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Banking Self Study Guide

Banking Self Study Guide

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2.2.1 2.2.2 2.2.3 2.2.4 2.2.5 2.2.6 Profit Centres Branches as Profit Centres Deposits Loans Managing interest rate risks with transfer pricing and cost of funds Funds in Foreign Currencies

3 3 4 6 7
7 7 7 7 7 8

3.1.1 3.1.2 3.1.3 3.1.4 3.1.5 3.1.6 3.1.7 3.1.8 Introduction Reasons behind foreign exchange transactions Example “SQUARING” the balance sheet: Foreign exchange transactions defined How foreign exchange profits are made Risks involved in foreign exchange Summary

9 9 10 11 11 12 12 16

4.1.1 4.1.2 4.1.3 4.1.4 4.1.5 Dealing Activity Back office Input processing Settlements and Nostro/Vostro accounts Reconciliations department

18 18 18 19 19


5.1.1 5.1.2 5.1.3 5.1.4 5.1.5 5.1.6 Cheques drawn on a domestic bank Holding funds Items sent on collection International payments International collections Correspondent accounts and banks

20 20 20 20 20 21

6.1.1 6.1.2 6.1.3 6.1.4 6.1.5 6.1.6 6.1.7 6.1.8 Advances repayments Treasury department Credit card transactions Types of Lending Facility Factors Governing Lending Decisions Loan Security Internal Control Summary

22 22 22 23 24 25 25 26

7.1.1 7.1.2 7.1.3 7.1.4 7.1.5 7.1.6 7.1.7 Introduction Documentary letters of credit Procedure Letter of Guarantee Bills of exchange (Trade bills) Performance bonds Summary

27 27 27 28 28 29 29

8.1.1 8.1.2 8.1.3 Introduction Types of Inve stment Generally Accepted Valuation Policies

30 30 32




This self study guide is designed to enable engagement staff to gain a basic understanding of the activities that a retail bank performs before they become involved in a banking engagement. Such knowledge should enable staff who are new to the industry to grasp what a bank is trying to achieve and why it is organised differently from other organisations. This will enable staff to add value to the audit team and to the client more quickly and allow them to rapidly develop industry experience. Staff who have developed basic banking knowledge and experience will then be invited to attend the Advanced Banking course where the concepts presented here are developed and analysed in much greater depth. After completing this guide it you should be able to: • • • • • Describe the routine processes that enable a bank to function and fulfil its objectives. Understand the practical aspect of how banks generate profit Understand how a typical bank is structured by department Understand the various departments interactions and their role in the objectives of the bank Understand the unique risks faced by each department and how auditors address those risks



The basis of banking is to put capital at risk in the pursuit of earnings. A bank takes risks, transforms risks and embeds risks in banking products/services. Risk levels vary in every area of banking and one dollar from low risk activities is not comparable with one dollar from high risk activities. Recognising this, banks have in recent years, moved away from the traditional goal of profit maximisation towards a more sophisticated goals such as maximising risk adjusted returns on capital and shareholders value added. The goals of a bank are also driven by regulatory requirements laid down by central banks. The central role of risk based capital in regulations focuses on the capital adequacy principle, which states that capital should match risks. As capital is a limited and expensive resource the advancement of regulation has contributed to the above shift in goals. Risk management is therefore a cornerstone of the banking industry and is a rapidly advancing area.




In its core principles, the Basle Committee on Banking Supervision1 sets out eight key risks which must be managed by banks. Banks’ organisational structure is designed to manage these risks either on a process basis or, more commonly, by department such that the institution can meet its goals. The risks are as follows: Credit risk The extension of loans is the primary activity of most banks. Lending activities require banks to make judgements related to the creditworthiness of borrowers. These judgements do not always prove to be accurate and the creditworthiness of a borrower may decline over time due to various factors. Consequently, a major risk that banks face is credit risk or the failure of a counterparty to perform according to a contractual arrangement. This risk applies not only to loans but to other on- and offbalance sheet exposures such as guarantees, acceptances and securities investments. Serious banking problems have arisen from the failure of banks to recognise impaired assets, to create reserves for writing off these assets, and to suspend recognition of interest income when appropriate. Large exposures to a single borrower, or to a group of related borrowers are a common cause of banking problems in that they represent a credit risk concentration. Large concentrations can also arise with respect to particular industries, economic sectors, or geographical regions or by having sets of loans with other characteristics that make them vulnerable to the same economic factors (e.g., highlyleveraged transactions). Connected lending - the extension of credit to individuals or firms connected to the bank through ownership or through the ability to exert direct or indirect control - if not properly controlled, can lead to significant problems because determinations regarding the creditworthiness of the borrower are not always made objectively. Connected parties include a bank’s parent organisation, major shareholders, subsidiaries, affiliated companies, directors, and executive officers. Firms are also connected when they are controlled by the same family or group. In these, or in similar, circumstances, the connection can lead to preferential treatment in lending and thus greater risk of loan losses. Country and transfer risk In addition to the counterparty credit risk inherent in lending, international lending also includes country risk, which refers to risks associated with the economic, social and political environments of the borrower’s home country. Country risk may be most apparent when lending to foreign governments or their agencies, since such lending is typically unsecured, but is important to consider when making any foreign loan or investment, whether to public or private borrowers. Market risk Banks face a risk of losses in on- and off-balance sheet positions arising from movements in market prices. Established accounting principles cause these risks to be typically most visible in a bank’s trading activities, whether they involve debt or equity instruments, or foreign exchange or commodity positions. One specific element of market risk is foreign exchange risk. Banks act as “market-makers” in foreign exchange by quoting rates to their customers and by taking open positions in currencies. The risks inherent in foreign exchange business, particularly in running open foreign exchange positions, are increased during periods of instability in exchange rates.

The Basle Committee on Banking Supervision is a Committee of banking supervisory authorities which was established by the central bank Governors of the Group of Ten countries in 1975.



Interest rate risk Interest rate risk refers to the exposure of a bank’s financial condition to adverse movements in interest rates. This risk impacts both the earnings of a bank and the economic value of its assets, liabilities and off-balance sheet instruments. Interest rate risk can arise in both the banking and trading book. Although such risk is a normal part of banking, excessive interest rate risk can pose a significant threat to a bank’s earnings and capital base. Liquidity risk Liquidity risk arises from the inability of a bank to accommodate decreases in liabilities or to fund increases in assets. When a bank has inadequate liquidity, it cannot obtain sufficient funds, either by increasing liabilities or by converting assets promptly, at a reasonable cost, thereby affecting profitability. In extreme cases, insufficient liquidity can lead to the insolvency of a bank. Operational risk The most important types of operational risk involve breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial losses through error, fraud, or failure to perform in a timely manner or cause the interests of the bank to be compromised in some other way, for example, by its dealers, lending officers or other staff exceeding their authority or conducting business in an unethical or risky manner. Other aspects of operational risk include major failure of information technology systems or events such as major fires or other disasters. Legal risk Banks are subject to various forms of legal risk. This can include the risk that assets will turn out to be worth less or liabilities to be greater than expected because of inadequate or incorrect legal advice or documentation. In addition, existing laws may fail to resolve legal issues involving a bank; a court case involving a particular bank may have wider implications for banking business and involve costs to it and many or all other banks; and, laws affecting banks or other commercial enterprises may change. Banks are particularly susceptible to legal risks when entering new types of transactions and when the legal right of a counterparty to enter into a transaction is not established. Reputational risk Reputational risk arises from operational failures, failure to comply with relevant laws and regulations, or other sources. Reputational risk is particularly damaging for banks since the nature of their business requires maintaining the confidence of depositors, creditors and the general marketplace.




To be able to understand the client’s business a basic understanding of how banks are structured and how the routine transactions flow is essential. What follows is an illustration of how a typical bank is broken down into departments and the departments’ interaction with each other and banking clients. Refer to Data Flow Diagram on routine transactions From the diagram, you will see that a typical bank is split into profit centres and cost centres which handle transactions as follows: Profit Centres (proactive) Branch Operations Offering deposits and dealing with customer service and enquiries. Card Services Issuance and maintenance of credit and charge card accounts. Credit (consumer and corporate/private) Administration and management of the loan portfolio. Treasury Trading Short term purchase and sale of interest rate and foreign exchange products. Cost Centres (reactive) Central Treasury The above profit centres handle a huge volume of transactions that result in an unbalanced asset/liability position i.e. the centre is either a net user or generator of funds. In aggregate, that net position (sometimes known as the banking book) is actively managed by the Asset and Liability Management function within the Treasury department. The treasury department receives the data from all the operating departments of the bank and is constantly reacting to cash flows in the various profit centres. Treasury makes sure that foreign exchange and money flow is sufficient to meet the needs of the bank by carrying out transactions subject to predefined limits set by the bank’s strategic planning committees such as ALCO (Asset and Liability Committee). This function and the mechanics of how Central Treasury ensures the bank is efficient and profitable is illustrated in more detail in section 2.2. Operations This department receives and processes all transactions details and generally includes the information technology function. Reconciliations and Settlements Typically part of operations these centres process transactions initiated by the retail departments and central treasury. Settlements ensures that money is in appropriate accounts to settle deals, while the reconciliations department ensures that the transactions with other banks were carried out as agreed. Financial Control Collects the data from all the subledgers of the various departments to produce the financial information to effectively manage the bank.




Within banks the various departments all compete for scarce resources. For banks this resource is funds. The activities which generate the highest returns, after discounting the return for the level of risk assumed, will be the most attractive area to allocate funds. Refer to Diagram on Central Pool of Funds 2.2.1 Profit Centres

All identifiable departments in banks are either profit centres or cost centres. Profit centres are those that offer products that generate interest revenue or fee based services. Other departments such as settlements, accounting, and reconciliations departments do not offer services outside the bank and therefore are cost centres. In order to measure the profitability of these various lines of activity the bank assigns a cost of funds for all banking activities. This cost of funds is the rate at which money can be invested risk free in the money markets. From a banker’s point of view he must make at least LIBOR on an activity to make a profit above the risk free rate. Therefore all requests for money from the different departments are priced at LIBOR and it is then up to the department to price its product such that an interest spread is earned which compensates for the risk involved. [NB. Throughout this guide the term LIBOR is used which stands for London Interbank Offer Rate. All countries have their own interbank rate at which all banks are willing to accept deposits from each other. For the purposes of this section all funds are considered to be borrowed and lent at LIBOR but in practice it could be at any rate. LIBOR has been used here as a means to simplify the concepts.] 2.2.2 Branches as Profit Centres

Each branch is responsible for generating business in the form of loans to customers and being a source of deposits that the bank can use to issue new loans or invest in other assets. 2.2.3 Deposits

When customers choose to place their excess money with a bank the bank records this liability to the client and either invests the money or lends it to another bank client. Banks accept many more deposits than they can lend out so excess deposits are invested in interest earning assets such as Treasury bills and other money market products. The branch then earns LIBOR on all of its deposits and pays something less than LIBOR to its client leaving an interest rate spread that yields profits. 2.2.4 Loans

Loans are granted by the branch to its clients and these are assumed to be funded by borrowing money at LIBOR and lending it to a client. The branch then charges its client interest greater than LIBOR to generate a profit on the interest rate spread. Therefore all loans are priced with LIBOR as its basis. 2.2.5 Managing interest rate risks with transfer pricing and cost of funds

Some banks may centralise the management of interest rate risk in a unit of the bank, usually the treasury unit, using a funds transfer pricing system. Funds transfer pricing allows the bank to transfer the impact on earnings of changing interest rates from individual business lines to the central unit. Profits of the bank are unaffected however, the earnings of the business lines can then be traced more directly to the business decisions of management. Funds transfer pricing also induces line managers to make pricing decisions that are with the interest rate risk management objectives of the treasury. The transfer pricing system removes interest rate risk profits and losses from individual business units. Banks can use several methods to determine the price of transferred funs. Using a “gap approach”, a


bank can group its assets and liabilities based on the maturity and repricing characteristics of the instruments and assign a transfer rate to each group. Alternatively, the treasury unit of a bank could assign a cost or earnings rate to every transaction. For example, treasury assigns a cost of funds to the commercial lending units for loans. A fixed rate, five-year loan might be assigned a cost-of-funds equivalent to the rate paid by the bank to borrow five-year money. The treasury will assign an earnings credit to the deposit or retail unit for the funds raised. In this way, the treasury unit acts as a middleman between the lending and retail units. Under a transfer pricing system, profits and losses arising from interest rate mismatches are transferred to a central unit, generally the treasury department. The treasury, which is responsible for funding the loans, may either match-fund the loans or maintain the repricing mismatch. If loans are matched-funded, no interest rate risk is assumed by either the lending units or treasury. If treasury decides to maintain the mismatch, perhaps funding a five-year fixed rate loan with a one-year deposit, the unit would earn the difference between its actual funding costs and what it has charged the lending units. For example, if treasury charges the lending units 10 percent for five-year funds and raises one-year money at 9 percent, treasury would earn a 1 percent spread. Obviously, the treasury unit has assumed interest rate risk. If rates were to rise, the spread earned could decline or even become negative. 2.2.6 Funds in Foreign Currencies

All banks deal in foreign currencies so that their clients can convert money earned outside the country into domestic currency and convert domestic currency into foreign currency when they have to make payments outside the country. This function and the related implications are illustrated in more detail in section 2.2.7 In terms of generating profits the bank earns money from foreign exchange by charging a premium to sell foreign currency and a discount to purchase it. When a client deposits foreign currency at a bank the treasury department has to make a decision whether to sell the foreign currency before the exchange rate fluctuates or hold it with the intention of selling it when the home currency depreciates to yield a gain. There is a cost to holding this foreign currency because it cannot be invested to earn interest because the dealer needs it to be able to sell it when the exchange rates are favourable. Therefore, this speculative activity also attracts the LIBOR cost of funds. This ensures that the foreign exchange positions are closely monitored to ensure profitability. That is, the longer the foreign currency is held the larger the exchange movement must be to pay the cost of funds charge.




Upon completing this section, you should be able to: • • • • • Understand the basic concept of foreign exchange and the market for foreign exchange. Appreciate the reasons behind foreign exchange transactions. Understand basic foreign exchange transactions, rates and what is meant by the term ‘position’. Identify the exposure to foreign exchange risks. Understand and identify the internal controls maintained to reduce risk exposure. Introduction


Refer to Diagram on Operations in Foreign Currency Foreign currencies in general and the process of exchanging the currency of one country for the currency of another country are both referred to as ‘foreign exchange’. This exchanging process or the conversion of one currency into another can take place locally, for example, when members of the public purchase foreign currency notes and travellers cheques or internationally when the conversion involves the receipt or payment of one currency for that of another. The market in which international conversions take place is known as the foreign exchange market. The price at which the exchange of currencies takes places is known as the rate of exchange. 3.1.2 Reasons behind foreign exchange transactions

The market for foreign exchange mirrors the physical trade that occurs between countries. For every sale/purchase of goods or services, there is a corresponding monetary transaction. It also reflects capital flows between countries. In simple terms, the market for foreign exchange enables debts between different countries to be settled by the exchange of one currency for another. The originators for foreign exchange funds are usually the large corporate entities. The foreign trade that they undertake eg. Buy foreign raw materials necessitate the need for foreign funds to pay for such goods and services. Banks may be approached if the size of funds required is huge but usually foreign exchange brokers are used. They in turn will contact the banks and transact on their clients behalf. Whilst, commercial traders enter into foreign exchange transactions through banks to settle liabilities or convert assets, banks themselves trade in foreign exchange for a number of reasons. The most important of these are: i) ii) iii) To service the foreign exchange requirements of their customers at a profit. To make a profit simply by buying and selling various currencies. To hedge the foreign currency assets and liabilities of the bank against adverse exchange rate movements. To acquire foreign currency assets in preference to the base or local currency which may be more sensitive to rate movements.




3.1.3 Example A bank starts operating from a position in foreign currency as follows: USD Assets Cash Loans Deposits with banks 1,000 _________ 1,600 ======== 100 500


100 500

Total Assets Liabilities Due to banks Customer’s deposits

1,000 _________ 1,600 ========



1,000 Other liabilities Total Liabilities Daily routine transactions are as follows: 200 _________ 1,600 ========

900 200 __________ 1,600 =========

1) A client exchanges USD800 for domestic currency 2) A DM500 loan is advanced
NEW BALANCE SHEET AS FOLLOWS: USD Assets Cash Loans Deposits with banks 1,000 _________ 2,400 ======== 1,000 _________ 2,100 ======== 900 500 100 1,000 DM

Total Assets Liabilities Due to banks Customer’s deposits



1,000 Other liabilities Total Liabilities Open position 200 _________ 1,600 ======== 800 ========

900 200 __________ 1,600 ========= 500 =========

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Action required by treasury department After the bank has processed these two routine transactions the treasury department is given the information and decides what action they will take. In effect the treasury has been given 2 positions as follows: 1) Money market position: A DM500 loan was advanced so the money market dealers must borrow DM500 from another bank to fund the loan. The decision then becomes at what term to fund the loan at. If interest rates are expected to decrease the money will be borrowed at short term rates until rates decline at which time the loan term will be increased to match the maturity of the loan granted to its customer. Foreign exchange position: By purchasing the dollars the treasury must sell them or be placed at risk of a change in the exchange rate. The DM 500 loan that was advanced must also be funded so DM 500 must also be purchased in the foreign exchange markets. In practice the treasury will probably sell its dollars in return for DM. “SQUARING” the balance sheet:



Once the USD 100 is sold, the assets in USD will equal the liabilities and the bank is no longer exposed to adverse changes in exchange rates. That is, the balance sheet is “squared”. Similarly once the DM 500 loan is borrowed from another bank, the liabilities in DM will equal the assets and the bank is no longer exposed to changes in exchange rates. 3.1.5 (a) Foreign exchange transactions defined Spot

When a sale or purchase is made spot, it means that delivery of the foreign exchange and the corresponding base currency must be made simultaneously at a fixed date within a few days after the sale or purchase was contracted (normally two business days for most currencies). (b) Forward

A forward exchange transaction involves the purchase or sale of foreign currency for delivery at some fixed future date. The rate at which the transaction is concluded is also fixed at the time of sale, but settlement is not made until the foreign currency is delivered by the seller at the fixed future date. The majority of forward exchange transactions are concluded for periods up to six months but can be concluded for considerably longer maturities, particularly in the more stable currencies. (c) Rates

The value of the world's currencies in the forward market is expressed in the forward rates which reflect current expectations and a large variety of related market forces. If a certain foreign currency is quoted at a higher rate ‘spot’ than ‘forward’, its forward rate is a ‘discount’. If the forward rate is higher, it is said to be trading at a ‘premium’. Different forward rates are quoted for different periods (one, two, three, six, or twelve months forward). It is possible that forward rates may be at a premium for one period and at a discount for the next. (d) Arbitrage

An arbitrage deal involves the simultaneous spot and forward transactions to take advantage of differences in exchange rates and interest rates. The most common form of arbitrage deal is interest arbitrage, whereby a bank attempts to take advantage of interest differentials between currencies and

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make a profit or derive funds for on-lending in currencies other than dollars at a cost which should be offset by the additional interest obtainable by lending in those other currencies. (e) Swaps

Swaps involve two linked exchange transactions for an identical amount of a currency with different value dates, for example, a spot purchase and a forward sale. A swap can take place when each party can access a particular market (either interest basis or currency) on comparatively better terms than the other. Parties will enter the markets where they have the advantage, and will agree to exchange (swap) payments and receipts between them which will result in better terms in their preferred market than if they had entered it directly themselves. The most usual types of swaps are interest rate swaps and currency swaps.


How foreign exchange profits are made

The two most common ways in which a bank makes a profit from the foreign exchange market are: From the "spread" in quoting currency prices From holding a currency position. (see 3.1.7 a)

The Spread The difference between the current buying and selling rates of a particular maturity date in the market is called the ‘spread’. For example: The Swiss franc was quoted at $ 0.4000-0.4002, indicating that at that moment a bank would pay 40c for a franc and would sell at 40.02c. The small spread between buying and selling rates - $0.0002 - is an indication of the importance small fractions play in day to day trading and of the narrow margin on which foreign exchange dealers operate to generate a profit. Another illustration of this is seen in the forward transaction area. On a given day a trader might quote a market rate as follows: Spot sterling - $1.7800 - .02 (which means he is prepared to buy points discount (which means he is prepared to buy at $1.7800 or to sell at $1.7802) six months - 453 to 448 forward at $0.0453 discount from the spot bid price or sell forward at $.0448 discount from the spot offered price). A customer calls to sell pounds six months forward to cover an investment in England. The trader would bid for the sterling at $1.7347 ($1.7800 less $0.0453) for delivery in six months. 3.1.7 Risks involved in foreign exchange

The foreign exchange risks which a bank is exposed to is dependent on the type of foreign exchange business undertaken. When only solely buying and selling foreign currency where time delay is minimal, the exchange risk is negligible. Where large positions are frequently taken and there is time delay in transactions being unmatured for a period, then risks undertaken are significantly higher. The risks associated with the foreign exchange activities may arise as follows: (a) Open positions

As explained above, a position in a currency arises when a bank is unmatched in that currency ie an excess of assets or liabilities in that currency. If there is a long position and the value of that currency falls in home currency terms, a loss will arise. Similarly, if there is a short position and the currency rises in home currency terms, again the bank will experience losses.

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The bank's open position includes unmatured exchange contracts and its exchange assets and liabilities. Where small open positions are maintained, movements in exchange rates will have little or negligible effect. Most of the substantial foreign exchange losses suffered by banks in recent years have resulted from a failure to manage and control large open positions properly. To control open position risks, it is important that the bank's management and dealers should receive prompt and regular reports showing the bank's spot and forward positions. These should be monitored against operating spot and forward limits established by the bank. In practice information is not updated to the treasury department on a real time basis. Rather, all transactions processed by the bank are batched and the resulting positions are given to the treasury department the following day. To manage the risk of having unknown open positions each individual foreign currency transaction with customers has limits placed on it. For example, if a customer has a large foreign currency transaction the treasury department must be contacted to be informed of the transaction so that it can close out the open position immediately. If this did not occur the position would be open overnight and the bank could sustain large holding losses if the rate changed by the next day. (b) Liquidity exposure

This is the risk that a bank may not be able to cover, on a particular day, net cash outflows which arise from sizeable mismatched exchange positions. Examples whereby the bank may not be able to cover such cash outflows are tight liquidity resulting from a central bank squeeze, (ie when the government reduces the amount of money in the economy), temporary market closure, sudden concern over the bank's credit standing or where selling new deposits and assets in adverse market conditions is insufficient to meet these outflows. This risk could lead to a forced sale of the banks assets which may not realise the full value of the assets. Large losses to the bank may not be avoided. To avoid this risk, significant long and short positions maturing on any one day should be avoided by management. (c) Maturity mismatch

This is due to spot and forward transactions which may be matched as to amount but individual transactions may mature on different dates. Maturity mismatch can therefore occur even though the bank may only have small open position but significant mismatching of maturity dates. Maturity mismatch risk should be controlled in a similar way as open position risks. The bank's spot and forward maturity profile should be reviewed regularly by senior management. The positions should also be regularly monitored against the limits set by the bank. Maturity mismatch can also lead to serious liquidity exposures experienced by the bank because the bank will not be able to meet obligations as they fall due. (d) Credit risk

This is the risk that the counter party may be unable, or unwilling to complete his part of the transaction. The potential loss when the bank becomes aware of the counterparty not being able to complete the transaction is the difference between the contracted value of the transaction and the cost of completing it with another party. Unlike credit risk in lending, the bank is not subjected to total loss in the value of transaction. This is because, in the event of default, the bank can undertake another equivalent transaction, albeit not at such favourable terms, and thus suffer partial loss. (e) Settlement risk

This is where, on value date, the bank transmits and pays funds to the benefit of the counterparty but the counterparty is unable to meet its obligations. The bank is therefore at risk of losing all the funds transmitted. This usually results from the time gap between paying out funds in one centre (eg. London) and the confirmation of receipt of funds in another centre (eg. New York), a 5-6 hour time zone

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difference. To minimise such risks, limits on the value of unmatured deals with individual customers should be set and regularly monitored. Internal control The various risks explained above, together with high volume (number of deals per day could range from 50-500) and often complex deals, volatile exchange rates and high cost of money, necessitate a high level of control over foreign exchange activities. The principal internal control is clear and effective segregation of duties between: initiation of the transaction control over the movement of funds maintenance of the accounting records including the valuation of open foreign exchange positions.

Other controls that warrant mention are: (i) Operational controls The procedures manual normally sets out precisely the procedures required of the foreign exchange dealers and the related settlement and accounting departments. It is essential that: · · dealers are fully aware of the bank's foreign exchange policies regular meetings are held between dealers and senior management to review policies and expected market conditions dealers are forbidden to trade on their own account dealers' remuneration is set at appropriate levels that are not excessively based on attaining performance targets ie levels of profitability which may encourage their taking risky positions; such targets should be set up cautiously dealers remain strictly independent of counterparties brokers are approved by the bank activities of dealers are subject to the chief dealer's review, who should act in a management capacity dealing outside domestic banking hours restricted to authorised personnel.

· ·

· · · · (ii) Limits

To reduce risks as explained earlier, limits should be pre-determined by senior management. Limits should be set for: · · · · · intra-day and overnight positions by currency total outstanding forward transactions maturity mismatch value of total exposure for settlement by individual counterparty value of deals maturing on any one day for each individual counterparty.

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Excesses over such limits should be ‘captured’ by exception reports which should be controlled and reviewed by senior management and authorised by them. (iii) Recording In order that the bank's accounting records are accurately recorded, the system of processing an internal control should ensure that: · a dealing slip is prepared for every foreign exchange transaction with all necessary details correctly included the position sheets are promptly and accurately updated for every transaction undertaken all transactions are promptly and accurately recorded the position sheets are reconciled daily to accounting records the accounting system produces regular reports including those on the bank's positions, maturity ladders, excesses of credit limits for management.


· · ·


Confirmations The prompt despatch of outward confirmations and the prompt and accurate checking of inward confirmations ensure that deals are recorded as transacted. The key controls relating to confirmations are: · all deals for which no inward confirmations have been received should be reviewed and chased up all incoming confirmations should be reviewed and checked independently of the dealing room, to deal tickets (outgoing confirmations); discrepancies should be promptly reported, investigated and resolved confirmations should be despatched the same day on which the transaction was done confirmations should be sequentially pre-numbered and controlled.



· (v)

Other controls which necessitate strict segregation of duties are: · position account maintenance - on an individual currency basis, the positions should be regularly monitored, controlled and checked against predetermined limits settlement of transactions - foreign exchange deals are completed by paying one currency and receiving another on the same business day. Inward and outward confirmations of settlement should be strictly controlled revaluation of positions - regular valuations, prepared independently on a consistent basis should be carried out internal audit - with the foreign exchange, recording settlement and accounting departments, internal audit inevitably plays a vital role in ensuring that various roles are carried out in accordance to the procedures manual. This ensures that the controls are adhered to.




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Foreign exchange is needed for the settlement of international trade transactions. Features of the foreign exchange markets: (a) (b) Most of the dealing is directed through the Interbank Market. Participants operate from eleven major centres ie London, New York, Frankfurt, Paris, Zurich, Bahrain, Singapore, Hong Kong, Tokyo, Chicago and Toronto. It comprises a vast network of buyers and sellers of currencies. Participants range from major banks to individuals who may only buy small amounts of foreign currency for their holidays. A large percentage of transactions on the foreign exchange market are speculative.

(c) (d)


Foreign exchange profits may be made through: (i) (ii) (iii) (iv) ‘spread of rates’ speculative dealing holding a position in the currency arbitrage

Foreign exchange risks experienced by banks are due to: (i) (ii) (iii) (iv) (v) open positions liquidity exposures maturity mismatch credit risk settlement risk

These risks have to be monitored in order that losses are not suffered. Limits are established and a high degree of internal control, essentially effective segregation of duties, maintained to ensure risks are minimised. TEST YOURSELF QUESTIONS 1 The act of purchasing foreign currency or travellers cheques involves the conversion or exchange of one currency for another. Does the receipt by a bank of £ 50,000 in cash for the credit of a customers sterling current account involve conversion? Can a counterparty be an individual? A spot or forward transaction normally involves simultaneous (same day) receipt and payment of currencies, therefore there is no risk involved because the exchange rate is fixed in advance. Is this correct? Explain with reasons. The only way in which banks make exchange profits is by selling foreign currencies at a higher rate of exchange than the rate at which they bought it. Is this correct? Explain. Why do banks enter into forward exchange transactions? A customer enquired ‘what is dollar/dinar at today’, the bank clerk replied '.297 - .299'. If the customer wishes to buy dollars which rate would apply?

2 3


5 6

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Every exchange transaction alters the overall currency or exchange position of a bank. But all foreign currency transactions may not necessarily affect the overall position. Explain.

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The following section will describe the routine data processes that a treasury department must carry out in order to meet the bank’s objectives. Specifically, how situations described earlier that are created by customer activity flow through the treasury department and how they are controlled. Refer to Diagram on Treasury Operations 4.1.1 Dealing Activity

When a customer decides to sell dollars to a branch over a certain limit the treasury foreign exchange desk is called. Some customers who deal in large amounts of F/X such as corporations call the desk directly. When a customer calls the desk a dealer completes the transaction for the customer as follows: a) The dealer checks that deal amount is within his limits and quotes a rate that currently the market is willing the purchase the dollars at plus a small commission.(spread) b) He then checks counterparty limits (to ensure they are within authorised limits) and sell the dollars. At this point the settlement date and correspondent banks brokers are also agreed between the dealers. c) The dealer fills out his deal ticket as the deal was agreed with the counterparty d) A confirmation comes to the dealer either from Reuters (a secure information gathering system) or by fax if it is with a broker not on the Reuters system. e) The deal ticket is then agreed to the confirmation to ensure that both parties agree to the terms of the deal. f) Both the deal tickets and confirmations are numerically sequenced as a completeness control over recorded deals. g) The dealer then updates his own foreign currency position and passes a copy of the deal ticket to the back office. 4.1.2 Back office

The back office is segregated from the dealing function and is an integral control over treasury operations. They manage the cash flow of the bank by producing all the reports regarding the bank’s positions as follows: a) Once the back office gets the deal ticket it also obtains its own confirmation either from a printer running in parallel with the dealing room or from Reuters itself. It is crucial that the confirmation function is segregated from the dealing function. The back office agrees the deal tickets to the confirmation and ensures it is within limits and with a suitable counterparty. The deal is then coded for input to the bank’s records by assigning the appropriate bank accounts the deal will be settled from with correspondent banks. If a broker is used with accounts in common with the bank a draft is issued to settle the deal. Input processing

b) c)


The processing department consists mainly of input clerks who will input the details of the deal tickets into the computer as well as other tasks as follows: a) Enters the approved deal ticket into the computer (ie. the date the transaction will be paid and from what accounts) b) Various reports will be generated such as daily deal listing, credit limits exceeded report. c) The deals are then printed as they have been input into the computer and returned to back office for further checking. d) Accounting records of the bank are now updated as soon as deals are input e) A settlements listing featuring amounts, currencies, dates and account numbers is sent to settlements department to ensure all amounts are paid as agreed on original deal tickets.

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Settlements and Nostro/Vostro accounts

Once the settlements listing is obtained the settlements department actually moves the funds around the bank. Banks have current accounts with each other in order to settle transactions. These are called Nostro/Vostro accounts. Nostro is our account with you and Vostro is your account with us. If a bank has to pay money to another bank it is placed in a Nostro account with them. If a bank is owed money they collect it from its vostro account. A facility known as “SWIFT”(Society for Worldwide Interbank Telecommunication) then simultaneously collects the funds from the Nostro account and deposits them in the Vostro account on the value date. a) They ensure that funds are deposited to accounts by the value dates so that SWIFT can collect the funds. b) If Nostro accounts go overdrawn because funds are not there according to value dates high penalty interest is charged. Nostro accounts don’t earn interest for excess funds either. c) Since interest is not earned on Nostro accounts it is up to Settlements department not to deposit funds too quickly or opportunities to generate interest are lost. 4.1.5 Reconciliations department

Once the deal has been settled the reconciliations department reconciles all of the Nostro accounts daily to ensure all deals that were intended to settle have been completed. That is, all funds have been withdrawn by SWIFT from the Nostro accounts. a) Reconciliations department looks at each Nostro and ensures that SWIFT has taken the specified amount of funds from the accounts. If there are discrepancies they are investigated. b) This is a key control to ensure that all deals have been completed as were originally agreed to. c) If there are old outstanding items in these accounts an enquiry is raised and sent to the counterparty to investigate the reason for the discrepancy. d) Statements are sent by the correspondent banks detailing all the activity in the accounts to help facilitate the reconciliations process.

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Refer to Diagram on Cheque Clearing 5.1.1 Cheques drawn on a domestic bank

If a customer deposits a cheque into his account the bank has to “clear” it. That is, the cheque must be paid by the financial institution it is drawn on. In this case the process of clearing a cheque drawn on a domestic bank will be detailed. a) b) c) A customer deposits a cheque for USD$500 into his USD savings account. The bank then starts paying him interest on the money but has not yet received the $500 from the bank it is drawn on. At the end of the day the teller balances all cheques that were processed that day and sends them to the clearing department of the bank. The clearing department then separates all the cheques from that branch into domestic banks and foreign banks. For each domestic bank all cheques drawn on that bank are bundled together and that total amount of money is owed by that bank. The bundle is then taken that night to a Central Clearing agent where all the other domestic banks have sent their cheques drawn on all other banks. The Central clearing agent then balances the two positions to reconcile which bank owes the other more money. That is, if bank A honoured more cheques of Bank B’s then a draft is sent along with Bank A’s cheques drawn on Bank B or vice versa. Now the clearing department has inward clearing negotiated at another bank the previous day. Therefore, all customers accounts are updated to reflect the cheque clearing their account. If there are no funds for withdrawal the cheque “bounces back” to the bank who negotiated it. The bank who honoured the cheque then has to try to obtain the funds back from its customer. Holding funds




When a cheque that bounces is returned to a bank unpaid this places funds at risk because there is no guarantee that the funds will be recoverable from the depositor. The bank can avoid this situation all together by placing a hold on the cheque when it is deposited. That is, the cheque is deposited but funds aren’t advanced on it until the danger of it being returned unpaid has lapsed. This is usually 3 days for cheques drawn on domestic banks. 5.1.3 Items sent on collection

The other alternative is for the bank to send the cheque out on collection. The bank sends the cheque in the outward clearing again with instructions to the bank it is drawn on to hold on to it for a period of time (usually 30 days). In this time period the bank tries to withdraw the funds from the account each day for the next 30 days in hopes of recovering the funds. If, after 30 days the cheque can’t be paid the cheque is sent back again and the bank must take a loss on the negotiation of the cheque or try more vigorously to recover the funds from the depositor. 5.1.4 International payments

When a customer presents a cheque drawn on an international bank it cannot clear in the same manner as a cheque drawn on a domestic bank. This is because the central clearing agent cannot deal with the foreign bank to obtain the funds to pay the domestic bank. 5.1.5 International collections

When a customer presents such a cheque the teller cannot give deposit value to it or cash it. It can take a substantial amount of time for the cheque to be paid and if it is in the customer’s account earning interest during this time the bank cannot invest the proceeds from the cheque in the money markets. Banks are unwilling to pay interest on funds that they cannot reinvest. Therefore, the customer obtains

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an assurance from the teller that once the funds are paid by the bank the funds will be deposited in their account. 5.1.6 Correspondent accounts and banks

When the foreign bank receives the cheque on collection it, in effect, receives instructions from the domestic bank to act as follows: a) b) c) d) Withdraw funds from the foreign customer’s account. Use those funds to purchase a draft drawn on a bank in the same country as the domestic bank who sent the item on collection. The foreign bank then interacts with its settlements department to move funds from the customer’s account and place them in the foreign banks Nostro account with a bank in that particular country. The draft is then sent back to the domestic bank who then deposit the draft drawn on a domestic bank now and sends it through the domestic bank clearing because it is now merely a cheque drawn on a bank in the same country. The domestic bank the cheque is drawn on pays it by releasing the money from its Nostro account where the foreign bank placed it.


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At the end of this session you should be able: • • • • • to describe how lending and card routine transactions are processed by the various departments to identify the various types of bank lending to understand the basic principles governing lending to recognise the various forms of security or lack thereof in the Middle East environment to identify the key internal control procedures within the lending framework.

Refer to Diagrams on Branch Lending and Card Services The processes involved for card transactions processing and consumer lending are very similar and will be described together as follows: 6.1.1 a) b) Advances repayments

A customer makes an instalment or pays his credit card balance at a branch. The loan or card account is updated for the transaction on either the card subsystem or the loans subsystem. Treasury department

6.1.2 a) b)



The acceptance or advancing of funds whether in foreign currency or domestic currency requires action by the treasury department If FC is transacted the treasury department must either buy or sell the FC as described earlier in the foreign exchange section. The deal is then settled by the settlements department exactly as any other F/X transaction. The treasury department is also given a money market position. That is, they either have a surplus of funds to invest or a shortfall of funds and need to borrow. Therefore, as described in the diagram the money is borrowed in the money market to fund a loan or invested in the money market in the case of cash surpluses. The borrowing or placement is then settled by settlements department exactly as described previously. Credit card transactions


There are a few unique features to card services. These unique transactions are between the card service provider and the card issuing bank. a) When a customer spends money in a foreign location the merchant is reimbursed by the card service provider, for example, Mastercard or Visa. b) When Mastercard or VISA interact with the customer’s bank, the card account is updated in domestic currency at the same rate the card company reimbursed the merchant at. c) The bank’s treasury then must carry out two transactions. d) Purchase foreign currency to reimburse Visa or Mastercard and finance the purchase of Foreign currency by borrowing in the market. Therefore, treasury has acted on a money market position and a foreign currency position just as in the loans example. e) Settlements department then settles the deals with the correspondent bank of the Credit card company. Bank lending, by way of loans overdrafts and advances, usually represents the largest single class of asset held by most banks and its major source of income. Due to this and also due to their nature ie.

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credit extended to corporate and personal customers, lending often carries the greatest risk to the bank, to which much emphasis and importance is placed by us as auditors. Loans and advances may be categorised in various ways: 1 Retail or wholesale - these terms are vaguely used to distinguish between local, often branch based lending as opposed to the larger corporate interbank and institutional lending which is usually head office based. Personal or corporate. Short term, medium term or long term.

2 3

6.1.4 A)

Types of Lending Facility Overdrafts

This is an agreed line of credit or borrowing facility (in writing) that a customer may use by drawing on a specified current account. Originally overdrafts were regarded as temporary facilities but in the Middle East it is far from unusual for a customer to maintain a ‘permanent’ overdraft albeit the balance fluctuating from day to day. Such overdrafts are nicknamed ‘evergreen’ being often the source of financing business on an on-going basis. In recent years in some countries pressure has been exerted by the Central Banks to make the commercial banks persuade their customers to take a term loan in place of an on-going permanent overdraft. Legally overdrafts are repayable on demand but in practice banks rarely call in any overdrafts where the customer keeps within agreed limits. It is also common to see accounts in excess of limits and although accounts are reviewed from time to time, both as to facility and limit, ‘temporary’ excesses often receive ‘temporary’ approval. Interest on overdrafts is calculated on the outstanding daily balance at a predetermined rate. B) Term Loans

These are made for a fixed period of time and can be repayable either in instalment or in full at the maturity date. A short term loan is generally regarded as being a loan which is repayable within one year from when it is granted. A medium term loan is generally regarded as being repayable after at least one year but before the expiry of five years. A long term loan is generally regarded as one that is not finally repayable until at least five years after it was granted. The interest rate is normally predetermined for short term loans and is likely to be of a floating nature for medium to long term loans. C) Syndicated Loans

A syndicated loan is one that is provided jointly by a number of banks or financial institutions who would be individually either unwilling or unable to provide in view of the size and nature of the amount. These banks or financial institutions are usually brought together by one or possibly more managing banks which have organised and negotiated the whole package. The managing (or sometime it's called lead) bank handles the negotiations with the borrower, perhaps the documentation, collects the funds from participants and then disburses the full amount to the borrower. Subsequently the managing bank is responsible for collecting all sums due from the borrower (both principal and interest) and for passing their share of these sums to the participants. Apart from the managing bank, the syndicate participants do not have any direct dealing with the borrower as all their information needs and any required action (eg. default) is dealt with solely by the managing bank. D) Personal (or Consumer) Loans

In addition to overdrafts banks provide a varied range of personal lending. These include:

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Fixed rate loans are generally provided to finance the purchase of cars or consumer durables. Often up to 3 year periods the documentation is simple and provides for usually equal monthly repayments of both principal and interest. Interest is usually fixed. Mortgage loans are becoming more usual and are for longer periods usually over 5 years. Loans are specifically granted for the purchase of property and are repayable in instalment (monthly, quarterly or half yearly). Interest is seldom of a fixed nature but likely to be floating. Credit cards are becoming more and more common and regarded as a strong marketing tool. Please note there is a difference between a ‘charge’ card (eg. American Express, Diners Club) and a ‘credit’ card (eg. Visa, Mastercard). Only the latter permits any form of extension of credit and the former requires immediate settlement on issue of the statement. Obviously in the case of the charge card there is an interest free credit period between when the card is used and the issue of the statement. Credit cards usually earn interest on the unpaid monthly balance at fixed monthly rates of interest and also the bank earns commission of varying amounts based on gross sale value of the transaction from the retailer or service company.




Sovereign Loans

Banks in the Middle East lend substantial sums to foreign governments, public sector organisations and large corporations in overseas countries. These loans are usually large in amount and of a medium or long term period. Often there is little or no security and reliance is placed on the credit worthiness of the country and also sometimes the guarantee of the borrowing government is provided. See also c), Syndicated Loans, which may also be part of the bank's overall sovereign risk. F) Other 1 Bills discounted: This is a form of facility granted to a customer based on a bill of exchange drawn on a third party and lodged with the bank as collateral. The bank grants immediate credit to its customer for the face value of the bill until maturity at which time it collects the face value. Often Central Bank offers a re-discount facility to banks whereby they can sell the bill at face value less discount and charges. It is important that as the bank relies on the bill as security, that it is satisfied as to the credit worthiness of the third party and that there is an underlying substance to the transaction. Documentary credit: This is discussed fully in section 7.



Factors Governing Lending Decisions

Having now seen the various types of lending let us look briefly at the basic principles and factors governing lending. Firstly there is the principle of stewardship ie. the bank is using money deposited with it by members of the public, companies and other banks and not its own and therefore this places on management a high moral duty to exercise care and integrity. Secondly banks must make a reasonable return on their lending. The basis here is that the higher the risk then the higher the expected rate of return. It is however the ability to strike an acceptable or reasonable balance between these two conflicting principles which makes banking such a fine art and is the essence of good banking. Factors taken into account by bankers when taking lending decisions include: a) b) the quality of the borrower (includes value and quality of security being offered) the purpose or nature of loan

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c) d) e) f)

the amount of loan the period of loan the repayment schedule proposed the banks own policy limits (eg. currency of loan, country, nature of industry).

Essentially a bank will look initially at the purpose of a loan, relating this to the amount requested, and of extreme importance, their clients demonstrated ability to repay. Under ideal conditions the loan will be self-financing ie. that sufficient cash flow is going to be generated from the employment of the loan proceeds to repay the loan. 6.1.6 Loan Security

A bank may lend with or without security. If the latter it is referred to as 'clean' ie. "clean" loan or "clean" overdraft. However when a bank takes security it does not usually expect to obtain repayment of the loan by realising that security. The security is there to reduce the risk that a loan will not be repaid if the borrower defaults. Therefore if the risk involved is to be totally eliminated then the security needs to be sufficient at its realisable value to repay the bank in full. It can be seen then that security evaluation against outstanding loans is an on-going and continuing process. There are two aspects to be considered - (a) Has the market value been maintained or has it fallen? eg. value of land or shares, and (b) Has the outstanding loan amount been reduced within the terms of the loan agreement. Thus a comparison of the loan outstanding amount should be regularly made against the current value of security held. In the Middle East a very common feature of bank lending is that it is often unsecured, or the only form of security given is a personal guarantee, and facilities are granted on a 'name lending' basis. It is important to realise that under these circumstances, the credit worthiness of the guarantor has to be assessed, and the general climate of the country in which the bank is situated becomes a major factor in the evaluation. 6.1.7 Internal Control

As mentioned earlier bank lending ie. loans and advances, usually represents the largest class of asset as the balance sheet. It is also a bank's greatest source of exposure to loss, and this necessitates a high degree of internal control, essentially in the following areas: (a) (b) Authorisation and terms of credit facilities Identification and treatment of potentially doubtful credit risks.

The controls usually implemented by banks in respect of the above are summarised below: (a) Authorisation and terms of credit facilities · · · · · · · · · (b) Formal risk policy Independent credit/risk review department Setting of country/currency risk limits Credit review of each applicant eg. obtaining latest financial statements Approval of extension/excess of facility by board of directors/loan committee Separate credit file maintained for each customer Regular review of customer credit status Application forms/agreements signed by the customer Standard documentation

Identification and treatment of potentially doubtful credit risks · · · Regular and independent review of individual risks and credit files Day by day monitoring to ensure that the customer carries out his payment obligations as per agreement terms Security regularly reviewed to assess it adequacy

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· · ·

All write offs require formal authorisation and approval Formal policy for determining adequacy of specific and general provisions for doubtful accounts and interest in suspense Regular review of problem accounts by board of directors/loan committee.

Policies and procedures operated by banks to implement the above controls should be fully explained in internally produced Credit Policy and Accounting and Operations Manuals. These should be adhered to at all times, and any non-compliance identified during the course of our audit brought to the bank's attention, usually by way of inclusion in the management letter. 6.1.8 a) Summary Lending usually represents the largest single class of asset of a bank, the most common lending types being: (i) (ii) (iii) (iv) (v) (vi) (vii) b) overdraft term loans syndicated loans personal loans sovereign loans discounted bills documentary credits

Strict internal control procedures must be maintained to enable: (i) (ii) (iii) proper approval/authorisation of credit facilities monitoring of performance identification of doubtful credit risks.

TEST YOURSELF QUESTIONS 1 2 3 4 5 6 What is the difference between a loan and an overdraft? Is a loan granted on the basis of a personal guarantee, secured or unsecured? What is the single most important criterion on which a bank extends a loan to a customer? Define the periods for short, medium and long term loans. What is the main feature of a syndicated loan? What do you understand in a sovereign risk?

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After studying this section, you should be able to: • • Understand why international trade finance is required. Identify the major types of trade finance.



In international trade, where parties to a contract may operate from geographically distant areas, it is necessary that each should be satisfied as to the ability of each to satisfy the other of their ability to trade and pay for the goods received. Trade finance plays a very important role in ensuring that international trade can occur by facilitating the payments for international trade. The most common forms of trade finance includes documentary letters of credit, guarantees and performance bonds. Bills of exchange (trade bills), forfeit and export finance insurance are used in international trade. 7.1.2 Documentary letters of credit

Where international trade occurs and each counterparty is to be satisfied as to the creditworthiness of the other, documentary letters of credit are used. The buyer must be satisfied that the seller has the capacity to produce, ship and deliver on time, and the seller must be satisfied that the buyer can and will pay on time. However, the seller may have little idea of the creditworthiness of the buyer. The commercial risks associated with international trade tend to be greater than domestic trade due to the time lag between ordering and receipt of goods and payment for these goods by the purchaser whose credit rating may be almost unknown to the seller. Both parties are at risk until the contract has been fulfilled and completed. A documentary letter of credit is a written undertaking by a bank (ie the two banks know each other) given to a seller on the instructions of the purchaser to pay a specified amount within a stated period against presentation of certain trade documents. Effectively the creditworthiness of the purchaser is replaced by that of the bank. The trade documents to be presented by the seller to his bank include invoices, bills of lading or other shipping advices, and insurance policy. The risk to the issuing bank is the credit risk as that arising from a loan. The supplier's bank may 'confirm' the letter of credit which means that the confirming bank will pay the supplier on production of the trade documents, irrespective of receiving the funds from the issuing bank. The confirming bank thus has a credit risk in respect of the issuing bank. Fees will be charged for these services provided, the level being dependent upon the assessment of the risks to which they expose themselves. Diagrammatically: 7.1.3 Procedure

a) The buyer and seller conclude a sales contract providing for payment by way of a Documentary Letter of Credit. b) The buyer then approaches his own bank, "the Issuing Bank", and requests the bank to issue a Documentary Letter of Credit in favour of the seller. c) Assuming the Issuing Bank is satisfied with the credit standing of the buyer, it will issue the Documentary Letter of Credit and request a bank in the seller's country to advise or confirm the credit. However, if the Issuing Bank is dissatisfied, the buyer will have to provide guarantees in the form of assets (money deposits and similar collateral) before the Issuing Bank is willing to issue the Letter of Credit. If this is not possible, the deal could be rejected.

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d) The advising/confirming Bank then advises the seller that the Documentary Letter of Credit has been issued. e) Once the seller has received a copy of the Letter of Credit and is satisfied that he can meet its terms and conditions he is in a position to dispatch the goods to the buyer. f) Having dispatched the goods and accumulated the required documents, the seller then sends the documents stipulated in the Letter of Credit to the advising/confirming Bank. g) The advising/confirming Bank then checks the documents against the Letter of Credit. Assuming the documents meet with the requirements of the Letter of Credit, the seller will receive payment in accordance with the terms stated in the Letter of Credit. h) Finally the Issuing Bank releases the documents and where these documents represent title to the goods, the buyer on presentation of these documents to the carrier gains possession of the relevant goods.


Letter of Guarantee

A guarantee is a promise by the guarantor to be liable for the debt of another person, the principal debtor, should the principal debtor fail to perform an obligation, provided that the guarantor is notified of that fact by the creditor. The guarantee is usually given after the bank has been suitably furnished with collateral (eg. customer deposits, title deeds to property). In international trade, the provision by a bank of a guarantee can enable the customer, who is perhaps new to a country, and may be unknown to local banks and suppliers, but already has an established credit rating in another country, to enjoy normal trading relationships. Income sources for the guarantor bank are: a) b) Commission over the period of guarantee. In some cases, an interest-free or ‘cheap’ deposit as security from the customer.

The risk for the guarantor varies in accordance to the nature and value of the security required. In the event of default the bank will exercise its right to recover losses by selling the collateral. If the collateral proceeds are sufficient to cover the losses, the balance is returned to the customer; if not then the loss suffered by the bank is the difference between the amount the bank paid out in the event of default and the collateral proceeds. 7.1.5 Bills of exchange (Trade bills)

It is defined as an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum of money to, or to the order of, a specified person or bearer. There are three types of bills normally encountered in banking in the Middle East: 1 2 3 Trade bills Treasury bills Bank bills

Trade bills are explained below. For treasury bills, see investments section of this study module. Briefly, bank bills are bills of exchange that have been endorsed or accepted by a bank. The endorsement by the bank basically ensures that the receiver is assured of payment because the endorsing bank will honour the bill. Therefore it is significant that the quality of the endorsement depends on the quality of the bank endorsing it.

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There are three parties to a trade bill a) the drawer being the party that draws (produces) the bill. In the case of a trade bill, the drawer will normally be the party who has provided goods or services; the drawee being the party on whom the bill is drawn and who is required to make payment as instructed by the bill; the payee is the party to whom the amount shown on the bill is to be paid.



One of the main advantages of a bill of exchange is that it is usually a negotiable instrument and the person holding it can sell it to another party for an immediate cash consideration. The proceeds received from the purchaser is generally less than the face value of the bill because of the outstanding period to maturity for which the purchaser must hold the bill. The amount of ‘discount’ depends mainly on prevailing interest rates and the ‘quality’ of the bill. (Quality is dependent mainly on the financial standing of the drawer and drawee).


Performance bonds

A performance bond is a form of guarantee issued normally in connection with a long-term contract whereby the guarantor is liable for a fixed sum, due if the customer fails to complete a contract. The performance bond has recently become an important feature in the international construction industry. 7.1.7 Summary

Trade finance helps ensure that international trade can occur by facilitating the payments for international trade. Common forms of trade finance: a) b) c) Documentary letters of credit Letters of guarantee Bills of exchange (3 types) (i) (ii) (iii) d) Trade bills Treasury bills Bank bills

Performance bonds

Banks earn commission/fees for providing these services, usually a small percentage of the actual value involved. TEST YOURSELF QUESTIONS 1 2 3 What is the main advantage to a buyer of using a documentary credit? What is the role of an advising bank in the settlement procedure? Would a credit application be required to be completed in all cases of documentary credits?

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This section provides a general description of the types of investments a bank may hold and discusses the reasons why banks have investments at all. After studying it you should be able to: · · Identify the various types of investments held by banks together with their purpose. Identify and understand the difference between trading investments and those held for the long term.



Securities (investments) usually represent a material, but relatively small part of the total assets of a bank. It is not usual for banks to deal actively in securities or to be long term holders of fixed interest stocks or other bonds. The underlying reasons why are simply because banks may find it difficult to switch from fixed term assets such as loans to liquid assets in order to meet any unexpected demand from its depositors. Consequently, banks hold such securities as ‘reserves’ and these not only generate income, and possibly capital appreciation, but are also readily convertible into cash. Banks also hold long term government stocks (which may be related to part of their free capital resources) to provide a fixed and secure source of income. Also in this regard may be held bonds, Eurobonds and other fixed date securities particularly where banks are involved in the secondary markets. Banks may also if actively dealing in stocks and shares seek to take advantage of any shortterm profits offered by new issues or movements in the gilt or equity markets.


Types of Investment

Banks may hold security both for dealing and for longer term investment. Their characteristics are as follows: 1 Dealing - Transactions are made frequently with the sole purpose of taking advantage of shortterm changes in market prices and yields. Investment - These are held for the longer term, usually to maturity. The bank's aim is to obtain regular interest (or dividend yield) and possibly, in the long term, capital appreciation.


It is important to realise that an exact distinction between dealing and investment securities may vary from bank to bank but once so categorised it is vital that no transfers are made from each type to the other. This is because the accounting treatment particularly as regards market valuation and recognition of gains or losses is usually quite different. Consistency is of vital importance from one accounting period to another. Specific types of securities Securities held by banks (whether for investment or dealing purposes) are usually described in their financial statements as investments and include the following: · securities issued, or guaranteed by governments, which, in the case of British Government securities, are often described as gilt-edged and are usually dated; liabilities of corporate bodies, which may take the form of shares, debentures, loans stocks or bonds. Gilt-edged securities



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Gilt-edged securities, which are either issued or guaranteed by the UK government, are usually listed and are considered absolutely safe in terms of interest payments and repayment at maturity. They present the investor with less risk but a potentially lower return than an investment in equities. The market value of gilt-edged securities is influenced by, among other factors, actual and prospective interest rates and their value will not, therefore be necessarily more stable than other securities. However, provided that they are dated, the total yield to maturity is guaranteed at the time of purchase. (b) Treasury bills

These are issued weekly to fund the government's short-term borrowing requirements and to control the money supply by absorption of surplus funds from the money market. Treasury bills do not carry any interest and therefore, when potential buyers tender for such bills, the tender price will be set at such a level that the difference between the offer price and the face value, known as the discount, will represent a reasonable rate of return in exchange to prevailing market conditions. The risks involved in holding such bills are low. On maturity of the bills, the Treasury will repay the bearer the face value of Treasury bill(s) it holds. Likelihood of default or non-settlement is nil because unless the government was bankrupt, these bills will be honoured on maturity. The discount on the bills is amortised over the period to maturity and is realised as income accordingly. (c) Equities

Equities (or ordinary shares) that are listed on a recognised stock exchange are generally more marketable than those that are unlisted. Although equities involve a higher degree of risk and may, in a thin market, be difficult to realise, they offer the opportunity to participate in a company's growth in both capital and income terms. Banks may therefore choose to hold some equities in order to provide a means to maintaining the value of their capital base. (d) Preference shares

Preference shares entitle holders to dividends, usually at a fixed annual rate, which are paid in priority to dividends on ordinary shares. These dividends are often cumulative (that is to say, if a preference dividend is passed because of an insufficiency of profits, it must be made good before any dividend can be paid on the ordinary shares in later years). Preference shareholders normally do not have voting rights; in the event of a liquidation, they rank before ordinary shareholders. (e) Bonds

A Bond is a document under seal requiring the payment of principal and interest on due dates. Bearer bonds, so called because they are payable to bearer, rather than registered in the name of a holder, are negotiable instruments to which title can be passed on transfer for value, in good faith and without notice of any defect. (f) Eurobonds

A eurobond is an instrument that evidences a long-term loan, often denominated in US dollars but which may also be in other currencies including sterling, issued by a large concern of international standing. It may carry a fixed or variable rate of interest. There is a secondary market for dealing in eurobonds and prices vary with the quality of the borrower and the prevailing rate of interest on eurocurrency deposits. The market in eurobonds goes back many years, but developed significantly after the Second World War when large amounts of US aid were given to European countries during the reconstruction period. In recent years the market has become very large indeed because of the calls made on banks to recycle petrodollars, the absence of regulation in the market and the levels of interest rates prevailing internationally.

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Finally banks may hold investments in unquoted companies. These usually represent long term holdings in subsidiaries or associated companies and often are in similar industries including other banks eg. consumer credit companies, investment or other financial institutions. These investments are made usually to promote growth particularly into other geographical areas and to widen the bank's customer base. 8.1.3 Generally Accepted Valuation Policies Investment a) Dealing/Trading Accepted policies The lower of cost and market value. This valuation must be done on a line by line basis.

This method of valuation is used to recognise the intention to hold the investments for short term capital gain and the bank's accounts should recognise this. b) Hold to redemption Historic cost but market value stated in the accounts.

Provided the ‘hold’ policy is adhered to, at redemption the proceeds will be the nominal value of the investment eg. the redemption value and the nominal value of £10,000 Treasury Bill 7-1/8% on maturity, will be £10,000. c) Hold for long term benefit Historic cost but provisions must be made for permanent diminution. Directors or market value may be stated.

Market forces acting on or profits/losses of the investee operation from year to year may give a misleading picture as to the value of an investment held for long term benefit. However, permanent diminution ie. continuing losses over a period of years, deficits on reserves or loss of material part of business will necessitate provisions to recognise a depreciation in value below cost where it is unlikely to be recouped in the foreseeable future. 8.1.4 a) Summary Investments are important constituents of a bank's asset portfolio, the most commonly held investments being: (i) (ii) (iii) (iv) (v) (vi) b) Gilt-edged securities Treasury bills Equities Preference shares Bonds Eurobonds.

Generally accepted valuation policies: (i) Dealing/trading investments valued at lower of cost and market value on a line by line basis. Investments to be held to redemption valued at historic cost but market value is stated in the accounts.


(iii) Investments held for long term benefit are valued at historic cost but provisions must be
made for permanent diminution of value.

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TEST YOURSELF QUESTIONS 1 2 3 4 What is the difference between a dealing (or trading) security and an investment security? Why do banks have investments? Is a bond always an investment security? Is an investment in a 100% owned subsidiary a liquid asset in the balance sheet?

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Card Member

Treasury Department

deal negotiated to pay FC to bank of card company

Foreign bank

Bank reimburses credit card company for settling with merchants in foreign currency Bank purchases foreign currency from another counterparty (other banks, customers, institutions)

FC Purchased Advance/ Payment Net asset and FC position Instructions sent to complete deals as agreed

F/X Counterparty

Settlements Department Account updated Card Subsystem

Settlements department ensures that Counterparty and Foreign Bank are paid as agreed

Bank Branch

Customer transactions in FC updated Merchant's bank


International Card System

Settlement made to merchant in Foreign currency

Purchase Purchase details in foreign currency Merchant POS Terminal

Card Member

Central Bank Libor Treasury Department Libor Libor Branches Profit is spread of A-B Card Services A= Libor +X B= Libor - Y Libor + Z Profit is spread of Z F/X Dealers Profit is change in F/X rate vs home currency Libor +/Other banks


Libor + change in F/X rate at time of selling FC




F/X dealers hold

Pays Interest

Receives Interest

Pays Interest

Deposits Foreign currency

Treasury Department Customer

deal negotiated to pay FC to foreign bank

Foreign bank

Bank reimburses foreign bank for advancing funds through ATM in Foriegn currency

FC Purchased Net asset and FC position
Deposit/ Withdraw Transfer

F/X Counterparties Instructions sent to complete deals as agreed

Bank purchases foreign currency from counterparties (other banks, customers, and institutions)

Subsystem Account updated Bank Branch Customer transactions in FC updated in home currency Settlement made to foreign bank in Foreign currency Settlements Department Settlements department ensures that counterparty and Foreign Bank are paid as agreed

ATM transaction carrier system

Foreign Bank ATM

Withdrawal Customer


Client Deal Confirmed Deal Confirmed Deal Ticket


Back Office


Settlements Listing

Reconciliations Department

Copy Approved Deal Ticket Computer input deal details Input Process (2 levels)

Deposit of money at Value Date

Balance reconciled

Nostro Accounts

Balance reconciled

Accounting Records updated

Funds on Value date transferred out

Accounting Department


funds on value date transferred in

Vostro of Client's Bank


Central Clearing Agent

Cheques drawn on Bank B Cheques drawn on other banks Bank B

Deposits cheque

Cheques drawn on other banks

Cheques accepted at other banks drawn on bank A

Customer accounts are updated for cheques negotiated at other banks

Bank Branch

Accounts updated

Clearing Department Bank A

Cheque sent on collection Cheque drawn on foreign bank that Bank A does not correspond with Central Clearing Agent

Foreign Bank trades cheque drawn on customer account with a draft drawn on a bank specified by Bank A

Foreign Bank


Bank draft in foriegn currency drawn on a correspondent bank


Treasury Department

For loans granted in foreign currency

Foreign bank

Bank agrees with a foreign bank to borrow an equal amount of foreign currency to match their FC loan to their customer

Loan advance/ repayment

Net asset and FC position

Instructions sent to complete deals as agreed Settlements Department Settlements department ensures that Foreign Bank is paid as agreed

Loans Subsystem Bank Branch Account updated

Net asset position

Treasury Department

Domestic Bank Funds borrowed from another bank to fund the loan


The money will be borrowed based on the assumption that on this banking day no funds are available to advance the loan


Branch Operations


Reconciliations Department

Transactions Card Services Transactions Operations Department Records Financial Control

Credit Transactions Transactions Net Asset/Liability Positions Treasury Trading

Settlements Department

Net A/L Position

Central Treasury

Strategic Planning and Limit Setting



ACCEPTANCE The bankers’ acceptance is a financing involvement. Through this facility, banks are able to provide credit, without requiring the use of their own funds, by creating a negotiable instrument. A bankers’ acceptance is an order in the form of a draft addressed by one party (the drawer) to a bank (the drawee) and accepted by that bank to pay a third party (the payee) a certain sum at a fixed future date. The bank creating an acceptance becomes liable primarily for the instrument, and all other parties are liable secondarily for generating payment to the holder, in due course. ANSWER BACK The telex users reference (numbers and letters) that comes up on the telex at the discretion of the sender. It is possible to insert answer back codes. ARBITRAGE 1 Exchange arbitrage: The process of taking advantage of the existence of different prices of the same currency at the same time but in different markets. 2 Interest arbitrage: The movement of funds out of one currency and into another for the purpose of profiting from interest rate differentials in those currencies. The process of interest arbitrage regulates the forward cost of foreign currencies. BACK-TO-BACK CREDIT This procedure arises where a customer of the bank acting as an intermediary in a trading transaction is the beneficiary under a documentary credit opened by the foreign buyer of his goods. On the strength and security of this credit, the customer’s bank agrees to open a credit for the benefit of the original supplier of the goods. As the applicant for the second credit, the customer is responsible for reimbursing the bank for payments made under it, regardless of whether or not he himself is paid under the first credit. In this way, the customer can avoid disclosing the identity of the original supplier to the ultimate purchaser. It is necessary to ensure that the documents called for under the second credit will satisfy the requirements of the first credit, in order that the seller, as beneficiary under the first credit, may be entitled to be paid within those limits.

Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

BEARER BONDS A bond for which the only evidence of ownership is possession. A bearer bond passes , by its mere delivery, the full benefits conferred by the bond, so long as the transferee takes it in good faith, for value, and without notice of any defect in the transferor’s title. If it should appear ultimately that the transferor had stolen the bond, or his title was defective in some other way, the transferee’s right to retain the bond would not be affected. BILL OF EXCHANGE An unconditional order in writing, addressed by one person to another and signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable time, a sum certain in money, to, or to the order of, a specified person, or bearer. BILLS UNDER LETTER OF CREDIT/BILLS NEGOTIATED UNDER CREDIT/PAYMENT AGAINST DOCUMENTS (BLC/BNC/PAD) In respect of sight letters of credit, the issuing bank will make payment to the beneficiary once the documents stipulated under the documentary credits have been received and the terms and conditions have been complied with. However, the applicant’s account is not debited until he takes delivery of the documents, normally on arrival of the goods in port. There is, therefore, a time lag between the point at which the issuing bank pays the beneficiary, and the point at which it is reimbursed by the applicant. In this intervening period, the amount receivable from the applicant is said to be an amount receivable in respect of BLC/BNC/PAD, sometimes called Advanced Against Merchandise (AAM). BLC/BNC/PAD – PAST DUE Once the BLC/BNC/PAD becomes due for payment by the applicant, and if such payment is not forthcoming, some banks will transfer the amount of the BLC/BNC/PAD to a “past due BLC/BNC/PAD account” (rather than debit the applicant’s account), which normally has a higher rate of interest. BILL FOR COLLECTION In this case, the bank acts merely as collecting agent. Acceptance agreement is reached between exporter and importer on the term of acceptance. The bank will, on receipt of the documents, notify the importer, who will sign the Bill of Exchange and collect the documents. He should then pay the amount due on the due date, but should he fail to do so, the bank will advise the exporter but bear no risk. BILLS DISCOUNTED A negotiable instrument that is payable at a date later than the date upon which it is bought. The instrument is bought at a value less than face value, the difference being the bank’s charges for interest and commission. BILL OF LADING A receipt for goods received for carriage to a stated destination, signed by or on behalf of a ship owner, undertaking to deliver the goods in the same condition as when he received them.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

BOND A negotiable instrument evidencing indebtedness. A legal contract sold by an issuer promising to pay the holder its face value plus amounts of interest at future dates. CALL MONEY Money lent by bankers and others at interest on the terms that it is repayable at call or on demand. CASHER’S SHEET/COUNTER SHEET A record of individual amounts paid to and by the cashier during the day, showing the opening and closing balance of cash on hand (similar to a cash-book). CEDEL A clearing system for the Eurocurrency market, which clears or handles the physical exchange of securities. Based in Luxembourg, the company is owned by several banks and operates through a network of agents. CENTRAL BANK The bank in any country that is authorised by the government of that country to control the amount of credit, supervise the operations of commercial banks, carry out the commercial business of the government (and maintain its accounts), control note issue and the country’s reserves, and preserve the value of the country’s currency on foreign exchanges. CERTIFICATE OF DEPOSIT Evidence of a deposit with a bank repayable upon a fixed date. It is a fully-negotiable bearer document transferable by delivery. The CD normally carries an interest rate marginally lower than a market rate for time deposits, reflecting its marketability. CLEARING BANK A bank that offers a full range of customer services – i.e., current, savings, and deposit accounts ; loans and overdrafts; foreign exchange; and finance. Such banks act as the clearing agents for cheques and credits in the banking system, the net balances of which are settled daily. COLLATERAL Security deposited by a third party (as opposed to primary security deposited by the borrower). CONFIRMATION A written advice of transaction exchanged by the parties to an agreement. “Our” confirmation is sent to the counter-party by the bank. “Their” confirmation is the advice sent to the bank by the counter-party.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

CONFIRMED CREDIT A credit that is opened by a bank in the importer’s country in favour of an exporter in another country is certified to the exporter through a bank in his own country. If this bank adds its confirmation to the certification, the exporter will enjoy the benefit of a confirmed credit. Not only has the issuing bank undertaken to pay the exporter against these specified documents, but a bank in his own country has also given a definite undertaking to pay, regardless of any other consideration and without recourse to the beneficiary, provided all documents are in order and the credit requirements are met. A bank thus confirming a credit will charge the opening banker an additional commission. CONSOLIDATED RISK RETURN A statement, prepared at periodic intervals, showing the total of direct and indirect risks outstanding against the bank’s customers in each class of risk for each customer. CONTRA ACCOUNT Accounts where the bank’s liability to a third party is covered by a customer’s liability to the bank for the same amount – e.g., letters of credit, guarantees, etc. CORRESPONDENT BANK A bank in one country that acts when so required for a bank in another country. The relationship is one of agency. CREDIT TRANSFER A system through which a person is able to pay money at any branch of a bank into the account of another person having an account at any branch of any bank. CROSS-GUARANTEE Security given for a loan to a parent company, or to any subsidiary in a group, that takes the form of a guarantee from each of the other companies in the group. Cross-guarantees are particularly appropriate where the banker is lending to more than one company. In the event of a liquidation, the banker will be able to prove against each company the amount of its individual debt, plus the total of its guarantees on account of all other companies. DEALERS’ DIARY The dealers’ working document, in which foreign exchange and money market transactions are recorded under their respective value dates. DEALING DATE The date upon which a deal is arranged. It is important to check this on counter-party confirmations in order to reveal suppressed/delayed deals. DEMAND DEPOSIT A deposit with a bank that can be withdrawn without prior notice.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

DEMAND DRAFT (DD) A cheque issued by one bank, drawn on another bank, and payable to a third party for a specific amount on demand. It is authenticated by authorised signature(s). DEPOSIT RECEIPT A receipt issued by bankers and others when money is lodged in a deposit account and no deposit, pass-book, or statement is issued. DIRECT DEBIT A direct claim made by a creditor on the customer’s account, to be paid by the bank on each occasion. The customer must approve this arrangement before any transfers are made. DOCUMENTARY CREDIT The best method of financing overseas trade is for the contracting parties to insert in the contract for the sale of goods a provision that payments shall be made by a banker under the provisions of a documentary credit. Under this system, a banker undertakes to pay the price of the goods, or accept a Bill of Exchange for the invoiced amount, in return for the delivery, to him by the exporter of the invoices and shipping documents (provided they conform with the details advised by the importer to the bank). The nature of the undertaking varies according to whether the credit is revocable, irrevocable, or confirmed. The issuing bank receives a percentage commission, and in most cases would expect the customer to furnish a security. The issuing banker will either advise the exporter directly, or do so through a correspondent banker in the exporter’s country. The letter of advice will state the conditions governing the credit, the nature and descriptions of the goods, the date by which the goods must be shipped, and the ports of loading and designation. The granting banker is under no obligation to honour drafts that have not been drawn within the terms of the credit, and he will be unable to debit his customer should he do so. DORMANT ACCOUNT An account that has not been used by a customer for a considerable time. The administration of dormant accounts should be separated from that of normal accounts in order to minimise the risk of manipulation by bank staff aware of the dormancy. DRAW-DOWN Disbursement of cash to a borrower under the terms of a loan agreement. Draw-down may be taken in several branches. The failure by the borrower to draw-down the facility at the due rate given in the loan agreement would normally involve the payment of a commitment fee (of approximately 0.5%) until actual draw-down takes place. EUROCLEAR International clearing system for the settlement of transactions in securities, essentially Eurobonds. It is based in Brussels and is provided under contract by Morgan Guaranty for the over 100 banks who own it.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

EURO CURRENCY A term used to describe deposits of a major world currency in a country other than that whose currency it is – e.g., Euro dollars. Throughout this transaction, the actual dollars would remain in the US; however, as borrowers and lenders conclude their agreement, various accounts in the US would be credited and debited by the sum in question. EUROPEAN CURRENCY UNIT (ECU) A multiple currency unit linked to the currencies of the six original EEC members. The investor receives payment in whichever currency is the strongest, but at its old parity. FACILITY LETTER A letter from a lending bank to a borrowing customer, confirming the terms upon which a loan has been agreed. Such a letter specifies the total sum to be lent, the rate of interest to be charged, the terms of repayment, and the security to be charged. It will also lay down certain conditions to be observed – e.g., balance sheet ratios, security margins, etc. FACTORING A specialist facility offered by some commercial banks, whereby the factor buys from his client, a trading company, its invoiced debts, becoming responsible for all credit control, sales control, and credit collection. Thus companies are able to sell their outstanding book debts for cash. A full factoring service comprises maintenance of a company’s sales ledger, credit control over the company’s customers, full protection against bad debts, and collection from debtors. Factoring is “disclosed” or undisclosed” according to whether the supplier has notified his customers that payment is to be made to the factor or not. FIXED DEPOSIT/TIME DEPOSIT/TERM DEPOSIT A sum of money placed by a customer with a bank for a specified period and at a specified rate of interest. FLOATING RATE NOTES Notes issued by a fund-raiser. These investments are dated and have the attraction of having their interest rate linked to current rates with a set minimum. They are not as freely negotiable as certificates of deposit and are dealt in secondary markets. FORWARD DEAL A deal with a value date longer than that of a spot deal. FORWARD EXCHANGE Buying or selling foreign currency in advance through the foreign exchange markets: the purchase or sale of foreign currency for delivery at a future date. FORWARD RATE The rate at which foreign currency can be bought or sold for delivery at a future time.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

FRONT-END FEE A fee payable to a bank at the inception of a long-term facility (e.g., loan, guarantee). The accounting treatment of front-end fees may have a significant effect on a bank’s income in a year in which the number of new facilities granted suffers a major increase or decrease. GAP The period, in foreign exchange transactions, between the maturities for purchases and the maturities for sales of each foreign currency. The term can also be used with reference to loans and deposits in one currency. Gap then denotes the difference between the maturity dates of the loan and the deposit. GUARANTEE An undertaking given to a bank by one person (guarantor) accepting responsibility for the debt of a principle debtor should he default. HEDGING A device used to reduce losses due to market fluctuations, by counter-balancing a current sale or purchase by another, usually future, sale or purchase. The desired result is that the profit or loss on the current sale or purchase will be offset by the loss or profit on the future sale or purchase. HIDDEN RESERVE/RESERVE FOR CONTINGENCIES/INNER RESERVE A reserve not disclosed separately in the accounts. It is usually shown as part of “current, deposit, and other accounts”. INTER-BANK RATES The interest and exchange rates at which banks deal with each other in the market. It is usually a tighter market (narrower spreads) than the markets offered on commercial transactions. INTEREST RATE DIFFERENTIAL The difference in the rate of interest offered in two currencies for investments of identical maturities. INTERVENTION Government or central bank purchase or sale of foreign exchange in an effort to hold steady or change the exchange rate in order to maintain an orderly market for the currency. INVESTMENT BANK A bank that provides long-term fixed capital for industry, in return for taking over shares in the borrowing companies in order to maintain some influence or control.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

IRREVOCABLE CREDIT A credit whose terms cannot be varied or changed without the concurrence of all parties to it. A strong exporter would normally always insist on payment by irrevocable credit. LEAD MANAGER The principal house in a syndicate making a new issue, which co-ordinates and directs the efforts of the syndicate in return for a management fee. LEADS AND LAGS The acceleration and delays in payment of disbursements due in a foreign currency, at a time when the rate of exchange of a country’s currency is rising or falling. LETTER OF CREDIT A document issued by a banker and authorising the bank to whom it is addressed to honour the cheques of the person named in the letter to the extent of a certain amount, charging these sums to the account of the grantor. The letter states the period for which the credit is to remain in force, and should be endorsed with the particulars of all drafts under the credit. LIEN The right to retain property belonging to another until a debt due from the owner of the debt to the possessor the property is paid. The ownership of the property is left undisturbed – i.e., the borrower retains ownership, but the lender has possession. LIEN LETTER A letter from a customer agreeing that the credit balance on a customer’s account is held as security for his advance on another account, and that the banker may combine the accounts without notice. LIQUIDITY RATIO The relationship between those assets of the bank that are in money or can be very quickly turned into cash, and the total balances that the customers of the bank have in their banking account – e.g., liquid assets to deposits. LIMITS Each bank has limits within which it may deal with other banks. These limits, normally set by head office, may cover: • • • • • • open exchange positions by currency amount of loans in total, by bank, country, and currency longest period of loans amount of forward exchange position by bank amount of spot exchange position by bank amount of guarantees, obligations under letters of credit, etc.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

LONDON INTER-BANK OFFERED RATE (LIBOR) The rate of interest offered on deposits with commercial banks operating in the London Eurocurrency market. LONG A surplus of foreign currency assets over foreign currency liabilities. This may be in an individual currency, or in all currencies taken together against the base currency. MANAGERS DISCRETIONARY LIMITS The limits to which a branch manager may commit the bank to lend without reference to higher authorities. MARGIN 1 2 3 The difference between the rate charged by a bank for loans and the rate allowed for deposits. An amount held by the bank as security against the issuance of a letter of credit or guarantee. A deposit of money, made in order to safeguard a broker against loss in commodities or securities transactions. The difference between the spot prices and the forward price of a currency, expressed as a premium or discount.


MATCHED A forward purchase is said to be matched when offset by a forward sale for the same or nearly the same date (or visa versa). MATURITY The date upon which a given security becomes payable to the holder in full. MONEY AT CALL AND SHORT NOTICE This item follows cash and cheques in the course of collection in the marshalling of a bank’s liquid resources in its balance sheet. The bulk of the money at call and short notice comprises money market loans usually on a day-to-day basis and at most at seven days. MONEY MARKET The market for the purchase and sale of short-term financial instruments. In this context, short-term is defined usually as less than one year.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

MORTGAGE The conveyance of a legal or equitable interest in real or personal property as security for a debt or for the discharge of an obligation. NEGOTIABLE INSTRUMENT Any instrument that satisfies the following tests: 1 2 That property in the instrument passes by mere delivery or by endorsement. A transferee taking the instrument in good faith and full value without notice of defect in the title of the transferor obtains title. No notice of the transfer need be given to the person liable on the instrument.


NOSTRO ACCOUNT A current account maintained by a home bank with the foreign bank. May be referred to as a correspondent account. OPEN POSITION The difference between assets and liabilities in a particular currency. This may be measured in an individual currency, or in all foreign currencies taken together. OPTION CONTRACT A forward exchange contract for which the rate is fixed, but which may be settled at any time between two specified dates at the counter-party’s option. OVERDRAFT Borrowing from a bank on a current account up to a maximum agreed with the bank, interest being calculated only on the daily balance outstanding. OVER-BOUGHT POSITION/LONG POSITION An over-bought position arises when the bank’s assets in a foreign currency exceeds its liabilities in that currency. OVER-SOLD POSITION/SHORT POSITION An over-sold position arises when the bank’s liabilities in a foreign currency exceed its assets in that currency. NB: It is important to establish what position(s) are being referred to. Thus, it is quite possible to be “long of the spot and short of the forward”.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

OVER-THE-COUNTER The purchase and sale of financial instruments not conducted on an organised exchange. PAR Price of 100% of a security’s face value. Principal amount at which an issuer of bonds agrees to redeem its bonds at maturity. PERFORMANCE BOND A bond for due performance issued by a bank at the request of a customer who is tendering for a contract in the building or construction industry. The bank should be satisfied that its customer is technically capable of handling the work and financially strong enough to see it through. The bank would normally take a counter indemnity or security to cover its own position. PERSONAL LOAN A bank loan to an individual, where the interest is added to the amount borrowed and the total is then repaid by a regular monthly repayment over an agreed period. PORTFOLIO Collection of financial instruments on transactions denominated in various currencies. PORTFOLIO MANAGEMENT SERVICE Management of a customer’s quoted securities by a bank. This includes the safekeeping of the securities, dealing with scrip and rights issues, the collection of dividends, and the preparation of valuations. The bank may also have discretion within pre-determined limits as to the purchase and sale of securities in the portfolio. POSITION A situation created through foreign exchange contracts in which changes in interest rates or exchange rates could create profits or losses for the operator. PREMIUM For security issues with prices greater than par value, the amount of the difference between par and the price. PRINCIPAL Par value or face amount of a security exclusive of any premium or interest; the basis for interest computations. PROJECT FINANCE The arrangement from a variety of sources of the finance which will be required to appraise, set up, and begin to operate a large capital project. Such loans would normally be made by a syndicate of lending banks.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

PROMISSORY NOTE An unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand or at a fixed or determinable future time a certain sum in money to, or to the order of, a specified person or bearer. QUOTE The market price of a given security. RED CLAUSE A clause in a documentary letter of credit designed to enable the beneficiary to draw up to 100% of the credit amount before shipping documents are presented, and even before shipment. RE-DISCOUNT The act of a person who has discounted a bill of exchange in subsequently selling to another person. REVOLVING CREDIT A credit containing a clause for an automatic renewal of the credit on a rollover basis. Thus any part of the credit used by the borrower and reimbursed to the banker within the term of the credit becomes available automatically again on such reimbursements. There is , therefore, no limit to the total of turnover, although there is a stated limit to the amount of drafts that may be outstanding at any one time. ROLLOVER A term indicating a continuance of existing credit. A limit on a rollover basis is renewed once it has been exhausted. If an interest rate is expressed to be on a rollover basis, it means that it will be negotiated at intervals – e.g., every three or six months. SAFE CUSTODY In order to keep them safe, articles of value may be left in bank strong rooms by customers . SAFE DEPOSIT Some banks may maintain a safe deposit service, where the customer himself deposits articles of value in a box or compartment to which he alone has the key. SHORT A surplus of foreign currency liabilities over foreign currency assets. This may be in an individual currency, or in all currencies taken together against the base currency.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

SHIPPING GUARANTEE If the Bills of Lading relating to a shipment are missing, the consignees may take delivery of the consignment by giving a written undertaking to indemnify the ship, her owners, and their agents against any harm arising as a result of releasing the consignment without production, and surrender of the Bills of Lading. The consignees’ bankers will guarantee the performance of such an undertaking and the guarantee so issued is called a shipping guarantee. The guarantee is normally valid for three years or until such time as it is released by the agents, normally upon production of the Bill of Lading, if sooner. SINKING FUND Repayment of debt by an issuer at stated regular intervals though purchases in the open market or drawings by lot. SOLVENCY RATIO The conventional relationship between a bank’s own capital resources and its total deposit liabilities. SPOT RATE The price of foreign currency for delivery in two business days. SQUARE A position where currency inflows and outflows are matched for a given date. STATUTORY DEPOSIT A deposit that a bank is required by law to a place with the central bank/monetary agency of the country in which it operates. The amount of such deposits is determined by regulations in force in that country. SWAPS OR DOUBLE DEALS Operations consisting of a simultaneous sale or purchase of spot currency accompanied by a purchase or sale respectively of the same currency for forward delivery. INVESTMENT SWAP An investment swap is a series of linked transactions comprising a deposit, spot exchange, loan, and forward exchange deal. The forward exchange deal is carried out as insurance against possible exchange rate fluctuations. SWAP COST OR GAIN The difference between the spot and forward rates at the time of dealing. In the case of investment swaps, it is normally quantified and apportioned over the period of the forward exchange contract.


Appendix A (cont’d.) Glossary of Banking Terms (cont’d.)

TELEGRAPH TRANSFER A payment made in international commerce by transfer of money by cable or telegraph from a bank account in one country to a beneficiary in another. The cost of the cable is charged to the customer. TERMS DEPOSITS Deposits that are repayable after a pre-determined time and not on demand. TEST OR SECURITY KEYS The code by which a bank authenticates payment instructions to its correspondents by telex or telegraph transfer. The code is normally comprised of the sum of such details as the date, a fixed number, and the number of digits in the amount. TRADE DATE The date upon which a transaction is executed. TRADER An individual who buys and sells securities with the objective of making short-term gains. TRUST RECEIPT A document signed by a customer of a bank where goods have been pledged as security for an advance. To repay the advance it is necessary for the customer to get the goods and sell them, but the documents of title that would enable him to get them are in the possession of the bank. Consequently, the bank releases the documents of title to the customer against his signature on a trust receipt, by the terms of which the customer undertakes to deal with the goods as an agent of the bank for the purposes of obtaining delivery of the goods and then selling or warehousing them. The trust letter protects the right of the banker as a pledge that he would otherwise lose when he gave up the documents of title, and protect him in the case of the customer’s bankruptcy. UNDERWRITE An agreement under which banks agree to each buy a certain agreed amount of securities of a new issue on a given date and at a given price, thereby assuring the issuer of the full proceeds of a financing. VALUE DATE The date on which funds are actually available for use in any bank account. VOSTRO ACCOUNT An account maintained abroad by a bank in the currency of the country in which the account is maintained. WASTE SHEET/JOURNAL A book of prime entry to which all the day’s vouchers (except cash transactions) are posted before they are sent to the machine operator(s) for posting to ledger cards.


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