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20918frpubcd Iasb4
20918frpubcd Iasb4
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January, 2010
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978-81-8441-296-3
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FOREWORD
With the significant developments that have taken place in the capital, money and foreign exchange markets in the recent years affecting volatility in exchange rates and accentuating liquidity constraints, organisations have started paying closer attention to the treasury management function. The globalization of the economy with mobilization and deployment of funds from/in other countries is also necessitating increased attention in the area of treasury management. Banking industry has been all long focusing on successful treasury management, which is extremely necessary for their strong, viable and profitable existence. In view of the complexity, volume and growth of treasury function in banks, internal auditors have a dynamic role to play to support the banks in helping to achieve the strategic goals. Internal auditors can strengthen the banks treasury functions by reviewing critical control systems and risk management processes and providing valuable suggestions. I am happy to note that the Internal Audit Standards Board of the Institute is issuing this publication Technical Guide on Internal Audit of Treasury Function in Banks containing extensive knowledge on this complex subject. I congratulate CA. Shanti Lal Daga, Chairman, Internal Audit Standards Board and the members of the Board on issuance of this publication. I am confident that this comprehensive publication would help the members as well as other readers in acquiring good knowledge of products, practices and regulations of treasury function in banks.
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PREFACE
In this financially globalized volatile world, banks treasury groups which are ultimately responsible for keeping their banks in business are witnessing tremendous changes. The change is being forced with rapid economic developments, globalizing industries and competition, new technologies and revolutionary changes in the regulatory environment. Apart from responding to these changes, treasury functions of banks are under pressure to add value to the banks through their operations and contribute to achieve strategic goals. Internal audit helps the organisations to achieve their stated objectives. Carrying out an internal audit of treasury functions in banks requires an in-depth understanding of the applicable statutes, systems and processes since it operates under a very regulated and governed atmosphere. Specialist knowledge in certain areas of banking is also of equal importance. In the wake of these developments in the field of treasury management in banks, the Internal Audit Standards Board of the Institute is issuing this publication Technical Guide on Internal Audit of Treasury Function in Banks for the members of the Institute as well as bankers. This publication is aimed to help the readers in understanding the roles and responsibilities of the treasury function in banks as well as in determining the nature of internal audit procedures to be undertaken. The Technical Guide has been divided into various chapters covering aspects such as treasury products and services, treasury dealing room, organisational structure of a banks treasury, investment portfolio, asset liability management, treasury risks. The guide also deals with the fundamental controls and the internal audit procedures with special reference to treasury/ market risk segments. It also contains detail checklist on internal audit of treasury operations, foreign exchange operations and domestic operations of treasury. It also includes a compilation of relevant circulars issued by the Reserve Bank of India applicable to treasury operations of a bank. For better understanding of the readers, the guide also contains an introduction section and also a glossary of some technical terms used in the Guide. At this juncture, I am grateful to CA. Rajkumar S. Adukia, Central Council Member and convenor of the Group ably assisted by other members of the Group, viz., CA. Pankaj Adukia, CA. Abhay Arolkar and CA. Vijay Joshi for
squeezing out time out of their professional and personal commitments and preparing the basic draft of this Technical Guide. I would also take the opportunity of placing on record my gratitude to CA. Akeel Master for reviewing the draft and giving his valuable comments and suggestions. I also wish to thank CA. Uttam Prakash Agarwal, President and CA. Amarjit Chopra, Vice President for their continuous support and encouragement to the initiatives of the Board. I must also thank my colleagues from the Council at the Internal Audit Standards Board, viz., CA. Ved Jain, CA. Abhijit Bandyopadhyay, CA. Bhavna G. Doshi, CA. Pankaj I. Jain, CA. Sanjeev K. Maheshwari, CA. Mahesh P. Sarda, CA. S. Santhanakrishnan, CA. Vijay K. Garg, Shri Krishna Kant, Shri Manoj K. Sarkar and Shri K. P. Sasidharan for their vision and support. I also wish to place on record my gratitude for the coopted members on the Board, viz., CA. N. K. Aneja, CA. Verendra Kalra, CA. M. Guruprasad, CA. Dilip Kumar Vadilal Shah and CA. K. S. Sundara Raman as also special invitees on the Board, viz., CA. K. P. Khandelwal, CA. S. Sundarraman, CA. Ravi H. Iyer, CA. Rajiv Dave, CA. Pawan Chagti, CA. Ram Mohan Johri and CA. Arindam Guha for their devotion in terms of time as well as views and opinions to the cause of the professional development. I also wish to place on record the efforts put in by CA. Jyoti Singh, Secretary, Internal Audit Standards Board and CA. Arti Aggarwal, Senior Executive Officer, for their inputs in giving final shape to the publication. I am sure that the members of the Institute would find the Technical Guide immensely useful in understanding the intricacies of the subject matter and in carrying out their professional duties diligently.
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CONTENTS
Foreword................................................................................................... iii Preface.......................................................................................................v Glossary.................................................................................................... ix Introduction ............................................................................................ xvii CHAPTER : 1. Treasury- An Introduction .............................................................. 1 - 4 2. Treasury Products and Services ............................................. 1 - 7 3. The Treasury Dealing Room................................................... 1 - 3 4. Organisational Structure of A Banks Treasury........................ 1 - 6 5. Investment Portfolio..................................................................... 1 - 13 6. Asset Liability Management...........................................................1 6 7. Treasury Risks....................................................................... 1 - 6 8. Treasury Unit Fundamental Controls........................................ 1 - 13 9. Internal Audit of Treasury Operations............................................ 1 - 6 ANNEXURES : Annexure A- Specimen Checklist for Internal Audit of Treasury Operations ...... Annexure B - Specimen Checklist for Internal Audit of Foreign Exchange Operations of Treasury......................................... Annexure C- Specimen Checklist for Internal Audit of Domestic Operations of Treasury ........................................................ Annexure D- Guidance Note on Market Risk Management ................... Annexure E - Assets Liability Management (ALM) System.................... Annexure F- RBI Mc Guide primary dealers 2009................................. Annexure G RBI Mc Capadeqrm 2009 .................................................
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Annexure H- RBI Mc Callmoney 2009.................................................. Annexure I - RBI Mc Cd 2009 .............................................................. Annexure J - RBI Mc Comlpaper 2009 ................................................. Annexure K- RBI Mc Prunormsinvestt 2009 ........................................
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GLOSSARY
Arbitrage The purchase or sale of an instrument and simultaneous taking of an equal and opposite position in a related market, in order to take advantage of small price differentials between markets. Securities with identical risk/reward composition, attributes and features. An option contract with identical risk/ reward composition and features. Investment practice that divides funds among different markets to achieve diversification for risk management purposes and/or expected returns consistent with an investors objectives. A risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. Risk associated with the unique circumstances of a particular entity, as they might affect the price of that entitys securities. The departments and processes related to the settlement of financial transactions. Money in the form of authorized currency (including coins) and bank balances. The strategy by which a administers and invests its cash. company
Business Risk
Technical Guide on Internal Audit of Treasury Function in Banks Cash Flow at Risk The Cash Flow at Risk approach answers the question of how large the deviation between actual cash flow and the planned value (or that used in the budget) is due to changes in the underlying risk factors. Cash Position in foreign exchange deals with all the transactions effecting Nostro account, funding of Nostro (in case of overdraft), utilization of surplus cash balance in Nostro and deployment of funds so as to ensure optimum utilization. Examples are delivery under forward contracts, inward /outward telex transfer, etc. It is also called fund position. The Centralised Funds Management System (CFMS) provides for a centralised viewing of balance positions of the account holders across different accounts maintained at various locations of the RBI. A protective options strategy that is implemented after a long position in a stock has experienced substantial gains. It is created by purchasing a put option while simultaneously writing a call option. (also known as hedge wrapper) Expenses incurred while a position is being held, for example, interest on securities bought on margin, dividends paid on short positions, and other expenses. Hedging a cash market position in a futures or option contract for a different but pricerelated commodity. Indias first credit information bureau- is a repository of information, which contains the credit history of commercial and consumer x
Cash Position
Collar Option
Cost of Carry
Cross Hedge
Glossary borrowers. CIBIL provides this information to its members in the form of credit information reports. Currency Position It deals with daily sale/purchase of foreign currency/transaction. It could be excess, less or equal. In that case we call it overbought (more purchase) oversold (more sales) or square (purchase matches sales) respectively. The probability of an adverse change in exchange rates. Refers to positions which are opened and closed on the same trading day. A contract that changes in value in relation to the price movements of a related or underlying security, future or other physical instrument. An option is the most common derivative instrument. The weighted average term to maturity of a security's cash flows, where the weights are the present value of each cash flow as a percentage to the security's price. Outcome of notional interest rate shock on interest income. Credit clearing ensures multiple repetitive credits to the accounts of constituents of banks situated at various branches of banks on the basis of a single debit to the account of a corporate customer called the user. Debit clearing ensures multiple repetitive debits to the accounts of constituents of banks situated at various branches of banks and a corresponding single debit to the account of a corporate customer called the user.
Duration
ECS (Debit)
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Technical Guide on Internal Audit of Treasury Function in Banks Expected Loss Financial Risk Forward High frequency but low severity from any activity or risk. Uncertainty of results to the investor due to financial modality. The pre-specified exchange rate for a foreign exchange contract settling at some agreed future date, based upon the interest rate differential between the two currencies involved. Analysis of economic and political information with the objective of determining future movements in a financial market. An obligation to exchange a good or instrument at a set price on a future date. (The primary difference between a future and a forward is that futures are typically traded over an exchange (Exchange Traded Contracts ETC), versus forwards, which are considered Over the Counter (OTC) contracts. An OTC is any contract not traded on an exchange.) Growth Stock Stock of a company which is growing earnings and/or revenue faster than its industry or the overall market, and as compared to stock with similar risk features. This risk was in focus in 1974 when Herstattt Bank (a German bank) had to shutter down, as settlement of second leg of currency could not be completed due to time zonefactors. A position or combination of positions that reduces the risk of your primary position. The Indian Financial Network (INFINET) is the communication backbone for the Indian xii
Fundamental Analysis
Futures Contract
Glossary Banking and Financial Sector. All banks, public sector undertakings, private sector organisations, co-operative, etc., and the premier financial institutions in the country are eligible to become members of the INFINET. Inflation An economic condition whereby prices for consumer goods rise, eroding purchasing power. The initial deposit of collateral required to enter into a position as a guarantee on future performance. Situation in which an option's strike price is below the current market price of the underlier (for a call option) or above the current market price of the underlier (for a put option). Such an option has intrinsic value. Statistics that are considered to predict future economic activity. An order with restrictions on the maximum price to be paid or the minimum price to be received. The ability of a market to accept large transaction with minimal to no impact on price stability. The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset.
Initial Margin
In the Money
Liquidity
Liquidity Risk
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Technical Guide on Internal Audit of Treasury Function in Banks Liquidation Long Position Market Risk Mark-to-Market The closing of an existing position through the execution of an off-setting transaction. A position that appreciates in value if market prices increase. Exposure to changes in market prices. Process of re-evaluating all open positions with the current market prices. These new values then determine margin requirements. The date for settlement or expiration of a financial instrument. All clearings conducted in all clearing houses in all parts of the country will be settled in a single centralized location in central bank money. Negotiated Dealing System (NDS) is an electronic platform for facilitating dealing in Government Securities and Money Market Instruments. The rate at which a dealer is willing to sell a currency. A deal not yet reversed or settled with a physical payment. The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. It is used to describe any transaction that is not conducted over an exchange. A trade that remains open until the next business day. Exposure to changes in governmental policy which will have an adverse effect on an investors position.
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Glossary Position Premium The netted total holdings of a given currency. In the currency markets, it describes the amount by which the forward or futures price exceed the spot price. Primary dealers can be referred to as Merchant Bankers to the Government of India, comprising the first tier of the government securities market. Satellite dealers work in tandem with the Primary dealers forming the second tier of the market to cater to the retail requirements of the market. An indicative market price, normally used for information purposes only. The price of one currency in terms of another, typically used for dealing purposes. Exposure to uncertain change, most often used with a negative connotation of adverse change. The employment of financial analysis and trading techniques to reduce and/or control exposure to various types of risk. Process whereby the settlement of a deal is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies. The process by which a trade is entered into the books and records of the counterparts to a transaction .The settlement of currency trades may or may not involve the actual physical exchange of one currency for another. The risk that one party will fail to deliver the terms of a contract with another party at the time of settlement.
Primary Dealers
Risk Management
Roll Over
Settlement
Settlement Risk
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Technical Guide on Internal Audit of Treasury Function in Banks Short Position Spot Price Investments position that benefit from a decline in market price. The current market price. Settlement of spot transactions usually occurs within two business days. The difference between the bid and offer prices. SFMS allows intra/inter bank message transfer. This also provides for transfer of file attached in a secured mode. A currency swap is the simultaneous sale and purchase of the same amount of a given currency at a forward exchange rate. Probability of loss due to most unsecured market movements. An effort to forecast prices by analyzing market data, i.e., historical price trends and averages, volumes, open interest, etc. The smallest increment in which the price for a futures contract can move. The cost of buying or selling a financial instrument. The date on which a trade occurs. The total money value of all executed transactions in a given time period. It is a measure of how the market value of an asset or of a portfolio of assets is likely to decrease over a certain time period under usual conditions. The percentage rate of return paid on a bond, note, or other fixed income security if the investor buys and holds it to its maturity date.
Tick Size Transaction Cost Transaction Date Turnover Value at Risk (VAR)
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INTRODUCTION
1. Preface to the Standards on Internal Audit issued by the Institute of Chartered Accountants of India defines Internal Audit as follows: Internal audit is an independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entitys strategic risk management and internal control system. Internal audit, therefore, provides assurance that there is transparency in reporting, as a part of good governance. 2. Internal audit objectives, with specific reference to treasury function in a bank, includes following important aspects: (a) To ensure that policies and procedures relating to all treasury activities have been framed and are periodically reviewed for adequacy and coverage. To determine whether management has planned for liquidity needs for both normal operating conditions and emergency situations. To ensure adequate physical and access control procedures are in place in the department. To verify existence of satisfactory controls in the processing of deals. To ascertain that the bank receives favorable rates for all its deals. To check authenticity and appropriateness of the sources of inputs used for valuation of unquoted treasury instruments. To check that there is accurate recording and accounting of positions. To ensure that proper documentation procedures and filing systems are in place. To ensure that limits are set for different procedures and they are adhered to in a consistent manner.
(j) (k)
To verify that any violations are promptly reported and properly dealt with. To ensure that reconciliation is being made timely and accurately, including daily reconciliation of the dealers profit and loss to the general ledger. To evaluate the adequacy and effectiveness of the internal control system and to suggest measures for improvement, if any. To indicate probable risk-prone areas within treasury, based on the prevailing external economic environment, and to offer views for safeguarding the interest of the bank. To aid and facilitate risk based supervision function of the RBI (Pillar 2 of the Basel Accord) in regard to a banks treasury/market risk business areas. To ensure compliance with the guidelines issued by the RBI, SEBI, FEMA, FEDAI, etc., and other guidelines issued from time to time. To verify that interest and dividend income is accounted for fully and correctly. To verify that all counterparty confirmations are received.
(l) (m)
(n)
3. The precise scope of risk-based internal audit of treasury transactions must be determined by each bank for low, medium, high, very high and extremely high risk areas. This Technical Guide contains matter relevant for domestic compliance only. In case of overseas treasury operations, the RBI guidelines on the subject and the domicile country requirements will also be required to be considered.
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CHAPTER 1
TREASURY- AN INTRODUCTION
Meaning
1.1 A treasury is any place where currency or items of high monetary value are kept. The term treasury was first used in classical times to describe the votive buildings erected to house gifts to the gods, such as the Siphnian Treasury in Delphi or other similar buildings erected in Olympia, Greece by competing citystates, to impress others during the ancient Olympic Games. 1.2 A treasury can either be: The part of a government which manages all money and revenue; The funds of a government or institution or individual; The government department responsible for collecting, managing and spending public revenues; A depository ( room or building) where wealth and precious objects can be kept; or The center of financial operations within an organisation.
Treasury in Banks
1.3 Traditionally, the treasury function in banks was limited to Funds management, i.e., maintaining adequate cash balances to meet day-to-day requirements and deploying surplus funds from operations. The treasury in a bank is also responsible for maintenance of reserve requirements (Cash Reserve Ratio and Statutory Liquidity Ratio). Treasury was considered a service centre and liquidity management was its main function. The scope of treasury has now expanded beyond liquidity management and treasury has now evolved as a profit centre with its own trading and investment activity. 1.4 Presently, as per RBI circular on Guidelines Accounting Standard 17 (Segment Reporting) Enhancement of Disclosures dated April 18, 2007, banks
Technical Guide on Internal Audit of Treasury Function in Banks are required to report under the following business segments as primary reporting format and for the purpose of segment reporting under Accounting Standard (AS) 17, Segment Reporting: (a) (b) (c) (d) Treasury Corporate / Wholesale banking Retail banking and Other banking operations
Domestic and International segments will be the geographic segments for disclosure. Treasury activity in a bank depends on its size, complexity of operations, area of operations and risk profile.
Integrated Treasury
1.5 Traditionally, the domestic treasury operations were independent of forex dealings of a bank. The need for an integrated treasury rose in the backdrop of interest rate deregulations, liberalization of exchange control, development of forex market and advancement in the settlement systems and dealing environment. The integrated treasury besides performing the functions of the traditional roles also performs the following functions: (a) Reserve management and Investment- This involves meeting Cash Reserve Ratio (CRR)/Statutory Liquidity Ratio (SLR) obligations and having an optimum mix of investment portfolio. (b) Liquidity and Funds management- This involves analysis of major cash flows; providing inputs to planning group on funding mix( currency, tenor and cost) and yield expected in credit and investment. (c) Asset liability management and term money- This involves determining the optimum size and growth rate of the balance sheet; and also price the assets and liabilities in accordance with the prescribed guidelines. (d) Risk Management- This involves managing all market risks associated with the banks assets and liabilities. Risk management also includes management of credit risks on treasury products and operations risks on payments and settlements. (e) Transfer pricing- Ideally , the integrated unit should provide benchmark rates after assuming market risks to various business groups and product
Treasury- An Introduction categories about adopting the correct business strategy to ensure that the funds are deployed optimally. (f) Derivative products- Treasury can develop Interest rate swaps, and other derivative products to hedge the banks exposure and also sell such products to customers or other banks. (g) Arbitrage- This involves simultaneous buying and selling of the same type of assets in two different markets in order to make risk-less profits. (h) Capital adequacy- This focuses on quality of assets and Return on investments is key criteria for evaluating the efficiency of deployed funds. (i) Canalizing and managing other asset instruments into investment instruments e.g., instruments resulting out of Corporate Debt Restructuring, Asset Reconstruction, Pass Thru certificates, Asset Backed Securitization (ABS), Mortgage Backed Securitization(MBS), etc. (j) To monitor the Rating Migrations on an on going basis and take timely corrective action. (k) To minimize the level of provisional requirements due to non-performing investments. 1.6 Treasury operations play a pivotal role in not only improving the bottom line of banks but also in Balance Sheet management by reducing risks by hedging sensitive exposures. Treasury management would, normally, consist of management of its cash flows, banking, money market and capital market transactions; effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks keeping in mind the business objectives and in consonance with the regulatory framework.
Technical Guide on Internal Audit of Treasury Function in Banks (d) To keep investment portfolio healthy and liquid. (e) To minimize non-performing investments. (f) To take advantage of market volatility and trade/arbitrage in permitted products (including overseas) and avail arbitrage opportunities between rupee and forex treasury operations. (g) To invest in tax free instruments as per the tax planning of the bank. (h) To conduct derivative transactions to hedge banks own balance sheet gaps and exposure of the clients. (i) To optimize returns from forex operations.
CHAPTER 2
Range of Products
2.2 (i) The Money Market Desk trades in the following Instruments: Treasury-Bills Treasury Bills (T-bills) are short-term debt instruments issued by the Central Government for maturities of 91, 182 and 364 days. Commercial banks, primary dealers, mutual funds, corporates, institutions, provident or pension funds and insurance companies can participate. RBI issues a calendar of T-bill auctions. Periodic auctions are held for their issue and these are tradable in the secondary market, which is quite active. T-bills are issued at a discount to face value and are redeemable at par on maturity. A Commercial Paper (CP) is an unsecured money market instrument through which corporate entities raise short-term money.
(ii)
Technical Guide on Internal Audit of Treasury Function in Banks (iii) It is issued as per RBI guidelines. (Refer Master Circular on Guidelines for Issue of Commercial Paper dated July 1, 2009.) It is issued at a discount to face value It can be issued either in the form of a promissory note or in a dematerialised form. It attracts issuance stamp duty in primary issue. It has to be mandatorily rated for issuance by one of the four credit rating agencies. It can be issued for maturities between a minimum of seven days and a maximum upto one year from the date of issue. Corporates can participate both as lenders and borrowers. It can be issued for a maximum period of 89 days. Pricing is linked to a benchmark like, MIBOR. Flexible call or put option could be exercised. Certificate of Deposits (CDs) are unsecured, negotiable money market instrument usually issued at a discount on face value. (Refer to RBI Master Circular on Guidelines for Issue of Certificates of Deposit dated July 1, 2009.) The maturity period is from 7 days to 12 months. It attracts issuance stamp duty and is issued in dematerialised form or as a Usance Promissory note. . They are negotiable, and transferred by endorsement and delivery, after 15 days of issue. CBLO is a money market instrument designed to meet the borrowing and lending needs of banks, financial institutions, mutual funds, NBFCs and corporates.
(iv)
(v)
Treasury Products and Services Borrowing and lending is collateralised i.e., secured using GSec or T-Bills.