1. INTRODUCTION
1.1 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.
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.
Fraud protection.
Control of Investments.
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.
PENALTIES
On 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.
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.
Auctions:
While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364-day Tbills 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.
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.
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
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
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.
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.
Issue announced ----------- When Issued Market ---------- day preceding the date of issue
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.
Investment by the Bank in unlisted Non-SLR securities should not exceed 10% of
its total Non-SLR investments.
No Bank shall offer any Portfolio Management Service or other such type of
schemes in future without obtaining specific prior approval from RBI.
Funds should not be used for lending in call / notice money, inter-bank
deposits, bill rediscounting markets and lending to corporate bodies.
Direct Exposure
It 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.
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)
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.
CREDIT RISK
Risk 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 RISK
This 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 RISK
Risk 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 RISK
An 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 RISK
The Risk Principle is an area of law closely tied to legal causation in negligence. It
provides limits on negligence for harm caused unforeseeably.
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.
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
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 assetliability management (ALM) departments to assess these asset-liability risk.
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.
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.
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
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.
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:
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.
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 Book
Author
P. Balachandaran
RBI
Websites Accessed
No.
Website
www.rbi.org.in
www.treasury.worldbank.org
www.ccilindia.com