TREASURY MANAGEMENT IN BANKS IN INDIA
1. INTRODUCTION1.1 Objectives of the study
To know about Treasury functions of a bank in India. To learn
about different types of financial instruments which bank deals on
a day to basis. This study enabled to have a greater exposure about
the practicality of treasury functions which I could study in
contrast with the theoretical context.
1.2 Overview
Treasury refers to the funds and revenue at the possession of
the bank and day to day management of the same. Idle funds are
usually source of loss, real or opportune, and, thereby need to be
managed, invested, and deployed with intent to improve
profitability. There is no profit or reward without attendant risk.
Thus treasury functions seek to maximize profit and earning by
investing available funds at an acceptable level of risks. Returns
and risks both need to be managed. If we examine the balance sheets
of commercial banks (Public Sector Bank, typically), we find
investment/deposit ratio has by far overtaken credit/deposit ratio.
Interest income from investments has overtaken interest income from
loans/advances. The special feature of such bloated portfolio is
that more than 85% of it is invested in government securities.
The reasons for such developments appear to be as under: Poor
credit off take coupled with high increase in NPAs. Banks
reluctance to cut down the size of their balance sheets.
Governments aggressive role in lowering cost of debt, resulting in
high inventory profit to commercial banks. Capital adequacy
requirements. The income flow from investment assets is real
compared to that of loan assets, as the latter is sizably a book
entry.
In this context, treasury functions are becoming more and more
important to the banks and a need for integration, both horizontal
and vertical, has come to the attention of the corporate. The basic
purpose of integration is to improve portfolio profitability, risk
insulation and also to synergize banking assets with trading
assets. In horizontal integration, dealing/trading rooms engaged in
the same trading activity are brought under same policy,
technological and accounting platform, while in vertical
integration, all existing and diverse trading and arbitrage
activities are brought under one control with one common pool of
funding and contributions.
2. FUNCTIONS OF THE TREASURY DEPARTMENT
Since 1990s, the prime movers of financial intermediaries and
services have been the policies of globalization and reforms. All
players and regulators had been actively participating, only with
variation of the degree of participation, to globalize the economy.
With burgeoning forex reserves, Indian banks and Financial
Institutions have no alternative but to be directly affected by
global happenings and trades. This is where integrated treasury
functions have emerged as a basic tool for key financial
performance.
A treasury department of a bank is concerned with the following
functions:
Risk exposure management, which embraces credit, country, and
liquidity and interest rate risk consideration together with those
risks associated with dealing in foreign exchange. Asset and
liability management, where liquidity, interest rate structures and
sensitivity, together with future maturity profiles, are the major
considerations in addition to managing day-to-day funding
requirements. Control and development of dealing functions. Funding
of investments in subsidiaries and affiliates. Capital debt / Loan
stock raising. Fraud protection. Control of Investments. TREASURY
MANAGEMENT IN BANKS IN INDIA
50
3. INVESTMENTS
3.1 Cash Reserve Ratio / Statutory Liquidity Ratio
Management
RBI having regard to the needs of securing monetary stability in
the country has mandated Banks to deposit the portion of their
money with RBI. CRR, or cash reserve ratio, refers to the portion
of NDTL i.e. Net Demand and Time liabilities that banks have to
maintain with RBI. This serves two purposes. First, it ensures that
a portion of NDTL is totally risk-free. Second, it enables RBI
control liquidity in the system, and thereby, inflation. Besides
CRR, banks are required to invest a portion (21.5 per cent now) of
their NDTL in government securities as a part of their statutory
liquidity ratio (SLR) requirements. The government securities (also
known as gilt - edged securities or gilts) are bonds issued by the
Central government to meet its revenue requirements. Although the
bonds are long-term in nature, they are liquid as they have a ready
secondary market.
For calculation of CRR and SLR, it is taken as a percentage of
Net demand and Time liabilities of the Bank.
Demand Liabilities:-It includes all liabilities which are
payable on demand such as current deposits, margins held against
LOC / guarantees, recurring deposits, demand drafts, etc.
Time Liabilities:-It includes all liabilities which are payable
otherwise than on demand such as fixed deposits, recurring
deposits, margins held against LOC / guarantees, cash certificates,
etc.
Other Demand and Time Liabilities: -Interest accrued on
deposits, Bills payable, unpaid dividends, etc. SCBs are not
required to include inter-bank term deposits / term borrowing
liabilities of original maturities of 15 days & above and up to
one year for calculation of NDTL in case of CRR. But in case of SLR
it needs to include inter-bank term deposits / term borrowing
liabilities of original maturities of 15 days & above and up to
one year. Banks need to maintain prescribed CRR & SLR as on
last Friday of fortnight. All SCBs are required to maintain minimum
CRR balance up to 95% of total CRR requirement on all days of
fortnight. CRR can be kept in form of cash, gold or approved
securities.
PENALTIESOn daily basis: Interest of 3% p.a. above the bank rate
will be recovered from bank. If it continues, 5% p.a. above bank
rate will be recovered.
What impact does a cut in CRR have on interest rates?
From time to time, RBI prescribes a CRR, or the minimum amount
of cash that banks have to maintain with it. The CRR is fixed as a
percentage of total NDTL. Banks are now required to maintain 4 per
cent of their NDTL with RBI. As more money chases the same number
of borrowers, interest rates come down.
Does a change in SLR impact interest rates?
SLR reduction is not so relevant in the present context for two
reasons: One, as a part of the reforms process, the government has
begun borrowing at market-related rates. Therefore, banks get
better interest rates compared with the earlier days for their
statutory investments in Government securities. Second, banks are
still the main source of funds for the government. This means
despite a lower SLR requirement, banks investment in government
securities will go up as government borrowing rises. As a result,
bank investment in gilts continues to be higher than 30 per cent
despite RBI bringing down the minimum SLR to 21.5 per cent a couple
of years ago.
Therefore, for the purpose of determining the interest rates, it
is not the SLR requirement that is important but the size of the
government-borrowing program. As government borrowing increases,
interest rates, too, look up. Besides, gilts also provide another
tool for RBI to manage interest rates. RBI conducts open market
functions by offering to buy or sell gilts. If it feels interest
rates are too high, it may bring them down by offering to buy
securities at a lower yield than what is available in the
market.
3.2 Dated Government Securities
The Government securities comprise dated securities issued by
the Government of India and state governments. The date of maturity
is specified in the securities therefore it is known as dated
government securities. The Government borrows funds through the
issue of long term-dated securities, the lowest risk category
instruments in the economy. These securities are issued through
auctions conducted by RBI, where the central bank decides the
coupon or discount rate based on the response received. Most of
these securities are issued as fixed interest bearing securities,
though the government sometimes issues zero coupon instruments and
floating rate securities also. In one of its first moves to
deregulate interest rates in the Economy, RBI adopted the market
driven auction method in FY 1991-92. Since then, the interest in
government securities has gone up tremendously and trading in these
securities has been quite active. They are not generally in the
form of securities but in the form of entries in RBI's Subsidiary
General Ledger (SGL).The investors in government securities are
mainly banks, FIs, insurance companies, provident funds and trusts.
These investors are required to hold a certain part of their
investments or liabilities in government paper. Foreign
institutional investors can also invest in these securities up to
100% of funds-in case of dedicated debt funds and 49% in case of
equity funds. Till recently, a few of the domestic players used to
trade in these securities with a majority investing in these
instruments for the full term. This has been changing of late, with
a good number of banks setting up active treasuries to trade in
these securities.Perhaps the most liquid of the long term
instruments, liquidity in gilts is also aided by the primary dealer
network set up by RBI and RBI's own open market functions.
3.3 Money Market Functions
Money Market is for short term assets that are very close
substitute of money. Money market instruments are liquid and can be
turned into cash quickly. The bank engages into a number of
instruments that are available in the Indian money market for the
purpose of enhancing liquidity as well as profitability.
A. Call Money Market
Call/Notice money is an amount borrowed or lent on demand for a
very short period. If the period is more than one day and up to 14
days it is called 'Notice money' otherwise the amount is known as
Call money'. Intervening holidays and/or Sundays are excluded for
this purpose. No collateral security is required to cover these
transactions.
The call market enables the banks and institutions to even out
their day-to-day deficits and surpluses of money. Banks (excluding
RRBs) and primary dealers are allowed to borrow and lend in this
market for adjusting their cash reserve requirements. Interest
rates in the call and notice money markets are market determined.
In view of the short tenure of such transactions, both the
borrowers and the lenders are required to have current accounts
with the Reserve Bank of India. It serves as an outlet for
deploying funds on short-term basis to the lenders having steady
inflow of funds.
B. Treasury Bills Market
Treasury bills (T-bills) offer short-term investment
opportunities, generally up to one year. They are thus useful in
managing short-term liquidity. In the short term, the lowest risk
category instruments are the treasury bills. RBI issues these at a
prefixed day and a fixed amount.
There are three types of treasury bills;
91-day T-bill - maturity is in 91 days. Its auction is on every
Wednesday of every week. The notified amount for this auction is
Rs.100 cr.
182-day T-bill - maturity is in 182 days. Its auction is on
every alternate Wednesday (which is not a reporting week). The
notified amount for this auction is Rs.100 cr.
364-Day T-bill - maturity is in 364 days. Its auction is on
every alternate Wednesday (which is a reporting week). The notified
amount for this auction is Rs.500 cr.
Treasury bills are available for a minimum amount of Rs.25000
and in multiples of Rs.25000. Treasury bills are issued at a
discount and are redeemed at par. Treasury bills are also issued
under the Market Stabilization Scheme (MSS).
Auctions:
While 91-day T-bills are auctioned every week on Wednesdays,
182-day and 364-day T-bills are auctioned every alternate week on
Wednesdays. The Reserve Bank of India issues a quarterly calendar
of T-bill auctions which is available at the website. It also
announces the exact dates of auction, the amount to be auctioned
and payment dates by issuing press releases prior to every
auction.
Auction of T-bills
* If the day of payment falls on a holiday, the payment is made
on the day after the holiday.
C. Ready Forward Contracts
It refers to a transaction in which two parties agree to sell
and repurchase the same security. Under such an agreement the
seller sells specified securities with an agreement to repurchase
the same at a mutually decided future date and a price. Similarly,
the buyer purchases the securities with an agreement to resell the
same to the seller on an agreed date in future at a predetermined
price. Such a transaction is called a Repo when viewed from the
prospective of the seller of securities (the party acquiring fund)
and Reverse Repo when described from the point of view of the
supplier of funds. Thus, whether a given agreement is termed as
Repo or a Reverse Repo depends on which party initiated the
transaction.
The lender or buyer in a Repo is entitled to receive
compensation for use of funds provided to the counter party.
Effectively the seller of the security borrows money for a period
of time (Repo period) at a particular rate of interest mutually
agreed with the buyer of the security who has lent the funds to the
seller. The rate of interest agreed upon is called the Repo rate.
The Repo rate is negotiated by the counter parties independently of
the coupon rate or rates of the underlying securities and is
influenced by overall money market conditions. Purchase & Sale
price should be in alignment with the ongoing market rates.
Treasury Bills, State & Central Government Securities are
eligible. PSU bonds and Private corporate instruments are also
permitted if they are in demat form. Further it can be undertaken
only in securities that are in excess of SLR requirements. The
minimum period for Reverse Repo by listed companies is 7 days.
However, period for Repo is for shorter time including fortnight.
The counterparty should be either bank or Primary Dealer
maintaining SGL with Reserve Bank Banks or PDs can enter in REPO
transactions among themselves subject to
a) Its not between SGL a/c holder and its constituents.
b) Its not between 2 gilt a/c holders having their account with
the same custodian. Securities purchased under Reverse repo should
not be classified under HTM category. In repo transaction, it
should be sold at market price & re-purchased at the derived
price.
The motivation for the banks and other organizations to enter
into a ready forward transaction is that it can finance the
purchase of securities or otherwise fund its requirements at
relatively competitive rates. On account of this reason the ready
forward transaction is purely a money lending operation. Under
ready forward deal the seller of the security is the borrower and
the buyer is the lender of funds. Such a transaction offers
benefits both to the seller and the buyer. Seller gets the funds at
a specified interest rate and thus hedges himself against volatile
rates without parting with his security permanently (thereby
avoiding any distressed sale) and the buyer gets the security to
meet his SLR requirements. In addition to pure funding reasons, the
ready forward transactions are often also resorted to manage short
term SLR mismatches.
Apart from inter-bank repos RBI has been using this instrument
effectively for its liquidity management, both for absorbing
liquidity and also for injecting funds into the system. Thus, Repos
and Reverse Repo are resorted to by the RBI as a tool of liquidity
control in the system. With a view to absorbing surplus liquidity
from the system in a flexible way and to prevent interest rate
arbitraging, RBI introduced a system of daily fixed rate repos from
November 29, 1997.
For any additional liquidity requirements Primary Dealers are
allowed to participate in the reverse repo auction under the
Liquidity Adjustment Facility along with Banks, introduced by RBI
in June 2000(Details given below). The major players in the repo
and reverse repurchase market tend to be banks that have
substantially huge portfolios of government securities. Besides
these players, primary dealers who often hold large inventories of
tradable government securities are also active players in the repo
and reverse repo market.
The Repo/Reverse Repo transaction can only be done between
parties approved by RBI and in securities as approved by RBI
(Treasury Bills, Central/State Govt securities).
Uses of Repo
It helps banks to invest surplus cash
It helps investor achieve money market returns with sovereign
risk.
It helps borrower to raise funds at better rates
An SLR surplus and CRR deficit bank can use the Repo deals as a
convenient way of adjusting SLR/CRR positions simultaneously.
RBI uses Repo and Reverse repo as instruments for liquidity
adjustment in the system.
INTEREST INCOME/EXPENDITURE
After the second leg is over of the transaction:-
Difference between clean price of 1st leg and 2nd leg is
interest income / expenditure.
Difference between the accrued interests paid between the two
legs.
3.4 Collateralized Borrowing and Lending Obligation
Introduction:Collateralized Borrowing and Lending Obligation
(CBLO)", a money market Instrument as approved by RBI, is a product
developed by CCIL for the benefit of the entities who have either
been phased out from interbank call money market or have been given
restricted participation in terms of ceiling on call borrowing and
lending transactions and who do not have access to the call money
market. CBLO is a discounted instrument available in electronic
book entry form for the maturity period ranging from one day to
ninety Days (can be made available up to one year as per RBI
guidelines). In order to enable the market participants to borrow
and lend funds.
CCIL provides the Dealing System through:
- Indian Financial Network (INFINET), a closed user group to the
Members of the
Negotiated Dealing System (NDS) who maintain Current account
with RBI.
- Internet gateway for other entities who do not maintain
Current account with RBI.
CBLO is explained as under:
An obligation by the borrower to return the money borrowed, at a
specified future date;
An authority to the lender to receive money lent, at a specified
future date with an option/privilege to transfer the authority to
another person for value received;
An underlying charge on securities held in custody (with CCIL)
for the amount borrowed/lent.
Membership:Membership to CBLO segment is extended to entities
that are RBI- NDS members viz.Nationalized Banks, Private Banks,
Foreign Banks, Co-operative Banks, Financial Institutions,
Insurance Companies, Mutual Funds, Primary Dealers etc. Associate
Membership to CBLO segment is extended to entities who are not
members of RBI- NDS viz. Co-operative Banks, Mutual Funds,
Insurance companies, NBFC's, Corporates, Provident/ Pension Funds
etc.
Eligible Securities:Eligible securities are Central Government
securities including Treasury Bills, as specified by CCIL from time
to time.
Borrowing Limit and Initial Margin:Borrowing limit for the
members is fixed every day after marking to market and applying
appropriate hair-cuts on the securities deposited in the CSGL
account. The post hair-cut Mark-to-Market value after adjusting for
the amounts already borrowed by the members is the borrowing limit,
which, in effect, denotes the drawing power up to which the members
can borrow funds. Members are required to deposit initial margin
generally in the form of Cash (minimum Rs.1 lac) and Government
Securities. Initial margin is computed at the rate of 0.50% on the
total amount borrowed/lent by the members. Intraday BL/IM
enhancements facility is also provided to CBLO members. Members can
also withdraw unencumbered portion of BL intraday. However,
intraday cash withdrawal is not possible.
3.5 Short SellingShort Selling refers to selling of securities
that one does not own. A bank can also undertake Notional short
sale of securities i.e. selling a security from HFT category even
if it is held under HTM / AFS category of investments of the bank.
Short sale transaction has to be covered within maximum period of 5
days i.e. T + 4 days. Short Sale transactions should be executed
only on NDS-OM.
Failure to settle the short sell transaction is considered as
SGL bouncing and Bank will be liable to action. Total Short sale
transaction of a bank should not exceed 0.5% of the total
outstanding stock. SCBs (other than RRB and LAB) & Primary
Dealers are permitted.
INTRA-DAY SHORT SELLING
Selling of securities that one does not own and the same being
covered by outright purchase within the same trading day.
3.6 When Issued Market
When, As and If issued is commonly known as When Issued. It
refers to the security that has been authorized for issuance but
not yet actually issued. In this market, trading takes place
between the period of new issue announced and actually issued. It
is settled on the date of issue. Only Primary Dealers are allowed
to short sell in When Issued Market.
Issue announced ----------- When Issued Market ---------- day
preceding the date of issue
Limits for transaction in When Issued Market
Non PDs Long position should not exceed 5% of the notified
amount.PDs Long position or Short position should not exceed 10% of
notified amount (Reissued Security)
Short Position not exceeding 6% of notified amount (New
Issue)
Long Position should not exceed 10% of notified amount (New
Issue)
3.7 Non-SLR Investments
Banks investment in Non-SLR securities issued by corporate,
banks, FIs and State & Central Government sponsored
institutions, etc. including capital gains bonds.
Banks should not invest in Non-SLR securities which have
maturity of less than 1 year other than Commercial Paper and
Certificate of Deposits.
It should not invest in unrated Non-SLR.
It should ensure that it makes investment only in listed
securities.
Investment by the Bank in unlisted Non-SLR securities should not
exceed 10% of its total Non-SLR investments.
Banks investment in Unlisted Non-SLR can exceed by additional
10% provided the further investment is in securitization of papers
issued for infrastructure projects and bonds issued by
reconstruction companies.
3.8 PORTFOLIO MANAGEMENT
No Bank shall offer any Portfolio Management Service or other
such type of schemes in future without obtaining specific prior
approval from RBI.
Non-Banking Financial Companies are allowed to undertake
PMS.
If Banks are offering PMS, then
- It should be entirely at customers risk without guaranteeing
any return.
Funds should be for period more than 1 year.
Funds should not be used for lending in call / notice money,
inter-bank deposits, bill rediscounting markets and lending to
corporate bodies.
Client wise account should be maintained.
Banks own investment and PMS investment should be distinct.
Clients portfolio should be maintained at market rates.
3.9 Banks exposure to Capital Markets
Direct ExposureIt refers to direct investment in equity shares,
convertible bonds, convertible debentures and units of equity
oriented mutual funds.\Indirect Exposure
1. Advances against securities to individuals for investment in
securities 20 lakhs per individual Physical form 20 lakhs per
individual - Demat form 10 lakhs per individual IPO
2. Advances against securities for any other purpose.
3. Advances to stockbrokers and guarantees issued 4. Loans
sanctioned to corporate against securities for raising funds.
5. And, all exposures to Venture capital funds.
3.10 Classification of Investment Portfolio
Banks investment portfolio is classified into 3 categories:-
Banks should decide the category of investment at the time of
acquisition.
(A) Held to Maturity (HTM)
Investments under Held to Maturity category are the securities
held by the bank with the objective to hold them up to maturity.
For example, 11.40% GOI Bond 2011. This security under HTM category
will be held till the year 2011. Only 25% of the total investments
can be included in this category.
Following investments fall under HTM category but are not
counted for the purpose of limit of 25%:-
a) Investment in Subsidiaries and Joint Venture.
b) Debentures/Bonds deemed to be advance.
c) Re-capitalization Bonds received from GOI towards their
re-capitalization requirement and held in their investment
portfolio.
It can exceed the limit of 25% provided
a) The excess comprises only of SLR securities
b) The total SLR held under HTM category is not more than 25% of
their NDTL
No fresh Non-SLR securities are permitted to be included in the
HTM category.(B) Held for Trading (HFT)
Securities acquired by the Banks with the intention to trade by
taking advantage of short-term price/interest rate movement comes
under Held for Trading category. These securities are to be sold
within 90 days. There is no limit on the extent of holdings.
(C) Available for Sale (AFS)
Securities which do not fall under HFT & HTM will come under
Available for Sale category. There is no limit on the extent of
holdings.
3.11 Non-Performing Investments
Non Performing investment is one where:
(a) Interest / Installment is due and remains unpaid for more
than 90 days.
(b) Fixed dividend of Preference Shares is not paid.
If any credit facility availed by the issuer is NPA in books of
Bank, investment in any securities issued by the same issuer would
be treated as NPI and vice versa.4. DERIVATIVES
4.1 Instruments
A financial instrument settled at a future date which requires
little or no investment compared to other types of contracts.
(1) Forward Rate AgreementIt is a contract between 2 parties for
the exchange of the interest payments for a principal amount on
settlement date. It is a contract in which one party pays fixed
interest rate and receives floating interest rate. It is for a
period from start date to maturity date.
(2) Interest Rate SwapsAn Interest Rate Swap (IRS) is a
financial contract between two parties exchanging or swapping a
stream of interest payments for a notional principal amount on
multiple occasions during a specified period. Such contracts
generally involve exchange of fixed to floating or floating to
floating rates of interest. (3) Interest Rate FuturesExchange
traded future.
(4) Foreign Currency ForwardIn this contract, purchaser and
seller agrees to buy & sell a specified amount of specified
currency on a certain date in future.
(5) Currency SwapsA foreign exchange agreement between two
parties where they agree to exchange the two currencies at the
prevailing spot exchange rate with an agreement to reverse the
exchange of currencies at the same spot exchange rate.
(6) Currency OptionsA contract where purchase has the right but
not the obligation to purchase (call) or sell (put) and the seller
agrees to sell or purchase an agreed amount of specified currency
at a price agreed and denominated in another currency in future.All
this instruments serve a useful risk-management purpose. It enables
transfer of various financial risks to entities who are more
willing or better suited to manage them. Users can hedge
specifically reduce or extinguish an existing identified risk on an
ongoing basis during the life of transaction or for transformation
of risk exposure.
4.2 Risks Associated
There are various risks to which Market Makers are exposed in
their Derivatives activities.
CREDIT RISKRisk of loss due to counterpartys failure to perform
on an obligation of the institution.There are two types of Credit
Risk:
(a) Pre-Settlement Risk The risk that one party of a contract
will fail to meet the terms of the contract and default before the
contract's settlement date, prematurely ending the contract.
(b) Settlement Risk The risk that one party will fail to deliver
the terms of a contract with another party at the time of
settlement. Its the risk that one party will not perform his part
of obligation even if the other party has already performed his
obligation.
MARKET RISKThis is a risk of loss due to adverse changes in the
market value of instruments. The change in the market value of the
instruments is due to changes in market factors such as interest
rates, exchange rates, equity prices, commodity prices.
LIQUIDITY RISKRisk of loss due to failure of an institution to
meet its funding requirements or to execute a transaction at a
reasonable price. In other words, the risk that a bank cannot meet
or generate sufficient cash resources to meet its payment
obligations in full as they fall due, or can only do so at
materially disadvantageous terms.
OPERATIONAL RISKAn operational risk is a risk arising from a
company's business functions and from the practical implementation
of the management's strategy. As such, it is a very broad concept
including e.g. information risks, fraud risks, physical or
environmental risks, etc.
LEGAL RISKThe Risk Principle is an area of law closely tied to
legal causation in negligence. It provides limits on negligence for
harm caused unforeseeably.
4.3 Market Risk Limits
1. VOLUME LIMITSThis refers to setting the limits in terms of
transaction volumes.
2. STOP LOSS LIMITSTo avoid unrealized loss if exceeded
specified level. Positions are either liquidated or hedged at this
limit.
3. MANAGEMENT ACTION TRIGGER (MAT)This is an addition to Stop
Loss limit. This limit is for early warning for the traders.
4. GAP OR MATURITY BAND LIMITS
5. VALUE-AT-RISK LIMIT (VAR) This is designed to restrict the
total potential loss from derivative products to levels approved by
the board. Management calculates the current market value of
positions and then uses statistical modeling techniques to assess
the probable loss. VAR is related directly to amount of capital or
earnings which are at risk. VAR reflects the maximum exposure
authorized by the Board.
5. RISK MANAGEMENT
5.1 Stress Testing
There are many statistical models that are available to measure
& manage the financial risks. These models provide a framework
for identifying, analyzing, measuring, communicating and managing
their risks. These models are not capable of capturing sudden and
dramatic changes. In order to deal with the changes, Banks
supplements these models with Stress Tests. It has become an
integral part of Banks Risk Management Systems.
Sensitivity Tests: - Normally used to assess the impact of
change in one variable such as significant movement in the foreign
exchange rates, equity index, etc. on the banks financial
position.
Scenario Tests: - simultaneous moves in a number of variables
such as equity prices, oil prices, foreign exchange rates, interest
rates, etc. based on single event experienced in past or an event
that has not yet happened. Stress testing framework helps banks to
be better equipped to meet the stress situations as & when they
arise and also overcome them so that they do not become a serious
threat. ROLE OF STRESS TESTING
Banks understanding of its risk profile. Assessing the adequacy
of internal capital. Supplementing the models which have a drawback
of predictive power. Introducing a forward looking element.
Stress Tests results may be used:
For setting risk limits. Allocating capital for various risks.
Managing risk exposures. Putting in place appropriate contingency
plans.
Stress test only indicates the likely impact and not the
likelihood of the stress events.5.2 CRAR
CAPITAL RISK ADEQUACY RATIO
It indicates the amount of capital that is backing up risk
weighted assets. Banks adopt standardized approach for credit risk
which requires all counterparties to be assigned risk weight basis
external credit ratings. Minimum CRAR of 9% is to be maintained by
the Banks. The fundamental objective behind the norms is to
strengthen the soundness and stability of the banking system. Tier
I Capital should at no point of time be less than 50% of the total
capital. This implies that Tier II cannot be more than 50% of the
total capital.
Capital fund:Capital Fund has two tiers Tier I capital
include*paid-up capital *statutoryreserves*other disclosed free
reserves*capital reserves representing surplus arising out of sale
proceeds of assets.
Minus*equity investments in subsidiaries, *intangible assets,
and*losses in the current period and those brought forward from
previous periods to work out the Tier I capital.
Tier II capital consists of:*Un-disclosed reserves and
cumulative perpetual preference shares:*Revaluation Reserves (at a
discount of 55 percent while determining their value for inclusion
in Tier II capital)*General Provisions and Loss Reserves up to a
maximum of 1.25% of weighted risk Assets:*Investment fluctuation
reserve not subject to 1.25% restrictions *Hybrid debt capital
Instruments (say bonds):*Subordinated debt (long term unsecured
loans:
5.3 Asset Liability Management
In banking, asset liability management is the practice of
managing risks that arise due to mismatches between the assets and
liabilities (debts and assets) of the bank. Banks face several
risks such as the liquidity risk, interest rate risk, credit risk
and operational risk. Asset Liability management (ALM) is a
strategic management tool to manage interest rate risk and
liquidity risk faced by banks, other financial services companies
and corporations.
Banks manage the risks of Asset liability mismatch by matching
the assets and liabilities according to the maturity pattern or the
matching the duration, by hedging and by securitization. Modern
risk management now takes place from an integrated approach to
enterprise risk management that reflects the fact that interest
rate risk, credit risk, market risk, and liquidity risk are all
interrelated.
Asset-Liability Management (ALM) can be termed as a risk
management technique designed to earn an adequate return while
maintaining a comfortable surplus of assets beyond liabilities. It
takes into consideration interest rates, earning power, and degree
of willingness to take on debt and hence is also known as Surplus
Management.
But in the last decade the meaning of ALM has evolved. It is now
used in many different ways under different contexts. ALM, which
was actually pioneered by financial institutions and banks, are now
widely being used in industries too. The Society of Actuaries Task
Force on ALM Principles, Canada, offers the following definition
for ALM: "Asset Liability Management is the on-going process of
formulating, implementing, monitoring, and revising strategies
related to assets and liabilities in an attempt to achieve
financial objectives for a given set of risk tolerances and
constraints."
Basis of Asset-Liability Management
Traditionally, banks and insurance companies used accrual system
of accounting for all their assets and liabilities. They would take
on liabilities - such as deposits, life insurance policies or
annuities. They would then invest the proceeds from these
liabilities in assets such as loans, bonds or real estate. All
these assets and liabilities were held at book value. Doing so
disguised possible risks arising from how the assets and
liabilities were structured.
Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a
year and lends the same money at 7 % to a highly rated borrower for
5 years. The net transaction appears profitable-the bank is earning
a 100 basis point spread - but it entails considerable risk. At the
end of a year, the bank will have to find new financing for the
loan, which will have 4 more years before it matures. If interest
rates have risen, the bank may have to pay a higher rate of
interest on the new financing than the fixed 7 % it is earning on
its loan.Suppose, at the end of a year, an applicable 4-year
interest rate is 8 %. The bank is in serious trouble. It is going
to earn 7 % on its loan but would have to pay 8 % on its financing.
Accrual accounting does not recognize this problem. Based upon
accrual accounting, the bank would earn Rs 100,000 in the first
year although in the preceding years it is going to incur a
loss.
The problem in this example was caused by a mismatch between
assets and liabilities. Prior to the 1970's, such mismatches tended
not to be a significant problem. Interest rates in developed
countries experienced only modest fluctuations, so losses due to
asset liability mismatches were small or trivial. Many firms
intentionally mismatched their balance sheets and as yield curves
were generally upward sloping, banks could earn a spread by
borrowing short and lending long.
Things started to change in the 1970s, which ushered in a period
of volatile interest rates that continued till the early 1980s. US
regulations which had capped the interest rates so that banks could
pay depositors, was abandoned which led to a migration of dollar
deposit overseas. Managers of many firms, who were accustomed to
thinking in terms of accrual accounting, were slow to recognize
this emerging risk. Some firms suffered staggering losses. Because
the firms used accrual accounting, it resulted in more of crippled
balance sheets than bankruptcies. Firms had no options but to
accrue the losses over a subsequent period of 5 to 10 years.
One example, which drew attention, was that of US mutual life
insurance company "The Equitable." During the early 1980s, as the
USD yield curve was inverted with short-term interest rates sky
rocketing, the company sold a number of long-term Guaranteed
Interest Contracts (GICs) guaranteeing rates of around 16% for
periods up to 10 years. Equitable then invested the assets
short-term to earn the high interest rates guaranteed on the
contracts. But short-term interest rates soon came down. When the
Equitable had to reinvest, it couldn't get even close to the
interest rates it was paying on the GICs. The firm was crippled.
Eventually, it had to demutualize and was acquired by the Axa
Group.
Increasingly banks and asset management companies started to
focus on Asset- Liability Risk. The problem was not that the value
of assets might fall or that the value of liabilities might rise.
It was that capital might be depleted by narrowing of the
difference between assets and liabilities and that the values of
assets and liabilities might fail to move in tandem.
Asset-liability risk is predominantly a leveraged form of risk.
The capital of most financial institutions is small relative to
the firm's assets or liabilities, and so small percentage changes
in assets or liabilities can translate into large percentage
changes in capital. Accrual accounting could disguise the problem
by deferring losses into the future, but it could not solve the
problem. Firms responded by forming asset-liability management
(ALM) departments to assess these asset-liability risk.
5.4 Interest Rate Risk
Due to the very nature of its business, a bank should accept
interest rate risk not by chance but by choice. And when the bank
has to take a risk as a choice, then it should ensure that the risk
taken is firstly manageable and secondly it does not get
transformed into yet another undesirable risk. As stated earlier,
the focal point in managing any risk will be to understand the
nature of the risk. This is especially essential for interest rate
risk management. Interest rate risk is the gain/loss that arises
due to sensitivity of the interest income/interest expenditure or
values of assets/liabilities to the interest rate fluctuations.
5.5 Contingency Funding Plan
The Reserve Bank of India working group on "market risk
management" has suggested that all commercial banks should put in
place contingency funding plans, which quantify the likely impact
of an event on their balance sheet and also evaluate their ability
to withstand a prolonged adverse liquidity environment.
As part of the detailed guidance note on MRM, the working group
said if the contingency funding plans, which are liquidity stress
tests, result in a funding gap within a three-month time frame, the
asset liability committee must establish an action plan to address
the situation.
MRM for a bank involves management of interest rate risk,
foreign exchange risk, commodity price risk and equity price risk.
Besides, it is equally concerned about the bank's ability to meet
its obligations as and when they fall due.
At a minimum, the CFPs under each scenario must consider the
impact of accelerated runoff of large funds providers and they must
take into account the impact of a progressive, tiered
deterioration, as well as sudden, drastic events. The note called
upon all banks to establish specific policies, which should
represent minimum requirements for them including approval levels
and requirements for any exceptions, deviations or waivers, on
MRM.
The policies should among others, cover the responsibilities of
the risk management committee/ risk taking unit/ market risk
manager; identify risks, limits and triggers. Further the risk
reporting should enhance risk communication across different levels
of the bank, from the trading desk to the CEO. Successful
implementation of any risk management process has to emanate from
the top management and its strong commitment to integrate basic
functions and strategic decision making with risk management.
Measuring and managing liquidity risk, which is the potential
inability of banks to meet liabilities as they become due, are
vital for effective operation of the banks.
Banks should track the impact of pre-payments of loans,
premature closure of deposits and exercise options built in certain
instruments which offer put/call options after specified times.
They should evolve a system for monitoring high value deposits
(other than inter-bank deposits) say Rs.10 million or more to track
volatile liabilities. The working group pointed out that management
of the interest rate risk should be one of the critical components
of MRM in banks as deregulation of the interest rates has exposed
them to the adverse impacts of interest rate risk.
6. FOREIGN EXCHANGE
The foreign exchange (currency or forex or FX) market exists
wherever one currency is traded for another. It is the largest
financial market in the world, and includes trading between large
banks, central banks, currency speculators, multinational
corporations, governments, and other financial markets and
institutions. The average daily trade in the global forex and
related markets currently is over US$ 3 trillion. Although exchange
rates are affected by many factors, in the end, currency prices are
a result of supply and demand forces. The world's currency markets
can be viewed as a huge melting pot: in a large and ever-changing
mix of current events, supply and demand factors are constantly
shifting, and the price of one currency in relation to another
shifts accordingly. No other market encompasses (and distills) as
much of what is going on in the world at any given time as foreign
exchange.
Supply and demand for any given currency and thus its value, are
not influenced by any single element, but rather by several. These
elements generally fall into three categories: economic factors,
political conditions and market psychology.
6.1 Exchange Rate Applications
An Exporter will be happy with the depreciation in the value of
the domestic currency as he will get more of domestic currency in
exchange of given foreign currency.
An Importer will be unhappy with the depreciation in the value
of the domestic currency as he will get less of domestic currency
in exchange of given foreign currency.
Hike in oil prices impacts the exchange rates. Data of the last
few years show that the Indian Rupee depreciated against all the
major currencies of the world.
Value of the Rupee is determined on daily basis by linking it to
a basket of currencies with different weightages.
DIRECT QUOTATIONS
Under direct quotation, the foreign currency is constant and
domestic currency differs. 1$ = 50.50 51.25
This quote shows that when a customer wants to buy 1 dollar he
will have to pay 51.25 rupees.
FOREX MARKET CONSISTS OF:
RBI
Authorized Dealers in FX
Exchange Brokers
Foreign / Overseas Market i.e. Banks & Brokers abroad
Customers needing / disposing foreign exchange
6.2 Financial instruments
Spot
A spot transaction is a two-day delivery transaction (except in
the case of the Canadian dollar, which settles the next day), as
opposed to the futures contracts, which are usually three months.
This trade represents a direct exchange between two currencies, has
the shortest time frame, involves cash rather than a contract; and
interest is not included in the agreed-upon transaction. The data
for this study come from the spot market. Spot has the largest
share by volume in FX transactions among all instruments.
Forward
One way to deal with the forex risk is to engage in a forward
transaction. In this transaction, money does not actually change
hands until some agreed upon future date. A buyer and seller agree
on an exchange rate for any date in the future, and the transaction
occurs on that date, regardless of what the market rates are then.
The duration of the trade can be a few days, months or years.
Future
Foreign currency futures are forward transactions with standard
contract sizes and maturity dates for example, 500,000 British
pounds for next November at an agreed rate. Futures are
standardized and are usually traded on an exchange created for this
purpose. The average contract length is roughly 3 months. Futures
contracts are usually inclusive of any interest amounts.
Swap
The most common type of forward transaction is the currency
swap. In a swap, two parties exchange currencies for a certain
length of time and agree to reverse the transaction at a later
date. These are not standardized contracts and are not traded
through an exchange.
Option
A foreign exchange option (commonly shortened to just FX option)
is a derivative where the owner has the right but not the
obligation to exchange money denominated in one currency into
another currency at a pre-agreed exchange rate on a specified date.
The FX options market is the deepest, largest and most liquid
market for options of any kind in the world.
6.3 Processing Corporate FX Deals
BOOKING
All the corporate deals are written by traders in serially
numbered corporate worksheets. The back office work is to ensure
that any corrections on the worksheet are duly authenticated by the
trader. If there is a break in the serial number order of the
worksheet, it should be investigated and reasons should be obtained
from the trader. It should be brought to the attention of the
Head-Corporate Advisory Services by way of a memo.
CONFIRMATION
The next morning contract confirmations are printed for all the
deals booked the previous day. On the reverse side of the
confirmation the back office mentions the underlying exposure as
indicated by the trader on the worksheets. Every corporate
confirmation has to be affixed with Rs. 100 agreement stamps and
defaced. The franking of stamps is done on the second copy of the
confirmation. This is the copy, which is signed by the customer and
returned as deal confirmation. All contract confirmations should be
sent to customers latest by T+1 date. Confirmations not received
from the counterparty duly signed by their authorized signatories
or confirmations received with discrepancies which are not resolved
within 10 days from the trade date, will be reported in the
month-end exception report.
CANCELLATION
When the trader receives intimation from the customer to cancel
a deal, the cancellation worksheet is completed which is a serially
numbered worksheet. The trader retrieves the deal which has to be
cancelled in T2 and compensated the deal in T2 to the extent of the
cancellation amount, which means a reverse deal is booked by the
system for the cancellation amount and the cancellation rate is
keyed in by the trader. If it is a cross currency cancellation, the
trader will have to book one more deal in addition to the
compensating deal, which is the compensation deal i.e. for
conveying the variable currency in the compensating deal into local
currency (INR). Compensation deals can be identified in T2 as they
are booked.
The compensating deals and compensation deals flow into the
system.
UTILISATION
The contract utilizations are reported to the trader by the
departments concerned. The trader confirms the same along with
their comments on Early Delivery charges (if any). The processing
of utilizations done by the back office is as follows:
6.4 Rate scan
This report is reviewed by the back-office. This reflects deals
which have been executed at rates which fall outside the tolerance
limit approved by the Country Treasurer. They will appear with a
single asterisk or double asterisk depending on a 0.5% or 1%
variance respectively, from the days reval rate. A second level
check is done by comparing the deal rate to the high and low rates
reflected. If it is within this range, a remark will be written on
the report that it is within the days range. If it is outside this
range, an explanation should be sought from the trader concerned.
The appropriate remarks are written on the Rate Scan Report.
7. CONCLUSION
Treasury refers to the fund and revenue at the possession of the
bank and day-to-day management of the same. The Treasury Functions
Department is responsible for Treasury's middle and back office
functions, all systems services, and provides Cash Management and
Banking Relations services as a whole.
Bank managements are highly sensitive to Treasury risks, as they
arise out of the high leverage of the treasury business. The risk
of losing capital is much higher than, say, in the credit business.
The second reason for managements concern is the large size of the
transaction done, at the sole discretion of the treasurers.
Treasury investments are categorized into government securities,
other approved securities, shares, debentures and bonds, commercial
papers, and mutual funds. In line with international best
practices, the investments are classified into three categories
HTM, HFT and AFS.
There are too many norms and regulation that the Banks have to
comply with while making all such treasury transactions. And,
inspite of RBI imposing SLR of 25%, banks investment in SLR
securities continue to be more than required. This shows that banks
are also keen towards investing in the Government securities rather
than anywhere else.
There are various risks to which banks are exposed to while
dealing in securities, forex market, derivative products. Risk
management is very important element that are need to be considered
while taking any decision or even while framing the investment
policy.
Treasury Functions are considered to be the heart of Indian
Banks without which the financial system would have been
incomplete.
8. BIBLIOGRAPHY
Books Referred
No.Name of BookAuthor
1Guidance Note on Audit of BanksVijay Kapur, ICAI
2Foreign Exchange A Practical ApproachP. Balachandaran
3RBI Master CircularsRBI
Websites Accessed
No.Website
1www.rbi.org.in
2www.treasury.worldbank.org
3www.ccilindia.com
