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Unified Financial Analysis Risk & Finance Lab

This chapter examines the costs in the financial industry, including cost definition, cost accounting methods, cost allocation rules, cost patterns, and the integration of cost into financial analysis.

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Unified Financial Analysis Risk & Finance Lab

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  1. Unified Financial Analysis Risk & Finance Lab Chapter 7: Costs Willi Brammertz / Ioannis Akkizidis

  2. Input elements Markets Counter-parties Behaviour Cost Contracts e1 e2 e3 … en Financial events t

  3. Cost definition • Cash flows not related to financial contracts • Other expenses • Salaries • Rent • Computers • Bonuses • Etc. • Other revenue • Wealth management • Money transfer revenues • Etc.

  4. Cost in financial vs. non-financial industry Banks Producing Industry Balance Sheet Assets Liabilities P&L Cost Reven. Balance Sheet Assets Liabilities P&L Cost Reven.

  5. 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)

  6. Appropriate methodActivity 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

  7. Cost allocation: Contract as primary and counterparty as secondary target

  8. 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

  9. 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

  10. 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)

  11. “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

  12. Cost in practice • Cost is managed in huge cost accounting systems • SAP • Oracle • Abacus • ….

  13. 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

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