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INTRODUCTION In general terms and from the perspective of commercial banking, treasury refers to the fund and revenue at the possession of the bank and day-to-day management of the same. Idle funds are usually source of loss, real or opportune, and, thereby need to be managed, invested, and deployed with intent to improve profitability. There is no profit or reward without attendant risk. Thus treasury operations seek to maximize profit and earning by investing available funds at an acceptable level of risks. Returns and risks both need to be managed. If we examine the balance sheets of Commercial Banks (Public Sector Banks, typically), we find investment/deposit ratio has by far overtaken credit/deposit ratio. Interest income from investments has overtaken interest income from loans/advances. The special feature of such bloated portfolio is that more than 85% of it is invested in government securities. The reasons for such developments appear to be as under:  Poor credit off-take coupled with high increase in NPAs.  Banks' reluctance to cut-down the size of their balance sheets.  Government's aggressive role in lowering cost of debt, resulting in high inventory profit to commercial banks.  Capital adequacy requirements.  The income flow from investment assets is real compared to that of loan-assets, as the latter is size ably a book-entry. In this context, treasury operations are becoming more and more important to the banks and a need for integration, both horizontal and vertical, has come to the attention of the corporate. The basic purpose of integration is to improve portfolio profitability, risk-insulation and also to synergize banking assets with trading assets. In horizontal integration, dealing/trading rooms engaged in the same trading activity are brought under same policy, technological and accounting platform, while in vertical integration, all existing and diverse trading and arbitrage activities are brought under one control with one common pool of funding and contributions. 2. FUNCTIONS OF THE TREASURY DEPARMENT IN BANKS Since 1990s, the prime movers of financial intermediaries and services have been the policies of globalization and reforms. All players and regulators had been actively participating, only with variation of the degree of participation, to globalize the economy. With burgeoning forex reserves, Indian banks and Financial Institutions have no alternative but to be directly affected by global happenings and trades. This is where; integrated treasury operations have emerged as a basic tool for key financial performance. A treasury department of a bank is concerned with the following functions:  Risk exposure management, which embraces credit, country and liquidity and interest rate risk consideration together with those risks associated with dealing in foreign exchange.  Asset and liability management, where liquidity, interest rate structures and sensitivity, together with future maturity profiles, are the major considerations in addition to managing day-to-day funding requirements.  Control and development of dealing functions.  Funding of investments in subsidiaries and affiliates.  Capital debt/ loan stock raising.  Fraud protection.  Control of investments. 3. ELEMENTS OF TREASURY MANAGEMENT 3.1 Cash Reserve Ratio / Statutory Liquidity Ratio Management CRR, or cash reserve ratio, refers to the portion of deposits that banks have to maintain with RBI. This serves two purposes. First, it ensures that a portion of bank deposits is totally risk-free. Second, it enables RBI control liquidity in the system, and thereby, inflation. Besides CRR, banks are required to invest a portion (25 per cent now) of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. The government securities (also known as gilt-edged securities or gilts) are bonds issued by the Central government to meet its revenue requirements. Although the bonds are long-term in nature, they are liquid as they have a ready secondary market. What impact does a cut in CRR have on interest rates? From time to time, RBI prescribes a CRR, or the minimum amount of cash that banks have to maintain with it. The CRR is fixed as a percentage of total deposits. Following the half percentage point reduction in CRR last week, banks are now required to maintain 10.5 per cent of their deposits with RBI. The deposits earn around 4 per cent interest, which is less than half of the average cost of funds for banks. At present, the total amount of deposits with banks is Rs 6,90,000 crore. Therefore, every one percentage point cut in CRR means the banking system will have nearly Rs 7,000 crore more available for lending. As more money chases the same number of borrowers, interest rates come down. Does a change in SLR impact interest rates? SLR reduction is not so relevant in the present context for two reasons: One, as a part of the reforms process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared with the earlier days for their statutory investments in Government securities. Second, banks are still the main source of funds for the government. Which means despite a lower SLR requirement, banks¶ investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be higher than 30 per cent despite RBI bringing down the minimum SLR to 25 per cent a couple of years ago. Therefore, for the purpose of determining the interest rates, it is not the SLR requirement that is important but the size of the government-borrowing programme. As government borrowing increases, interest rates, too, look up. Besides, gilts also provide another tool for RBI to manage interest rates. RBI conducts open market operations by offering to buy or sell gilts. If it feels interest rates are too high, it may bring them down by offering to buy securities at a lower yield than what is available in the market. 3.2 Dated Government Securities The Government securities comprise dated securities issued by the Government of India and state governments. The date of maturity is specified in the securities therefore it is known as dated government securities. The Government borrows funds through the issue of long term-dated securities, the lowest risk category instruments in the economy. These securities are issued through auctions conducted by RBI, where the central bank decides the coupon or discount rate based on the response received. Most of these securities are issued as fixed interest bearing securities, though the government sometimes issues zero coupon instruments and floating rate securities also. In one of its first moves to deregulate interest rates in the economy, RBI adopted the market driven auction method in FY 1991-92. Since then, the interest

500 cr. immediately after its issue and immediately before its redemption. with a good number of banks setting up active treasuries to trade in these securities. Its auction is on every Friday of every week. Mutual Funds and certain specified entities are allowed to access Call/Notice money only as lenders. are all the driving forces for the development of the term money market.  Interest rates in the call and notice money markets are market determined. they are issued not as securities but as entries in the Subsidiary General Ledger (SGL). coupled with the proposals for Nationalization of reserve requirements and stringent guidelines by regulators/managements of institutions.  Specified All-India Financial Institutions. insurance companies and FIs. both the borrowers and the lenders are required to have current accounts with the Reserve Bank of India. The notified amount for this auction is Rs. generally a result of high liquidity in banking system as indicated by low call rates.3 Money Market Operations The bank engages into a number of instruments that are available in the Indian money market for the purpose of enhancing liquidity as well as profitability. there are dated securities with a tenor up to 20 years in the market. Inter-Bank Term Money Inter bank market for deposits of maturity beyond 14 days and up to three months is referred to as the term money market. These.  In view of the short tenure of such transactions. The notified amount for this auction is Rs. The DFHI. No collateral security is required to cover these transactions. These securities are eligible for SLR requirements. Its auction is on every Friday of every week. would divert the funds from this market to other markets. These investors are required to hold a certain part of their investments or liabilities in government paper.  It serves as an outlet for deploying funds on short-term basis to the lenders having steady inflow of funds. Features:  The call market enables the banks and institutions to even out their day-to-day deficits and surpluses of money. in the asset/liability and interest rate risk management. The market in this segment is presently not very deep. This has been changing of late. This would be particularly so. manages and services these securities through its Public Debt Offices (PDO) located at various places. the move towards fuller integration between forex and money markets. Perhaps the most liquid of the long term instruments.  Commercial banks. These securities are repoable. the volatility in the call money market with accompanying risks in running asset/liability mismatches. The investors in government securities are mainly banks. 100 cr. These securities are open to all types of investors including individuals and there is an active secondary market. C. which is maintained by RBI. Till recently. Low yield on T-bills. the lowest risk category instruments are the treasury bills. Its auction is on every alternate Wednesday (which is a reporting week). can be traded in the market. The notified amount for this auction is Rs.maturity is in 364 days. Most of the time. 100 cr. unless the investor requests specifically. liquidity in gilts is also aided by the primary dealer network set up by RBI and RBI's own open market operations. Based on the bids received at the auctions. etc. 3. The specified entities are not allowed to lend beyond 14 days. FIs. The yield on T-bills is dependent on the rates prevalent on other investment avenues open for investors. Co-operative Banks and primary dealers are allowed to borrow and lend in this market for adjusting their cash reserve requirements. a few of the domestic players used to trade in these securities with a majority investing in these instruments for the full term.maturity is in 182 days. RBI issues these at a prefixed day and a fixed amount. At present. as a major player in the market. The development of the term money market is inevitable due to the following reasons  Declining spread in lending operations  Volatility in the call money market . Call Money Market Call/Notice money is an amount borrowed or lent on demand for a very short period. Foreign institutional investors can also invest in these securities up to 100% of funds-in case of dedicated debt funds and 49% in case of equity funds. The notified amount for this auction is Rs. They are not generally in the form of securities but in the form of entries in RBI's Subsidiary General Ledger (SGL). There are four types of treasury bills. The declining spread in lending operations.maturity is in 91 days. 364-Day T-bill . 91-day T-bill . Treasury Bills Market In the short term.in government securities has gone up tremendously and trading in these securities has been quite active.maturity is in 14 days. Intervening holidays and/or Sundays are excluded for this purpose. Features: RBI. 100 cr. These T-bills. provident funds and trusts. B. The usual investors in these instruments are banks who invest not only to part their short-term surpluses but also since it forms part of their SLR investments. Some of these instruments are as follows: A. RBI decides the cut off yield and accepts all bids below this yield.     Features:     A considerable part of the government's borrowings happen through T-bills of various maturities. FIIs so far have not been allowed to invest in this instrument. 14-day T-bill . the growing desire for fixed interest rate borrowing by corporates. which are issued at a discount. is putting in all efforts to activate this market. as an agent of the Government. should stimulate the evolution of term money market sooner than later.  It is a completely inter-bank market hence non-bank entities are not allowed access to this market. If the period is more than one day and up to 14 days it is called 'Notice money' otherwise the amount is known as Call money'. The transactions cost on T-bill are non-existent and trading is considerably high in each bill. if banks already hold the minimum stipulated amount (SLR) in government paper. 182-day T-bill . Its auction is on every alternate Wednesday (which is not a reporting week). insurance companies.

E. Low call rates would mean higher liquidity in the market. Rating Requirement All eligible participants should obtain the credit rating for issuance of Commercial Paper. the next lowest risk category investment option is the certificate of deposit (CD) issued by banks and FIs.CP can be held only in demateralised form. (CRISIL) or the Investment Information and Credit =Rating Agency of India Ltd. the company would be liable to make payment on the immediate preceding working day. whether a given agreement is termed as Repo or a Reverse Repo depends on which party initiated the transaction. from either the Credit Rating Information Services of India Ltd. Banks and All-India financial institutions are prohibited from underwriting or co-accepting issues of Commercial Paper.  The Repo rate is negotiated by the counter parties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions. (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs. Mode of Issuance CP can be issued only in a dematerialised form through any of the depositories approved by and registered with SEBI. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. CP will be issued at a discount to face value as may be determined by the issuer. Certificates Of Deposits After treasury bills. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. high net worth individuals. other corporate bodies registered or incorporated in India and unincorporated bodies.  The foreign and private banks. the maturity most quoted in the market is for 90 days. which do not have large branch networks and hence lower deposit base use this instrument to raise funds. is not less than Rs. Maturity CP can be issued for maturities between a minimum of 15 days and a maximum up to one year from the date of issue. especially. Also the interest rate on one-year bank deposits acts as a lower barrier for the rates in the market. (ICRA) or the Credit Analysis and Research Ltd. Further. It is issued at a discount to the face value. Though RBI allows CDs up to one-year maturity. A CD is a negotiable promissory note.(a) the tangible net worth of the company. A company shall be eligible to issue CP provided . F. Payment of CP On maturity of CP.4 crore and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s. Similarly. 4 crore.   Who can issue Commercial Paper (CP)? Highly rated corporate borrowers. for the purpose. investment by FIIs would be within the 30 per cent limit set for their investments in debt instruments. secure and short term (up to a year) in nature. CDs were one of RBI's measures to deregulate the cost of funds for banks and FIs. primary dealers (PDs) and satellite dealers (SDs) and all-India financial institutions (FIs) which have been permitted to raise resources through money market instruments under the umbrella limit fixed by Reserve Bank of India are eligible to issue CP. Features  The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counter party. Denominations CP can be issued in denominations of Rs.  The rates on these deposits are determined by various factors. Thus. Investment in CP CP may be issued to and held by individuals. Commercial Paper (CP) Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. Ready Forward Contracts It is a transaction in which two parties agree to sell and repurchase the same security. the participants shall ensure at the time of issuance of CP that the rating so obtained is current and has not fallen due for review. the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction offers benefits both to the seller and the buyer. Features: Allowed in 1989. Seller gets the funds at a specified interest rate and thus hedges himself against volatile rates without parting with his security permanently . However.5 lakh or multiples thereof. CP was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors. The motivation for the banks and other organizations to enter into a ready forward transaction is that it can finance the purchase of securities or otherwise fund its requirements at relatively competitive rates. (CARE) or the Duff & Phelps Credit Rating India Pvt.  CDs are issued by banks and FIs mainly to augment funds by attracting deposits from corporates.  The secondary market for this instrument does not have much depth but the instrument itself is highly secure. the holder of the CP will have to get it redeemed through the depository and receive payment from the IPA. The rate of interest agreed upon is called the Repo rate. the discount rate being negotiated between the issuer and the investor. Under ready forward deal the seller of the security is the borrower and the buyer is the lender of funds.   Growing desire for fixed interest rates borrowing by corporate Move towards fuller integration between forex and money market Stringent guidelines by regulators/management of the institutions D. trusts. the issue of CDs reached a high in the last two years as banks faced with a reducing deposit base secured funds by these means. etc. (DCR India) or such other credit rating agency as may be specified by the Reserve Bank of India from time to time. Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). On account of this reason the ready forward transaction is purely a money lending operation. Ltd. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds. banking companies. If the maturity date is a holiday. as per the latest audited balance sheet.

will be received by the bank. With the plugging of loophole in the operation. with approved institutions (viz. Accordingly. 3. If the bank needs fund during the currency of the bill then it can rediscount the bill already discounted by it in the commercial bill rediscount market at the market related discount rate. on each payment date that occurs during the swap period-cash payments based on fixed/floating and floating rates. The liquidity support is presently given to the Primary Dealers for a fixed quantum and at the Bank Rate based on their bidding commitment and also on their past performance. Thus. 3. 2. Commercial Banks. Uses of Repo  It helps banks to invest surplus cash  It helps investor achieve money market returns with sovereign risk. These bills are called trade bills. In addition to Treasury Bills. thus increasing the number of eligible non-bank participants to 64. cash payments based on contract (fixed) and the settlement rate. are made by the parties to one another. 4. G. Such contracts generally involve exchange of µfixed to floating µor¶ floating to floating rates of interest. The relaxations over the years made by RBI with regard to repo transactions are: 1. This procedure was also subsequently dispensed with and Reserve Bank of India began giving liquidity support to PDs through their holdings in SGL A/C. The RBI introduced the Bills Market scheme (BMS) in 1952 and the scheme was later modified into New Bills Market scheme (NBMS) in 1970. the conditions have been relaxed gradually. RISK MANAGEMENT INSTRUMENT FOR TREASURY MANAGEMENT 4. While inter-bank Repos were being allowed prior to 1992 subject to certain regulations. Hence permission of such entities to participate in call/notice money market will be withdrawn from December 2000. If the bill is payable at a future date and the seller needs money during the currency of the bill then he may approach his bank for discounting the bill. In terms of instruments. both for absorbing liquidity and also for injecting funds into the system. introduced by RBI in June 2000(Details given below). etc. repos have also been permitted in PSU bonds and private corporate debt securities provided they are held in dematerialised from in a depository and the transactions are done in a recognised stock exchange. The maturity proceeds or face value of discounted bill.). RBI introduced a system of daily fixed rate repos from November 29. primary dealers who often hold large inventories of tradable government securities are also active players in the repo and reverse repo market. Commercial Bills Bills of exchange are negotiable instruments drawn by the seller (drawer) of the goods on the buyer (drawee) of the goods for the value of the goods delivered. Purchase and sale price should be in alignment with the ongoing market rates 2. Mutual Funds. Apart from inter-bank repos RBI has been using this instrument effectively for its liquidity management. 5. for a specified period from start date to maturity date. These DUPNs are sold to investors in convenient lots of maturities (from 15 days upto 90 days) on the basis of genuine trade bills. the corresponding amount should be reduced from the investment account of the seller. the ready forward transactions are often also resorted to manage short term SLR mismatches. Reserve Bank of India was earlier providing liquidity support to PDs through the reverse repo route. The major players in the repo and reverse repurchase market tend to be banks who have substantially huge portfolios of government securities. from the drawee. the Reserve Bank would move towards a pure inter-bank (including PDs) call/notice money market. Besides banks. RBI has further widened the scope of participation in the repo market to all the entities having SGL and Current with RBI. With a view to absorbing surplus liquidity from the system in a flexible way and to prevent interest rate arbitraging. Internationally. In view of this non-bank entities will be allowed to borrow and lend only through Repo and Reverse Repo.  RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system. 4. A Forward Rate Agreement (FRA) is a financial contract between two parties to exchange interest payments for a µnotional principal¶ amount on settlement date. These trade bills are called commercial bills when they are accepted by commercial banks. The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills.. Mumbai. on the settlement date. Under the scheme. Development Financial Institutions. In addition to pure funding reasons. all central and State Government securities are eligible for repo. RBI has prescribed that following factors have to be considered while performing repo: 1. there were large scale violation of laid down guidelines leading to the µsecurities scam¶ in 1992. Primary Dealer. It was indicated in the µMid-Term Review¶ of October 1998 that in line with the suggestion of the Narasimham Committee II. So the need for physical transfer of bills has been waived and the bank that originally discounts the bills only draws DUPN. are made by the parties to one another. Accordingly.(thereby avoiding any distressed sale) and the buyer gets the security to meet his SLR requirements.1 Interest Rate Swaps And Forward Rate An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a µnotional principal¶ amount on multiple occasions during a specified period. No sale of securities should be affected unless the securities are actually held by the seller in his own investment portfolio. . Repos are versatile instruments and used extensively in money market operations. For any additional liquidity requirements Primary Dealers are allowed to participate in the reverse repo auction under the Liquidity Adjustment Facility along with Banks. Repos and Reverse Repo are resorted to by the RBI as a tool of liquidity control in the system. which were originally discounted by them. Immediately on sale.  It helps borrower to raise funds at better rates  An SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously. this led Government and RBI to clamp down severe restrictions on the usage of this facility by the different market participants. The settlement rate is the agreed bench-mark/ reference rate prevailing on the settlement date. the RBI introduced an instrument called Derivative Usance Promissory Notes (DUPN). discounted by the discounting bank. 1997. Central/State Govt securities). Besides these players. The securities under repo should be marked to market on the balance sheet date. commercial banks can rediscount the bills. PDs are allowed to undertake both repo/reverse repo transactions. 4. With the intention of reducing paper movements and facilitate multiple rediscounting.

then it should ensure that the risk taken is firstly manageable and secondly it does not get transformed into yet another undesirable risk. Volatility 2. The present interest rate restructuring taking place in the Indian markets is a very good example of this aspect. Consequently the loss of interest income on assets is likely to be higher than the reduction in the interest cost of deposits leading to lower spreads. The parties should appropriately change the Schedule to the agreement according to the terms and conditions settled between them. there are short term fluctuations which are to be considered in deciding on the mix of assets and liabilities. affect decisions regarding the type and the mix of assets/liabilities to be maintained and their maturing periods. which has further stimulated the growth in the fund raising activities. meeting liquidity needs and acquiring required capital. it can be seen that the affect of fluctuations in the short term have a greater impact since the adjustment period is very short. For instance. Thus a comprehensive ALM process aims on profitability and long term viability. The developments that have taken place since liberalization have led to a remarkable transition in the risk profile of the financial intermediaries.Scheduled commercial banks (excluding Regional Rural Banks). the industry profile and the exposure limits for the same. Prepayment Risk The fluctuations in the interest rate may sometimes lead to prepayment of loans. The transactions for market making purposes should be marked to market (at least at fortnightly intervals). there has also been a remarkable shift in the features of the sources and uses of funds of the banks. Types Of Interest Rate Risks The sensitivity to interest rate fluctuations will arise due to the mixed affect of a host of other risks that comprise the interest rate risk. Product Innovations 3. 2) Documentation: The counterparties should sign ISDA master agreement before entering into a swap deal. The interest rate in the call money market. With the rise in the demand for funds. many banks borrowed funds at high rates. The 1994 volatility witnessed in the Indian call money market explains the presence and the impact of volatility risk. Interest Rate Risk Due to the very nature of its business. The parties should make clear distinction between swaps that are entered into for hedging their own balance sheet positions and more which are entered into for trading. has been lowering the Statutory Cash Reserve Ratio for banks in a phased manner from 12% to 8% since 1996. credit risk and contingency risk also form a part of the ALM. in a situation where the interest rate is declining. This phenomenon will. As stated earlier. Every time the CRR is lowered. which will lower the marginal costs of funds. The significance of ALM to the financial sector is further highlighted due to dramatic changes that have occurred in recent years in the assets (uses of funds) and liabilities (sources of funds) of banks. Also a suitable counterparty limit for entering into IRS/FRA has to be fixed. The Reserve Bank of India which is the apex body regulating the Indian monetary system. Guidelines inter alia include directions for classification of various assets and liabilities. Banks/FIs/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures. However. Rate Level Risk During a given period there is possibility for restructuring the interest rate levels either due to the market conditions or due to regulatory intervention. The risk that arises due to this reduction can be understood from the fact that the revised rates of interest will be applicable to all the new deposits. in the long run. competition has narrowed down the spread of banks. Rules for entering into IRS/FRA: The party intending to enter into IRS/FRA will have to collect all information/documents relating to status of the counter party. Mutual funds and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own balance sheet management or for market making. 1) Status of the Counter party: Before entering into a deal. This not only has led to the introduction of discriminate pricing policies. The changes in the profile of the sources and uses of funds are reflected in the borrowers¶ profile. However. 2. any cash inflows that arise due to prepayment of loans will have to be redeployed at a lower rate invariably resulting in lowered yields. which had substantially reduced their profits. the affect will be seen on all the existing assets. a bank should accept interest rate risk not by chance but by choice. and frequency of evaluation of exposure. In India. the post liberalization witnessed a rapid industrial growth. 3. parameterisation of various associated market risks. first determine whether the counterparty has legal capacity. 3) Accounting of IRS/FRA: The parties can enter into swap deals for hedging interest rate risk on their own portfolio or for market making. 1994. A 2% cut in the CRR from 10% to 8% in the Busy Season Credit Policy announced in October 1997 was immediately followed by a cut in the PLR/interest rates of Banks and FI¶s. primary dealers (PDs). and those for hedging purposes could be accounted for on accrual basis. However in the deregulated environment. power and authority to enter into an interest rate swap transaction. there is an increase in the liquidity which further results in lowering of the interest rate levels. This is especially essential for interest rate risk management. which generally hovered around 5-7 %. interest rate structure for deposits and advances. etc. Interest rate risk is the gain/loss that arises due to sensitivity of the interest income/interest expenditure or values of assets/liabilities to the interest rate fluctuations. . Regulatory environment 4. duly executed swap agreements etc. 4. Volatility Risk In additions to the long run implications of the interest rate changes. While managing these three risks forms the crux of ALM. 1. Board resolution for authorisation of swap deals and signatures of authorised persons should be obtained and scrutinised. While some banks defaulted in the maintenance of CRR. Enhanced awareness of top management RBI GUIDELINES ON ALM The Reserve Bank Of India in Feb 1999 has issued comprehensive guidelines for banks for Asset Liability Management. Significance Of ALM The main reasons for the growing significance of ALM are: 1. the pricing policies and thereby the business volumes. exchange rates and the liquidity position of the bank. The process of ALM has to be carried out against many balance sheet constraints. the focal point in managing any risk will be to understand the nature of the risk. These risks when segregated fall into the following categories. zoomed to 95% within a couple of weeks during September. the risk will acquire serious proportions in a highly volatile market when the impact will be felt on the cash flows and profits. And when the bank has to take a risk as a choice.2 Asset Liability Management ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates. The Memorandum and Articles of Association. but has also highlighted the need to match the maturities of the assets and liabilities. which amongst others include maintaining credit quality. Thus.

while the yields from the bonds will be14. A call option is generally exercised in a declining interest rate scenario. For instance. the yield on 10 yr government security came down only by 30bp. will have to face greater replacement costs. .2 where. The objective of this method is to stabilize/improve the net interest income in the short run over discreet. highlights on the gap that is present between the RSAs and the RSIs. the cost of funds for 1 yr bank deposits will be 9%( 1 % less than the prevailing Bank Rate 10%). RSG = Rate Sensitive Gap based on maturity The gap so analyzed can be used to cut down the interest rate exposure in two ways. Maturity Gap Method: This asset-liability management technique aimed to tackle the interest rate risk. there will be a 1 percent fall in the rate of in the rate of interest for both assets and liabilities. If the bank rate is cut by 1 percent. A call option is exercised by an issuer to redeem the bonds before maturity. it is quite common to find that the interest rates on term deposits rise fall with changes in interest rates though the same does not effect the interest paid on savings bank. these intermediate cash flows when received may have to be reinvested at a lower rates resulting in lower yields. according to the gap method. the maturity periods of the same and the gap period. This variability in the returns from the reinvestments due to changes in the interest rates is called the reinvestment risk. 5. Reinvestment Risk The risk can be associated to the intermediate cash flows arising due to the payment of interest.4. In reality.. These two options expose to a risk when the interest rate fluctuate. which issue the bonds. installments on loans etc.55-9) is available. These risks will affect the income/expenses of the bank¶s asset/liability portfolio. 6. This rate remains constant irrespective of any amount of fluctuation in the interest rate of the bank. Similarly.25 percent. on the assets and liability spreads of 5. The bank can use it to maintain/improve its net interest income for changing interest rates. the market may also perceive the rate fluctuations differently for the long-term interest rates and the short-term interest rates. Basis Risk When the cost of liabilities and the yields of assets are linked to different benchmarks resulting in a floating rate and there are no simultaneous matching movements in the benchmark rates. In either way. the banks. This. With these floating rates of interest. Due to the volatility in the interest rates. During a selected gap period. Thus.05%. the spread will increase to 6. Alternatively. all the RSAs and RSLs are grouped into 'maturity bucket' based on the maturity and the time until the first possible re pricing due to change in the interest rate. Firstly. Eq.25%. Similarly. Assume that there is a 1% cut in the bank rate. This might eventually lead to a fall in the interest rate by less than 1 percent. The RSG will be positive when the RSAs are more than the RSLs. consider the differential interest rate loan extended by banks. As a result of this interest rate change.55% (14. 3. The presence of the above mentioned risk would either individually or collectively result in interest rate risk. This will affect the bank if it invests in such bonds since the intermediate cash inflows will have to be reinvested at a lower rate. it may not be the case basically due to two main reasons. For instance. which has an interest rate of 4 percent.75 percent fall in the short term interest rates while the long-term rates may witness a mere decrease by 0. which has to be considered in order to assess the real interest cost/yields. however. The gap is then calculated by considering the difference between the absolute values of the RSAs and the RSLs. This occurs because the changes in the nominal interest rates may not match with the changes in inflation. is not uniform. Approaches Adopted To Quantify Interest Rate Risks:  Maturity Gap Method  Rate Adjusted Gap  Duration Analysis  Hedging  Sensitivity Analysis  Simulation and Game Theory. thereby bringing down the return on the Easy Exit Bond to 14.75%. Having chosen the same.5% over 10 yr government bond of 13. However this may not be the case if the market perception for the decline in the interest rate is short-term in nature. it may include call/put options.1 Gap Ratio = RSAs / RSLs «««««««««««««««««Eq 3. Call/Put Risk Sometimes when the funds are raised by the issue of bonds/securities. when the investor exercises the put option in an increasing interest rate scenario. Consider the following illustration to understand the approach. which is mathematically expressed as: RSG = RSAs ± RSLs «««««««««««««««««. it will lead to a decrease/increase in the spreads. This will bring down the cost of funds to 8%. While the bank rate declined by 1%. consider that the funds raised by way of 1 yr bank deposits are invested in the Easy Exit Bond of the IDBI flexi bond issue. negative when the RSLs are in excess of the RSAs and zero when the RSAs and RSLs are equal. To explain this further. Real Interest Rate Risk Yet another dimension of the interest rate risk is the inflation factor. These intermediate cash flows arising from a security/loan are usually reinvested and the income from such reinvestments will depend on the prevailing rate of interest at the time of reinvestment and the reinvestment strategy. which are set as a benchmark for assets/liabilities. Further. 7. the basic assumption of this model is that there will he an equal change in interest rates for all assets and liabilities. For instance rate fluctuation may lead to a 0. the maturity gap method suggests various positions that the treasurer can take in order to tackle with the rising/falling interest rate structures. it leads to basis risk. periods of time called the gap periodsThe first step is Thus-to select the gap period which can be anywhere between a month to a year. the market perception towards the change in the interest rate may be different from the actual rise/fall in the interest rates. The second reason for differential rise/fall in interest rates of assets/liabilities can be the presence of a certain regulation. thereby affecting even the market value of the bank. Rate Adjusted Gap The Maturity Gap approach assumes a uniform change in the interest rates for all assets and liabilities. further. while the put option is exercised by the investor to seek redemption before maturity. when the change in the interest rates. will also have an impact on the value of assets and liabilities of the bank.55% which is 1. assume that the return on 10 yr government bond has also come down to 12. otherwise adopt a speculative strategy wherein by altering the gap effectively depending on the interest rate forecasts net interest income can be improved.25%. Based on these outcomes. Some of the approaches used to tackle interest rate risk are given below and a discussion on the same is followed. In this case. As mentioned earlier.

These two methods distinguish from each other in their strategically approach to eliminate liquidity risk. the easier method of financing the assets. Thus. While the fundamental approach aims to ensure the liquidity for long run sustenance of the bank. However. the Rate Sensitive Gap calculated in Duration Analysis is based on the duration and not the maturity of the assets and liabilities. especially in a situation where there is a maturity mismatch. it is essential to understand the concept of liquidity management. In addition to this. Thus. Sensitivity Analysis: The sensitivity of an asset/liability can be assessed by the quantum of increase/decrease in the value of the assets/liabilities of varying maturities due to the interest rate fluctuations. II. Yet another means of managing the interest-rate risk is by hedging with the use of derivative securities. with the help of duration. medium and log-term assets and liabilities. An intricate part of fund management is liquidity management. Further action will be taken to manage the gap so as to restrict the interest rate risk. This situation occurs as the floating rate passes the burden of the interest-rate risk on the borrower. For instance. so is liquidity. Efficient matching of prices to manage the interest rate risk does not suffice to meet the ALM objective. the bank should continuously monitor its liquidity position in the long run and also on a day-to-day basis. the affect of rate fluctuation on the NIM and the market value of the assets/liabilities of a bank can be assessed further by computing the Duration Gap for the portfolio of its assets and liabilities. which is represented by the quality and marketability of the assets and liabilities. Duration Analysis concentrates on the price risk and the reinvestments risk while managing the interest rate exposure. hedging proves to be an effective method to manage the interest rate risk. Though this process of price matching can be done well within the risk/exposure levels set for rate fluctuations it may. This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable. Before attempting to analyze the elimination of liquidity risk. however. The core activity of any bank is to attain profitability through fund management i. Consider the following illustration 3. originates from the potential inability of the bank to generate cash to cope with the decline in liabilities or increase in assets. Liquidity management relates primarily to the dependability of cash flows. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. In a situation where there is an unexpected change in the interest-rate structure or when interest-rate forecasting becomes a difficult task. In this approach all the rate sensitive asset's and liabilities will he adjusted by assigning weights based on the estimated change in the rate for the different assets/liabilities for a given change in interest rates. Duration Analysis studies the affect of rate fluctuation on the market value of the assets and liabilities and net interest margins (NIM). futures and options. Fundamental Approach. exposes the firm to liquidity risk. Duration Analysis One of the limitation of the Maturity Gap approach is that it ignores the time value of money for the cash flows while determining the gap. simulation is done by varying the interest rate structures to predict the short/medium/long-term implications of the same. . a proper understanding of the hedging mechanism is a must for the effective usage of the derivative instruments. the concept of duration helps in immunizing the interest rate risk by holding an investment till the end of duration instead of maturity Having determined the duration. Due to these features. As seen earlier. The underlying implication of this interlinkage is that rate fluctuations may lead to defaults severely affecting the asset-liability position.e. Further in a highly volatile situation it may lead to liquidity crisis forcing the closure of the bank. Working towards this end. Though the management of liquidity risk and interest rate risks go hand in hand. while management of the prices of assets and liabilities is an essential part of ALM. to monitor the impact of rate fluctuation on NIM using duration. Liquidity. while elimination risk does result in long-term sustenance. Simulation and Game Theory: Given the expected changes in the short and the long-term operative environment Game Theory simulates and forecasts the future trends. swaps. Using this concept the expected risk and rewards of the different asset and liability classes are given along with the risk sensitivity and gap between the short. acquisition and deployment of financial resources. Then.4 Liquidity Risk Management: While introducing the concept of asset-liability management it has been mentioned that the object of any ALM policy is twofold ± ensuring profitability and liquidity. The sensitivity model then suggests the assessment of the gap between the assets and liabilities having a similar sensitivity index to the interest rate fluctuation. 4.4 Hedging It is often felt that a floating rate mechanism can minimize the interest-rate risk. Based on the sensitivity. however. the technical approach targets the liquidity in the short run. both I flows and outflows and the ability of the bank to meet maturing liabilities and customer demands for cash within the basic pricing policy framework. it should however be noted that the possibility of the interest rate risk getting transformed into credit risk due to this mechanism is always present. This approach seems to be a better alternative. This again requires a proper benchmark for the interest rates and also an active floating rate market. when liabilities are mostly short-term in nature and assets are long term. While managing these two risks. the cause and effect of liquidity risk are primarily linked to the nature of the assets and liabilities of the bank. The interlinkage between the interest rate risk and the liquidity of the firm highlights the need for maturity matching. Technical Approach. rather than trying to match the maturing periods is by the use of derivative securities. there is. there are certain prerequisites for the effective utilization of the hedging instruments and their relating operations. Approaches: Given below are two approaches that relate to these two situational decisions: I. In such a scenario. the Rate Adjusted Gap methodology seems to be superior than the Maturity Gap methodology. lest it may lead to an overall increase in the risk. irrespective of whether they have long term or short term implications do effect the asset-liability position of the bank which may further affect its liquidity position. However. Price matching should be coupled with proper maturity matching. Though this is true. All investment and financing decisions of the bank. Attending to this limitation of the Maturity Gap approach is the Duration Gap Method. viz. Liquidity risk hence. First and foremost is the existence of a market that is deep and highly liquid. the bank generally maintains profitability/spreads by borrowing short (lower costs) and lending long (higher yields). the two approaches supplement each other in eliminating the liquidity risk and ensuring profitability. place the bank in a potentially illiquid position. all the assets/liabilities are regrouped.Having done away with the assumption of a uniform change in interest rates of assets/liabilities. a phenomenal difference in the approach to tackle both these risks. the method followed is similar to the one used in maturity gap approach. In the first case.

deposits and float funds. which are sure to be withdrawn during the period for which the liquidity estimate is to be made. the amount of liquidity is given as a percentage to the total working funds. adverse clearing balances or any other reasons. Working Funds Approach and the Cash Flows Approach are the two methods to assess the liquidity position in the short run.e. it also advises the bank on its investments and borrowing requirements well in advance. Technical Approach: As mentioned earlier. Thus. In this approach. The bank can dispose these secondary reserves to honor demands for deposit withdrawals. Working Funds Approach: Under this approach. are categorized as vulnerable deposits. due to its very nature of being owners¶ capital will be nil. When asset management is resorted to for liquidity. it will be through liquidation of secondary reserves. liquidity position is assessed based on the quantum of working funds available to the bank. This implies that liquidity can be imparted into the system either by liability creation or by asset liquidation. most of the liquidity is generally attained from the secondary reserves. Discussed below are these two models of technical approach used for liquidity risk management. When asset management is resorted to. The bank can arrive at this percentage based on its historical performance. The underlying implications of this process will be that the bank mostly will be investing in long-term securities /loans (since the short-term surplus balance will mostly be in a deficit position) and further. raised from the corporate high net worth clients of the bank. Included in this category of volatile funds are current deposits of corporates that also have a high degree of variability. which focuses on the sources of funds. Thus in liability management a proposal may be passed even when there is no surplus balance since the bank intends to raise the required funds from external sources. which include those assets held primarily for liquidity purposes. the liquidity requirements of which depend on the maturity profile. which when converted into cash carry little risk of loss in their value. The latter approach goes a step forward and forecasts the cash flows i. the liquidity requirements are generally met from primary and secondary reserves. Further. The liquidity for the owned funds component. Due to the nature of the volatile funds. it can be observed from the operations of the bank. Since working funds reflect the total resources available with the bank to execute its business operations. they can also be converted into cash prior to their maturity at the discretion of the management. that there will be a certain level up to which the funds are stable i. These include. the bank will have to assess the liquidity requirements for each of the components of working funds. it is the cash flows position that needs to be tackled. II. Of the two strategies available in fundamental approach. which eve suite the situation. This is possible mainly due to the flexibility in the cash reserve balances (statutory cash reserves are required to be maintained only on a daily average basis for a reserve maintenance period). the bank should categorize them into different segments based on the withdrawal pattern. The bank should on the one hand be able to raise funds at low cost and on the other hand ensure that the maturity profile of the instrument does not lead to or enhance the liquidity risk and the interest rate risk.e. the bank can have a segment-wise break up of the working funds to arrive at the percentage for maintaining liquidity. the entire quantum of savings deposits cannot be considered as vulnerable. Asset Management: Asset management is to eliminate liquidity risk by holding near cash assets i. However. A very good example of this type of deposits is the savings deposits. These secondary reserves are highly liquid assets. However. etc. the level below which the funds will not be . Liquidity in the short run is primarily linked to the cash flows arising due to the operational transactions. they can be held as second line of defense against daily demand for cash. Thus. Here the bank is not maintaining any surplus funds. which can be turned into cash whenever required. Thus apart from assessing the liquidity requirements. Primary reserves refer to cash assets held to meet the statutory cash reserve requirements (CRR) and other operating purposes. Of these two approaches. when technical approach is adopted to eliminate liquidity risk. it is understood that while asset management tries to answer the basic question of how to deploy the surplus to eliminate liquidity risk. The second component of working funds is deposits. All deposits based on their maturity fall under the following three categories:  Volatile Funds  Vulnerable Funds  Stable Funds Volatile funds include those deposits. The working funds comprise of owned funds. 1. the bank will have to invest borrow the surplus/deficit balances to adjust the liquidity position. it will also fetch higher yields due to the long-term investments. The two alternatives available to control the liquidity exposure under this approach are Asset Management and Liability Management. liability management tries to achieve the same by mobilizing additional funds. estimates any change in the deposits withdrawals credit accommodation etc. but tries to achieve the required liquidity by borrowing funds when the need arises. For instance. prior to assessing the liquidity requirements of these deposits. they demand almost 100 percent liquidity maintenance since the demand for funds can arise at any time. On an average. the former concentrates on the actual cash position and depending on the factual data. it forecasts the liquidity requirements. Fundamental Approach: Since long run sustenance is driving factor in this approach. Based on the position of the limit arrived as above and the available liquidity. A prudent way of tackling this situation can be by adjusting the maturity of assets and liabilities or by diversifying and broadening the sources of funds. However. The probability of these funds being withdrawn before or on their maturity is high. Assets that fall under this category generally take the form of unsecured marketable securities. it will not depend on its liquidity position/surplus balance for credit accommodation/business proposals. Though it involves a greater risk for the bank. the cost and the maturity of the instrument used for borrowing funds play a vital role in liability management. Though primary reserves do not serve the purpose of liquidity management for long period. Deposits. short-term deposits like the 30 days deposits. Instead of a consolidated approach. the bank tries to tackle /eliminate the liquidity risk in the long run by basically controlling its assets-liability position. Liability Management: Converse to the asset management strategy is liability management. sustenance of such high spreads will depend on the cost of borrowing. Thus. This approach of forecasting liquidity requirement takes a broad overview of the liquidity position since the working funds are taken as a consolidated figure.e. sale of securities from the investment portfolio can enhance liquidity. those assets. technical approach focuses on the liquidity position of the bank in the short run. The bank should know its cash requirements and the cash inflows and adjust these two to ensure a safe level for its liquidity position.I. which are likely to be withdrawn during the planning tenure.

branch networking. when the forecasting period is chosen as a month. Similarly when the planning horizon is too short. These include cash outflows for installation of the necessary information system that collates and maintains the data necessary for forecasting. Hence. These forecasting costs can further be classified into recurring costs and non-recurring costs. there are certain recurring costs occurring on a regular basis. There are various factors both external and internal to the bank which have an impact on the forecasted cash flows. The bank should ensure that the planning horizon for estimating the liquidity position should neither be too long or too short if the benefits of forecasting are to be reaped. the bank will now have to estimate the average cash and bank balances that are to be maintained. which are the third component of the working funds. Hence. This difficulty in the forecasting of cash flows coupled with the mismatches arising due to the maturity pattern of assets and liabilities result in the liquidity risk. In order to manage the intra-month liquidity problems. which needs no explanation. it is the decision regarding the planning horizon for the forecasts and secondly. a few months to a quarter/half-year period. Following such decisions will be the assessment of the liquidity position based on the forecasts made for the cash inflows and outflows. the liquidity requirements to meet the maturity of the vulnerable funds will be less than 100 percent and varies depending upon the risk-return policy of the bank. there should always be a surplus balance. Based on the working funds.  Lay down the range of variance that can be taken as the acceptance level. a dynamic figure since it depends on the working funds that may keep changing from time to time. This objective can. which occur when the bank initiates the cash forecasting process. To tackle such a situation. On the other hand. by their nature fall under this category. the costs involved in forecasting. the stable portion of the savings deposits fall under this category. However. This percentage level is based on forecasts. These deposits have the least probability of being withdrawn during the planning period and hence the liquidity to be maintained to meet the maturing stable deposits will also be lower when compared to the other two types of deposits. when the bank plans to forecast its cash position for every month during the planning horizon of. Thus. Having obtained the consolidated/component-wise working funds. these three factors have a direct influence on the forecasting costs. involves expenditure. The basic steps involved in this process are as follows:  Estimate anticipated changes in deposits  Estimate the cash inflows by way of loan recovery  Estimate the cash outflows by way of deposit withdrawals and credit accommodations  Forecast these for the end of each period  Estimate the liquidity needs over the planning horizon The most critical task of liquidity management is predicting the expected cash inflows coming by way of incremental deposits and recovery of credit and the outflows relating to deposit withdrawals and loan disbursals. etc. it is essential that the benefits drawn by the bank from such forecasting should be substantially large to give some residual gains after meeting the forecasting costs. The other major task of liquidity management is to manage this liquidity gap by adjusting the residual surplus/deficit balances. Similarly. There are. Firstly. This acceptance level is. say a year. 5. forecasting periods within the planning horizon and the details of information required for forecasting. Float funds. consolidated or component-wise. accuracy levels when a bank forecasts cash outflows by way of deposit withdrawals and credit disbursals are fairly high. it will definitely have to incur more expenditure since data has to be collated from such a wide network accurately and at regular intervals. the residual of the deposit base after segregating them into the above two categories will fall under the stable funds category. trend can be established based on historical data about the change in the deposits and loans. the bank will have to assess the cash balances/ liquidity position in the following manner:  Lay down the average cash and bank balances to be maintained as a percentage of total working funds. Forecasting cash flows to assess and manage the liquidity position of the bank. INVESTMENT BORROWING DECISIONS Assessment of the liquidity gap based on the forecasts is essentially one aspect of the liquidity management. the bank should decide on a period which will not affect the forecasted cash flows to a large extent and at the same time will enable it to make optimal investment-borrowing decisions.withdrawn. Banker¶s cheques. the cost of forecasting will be more as compared to the expenditure incurred for forecasting will be more as compared to the expenditure incurred for forecasting for every quarter/half-yearly period. 100 percent liquidity will have to be provided for the variable component. The bank should first decide on the planning horizon that suits its operational style and then based on the cost constant decide on the number of forecasting periods and other such details. In such a scenario. be attained only if the bank makes prudent investment/borrowing decisions to manage the surplus/deficit. Non-recurring costs are those.e. which may be presented for payment at any time. Most of the term deposits. are much similar to the volatile funds. In this process. Thus. which include the man-hours spent. when compared to the cash inflow forecasts relating to loan repayments and deposit accretion. Thus the process of forecasting cash flows with a high degree of accuracy holds the key to risk management. it is always better for the bank to consider that the deficit occurs at the beginning of the period while the surplus occurs at the end of the period. data transmission costs and the maintenance of the systems used for this process. decisions relating to borrowings and investments may not be effective enough to increase profitability. however. Hence. By nature. Thus. however. however. it is advisable for the bank to set up a variance range for acceptance depending on its profitability requirements. as long as the average balances vary within this tolerance range. a few factors which must be considered before deciding on the deployment of excess funds/borrowings for meeting the deficit which are given below:  Deposit Withdrawals  Credit Accommodation  Profit fluctuation . Considering the high costs associated with cash forecasting. 2. As explained above. These funds are generally in transit and comprise of DD¶s. Considering these factors. These costs incurred in forecasting further depend on three important factors viz. this segment also has a minimum level over and above which the variability occurs. All estimates are generally given as at the beginning of the month or at the end of the month and are silent upon the fluctuations that may occur during the month. Cash Flows Approach: This method of forecasting liquidity tries to eliminate the drawback faced in the Working Funds approach by forecasting the potential increase/decrease in deposits/credits accommodation. however. profitability and liquidity are ensured. The planning horizon of a bank may be a financial year or a part of it i. the accuracy levels of which vary depending on the factors affecting the cash flows. Any balance beyond this range will necessitate corrective action either by deploying the surplus funds or by borrowing funds to meet the deficit. Before proceeding to discuss about the cash flows approach it is essential to understand two important parameters that relate to the approach. This average balance can be maintained as a percentage to the total working funds. when the forecasts are made for a long period they might actually not remain the same thereby affecting all the decisions that have been taken based on such forecasts. funds should be provided to meet the deficit balance at the beginning of the forecasting period. This can be explained by the fact that if the bank has a wide branch network. Higher costs are involved when detailed information is sought. Finally.

e. While deposit withdrawals must be honored immediately. If the bank decides to go for liability management then the investment policy ill be long term. In such a case. Securitisation can in fact be taken up on a continuous basis to supplement the other approaches. how to meet the deficit cash balances. securitisation can impart liquidity on a continuous basis and has little or no relation to be surplus deficit balances. While the bank may use asset management or liability management in their investment decisions they may nevertheless face certain critical charges in their operational environment which make the strategic policies unsuitable. the shortfalls can be met either by disinvesting the securities or by borrowing funds from the market. 7. While doing this.e. These occurrences explain the fact that the long-term investments do give higher yields than short-term investments.as there is a surplus arising at the end of June. May and June. are the Baumol Model and the Miller and Orr Model. There are generally 2 options available to the ban while it makes its investment decisions. On the contrary when the profits are showing increasing growth rates. This further improves its profitability levels. aggressive/conservative. a decrease in NIM. Influencing the strategic issues of bank¶s investments are the tactical issues. Hence the bank should make optimum use of its idle funds by investing in such a way that the yields earned are greater. Liquidity is further influenced by the fluctuation in the business profits of the bank. SECURITIZATION Yet another method of imparting liquidity into the system by way of securitisation. the criteria while taking such decisions will be to increase yields on investments and lower the costs of borrowings. Satisfactory credit accommodation ultimately results in more business for the bank. provide for deposits withdrawals and secondly to accommodate the increase in credit demands.The liquidity level to be maintained by a bank should firstly. Implies that if the bank¶s strategic policy is liability management. which might affect its liquidity position. It might thus resort to gap management. then the surplus of Rs 19 cr. a remarkable difference in this strategy used in this approach when compared to the earlier models. Yield curves often are sloping upwards since higher interest rates are associated with long term and relatively less liquid assets. the bank has the option of either maintaining cash balances or investing these excess funds in securities/loans. The firm will also have to consider the transaction cost involved while converting its marketable securities. for 2 months i. Internal funds can be effectively used when the cost of borrowing is relatively high. the bank would prefer to maintain higher liquidity position by utilizing the cash balances for investments loan disbursals. 6.e. For the. Thus there should be optimization in the investment deposit ratio to ensure that the level of idle funds at any point of time is not as high so as to cut into profitability of the bank. such a policy will not be advisable. while the bank can take its investment decisions based on its strategic policy the same will have to be reviewed to adopt tactical policy to suit the changes in the operating environment. management can have a policy which has a relatively large/small amount of liquidity. This model analyses the income foregone when the firm holds cash balances (rather than investing the same in the marketable securities). which resort to a sale of securities/borrowings as and when the need for funds arises. The loan profile of the bank will generally be long term in nature. invest for a longer period after properly assessing the cash requirements through the forecasting process. On the other hand. Distinguishing itself from the earlier methods. If the bank opts for liability management. securitisation also reduces the interest rate exposure for the bank since risk associated to the risk fluctuations will also be eliminated. which have been commonly used. IN this decision making process one has to. It has already been explained that any fluctuation in the interest rates may result in an increase decrease in the NIM of the bank. the bank will have to go for asset management and the time the interest rates stabilize and revert back to the liability management. against the transaction costs incurred when the marketable securities are converted into cash. Surplus Balance: In case of a surplus balance. In this option. the number of forecasting periods plays a vital role. arising at the end of April will be invested for the next five months and to meet the deficit arising at the beginning of may the bank will borrows Rs 4 cr. It can invest either for a short term and roll over until the funds are required for some other purpose of. Though holding adequate cash reserves can eliminate the liquidity risk completely. This trade off decision of the bank depends upon its attitude towards the liquidity policy i. This arrangement induces liquidity into the system by imparting liquidity to the highly illiquid asset. the cost involved in doing so could be prohibitive. If this fluctuation results in a negative growth i. Considering these factors. The cash management model given by Baumol extends the Economic Order Quantity concept used in inventory management to discuss the d\cash conversion size. Two models. There are various models that discuss the suitable ratio that can be maintained between the cash balances and the investments. which influences the average cash holding of the firm. the bank should adjust its surplus deficit to meet the liquidity gap.) for May and June (since there is again a deficit arising at the beginning of July). This again will depend on the strategical issue of whether the bank prefers to manage its liquidity risk using asset management or liability management. especially for a bank. if the bank adopts asset management and hence opts for short term investment policy then the bank will adjust the deficit arising in May with the surplus of April and invest the remaining funds (i. CASE STUDY State Bank of India TREASURY Profile . In the process of enhancing liquidity. The Miller and Orr model considers that there will be different cash balances at different periods and thus a firm should accordingly decide on the amount and the timing for the transfer of funds from marketable securities to cash. the aim of the bank should be to keep its cost of raising such short-term funds as low as possible. expectations theory which explains the relation between the interest rates and the investment period does not hold good in reality. The important criteria in taking such decisions will also be the yields on investments and the cost of borrowing. it is also of priority to ensure that legitimate loan requests of customers are met regardless of the funds position. however. The only alternative available to meet its deficit is by borrowing funds from the market. 19-4 = Rs 15 cr. Large volumes of funds get blocked in project financing and asset financing activities of the institution. In securitisation the future cash flows from the advances made by the bank are repackaged into negotiable securities and issued to the investors. While surplus funds can be invested in short/long-term securities depending on the bank¶s investment policy. in an increasing interest rate scenario. Depending on the liquidity position to be maintained. Thus. Thus. however. the risk preferences and risk factors. Consider illustration 3. then the bank should review its RSAs and RSLs.8 where the planning horizon is six months and the forecasting period is one month. There is. The bank also has an option of meeting its deficit by internal sources by adjusting against surplus balances obtained earlier.e. Deficit Balance: The second important question that the bank will have to face is. Securitisation is an effective way to release these funds for further investments. consider/understand the behavior of the yield curves on the long/short-term investments.

non-convertible debentures. They can also be customized in terms of tenors and liquidity options. of State Bank of India. Portfolio Management & Custodial Services The Portfolio Management Services Section (PMS) of State bank of India has been set up to handle investment and regulatory related concerns of Institutional investors functioning in the area of Social Security. investments and trading. These products allow you to leverage the flexibility of financial markets. SBI's treasury operations are channeled through the Rupee Treasury. marketing. The Rupee Treasury deals in the domestic money and debt markets while the Forex Treasury deals mainly in the local foreign exchange market. maturity profiles of assets and liabilities and interest rate risks at the foreign offices. Products and Services  Asset Liability Management (ALM): The ALM function comprises management of liquidity. SBI is the biggest lender in call. composition and size of the portfolio. securitized paper. as per the norms of the Reserve Bank of India. fixed and floating rate products. corporate bonds. these include asset liability management.foreign currency swaps. rupee-foreign currency interest rate swaps and cross currency swaps. SBI invests in primary and secondary market equity as per its own discretion. investments and forex operations. backed by the assured expertise of informed professionals. The FX Treasury can also structure and facilitate execution of derivatives including long term rupee-foreign currency swaps. thus providing you a dynamic substitute for traditional credit options. skilled and professional dealers can tailor customized solutions that meet your specific requirements and extract maximum value out of each market situation.Profile India's largest bank is also home to the country's biggest and most powerful Treasury. call money and other instruments. such as  Adherence to stated investment objectives  Security selection quality considerations  Conformity to policy constraints  Investment returns . preference shares. the SBI extends round-the-clock support to clients in managing their forex and interest rate exposures. Forex Treasury (FX) The SBI is the country¶s biggest and most important Forex Treasury. Commodity hedging is one of the recent activities taken up by TMG. The Rupee Treasury handles the bank¶s domestic investments. contributing to a major chunk of the total turnover in the money and forex markets. enable efficient interest risk management and optimize the cost of funds. Products and Services  Asset Liability Management (ALM): The ALM function comprises management of liquidity. Investment operations are conducted in accordance with the investment policy for foreign offices formulated by TMG. Through a network of state-of-the-art dealing rooms in India and abroad. PMS was set up exclusively for management of investments of Social Security funds and custody of the securities related thereto.  Investments: Monitoring of investment operations of the foreign offices of the bank is one of the principal activities of TMG. The Rupee Treasury also manages the bank¶s position regarding statutory requirements like the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).  Reciprocal Lines: The department is also responsible for maintenance of reciprocal lines with international banks. the Forex Treasury and the Treasury Management Group. SBI¶s relationships with over 700 correspondent banks and institutions across the globe enhance the strength of the Forex treasury. maturity profiles of assets and liabilities and interest rate risks. foreign currency interest rate swaps. The bank¶s team of seasoned. even the most sophisticated investors are finding it difficult to address day to day investment concerns. The TMG monitors the investment. The main objectives of investment operations at our foreign offices. OVERSEAS TREASURY OPERATION Treasury Management Group The Treasury Management Group (TMG) is a part of the International Banking Group (IBG) and functions under the Chief General Manager (Foreign Offices). The activites include appraisal of the performance of the foreign offices broad parameters such as income earned from investment operations. apart from compliance with the regulatory requirements of the host country. cross currency swaps and forward rate agreements. SBI's relationships with over 700 correspondent banks are also leveraged in extracting maximum value from treasury operations. The bank¶s dealing rooms provide 24-hour trading facilities and employs state-of-the-art technology and information systems. long term rupee . SBI invests in these instruments issued by your company.  Forex monitoring: Monitoring of forex operations of our foreign offices is done with the objective of optimising of returns while managing the attendant risks. Broadly.  Investments: SBI offers financial support through a wide spectrum of investment products that can substitute the traditional credit avenues of a corporate like commercial papers. (b) optimisation of profits from investment operations and (c) maintenance of liquidity. both in the Interbank and Corporate Foreign Exchange markets. In the increasingly complex regulatory and investment environment of today.  Forex and Interest rate (Foreign Currency) derivatives: TMG also plays an important role in structuring. and deals with all the major corporates and institutions in all the financial centers in India and abroad. Trading The bank¶s trading operations are unmatched in size and value in the domestic market and cover government securities. As the name implies the department monitors the management of treasury functions at SBI¶s foreign offices including asset liability management. facilitating execution of foreign currency derivatives including currency options. risk and asset-liability management aspects of the Bank's overseas offices. The PMS forms part of the Treasury Dept. Rupee Treasury The Rupee Treasury carries out the bank¶s rupee-based treasury functions in the domestic market. and is based at Mumbai. are (a) safety of the funds invested. performance vis-à-vis the budgeted targets and the market value of the portfolio.

a thorough understanding of the various operations on its assets liabilities becomes essential. has definitely led to ALM assuming a center stage. The capabilities of the team range from Investment Management and Custody to Information Reporting. Undoubtedly all financial institutions need to perform ALM. . 8.The team manning the PMS Section consists of highly experienced officers of State Bank of India. Such an understanding will enable the financial institution to identify and unbundled the risks and further aid in adopting and developing appropriate risk management models to manage risks. CONCLUSION To sum up. the paradigm shift in the risk exposure levels of the financial institutions. who have the required depth of knowledge to handle large investment portfolios and address the concern of large investors. But to have a proper ALM process in place.

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