© Brammertz Consulting, 20091Date: Unified Financial Analysis Risk & Finance Lab Chapter 7: Costs Willi Brammertz / Ioannis Akkizidis

© Brammertz Consulting, 20092Date: Input elements Contracts Counter- parties Markets Behaviour Financial events e1e1 e2e2 e3e3 enen … t Cost

© Brammertz Consulting, 20093Date: Cost definition > Cash flows not related to financial contracts > Other expenses > Salaries > Rent > Computers > Bonuses > Etc. > Other revenue > Wealth management > Money transfer revenues > Etc.

© Brammertz Consulting, 20094Date: Cost in financial vs. non-financial industry Balance Sheet Assets Liabilities P&L Cost Reven. Banks P&L Cost Reven. Producing Industry Balance Sheet Assets Liabilities

© Brammertz Consulting, 20095Date: Cost accounting methods > Variable cost should always be directly allocated > Different methods are related to fixed cost > There are basically two methods of cost accounting or allocation > Standard cost accounting > Activity based cost accounting (ABC method)

© Brammertz Consulting, 20096Date: Appropriate method Activity Based Costing (ABC) > Only activity based cost accounting is appropriate within our framework > As much s possible should be allocated directly; implies, not all cost can be directly allocated

© Brammertz Consulting, 20097Date: Cost allocation: Contract as primary and counterparty as secondary target

© Brammertz Consulting, 20098Date: Cost allocation rules > As much as possible, cost must be allocated to the “product” > “Product” in the financial industry is a financial contract > Primary allocation target must therefore be the single contracts > Counterparties have several relationships with banks wherefore it is not always possible to allocate cost to a single contract > Secondary allocation target is therefore the counterparty > Tertiary (and final allocation) should be the profit or cost center

© Brammertz Consulting, 20099Date: Cost patterns > For a full integration of cost into an event driven framework, cost patterns become important > Cost patterns describe cost (and revenues) cash flows on the time line

© Brammertz Consulting, Date: Temporal modes of cost > The three temporal modes of financial analysis apply for cost as well > Historic > Static > Dynamic > Historic is dominant view today > Static view not very common (needs cost patterns for existing contracts) > Dynamic (to be discussed in part IV)

© Brammertz Consulting, Date: “Natural” cost integration > Cost closely related to operation > Cost drivers would have to be modeled along with (people, premises …) > Cost patterns are necessary to produce cash flows > Real integration only in dynamic mode possible > Increased importance of cost > Banking > Life insurance > Non-life insurance > Non-financial sector

© Brammertz Consulting, Date: Cost in practice > Cost is managed in huge cost accounting systems > SAP > Oracle > Abacus > ….

© Brammertz Consulting, Date: Cost and risk > Cost is closely related to operational risk > In the insurance sector: Cost is considered explicitly as a risk factor > Little recognition of cost as a risk factor in the banking sector