive advantages for this in another post, but today we’ll analyze Capital Optimization from the perspective of Risk Optimization.

Reducing the Risk of the investment requires analyzing the expected behavior of Exposures and Counterparts, or utilizing Risk Mitigation Techniques.

Determine effectively the performance of the Bank’s exposures and behavior of the counterparts is a difficult activity, in which statistics calculation, historical patterns and capital markets information can be very useful.

We discussed about SAP Banking components for a holistic Rating and Credit Risk analysis in previous posts

http://sapbank.blogspot.com/2013/05/rating-scoring-and-sap-banking-chapter-i.htmlhttp://sapbank.blogspot.com/2013/06/rating-scoring-and-sap-banking-chapter.htmlhttp://sapbank.blogspot.com/2013/08/implicit-ratings-uncertainty-efficiency.html

We will look at this topic in the future again, but today, we’re going to look at Capital Optimization from the perspective of the Risk mitigation techniques; typically Collaterals and Guarantees.

SAP Banking has an excellent Collaterals Management System, integrated with the SAP Banking Components; Loans Management, Treasury and Risk (for Corporate Banking trade), Reserve for Bad Debts (for Impairment Provisions Calculation) and Bank Analyzer (for Capital Consumption).

The main advantage of SAP-CMS is its integration capacity.

In many Banking legacy systems, their legacy “Collaterals Management System” has been built as a sub-component of the Loans management system. This approach represents a serious limitation from an Architecture Perspective.

In reality, the right or asset which is going to be used in a collateral agreement can collateralize to more than one Loan (or any other exposure), it can exist before the exposure, and in fact, its lifecycle is not dependent on the exposures it’s covering.

A central vision of the value of the Collateral (including potential haircuts) and its charges is mandatory, for assuring that the collateral will fulfill its functions as Risk mitigator.

Take into account that in Banking Legacy systems, we normally find more than one Loans system, with limited integration among them, and minimal (if some) integration with the Corporate and Derivative products’ Banking System.

With this niche architecture, managing centrally the charges supported by the collaterals, and measuring potential hair-cuts on the value of the guarantees, and the subsequent impact on the Bank’s regulatory capital, is “Science Fiction”.

Seven years ago I was working on one of the biggest Bank Analyzer-Basel II implementations for a European Bank. The Bank was performing very well at the time (in the middle of a huge Real Estate bubble I must say),but I still remember how shocked I was when I understood the lack of control on the management of the Bank’s Real Estate Collaterals, which were supposed to mitigate the Credit Risk of the Bank’s exposures.

Actually, when just some months ago, I saw in the news that the Bank had to be bailed out, I was not surprised.

This is the past and we cannot change the past, we have wasted Capital for decades and now the situation is what it is.

Now it's the time to implement the new paradigm and SAP has the technology which makes it possible.

Looking forward to read your opinions.

K. Regards,

Ferran.

I wish it were you decision Mr. Bernanke - Chapter III

Dear,

This week the Federal Reserve decided to keep injecting liquidity in the Financial System by not changing its $85 billion a month bond-buying strategy.

http://www.reuters.com/article/2013/09/19/us-usa-fed-idUSBRE98G1D620130919

And the stock markets went up

http://www.reuters.com/article/2013/09/17/us-markets-stocks-idUSBRE9890IQ20130917

If the stock market prices were a fair representation of the economic health of the world, this would be great news.

Unfortunately, this is a purely speculative movement; injecting liquidity will never fix a solvency problem.

A Fractional Reserve banking system requires growth for being solvent, and we’re not going to grow, because scarcity of natural resources and global debt is making it impossible to grow at historical rates.

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

And this is the real problem, lack of solvency in the Financial System. Federal Reserve is giving Red Bull bottles to a Financial System with a metastatic cancer. Maybe it looks like healthier, but at the same time the tumour is spreading.

The reality is that with limited growth, Capital becomes scarce, and no liquidity program can fix that.

As Mr. Jaime Caruana, General Manager of the Bank for International Settlements (Central Bank of the Central Banks) explained clearly some months ago, these stimulus programs are just borrowing time.

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

And we’re all going to pay a very high price for it; we are wasting funds that we’ll need in the future.

One month ago, William White, BIS’s former chief economist, gave another clear warning; “This looks like to me like 2007 all over again, but even worse,”

http://www.telegraph.co.uk/finance/10310598/BIS-veteran-says-global-credit-excess-worse-than-pre-Lehman.html

In fact, debt volume in the developed world is 30% higher today than on 2007.

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

These debt levels are unsustainable, un-payable, and recognizing the fact will be the biggest bubble burst in the recent economic history.

Remember; financially, recognizing un-payable debts means writing them off. Trillions of dollars in assets will disappear, reducing dramatically the world’s Gross Domestic Product.

Abruptly, the global economic system will accept that we’re much poorer than we think we are.

But this was not meant to be a scary post, the day after the crash, sun will rise again, and we’ll wake up to live in a different world. At the time, it will be so clear that Capital is scarce that we’ll be ready to accept the only alternative; Efficient Capital Management.

The question is, what are we doing to be prepared for the systemic change?

Regulation is just part of the story, deregulation brought Capital waste, but a more stringent regulation is not enough for making the change happen.

Let me give you a simple example, governments can issue a law penalizing speeding, but if they don’t give radar speed guns to the police, speeding will not be prevented.

We’re not talking about plastic surgery here; we’re talking about changing the foundation of the financial system, from a business model based in volume to a business model based in efficient Capital management, a huge challenge indeed.

A holistic and integrated vision of Banks’ activities is mandatory, and in my opinion, SAP is the only software company with the vision and resources, for building the required technologic infrastructure.

But this capacity is useless if we don’t make it effective.

Some weeks ago, I talked to a friend who has had SAP Banking sales responsibilities for more than 10 years; he literally told me “Bank Analyzer is difficult to sell because we don’t have many people who really knows how it works”

This cannot be an excuse, we’re in the middle of a Systemic Change and we have to make it happen; whatever it takes.

Looking forward to read your opinions.

K. Regards,

Ferran.

Assets Protection Schemes. Efficient Management of Public Funds and Bank Analyzer.

Dear,
Capital Scarcity is the main threat for the financial system, and it is driving it from a Business Model based on Volume to a Business Model based on Efficient Capital Management.

Efficient management has some requirements; the main one is providing the Banks’ managers and auditors with a holistic vision of all Bank’s rights (Assets) and obligations (Liabilities).

Unfortunately, in the traditional accounting systems, some of the Banks’ rights don’t have full recognition, when they have the same capacity of value generation than other, fully recognized assets.

A quite interesting case is the representation of the Assets Protection Schemes (APS’s), commonly used since the starting of the Financial Crisis on 2008.

Simplifying, the basic idea under APS’s is the following; Banks on financial difficulties were recapitalized by receiving special guarantees from the government. Those guarantees protected them from potential losses in damaged assets.

APS’s directly improved the solvency of rescued banks, giving them access to the capital markets where they would get liquidity, and provided them with free-capital, that they were able of allocating, according to the strategy defined by Bank’s executives.

Of course, the transfer of solvency came with a price; as Banks improved their solvency, public finances suffered the losses, represented by reductions in their solvency ratings.

Rescued packages have offered some stability to the Financial System, but there’re some doubts about the long term effectiveness of the program; particularly, when it comes to the good utilization of those public funds. At least partially, the reason has to do with the capabilities of the Bank’s information systems, for tracking the allocation of the public funds transferred to them, and the way those rights were represented.

APS’s have been modeled in most of Bank’s Information Systems as collaterals of the damaged assets. As the risky assets are now highly collateralized, the banks have been able of using them in securitization processes or repo-style transactions, in exchange for liquidity.

On the other hand APS’s can also be modeled as Over-the-Counter Credit Derivatives (Options), capable of hedging the Default Risk of the Banks’ damaged Assets.

While improvement of the solvency position is recognized by both approaches, the value of the transferred funds is not equally represented in the balance sheet. With the first approach; the impact of an over-collateralized asset in the balance sheet could be minimal, as the collateral value is represented in books when the collateralized asset becomes impaired.

On the other hand; with the second approach, the Over-the-Counter Credit Derivatives Fair Value have full recognition from the time it is acquired, including any potential Hedge-Accounting adjustment.

As mentioned at the beginning of this post, the objective should be achieving a holistic representation of all Bank’s rights and obligations; supported by functionalities, capable of tracking capital consumption, and actual return of the allocated capital.

Giving visibility to capital and its utilization, is the first step for building a system which supports its efficient management. In my opinion, Accounting standards and the flat structure of the General Ledger don’t provide the best info-structure for offering that visibility.

On the contrary, the Integrated Financial and Risk Architecture of the Bank Analyzer offers the required holistic approach, representing the underlines, risk of assets, and their expected and actual return. Additionally, their multi-accounting system functionalities, provides the capacity of reporting the bank’s position according to multiple approaches.

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