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Treasury Management In Banks

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Particulars Introduction Functions Of Treasury Management Elements Of Treasury Management 1. !! and S"! Management 2. #ated $o%ernment Security 3. Money Mar&et O'erations

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!is& Management Instruments For Treasury Management 1. 2. 3. 4. Interest !ate S)a' *nd For)ard !ate *sset "ia+ility Management Interest rate !is& Management "i,uidity !is& Management

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In%estment .orro)ing #ecisions Securiti1ation ase Study 3 State .an& of India onclusion .i+liogra'5y

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Thakur Institute of Management Studies and Research

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Treasury Management In Banks 1. INT!O#6 TION 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 !ith intent to improve profitability There is no profit or re!ard !ithout attendant risk Thus treasury management seek to ma"imi#e profit and earning by investing available funds at an acceptable level of risks Risks and Returns both needs to be managed If !e e"amine the balance sheets of $ommercial Banks %&ublic Sector Banks, typically', !e 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 )*+ of it is invested in government securities The reasons for such developments appear to be as under,  &oor credit off-take coupled !ith high increase in -&.s  Banks/ reluctance to cut-do!n the si#e of their balance sheets  0overnment/s aggressive role in lo!ering cost of debt, resulting in high profit to commercial banks  $apital ade1uacy re1uirements  The income flo! from investment assets is real compared to that of loan-assets, as the latter is si#e ably a book-entry In this conte"t, treasury operations is becoming more and more important to the banks and a need for integration, both hori#ontal and vertical, has come to the attention of the corporate The basic purpose of integration is to improve portfolio profitability, riskinsulation and also to synergi#e banking assets !ith trading assets In hori#ontal integration, dealing(trading rooms engaged in the same trading activity are brought under same policy, technological and accounting platform, !hile in vertical integration, all e"isting and diverse trading and arbitrage activities are brought under one control !ith one common pool of funding and contributions inventory

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Treasury Management In Banks

2. F6N TIONS OF T7E T!E*S6!8 #EP*!MENT IN .*N9S Since 1334s, the prime movers of financial intermediaries and services have been the policies of globali#ation and reforms .ll players and regulators had been actively Thakur Institute of Management Studies and Research 5

Treasury Management In Banks participating, only !ith variation of the degree of participation, to globali#e the economy 6ith burgeoning fore" reserves, Indian banks and 7inancial Institutions have no alternative but to be directly affected by global happenings and trades This is !here8 integrated treasury operations have emerged as a basic tool for key financial performance . treasury department of a bank is concerned !ith the follo!ing functions,  Risk e"posure management, !hich embraces credit, country, li1uidity and interest rate risk consideration together !ith those risks associated !ith dealing in foreign e"change  .sset and liability management, !here li1uidity, interest rate structures and sensitivity, together !ith future maturity profiles, are the ma9or considerations in addition to managing day-to-day funding re1uirements  $ontrol and development of dealing functions  7unding of investments in subsidiaries and affiliates  $apital debt( loan stock raising  7raud protection  $ontrol of investments

3. E"EMENTS OF T!E*S6!8 M*N*$EMENT 3.1 as5 !eser%e !atio and Statutory "i,uidity !atio Management $RR, or cash reserve ratio, refers to the portion of deposits that banks have to maintain !ith RBI This serves t!o purposes 7irst, it ensures that a portion of bank deposits is totally risk-free Second, it enables RBI control li1uidity in the system, and thereby, Thakur Institute of Management Studies and Research :

R' re1uirements The government securities %also kno!n as gilt-edged securities or gilts' are bonds issued by the $entral government to meet its revenue re1uirements . as a part of the reforms process.s a result. the government has begun borro!ing at market-related rates Therefore.444 crore then. or the minimum amount of cash that banks have to maintain !ith it The $RR is fi"ed as a percentage of total deposits Banks are no! re1uired to maintain < * per cent of their deposits !ith RBI The deposits earn around : percent interest.R re1uirement that is important but the si#e of the government-borro!ing programme . 7rom time to time.444 crore more available for lending . =ne. interest rates.R to 2* per cent a couple of years ago Therefore.s government borro!ing increases.lthough the bonds are long-term in nature. it is not the S.s more money chases the same number of borro!ers.R re1uirement.Treasury Management In Banks inflation Besides $RR. interest rates come do!n #oes a c5ange in S"! im'act interest rates. !hich is less than half of the average cost of funds for banks 7or e g if the total amount of deposits !ith banks is Rs <. banks get better interest rates compared !ith the earlier days for their statutory investments in 0overnment securities Second.R reduction is not so relevant in the present conte"t for t!o reasons. bank investment in gilts continues to be higher than 54 per cent despite RBI bringing do!n the minimum S. S. for the purpose of determining the interest rates. banks> investment in government securities !ill go up as government borro!ing rises . look up Besides. too. gilts also provide another tool for RBI to manage interest rates RBI conducts open market operations by offering to buy  Thakur Institute of Management Studies and Research * . banks are re1uired to invest portion %2* per cent' of their deposits in government securities as a part of their statutory li1uidity ratio %S.44. banks are still the main source of funds for the government This means despite a lo!er S. every one percentage point cut in $RR means the banking system !ill have nearly Rs <. they are li1uid as they have a ready secondary market  :5at im'act does a cut in !! 5a%e on interest rates. RBI prescribes a $RR.

insurance companies. the interest in government securities has gone up tremendously and trading in these securities has been 1uite active They are not generally in the form of securities but in the form of entries in RBI/s Subsidiary 0eneral .Treasury Management In Banks or sell gilts If it feels interest rates are too high. the lo!est risk category instruments in the economy These securities are issued through auctions conducted by RBI. RBI adopted the market driven auction method in 7? 1331-32 Since then. it may bring them do!n by offering to buy securities at a lo!er yield than !hat is available in the market 3. 7IIs. though the government sometimes issues #ero coupon instruments and floating rate securities also In one of its first moves to deregulate interest rates in the economy.' The investors in government securities are mainly banks.edger %S0. !ith a good number of banks setting up active treasuries to trade in these securities &erhaps the most li1uid of the long term instruments. a fe! of the domestic players used to trade in these securities !ith a ma9ority investing in these instruments for the full term This has been changing of late. li1uidity in gilts is also aided by the primary dealer net!ork set up by RBI and RBI/s o!n open market operations Features< Thakur Institute of Management Studies and Research @ .2 #ated $o%ernment Securities The 0overnment securities comprise dated securities issued by the 0overnment of India and state governments The date of maturity is specified in the securities therefore it is kno!n as dated government securities The 0overnment borro!s funds through the issue of long term-dated securities. !here the central bank decides the coupon or discount rate based on the response received Most of these securities are issued as fi"ed interest bearing securities. provident funds and trusts These investors are re1uired to hold a certain part of their investments or liabilities in government paper 7oreign institutional investors can also invest in these securities up to 144+ of funds-in case of dedicated debt funds and :3+ in case of e1uity funds Till recently.

Mutual 7unds and certain specified entities are allo!ed to access $all(-otice money only as lenders  It is a completely inter-bank market hence non-bank entities are not allo!ed access to this market  Interest rates in the call and notice money markets are market determined Thakur Institute of Management Studies and Research < .  The call market enables the banks and institutions to even out their day-to-day deficits and surpluses of money  $ommercial banks. all Money Mar&et $all(-otice money is an amount borro!ed or lent on demand for a very short period If the period is more than one day and up to 1: days it is called /-otice money/ other!ise the amount is kno!n as $all money/ Intervening holidays and(or Sundays are e"cluded for this purpose -o collateral security is re1uired to cover these transactions Features. $o-operative Banks and primary dealers are allo!ed to borro! and lend in this market for ad9usting their cash reserve re1uirements  Specified .R re1uirements These securities are repoable 3.t present. there are dated securities !ith a tenor up to 24 years in the market These securities are open to all types of investors including individuals and there is an active secondary market These securities are eligible for S.Treasury Management In Banks RBI.ll-India 7inancial Institutions. as an agent of the 0overnment. manages and services these securities through its &ublic Aebt =ffices %&A=' located at various places . *.3 Money Mar&et O'erations The bank engages into a number of instruments that are available in the Indian money market for the purpose of enhancing li1uidity as !ell as profitability Some of these instruments are as follo!s.

!hich are issued at a discount.Treasury Management In Banks  In vie! of the short tenure of such transactions.maturity is in 5@: days Its auction is on every alternate 6ednesday %!hich is a reporting !eek' The notified amount for this auction is Rs 1444 cr Features<  . unless the investor re1uests specifically.444 There are three types of treasury bills  31-day T-bill . both the borro!ers and the lenders are re1uired to have current accounts !ith the Reserve Bank of India  It serves as an outlet for deploying funds on short-term basis to the lenders having steady inflo! of funds . Treasury . can be traded in the market Most of the time..ills Mar&et In the short term. insurance companies and 7Is 7IIs so far have not been allo!ed to invest in this instrument  These T-bills. considerable part of the government/s borro!ings happen through T-bills of various maturities Based on the bids received at the auctions. they are issued not as securities but as Thakur Institute of Management Studies and Research ) .444 and in multiples of Rs 2*. the lo!est risk category instruments are the treasury bills RBI issues these at a prefi"ed day and a fi"ed amount Treasury bills are available for a minimum amount of Rs 2*.R investments. RBI decides the cut off yield and accepts all bids belo! this yield  The usual investors in these instruments are banks !ho invest not only to part their short-term surpluses but also since it forms part of their S.maturity is in 1)2 days Its auction is on every alternate 6ednesday %!hich is not a reporting !eek' The notified amount for this auction is Rs *44 cr  5@:-Aay T-bill .maturity is in 31 days Its auction is on every 7riday of every !eek The notified amount for this auction is Rs *44 cr  1)2-day T-bill .

R' in government paper .edger %S0. coupled !ith the proposals for -ationali#ation of reserve re1uirements and stringent guidelines by regulators(managements of institutions. Inter=.o! yield on T-bills. !hich is maintained by RBI The transactions cost on T-bill are non-e"istent and trading is considerably high in each bill. generally a result of high li1uidity in banking system as indicated by lo! call rates.Treasury Management In Banks entries in the Subsidiary 0eneral . !ould divert the funds from this market to other markets This !ould be particularly so. the gro!ing desire for fi"ed interest rate borro!ing by corporates. the move to!ards fuller integration bet!een fore" and money markets. the volatility in the call money market !ith accompanying risks in running asset(liability mismatches. in the asset(liability and interest rate risk management. as a ma9or player in the market. if banks already hold the minimum stipulated amount %S. is putting in all efforts to activate this market The development of the term money market is inevitable due to the follo!ing reasons      Aeclining spread in lending operations Colatility in the call money market 0ro!ing desire for fi"ed interest rates borro!ing by corporate Move to!ards fuller integration bet!een fore" and money market Stringent guidelines by regulators(management of the institutions Thakur Institute of Management Studies and Research 3 .'. etc are all the driving forces for the development of the term money market These. should stimulate the evolution of term money market sooner than later The A7BI.an& Term Money Inter bank market for deposits of maturity beyond 1: days and up to three months is referred to as the term money market The specified entities are not allo!ed to lend beyond 1: days The market in this segment is presently not very deep The declining spread in lending operations. immediately after its issue and immediately before its redemption  The yield on T-bills is dependent on the rates prevalent on other investment avenues open for investors .

ommercial Pa'er > P? Thakur Institute of Management Studies and Research 14 . $As !ere one of RBI/s measures to deregulate the cost of funds for banks and 7IIs  . etc the issue of $As reached a high in the last t!o years as banks faced !ith a reducing deposit base secured funds by these means  The foreign and private banks.o! call rates !ould mean higher li1uidity in the market . especially. the discount rate being negotiated bet!een the issuer and the investor Though RBI allo!s $As up to one-year maturity. the maturity most 1uoted in the market is for 34 days  The secondary market for this instrument does not have much depth but the instrument itself is highly secure  $As are issued by banks and 7IIs mainly to augment funds by attracting deposits from corporates. $A is a negotiable promissory note. high net !orth individuals. trusts. !hich do not have large branch net!orks and hence lo!er deposit base use this instrument to raise funds  The rates on these deposits are determined by various factors . the ne"t lo!est risk category investment option is the certificate of deposit %$A' issued by banks and 7IIs Features<  .llo!ed in 13)3.Treasury Management In Banks #. ertificates of #e'osits .fter treasury bills.lso the interest rate on one-year bank deposits acts as a lo!er barrier for the rates in the market E. secure and short term %up to a year' in nature It is issued at a discount to the face value.

from either the $redit Rating Information Services of India .%a' the tangible net !orth of the company.td %I$R. primary dealers %&As' and satellite dealers %SAs' and all-India financial institutions %7Is' !hich have been permitted to raise resources through money market instruments under the umbrella limit fi"ed by Reserve Bank of India are eligible to issue $& .' or the $redit .td %$RISI. company shall be eligible to issue $& provided . or such e1uivalent rating by other agencies 7urther.nalysis and Research .gency of India . for the purpose The minimum credit rating shall be &-2 of $RISI.sset by the financing bank(s  !ating !e. is not less than Rs : crore8 %b' the !orking capital %fund-based' limit of the company from the banking system is not less than Rs : crore and %c' the borro!al account of the company is classified as a Standard . as per the latest audited balance sheet.Treasury Management In Banks $ommercial &aper %$&' is an unsecured money market instrument issued in the form of a promissory note $& !as introduced in India in 1334 !ith a vie! to enabling highly rated corporate borro!ers to diversify their sources of short-term borro!ings and to provide an additional instrument to investors  :5o can issue ommercial Pa'er > P?. Bighly rated corporate borro!ers. the participants shall ensure at the time of issuance of $& that the rating so obtained is current and has not fallen due for revie!  Maturity Thakur Institute of Management Studies and Research 11 .' or the Investment Information and $redit DRating .td %$.uirement .RE' or the Auff F &helps $redit Rating India &vt .td %A$R India' or such other credit rating agency as may be specified by the Reserve Bank of India from time to time.ll eligible participants should obtain the credit rating for issuance of $ommercial &aper.

Treasury Management In Banks $& can be issued for maturities bet!een a minimum of 1* days and a ma"imum up to one year from the date of issue If the maturity date is a holiday. F. -on-Resident Indians %-RIs' and 7oreign Institutional Investors %7IIs' Bo!ever.ll-India financial institutions are prohibited from under!riting or co-accepting issues of $ommercial &aper  Payment of P =n maturity of $&. the holder of the $& !ill have to get it redeemed through the depository and receive payment from the I&. investment by 7IIs !ould be !ithin the 54 per cent limit set for their investments in debt instruments  Mode of Issuance $& can be issued only in a demateriali#ed form through any of the depositories approved by and registered !ith SEBI $& can be held only in demateriali#ed form $& !ill be issued at a discount to face value as may be determined by the issuer Banks and . !eady For)ard ontracts It is a transaction in !hich t!o parties agree to sell and repurchase the same security Gnder such an agreement the seller sells specified securities !ith an agreement to Thakur Institute of Management Studies and Research 12 . the company !ould be liable to make payment on the immediate preceding !orking day  #enominations $& can be issued in denominations of Rs * lakh or multiples thereof  In%estment in P $& may be issued to and held by individuals. banking companies8 other corporate bodies registered or incorporated in India and unincorporated bodies.

Repos are versatile instruments and used e"tensively in money market operations 6hile inter-bank Repos !ere being allo!ed prior to 1332 sub9ect to certain regulations.Treasury Management In Banks repurchase the same at a mutually decided future date and a price Similarly. the ready for!ard transactions are often also resorted to manage short term S. the buyer purchases the securities !ith an agreement to resell the same to the seller on an agreed date in future at a predetermined price Such a transaction is called a Repo !hen vie!ed from the prospective of the seller of securities %the party ac1uiring fund' and Reverse Repo !hen described from the point of vie! of the supplier of funds Thus. !hether a given agreement is termed as Repo or a Reverse Repo depends on !hich party initiated the transaction Features  The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counter party Effectively the seller of the security borro!s money for a period of time %Repo period' at a particular rate of interest mutually agreed !ith the buyer of the security !ho has lent the funds to the seller The rate of interest agreed upon is called the Repo rate  The Repo rate is negotiated by the counter parties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions The motivation for the banks and other organi#ations to enter into a ready for!ard transaction is that it can finance the purchase of securities or other!ise fund its re1uirements at relatively competitive rates =n account of this reason the ready for!ard transaction is purely a money lending operation Gnder ready for!ard deal the seller of the security is the borro!er and the buyer is the lender of funds Such a transaction offers benefits both to the seller and the buyer Seller gets the funds at a specified interest rate and thus hedges himself against volatile rates !ithout parting !ith his security permanently %thereby avoiding any distressed sale' and the buyer gets the security to meet his S. there !ere large scale violation of laid do!n guidelines leading to the Thakur Institute of Management Studies and Research 15 .R mismatches Internationally.R re1uirements In addition to pure funding reasons.

the Reserve Bank !ould move to!ards a pure inter-bank %including &As' call(notice money market In vie! of this non-bank entities !ill be allo!ed to borro! and lend only through Repo and Reverse Repo Bence permission of such entities to participate in call(notice money market !ill be !ithdra!n from Aecember 2444 Thakur Institute of Management Studies and Research 1: . Mumbai. the conditions have been rela"ed gradually !.I 5as 'rescri+ed t5at follo)ing factors 5a%e to +e considered )5ile 'erforming re'o< 1 2 &urchase and sale price should be in alignment !ith the ongoing market rates -o sale of securities should be affected unless the securities are actually held by the seller in his o!n investment portfolio 5 Immediately on sale.I )it5 regard to re'o transactions are< 1 2 5 In addition to Treasury Bills. all central and State 0overnment securities are eligible for repo Besides banks. and $urrent !ith RBI. the corresponding amount should be reduced from the investment account of the seller : The securities under repo should be marked to market on the balance sheet date T5e rela@ations o%er t5e years made +y !.Treasury Management In Banks Hsecurities scam> in 13328 this led 0overnment and RBI to clamp do!n severe restrictions on the usage of this facility by the different market participants 6ith the plugging of loophole in the operation. thus increasing the number of eligible non-bank participants to @: : It !as indicated in the HMid-Term Revie!> of =ctober 133) that in line !ith the suggestion of the -arasimham $ommittee II. &As are allo!ed to undertake both repo(reverse repo transactions RBI has further !idened the scope of participation in the repo market to all the entities having S0.

Repos and Reverse Repo are resorted to by the RBI as a tool of li1uidity control in the system 6ith a vie! to absorbing surplus li1uidity from the system in a fle"ible !ay and to prevent interest rate arbitraging. primary dealers !ho often hold large inventories of tradable government securities are also active players in the repo and reverse repo market The Repo(Reverse Repo transaction can only be done at Mumbai bet!een parties approved by RBI and in securities as approved by RBI %Treasury Bills. 133< Reserve Bank of India !as earlier providing li1uidity support to &As through the reverse repo route This procedure !as also subse1uently dispensed !ith and Reserve Bank of India began giving li1uidity support to &As through their holdings in S0. $entral(State 0ovt securities' 6ses of !e'o  It helps banks to invest surplus cash  It helps investor achieve money market returns !ith sovereign risk  It helps borro!er to raise funds at better rates  .($ The li1uidity support is presently given to the &rimary Aealers for a fi"ed 1uantum and at the Bank Rate based on their bidding commitment and also on their past performance 7or any additional li1uidity re1uirements &rimary Aealers are allo!ed to participate in the reverse repo auction under the .R($RR positions simultaneously Thakur Institute of Management Studies and Research 1* .d9ustment 7acility along !ith Banks. repos have also been permitted in &SG 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 e"change .R surplus and $RR deficit bank can use the Repo deals as a convenient !ay of ad9usting S. RBI introduced a system of daily fi"ed rate repos from -ovember 23. introduced by RBI in Iune 2444%Aetails given belo!' The ma9or players in the repo and reverse repurchase market tend to be banks that have substantially huge portfolios of government securities Besides these players.Treasury Management In Banks * In terms of instruments. both for absorbing li1uidity and also for in9ecting funds into the system Thus.i1uidity .part from inter-bank repos RBI has been using this instrument effectively for its li1uidity management. .n S.

discounted by the discounting bank Thakur Institute of Management Studies and Research 1@ . &rimary Aealer. !ill be received by the bank 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 The RBI introduced the Bills Market scheme %BMS' in 13*2 and the scheme !as later modified into -e! Bills Market scheme %-BMS' in 13<4 Gnder the scheme. !hich !ere originally discounted by them. from the dra!ee.ills Bills of e"change are negotiable instruments dra!n by the seller %dra!er' of the goods on the buyer %dra!ee' of the goods for the value of the goods delivered These bills are called trade bills These trade bills are called commercial bills !hen they are accepted by commercial banks 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 The maturity proceeds or face value of discounted bill. the RBI introduced an instrument called Aerivative Gsance &romissory -otes %AG&-' So the need for physical transfer of bills has been !aived and the bank that originally discounts the bills only dra!s AG&. Mutual 7unds.Treasury Management In Banks  RBI uses Repo and Reverse repo as instruments for li1uidity ad9ustment in the system $. !ith approved institutions %vi# . ommercial . Aevelopment 7inancial Institutions. etc ' 6ith the intention of reducing paper movements and facilitate multiple rediscounting. commercial banks can rediscount the bills. $ommercial Banks.These AG&-s are sold to investors in convenient lots of maturities %from 1* days upto 34 days' on the basis of genuine trade bills.

n Interest Rate S!ap %IRS' is a financial contract bet!een t!o parties e"changing or s!apping a stream of interest payments for a Hnotional principal> amount on multiple occasions during a specified period Such contracts generally involve e"change of Hfi"ed to floating Hor> floating to floating rates of interest . cash payments based on contract %fi"ed' and the settlement rate. are made by the parties to one another The settlement rate is the agreed bench-mark( reference rate prevailing on the settlement date Scheduled commercial banks %e"cluding Regional Rural Banks'. on the settlement date. on each payment date that occurs during the s!ap period-cash payments based on fi"ed(floating and floating rates. duly e"ecuted s!ap agreements etc Thakur Institute of Management Studies and Research 1< .ccordingly. !ill have to collect all information(documents relating to status of the counter party.ccordingly.1 Interest !ate S)a's *nd For)ard !ate .' is a financial contract bet!een t!o parties to e"change interest payments for a Hnotional principal> amount on settlement date.Treasury Management In Banks 4. primary dealers %&As'. are made by the parties to one another .s(IRS as a product for their o!n balance sheet management or for market making Banks(7IIs(&As can also offer these products to corporates for hedging their %corporates' o!n balance sheet e"posures  !ules for entering into I!SAF!*< The party intending to enter into IRS(7R. Mutual funds and all-India financial institutions %7IIs' are free to undertake 7R. for a specified period from start date to maturity date . !IS9 M*N*$EMENT INST!6MENT FO! T!E*S6!8 M*N*$EMENT 4. 7or!ard Rate .greement %7R.

M is concerned !ith strategic balance sheet management involving risks caused by changes in the interest rates. !hich amongst others include maintaining credit 1uality. and those for hedging purposes could be accounted for on accrual basis 4. credit risk and contingency risk also form a part of the .M The significance of .2 *sset "ia+ility Management .. has to be fi"ed 2? #ocumentation< The counterparties should sign ISA.ssociation.. first determine !hether the counterparty has legal capacity..rticles of .M process aims on profitability and long term viability The process of .M 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 Thus a comprehensive .. Board resolution for authori#ation of s!ap deals and signatures of authori#ed persons should be obtained and scrutini#ed .lso a suitable counterparty limit for entering into IRS(7R. master agreement before entering into a s!ap deal The parties should appropriately change the Schedule to the agreement according to the terms and conditions settled bet!een them 3? *ccounting of I!SAF!*< The parties can enter into s!ap deals for hedging interest rate risk on their o!n portfolio or for market making The parties should make clear distinction bet!een s!aps that are entered into for hedging their o!n balance sheet positions and more !hich are entered into for trading The transactions for market making purposes should be marked to market %at least at fortnightly intervals'.M has to be carried out against many balance sheet constraints. meeting li1uidity needs and ac1uiring re1uired capital Thakur Institute of Management Studies and Research 1) ... po!er and authority to enter into an interest rate s!ap transaction The Memorandum and . e"change rates and the li1uidity position of the bank 6hile managing these three risks forms the cru" of .Treasury Management In Banks 1? Status of t5e ounter 'arty< Before entering into a deal.M.

M are. but has also highlighted the need to match the maturities of the assets and liabilities The changes in the profile of the sources and uses of funds are reflected in the borro!ers> profile. then it should ensure that the risk taken is firstly manageable and secondly it does not get transformed into yet another undesirable risk . !hich has further stimulated the gro!th in the fund raising activities 6ith the rise in the demand for funds.3 Interest !ate !is& Aue to the very nature of its business.Treasury Management In Banks In India.. parameterisation of various associated market risks. competition has narro!ed do!n the spread of banks This not only has led to the introduction of discriminate pricing policies. interest rate structure for deposits and advances. 1 2 5 : Colatility &roduct Innovations Regulatory environment Enhanced a!areness of top management  RBI GUIDELINES ON ALM The Reserve Bank of India in 7eb 1333 has issued comprehensive guidelines for banks for . etc The developments that have taken place since liberali#ation have led to a remarkable transition in the risk profile of the financial intermediaries  Significance Of *"M The main reasons for the gro!ing significance of . there has also been a remarkable shift in the features of the sources and uses of funds of the banks Bo!ever in the deregulated environment. the post liberali#ation !itnessed a rapid industrial gro!th. the focal point in managing any risk !ill be to understand the nature of the risk This is especially essential for interest rate risk management Interest rate risk is the gain(loss that arises due to sensitivity of the Thakur Institute of Management Studies and Research 13 . the industry profile and the e"posure limits for the same. and fre1uency of evaluation of e"posure 4. a bank should accept interest rate risk not by chance but by choice .s stated earlier.iability Management 0uidelines inter alia include directions for classification of various assets and liabilities.nd !hen the bank has to take a risk as a choice.sset .

2+ cut in the $RR from 14+ to )+ in the Busy Season $redit &olicy announced in =ctober 133< !as immediately follo!ed by a cut in the &. has been lo!ering the Statutory $ash Reserve Ratio for banks in a phased manner from 12+ to )+ since 133@ Every time the $RR is lo!ered.Treasury Management In Banks interest income(interest e"penditure or values of assets(liabilities to the interest rate fluctuations  Ty'es Of Interest !ate !is&s The sensitivity to interest rate fluctuations !ill arise due to the mi"ed affect of a host of other risks that comprise the interest rate risk These risks !hen segregated fall into the follo!ing categories 1. Rate . !hich !ill lo!er the marginal costs of funds Bo!ever. in the long run.evel Risk Auring a given period there is possibility for restructuring the interest rate levels either due to the market conditions or due to regulatory intervention This phenomenon !ill.R(interest rates of Banks and 7II>s The risk that arises due to this reduction can be understood from the fact that the revised rates of interest !ill be applicable to all the ne! deposits. affect decisions regarding the type and the mi" of assets(liabilities to be maintained and their maturing periods The present interest rate restructuring taking place in the Indian markets is a very good e"ample of this aspect The Reserve Bank of India !hich is the ape" body regulating the Indian monetary system. there are short term fluctuations !hich are to be considered in deciding on the mi" of assets and liabilities. the risk !ill ac1uire serious Thakur Institute of Management Studies and Research 24 . the pricing policies and thereby the business volumes Bo!ever. Colatility Risk In additions to the long run implications of the interest rate changes. there is an increase in the li1uidity !hich further results in lo!ering of the interest rate levels . the affect !ill be seen on all the e"isting assets $onse1uently the loss of interest income on assets is likely to be higher than the reduction in the interest cost of deposits leading to lo!er spreads 2.

!hich issue the bonds. it can be seen that the affect of fluctuations in the short term have a greater impact since the ad9ustment period is very short 3.Treasury Management In Banks proportions in a highly volatile market !hen the impact !ill be felt on the cash flo!s and profits The 133: volatility !itnessed in the Indian call money market e"plains the presence and the impact of volatility risk The interest rate in the call money market. call option is generally e"ercised in a declining interest rate scenario This !ill affect the bank if it invests in such bonds since the intermediate cash inflo!s !ill have to be reinvested at a lo!er rate Similarly. these intermediate cash flo!s !hen received Thakur Institute of Management Studies and Research 21 . it may include call(put options . Reinvestment Risk The risk can be associated to the intermediate cash flo!s arising due to the payment of interest. #oomed to 3*+ !ithin a couple of !eeks during September. in a situation !here the interest rate is declining. !ill have to face greater replacement costs (. many banks borro!ed funds at high rates. 133: 6hile some banks defaulted in the maintenance of $RR. installments on loans etc These intermediate cash flo!s arising from a security(loan are usually reinvested and the income from such reinvestments !ill depend on the prevailing rate of interest at the time of reinvestment and the reinvestment strategy Aue to the volatility in the interest rates. any cash inflo!s that arise due to prepayment of loans !ill have to be redeployed at a lo!er rate invariably resulting in lo!ered yields 4. call option is e"ercised by an issuer to redeem the bonds before maturity. $all(&ut Risk Sometimes !hen the funds are raised by the issue of bonds(securities. &repayment Risk The fluctuations in the interest rate may sometimes lead to prepayment of loans 7or instance. !hich had substantially reduced their profits Thus. !hile the put option is e"ercised by the investor to seek redemption before maturity These t!o options e"pose to a risk !hen the interest rate fluctuate . !hich generally hovered around *-< +. !hen the investor e"ercises the put option in an increasing interest rate scenario. the banks.

Basis Risk 6hen the cost of liabilities and the yields of assets are linked to different benchmarks resulting in a floating rate and there is no simultaneous matching movements in the benchmark rates. the cost of funds for 1 yr bank deposits !ill be 3+% 1 + less than the prevailing Bank Rate 14+'. the yield on 14 yr government security came do!n only by 54bp Thus. the spread !ill increase to @ 2*+ 6hile the bank rate declined by 1+. consider that the funds raised by !ay of 1 yr bank deposits are invested in the Easy E"it Bond of the IABI fle"i bond issue In this case. !hich has to be considered in order to assess the real interest cost(yields This occurs because the changes in the nominal interest rates may not match !ith the changes in inflation The presence of the above mentioned risk !ould either individually or collectively result in interest rate risk These risks !ill affect the income(e"penses of the bank>s asset(liability portfolio This. on the assets and liability spreads of * **+ %1: **-3' is available . thereby bringing do!n the return on the Easy E"it Bond to 1: 2*+ . it !ill lead to a decrease(increase in the spreads 2. !hile the yields from the bonds !ill be1: **+ !hich is 1 *+ over 14 yr government bond of 15 4*+ !ith these floating rates of interest.ssume that there is a 1+ cut in the bank rate This !ill bring do!n the cost of funds to )+ 7urther. !ill also have an impact on the value of assets and liabilities of the bank. further. thereby affecting even the market value of the bank Thakur Institute of Management Studies and Research 22 . !hich are set as a benchmark for assets(liabilities. !hen the change in the interest rates. it leads to basis risk 7or instance. is not uniform. Real Interest Rate Risk ?et another dimension of the interest rate risk is the inflation factor. assume that the return on 14 yr government bond has also come do!n to 12 <*+.Treasury Management In Banks may have to be reinvested at a lo!er rates resulting in lo!er yields This variability in the returns from the reinvestments due to changes in the interest rates is called the reinvestment risk 0.s a result of this interest rate change.

s and RS.s and the RSIs. RS0 D Rate Sensitive 0ap based on maturity D RS.nalysis  Simulation and 0ame Theory Maturity $a' Met5od< This asset-liability management techni1ue aimed to tackle the interest rate risk.s KKKKKKKKKKKKKKKKKE1 2 Thakur Institute of Management Studies and Research 25 .s and the RS. the maturity periods of the same and the gap period The ob9ective of this method is to stabili#e(improve the net interest income in the short run over discreet. all the RS.s KKKKKKKKKKKKKKKKK E1 1 0ap Ratio D RS.d9usted 0ap  Auration . !hich is mathematically e"pressed as.nalysis  Bedging  Sensitivity .s 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 The gap is then calculated by considering the difference bet!een the absolute values of the RS.s J RS. RS0 !here.s ( RS. highlights on the gap that is present bet!een the RS.s.Treasury Management In Banks Some of the approaches used to tackle interest rate risk are given belo! and a discussion on the same is follo!ed  *''roac5es *do'ted To Buantify Interest !ate !is&s<  Maturity 0ap Method  Rate . periods of time called the gap periodsThe first step is Thus-to select the gap period !hich can be any!here bet!een a month to a year Baving chosen the same.

Treasury Management In Banks The gap so analy#ed can be used to cut do!n the interest rate e"posure in t!o !ays. according to the gap method.<* percent fall in the short term interest rates !hile the long-term rates may !itness a mere decrease by 4 2* percent The second reason for differential rise(fall in interest rates of assets(liabilities can be the presence of a certain regulation To e"plain this further. consider the differential interest rate loan e"tended by banks.s are in e"cess of the RS. other!ise adopt a speculative strategy !herein by altering the gap effectively depending on the interest rate forecasts net interest income can be improved In either !ay. the maturity gap method suggests various positions that the treasurer can take in order to tackle !ith the rising(falling interest rate structures $onsider the follo!ing illustration to understand the approach !ate *dCusted $a' The Maturity 0ap approach assumes a uniform change in the interest rates for all assets and liabilities In reality. negative !hen the RS. the market may also perceive the rate fluctuations differently for the longterm interest rates and the short-term interest rates 7or instance rate fluctuation may lead to a 4. it may not be the case basically due to t!o main reasons 7irstly. !hich has an interest rate of : percent This rate remains constant irrespective of any amount of fluctuation in the interest rate of the bank Similarly. ho!ever. the basic assumption of this model is that there !ill he an e1ual change in interest rates for all assets and liabilities Auring a selected gap period.s and RS.s are e1ual Based on these outcomes. the market perception to!ards the change in the interest rate may be different from the actual rise(fall in the interest rates. .lternatively.s are more than the RS. The RS0 !ill be positive !hen the RS.s and #ero !hen the RS. The bank can use it to maintain(improve its net interest income for changing interest rates. 7or instance.s mentioned earlier. If the bank rate is cut by 1 percent. it is 1uite common to find that the interest rates on term deposits rise fall !ith changes in interest rates though the same does not effect the interest paid on savings bank Thakur Institute of Management Studies and Research 2: .s. there !ill be a 1 percent fall in the rate of in the rate of interest for both assets and liabilities Bo!ever this may not be the case if the market perception for the decline in the interest rate is short-term in nature This might eventually lead to a fall in the interest rate by less than 1 percent .

the Rate Sensitive 0ap calculated in Auration .d9usted 0ap methodology seems to be superior than the Maturity 0ap methodology In this approach all the rate sensitive asset/s and liabilities !ill he ad9usted by assigning !eights based on the estimated change in the rate for the different assets(liabilities for a given change in interest rates #uration *nalysis =ne of the limitation of the Maturity 0ap approach is that it ignores the time value of money for the cash flo!s !hile determining the gap .s seen earlier.ttending to this limitation of the Maturity 0ap approach is the Auration 0ap Method Auration .Treasury Management In Banks Baving done a!ay !ith the assumption of a uniform change in interest rates of assets(liabilities. it should ho!ever be noted that the possibility of the interest rate risk getting Thakur Institute of Management Studies and Research 2* . the concept of duration helps in immuni#ing the interest rate risk by holding an investment till the end of duration instead of maturity Baving determined the duration. Auration . !ith the help of duration . the Rate .nalysis is based on the duration and not the maturity of the assets and liabilities 7edging It is often felt that a floating rate mechanism can minimi#e the interest-rate risk Though this is true.nalysis studies the affect of rate fluctuation on the market value of the assets and liabilities and net interest margins %-IM'. the affect of rate fluctuation on the -IM and the market value of the assets(liabilities of a bank can be assessed further by computing the Auration 0ap for the portfolio of its assets and liabilities In the first case. to monitor the impact of rate fluctuation on -IM using duration the method follo!ed is similar to the one used in maturity gap approach Bo!ever.nalysis concentrates on the price risk and the reinvestments risk !hile managing the interest rate e"posure 6hile managing these t!o risks.

a proper understanding of the hedging mechanism is a must for the effective usage of the derivative instruments. futures and options This approach seems to be a better alternative. vi# s!aps. all the assets(liabilities are regrouped The sensitivity model then suggests the assessment of the gap bet!een the assets and liabilities having a similar sensitivity inde" to the interest rate fluctuation 7urther action !ill be taken to manage the gap so as to restrict the interest rate risk Simulation and $ame T5eory< 0iven the e"pected changes in the short and the long-term operative environment 0ame Theory simulates and forecasts the future trends Gsing this concept the e"pected risk and re!ards of the different asset and liability classes are given along !ith the risk sensitivity and gap bet!een the short. simulation is Thakur Institute of Management Studies and Research 2@ .Treasury Management In Banks transformed into credit risk due to this mechanism is al!ays present This situation occurs as the floating rate passes the burden of the interest-rate risk on the borro!er ?et another means of managing the interest-rate risk is by hedging !ith the use of derivative securities. there are certain prere1uisites for the effective utili#ation of the hedging instruments and their relating operations 7irst and foremost is the e"istence of a market that is deep and highly li1uid This again re1uires a proper benchmark for the interest rates and also an active floating rate market In addition to this. especially in a situation !here there is a maturity mismatch 7or instance. medium and log-term assets and liabilities Then. hedging proves to be an effective method to manage the interest rate risk Bo!ever. rather than trying to match the maturing periods is by the use of derivative securities In a situation !here there is an une"pected change in the interest-rate structure or !hen interest-rate forecasting becomes a difficult task. !hen liabilities are mostly short-term in nature and assets are long term. the easier method of financing the assets. lest it may lead to an overall increase in the risk Sensiti%ity *nalysis< The sensitivity of an asset(liability can be assessed by the 1uantum of increase(decrease in the value of the assets(liabilities of varying maturities due to the interest rate fluctuations Based on the sensitivity.

bank generally aims to eliminate the li1uidity risk !hile it only tries to manage the interest rate risk This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable.M ob9ective &rice matching should be coupled !ith proper maturity matching The interlinkage bet!een the interest rate risk and the li1uidity of the firm highlights the need for maturity matching The underlying implication of this interlinkage is that rate fluctuations may lead to defaults severely affecting the asset-liability position 7urther in a highly volatile situation it may lead to li1uidity crisis forcing the closure of the bank Thus.n intricate part of fund management is li1uidity management . both I flo!s and outflo!s and the ability of the bank to meet maturing Thakur Institute of Management Studies and Research 2< .. it is essential to understand the concept of li1uidity management The core activity of any bank is to attain profitability through fund management i e ac1uisition and deployment of financial resources .uidity !is& Management< 6hile introducing the concept of asset-liability management it has been mentioned that the ob9ect of any . place the bank in a potentially illi1uid position Efficient matching of prices to manage the interest rate risk does not suffice to meet the .M. there is. !hile management of the prices of assets and liabilities is an essential part of . ho!ever. so is li1uidity . a phenomenal difference in the approach to tackle both these risks . the bank generally maintains profitability(spreads by borro!ing short %lo!er costs' and lending long %higher yields' Though this process of price matching can be done !ell !ithin the risk(e"posure levels set for rate fluctuations it may.. e"poses the firm to li1uidity risk Though the management of li1uidity risk and interest rate risks go hand in hand. ho!ever..i1uidity.4 "i. !hile elimination risk does result in long-term sustenance Before attempting to analy#e the elimination of li1uidity risk.i1uidity management relates primarily to the dependability of cash flo!s.Treasury Management In Banks done by varying the interest rate structures to predict the short(medium(long-term implications of the same 4. !hich is represented by the 1uality and marketability of the assets and liabilities.M policy is t!ofold J ensuring profitability and li1uidity 6orking to!ards this end.

the bank tries to tackle (eliminate the li1uidity risk in the long run by basically controlling its assets-liability position . originates from the potential inability of the bank to generate cash to cope !ith the decline in liabilities or increase in assets Thus. the t!o approaches supplement each other in eliminating the li1uidity risk and ensuring profitability L I.ll investment and financing decisions of the bank. !hich eve suite the situation L *sset Management< Thakur Institute of Management Studies and Research 2) . the technical approach targets the li1uidity in the short run Aue to these features.iability Management This implies that li1uidity can be imparted into the system either by liability creation or by asset li1uidation. I 7undamental .Treasury Management In Banks liabilities and customer demands for cash !ithin the basic pricing policy frame!ork . irrespective of !hether they have long term or short term implications do effect the assetliability position of the bank !hich may further affect its li1uidity position In such a scenario. the bank should continuously monitor its li1uidity position in the long run and also on a day-to-day basis  *''roac5es< 0iven belo! are t!o approaches that relate to these t!o situational decisions. prudent !ay of tackling this situation can be by ad9usting the maturity of assets and liabilities or by diversifying and broadening the sources of funds The t!o alternatives available to control the li1uidity e"posure under this approach are .i1uidity risk hence. the cause and effect of li1uidity risk are primarily linked to the nature of the assets and liabilities of the bank . Fundamental *''roac5: Since long run sustenance is driving factor in this approach.pproach These t!o methods distinguish from each other in their strategically approach to eliminate li1uidity risk 6hile the fundamental approach aims to ensure the li1uidity for long run sustenance of the bank.pproach II Technical .sset Management and .

the cost and the maturity of the Thakur Institute of Management Studies and Research 23 . they can also be converted into cash prior to their maturity at the discretion of the management 6hen asset management is resorted to for li1uidity. !hich can be turned into cash !henever re1uired 7or instance. they can be held as second line of defense against daily demand for cash This is possible mainly due to the fle"ibility in the cash reserve balances %statutory cash reserves are re1uired to be maintained only on a daily average basis for a reserve maintenance period' L Bo!ever.sset management is to eliminate li1uidity risk by holding near cash assets i e those assets. it !ill be through li1uidation of secondary reserves . sustenance of such high spreads !ill depend on the cost of borro!ing Thus. sale of securities from the investment portfolio can enhance li1uidity 6hen asset management is resorted to.Treasury Management In Banks . adverse clearing balances or any other reasons "ia+ility Management< $onverse to the asset management strategy is liability management. it !ill also fetch higher yields due to the long-term investments Bo!ever. !hich !hen converted into cash carry little risk of loss in their value 7urther. the li1uidity re1uirements are generally met from primary and secondary reserves &rimary reserves refer to cash assets held to meet the statutory cash reserve re1uirements %$RR' and other operating purposes Though primary reserves do not serve the purpose of li1uidity management for long period.ssets that fall under this category generally take the form of unsecured marketable securities The bank can dispose these secondary reserves to honor demands for deposit !ithdra!als. it !ill not depend on its li1uidity position(surplus balance for credit accommodation(business proposals Thus in liability management a proposal may be passed even !hen there is no surplus balance since the bank intends to raise the re1uired funds from e"ternal sources Though it involves a greater risk for the bank. !hich focuses on the sources of funds Bere the bank is not maintaining any surplus funds. most of the li1uidity is generally attained from the secondary reserves. !hich include those assets held primarily for li1uidity purposes These secondary reserves are highly li1uid assets. but tries to achieve the re1uired li1uidity by borro!ing funds !hen the need arises The underlying implications of this process !ill be that the bank mostly !ill be investing in long-term securities (loans %since the short-term surplus balance !ill mostly be in a deficit position' and further.

it is the cash flo!s position that needs to be tackled The bank should kno! its cash re1uirements and the cash inflo!s and ad9ust these t!o to ensure a safe level for its li1uidity position 6orking 7unds . li1uidity position is assessed based on the 1uantum of !orking funds available to the bank Since !orking funds reflect the total resources available !ith the bank to e"ecute its business operations.s mentioned earlier. the former concentrates on the actual cash position and depending on the factual data. technical approach focuses on the li1uidity position of the bank in the short run .i1uidity in the short run is primarily linked to the cash flo!s arising due to the operational transactions Thus.Treasury Management In Banks instrument used for borro!ing funds play a vital role in liability management The bank should on the one hand be able to raise funds at lo! cost and on the other hand ensure that the maturity profile of the instrument does not lead to or enhance the li1uidity risk and the interest rate risk =f the t!o strategies available in fundamental approach.pproach and the $ash 7lo!s . it forecasts the li1uidity re1uirements The latter approach goes a step for!ard and forecasts the cash flo!s i e estimates any change in the deposits !ithdra!als credit accommodation etc Thus apart from assessing the li1uidity re1uirements. Tec5nical *''roac5.pproach are the t!o methods to assess the li1uidity position in the short run =f these t!o approaches. it also advises the bank on its investments and borro!ing re1uirements !ell in advance Aiscussed belo! are these t!o models of technical approach used for li1uidity risk management 1 6orking 7unds .pproach. !hen technical approach is adopted to eliminate li1uidity risk. it is understood that !hile asset management tries to ans!er the basic 1uestion of ho! to deploy the surplus to eliminate li1uidity risk. Gnder this approach. liability management tries to achieve the same by mobili#ing additional funds II. . the amount of li1uidity is given as a percentage to the total !orking funds The bank can arrive at this percentage based on its historical performance This approach of forecasting li1uidity re1uirement takes a broad Thakur Institute of Management Studies and Research 54 .

the bank !ill have to invest borro! the surplus(deficit balances to ad9ust the li1uidity position In this approach. prior to assessing the li1uidity re1uirements of these deposits. the li1uidity re1uirements to meet the maturity of the vulnerable funds !ill be less than 144 percent and varies depending upon the risk-return policy of the bank Thakur Institute of Management Studies and Research 51 . it can be observed from the operations of the bank.  Colatile 7unds  Culnerable 7unds  Stable 7unds Colatile funds include those deposits. etc raised from the corporate high net !orth clients of the bank The probability of these funds being !ithdra!n before or on their maturity is high Included in this category of volatile funds are current deposits of corporates that also have a high degree of variability Aue to the nature of the volatile funds.Treasury Management In Banks overvie! of the li1uidity position since the !orking funds are taken as a consolidated figure The !orking funds comprise of o!ned funds. the bank can have a segment-!ise break up of the !orking funds to arrive at the percentage for maintaining li1uidity Based on the position of the limit arrived as above and the available li1uidity. deposits and float funds Instead of a consolidated approach. the entire 1uantum of savings deposits cannot be considered as vulnerable =n an average. the li1uidity re1uirements of !hich depend on the maturity profile Thus. that there !ill be a certain level up to !hich the funds are stable i e the level belo! !hich the funds !ill not be !ithdra!n Bence. !hich are likely to be !ithdra!n during the planning tenure.ll deposits based on their maturity fall under the follo!ing three categories. very good e"ample of this type of deposits is the savings deposits Bo!ever. short-term deposits like the 54 days deposits. due to its very nature of being o!ners> capital !ill be nil The second component of !orking funds is deposits. the bank !ill have to assess the li1uidity re1uirements for each of the components of !orking funds The li1uidity for the o!ned funds component. !hich are sure to be !ithdra!n during the period for !hich the li1uidity estimate is to be made These include. are categori#ed as vulnerable deposits . the bank should categori#e them into different segments based on the !ithdra!al pattern . they demand almost 144 percent li1uidity maintenance since the demand for funds can arise at any time Aeposits.

profitability and li1uidity are ensured . as long as the average balances vary !ithin this tolerance range. !hich are the third component of the !orking funds. the residual of the deposit base after segregating them into the above t!o categories !ill fall under the stable funds category These deposits have the least probability of being !ithdra!n during the planning period and hence the li1uidity to be maintained to meet the maturing stable deposits !ill also be lo!er !hen compared to the other t!o types of deposits . it is advisable for the bank to set up a variance range for acceptance depending on its profitability re1uirements Thus. this segment also has a minimum level over and above !hich the variability occurs Bence. the accuracy levels of !hich vary depending on the factors affecting the cash flo!s Bence.pproach. etc !hich may be presented for payment at any time Bo!ever. This method of forecasting li1uidity tries to eliminate the dra!back faced in the 6orking 7unds approach by forecasting the potential increase(decrease in deposits(credits Thakur Institute of Management Studies and Research 52 .ay do!n the range of variance that can be taken as the acceptance level Baving obtained the consolidated(component-!ise !orking funds.  . the bank !ill no! have to estimate the average cash and bank balances that are to be maintained This average balance can be maintained as a percentage to the total !orking funds This percentage level is based on forecasts.s e"plained above. the stable portion of the savings deposits fall under this category Most of the term deposits. are much similar to the volatile funds These funds are generally in transit and comprise of AA>s. ho!ever. 144 percent li1uidity !ill have to be provided for the variable component Based on the !orking funds. a dynamic figure since it depends on the !orking funds that may keep changing from time to time 2 $ash 7lo!s . consolidated or component-!ise. Banker>s che1ues. the bank !ill have to assess the cash balances( li1uidity position in the follo!ing manner.ay do!n the average cash and bank balances to be maintained as a percentage of total !orking funds  .Treasury Management In Banks 7inally.ny balance beyond this range !ill necessitate corrective action either by deploying the surplus funds or by borro!ing funds to meet the deficit This acceptance level is. by their nature fall under this category 7loat funds.

Treasury Management In Banks accommodation To tackle such a situation. trend can be established based on historical data about the change in the deposits and loans Before proceeding to discuss about the cash flo!s approach it is essential to understand t!o important parameters that relate to the approach 7irstly. it is the decision regarding the planning hori#on for the forecasts and secondly. data transmission costs and the maintenance of the systems used for this process These costs incurred in forecasting further depend on three important factors vi# branch net!orking. !hich occur !hen the bank initiates the cash forecasting process These include cash outflo!s for installation of the necessary information system that collates and maintains the data necessary for forecasting =n the other hand. the bank should decide on a period !hich !ill not affect the forecasted cash flo!s to a large e"tent and at the same time !ill enable it to make optimal investment-borro!ing decisions 7orecasting cash flo!s to assess and manage the li1uidity position of the bank. the costs involved in forecasting The planning hori#on of a bank may be a financial year or a part of it i e a fe! months to a 1uarter(half-year period The bank should ensure that the planning hori#on for estimating the li1uidity position should neither be too long or too short if the benefits of forecasting are to be reaped There are various factors both e"ternal and internal to the bank !hich have an impact on the forecasted cash flo!s Thus. !hen 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 Similarly !hen the planning hori#on is too short. !hich include the man-hours spent. forecasting periods !ithin the planning hori#on and the details of information re1uired for forecasting By nature. involves e"penditure These forecasting costs can further be classified into recurring costs and non-recurring costs -on-recurring costs are those. there are certain recurring costs occurring on a regular basis. these three factors have a direct influence on the forecasting costs This can be e"plained by the fact that if the bank has a !ide branch net!ork. it !ill definitely have to incur more e"penditure since data has to be collated from such a !ide net!ork accurately and at regular intervals Similarly. ho!ever. say a Thakur Institute of Management Studies and Research 55 . !hen the bank plans to forecast its cash position for every month during the planning hori#on of. decisions relating to borro!ings and investments may not be effective enough to increase profitability $onsidering these factors.

!hen compared to the cash inflo! forecasts relating to loan repayments and deposit accretion This difficulty in the forecasting of cash flo!s coupled !ith the mismatches arising due to the maturity pattern of assets and liabilities result in the li1uidity risk Thus the process of forecasting cash flo!s !ith a high degree of accuracy holds the key to risk management .  Estimate anticipated changes in deposits  Estimate the cash inflo!s by !ay of loan recovery  Estimate the cash outflo!s by !ay of deposit !ithdra!als and credit accommodations  7orecast these for the end of each period  Estimate the li1uidity needs over the planning hori#on The most critical task of li1uidity management is predicting the e"pected cash inflo!s coming by !ay of incremental deposits and recovery of credit and the outflo!s relating to deposit !ithdra!als and loan disbursals In this process. !hich needs no e"planation The bank should first decide on the planning hori#on that suits its operational style and then based on the cost constant decide on the number of forecasting periods and other such details 7ollo!ing such decisions !ill be the assessment of the li1uidity position based on the forecasts made for the cash inflo!s and outflo!s The basic steps involved in this process are as follo!s. it is al!ays better for the bank to consider that the deficit occurs at the beginning of the period !hile the surplus occurs at the end of the period Thus. !hen the forecasting period is chosen as a month In order to manage the intra-month li1uidity problems.ll 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. there should al!ays be a surplus balance In such a scenario. the cost of forecasting !ill be more as compared to the e"penditure incurred for forecasting !ill be more as compared to the e"penditure incurred for forecasting for every 1uarter(half-yearly period Bigher costs are involved !hen detailed information is sought. accuracy levels !hen a bank forecasts cash outflo!s by !ay of deposit !ithdra!als and credit disbursals are fairly high.Treasury Management In Banks year. funds should be provided to meet the deficit balance at the beginning of the forecasting period Thakur Institute of Management Studies and Research 5: .

ssessment of the li1uidity gap based on the forecasts is essentially one aspect of the li1uidity management The other ma9or task of li1uidity management is to manage this li1uidity gap by ad9usting the residual surplus(deficit balances $onsidering the high costs associated !ith cash forecasting. it is essential that the benefits dra!n by the bank from such forecasting should be substantially large to give some residual gains after meeting the forecasting costs This ob9ective can. INDESTMENT . provide for deposits !ithdra!als and secondly to accommodate the increase in credit demands 6hile deposit !ithdra!als must be honored immediately. be attained only if the bank makes prudent investment(borro!ing decisions to manage the surplus(deficit There are.  Aeposit 6ithdra!als  $redit . it is also of priority to ensure that legitimate loan re1uests of customers are met regardless of the funds position Satisfactory credit accommodation ultimately results in more business for the bank Thakur Institute of Management Studies and Research 5* .O!!O:IN$ #E ISIONS .ccommodation  &rofit fluctuation The li1uidity level to be maintained by a bank should firstly. a fe! factors !hich must be considered before deciding on the deployment of e"cess funds(borro!ings for meeting the deficit !hich are given belo!. ho!ever.Treasury Management In Banks (. ho!ever.

such a policy !ill not be advisable In such a case.s It might thus resort to gap management. if the bank adopts asset management and hence opts for short term investment policy then the bank !ill ad9ust the deficit arising in May !ith the surplus of .s and RS. !hile the bank can take its investment decisions based on its strategic policy the same !ill have to be revie!ed to adopt tactical policy to suit the changes in the operating environment The important criteria in taking such decisions !ill also be the yields on investments and the cost of borro!ing Thakur Institute of Management Studies and Research 5@ . the shortfalls can be met either by disinvesting the securities or by borro!ing funds from the market This again !ill depend on the strategical issue of !hether the bank prefers to manage its li1uidity risk using asset management or liability management If the bank decides to go for liability management then the investment policy ill be long term $onsider illustration 5 ) !here the planning hori#on is si" months and the forecasting period is one month If the bank opts for liability management.Treasury Management In Banks .pril and invest the remaining funds %i e 13-: D Rs 1* cr ' for May and Iune %since there is again a deficit arising at the beginning of Iuly' Influencing the strategic issues of bank>s investments are the tactical issues 6hile the bank may use asset management or liability management in their investment decisions they may nevertheless face certain critical charges in their operational environment !hich make the strategic policies unsuitable Implies that if the bank>s strategic policy is liability management.as there is a surplus arising at the end of Iune =n the other hand. in an increasing interest rate scenario. then the bank should revie! its RS. !hich might affect its li1uidity position =n the contrary !hen the profits are sho!ing increasing gro!th rates. the bank should ad9ust its surplus deficit to meet the li1uidity gap 6hile surplus funds can be invested in short(long-term securities depending on the bank>s investment policy.i1uidity is further influenced by the fluctuation in the business profits of the bank It has already been e"plained that any fluctuation in the interest rates may result in an increase decrease in the -IM of the bank If this fluctuation results in a negative gro!th i e a decrease in -IM. then the surplus of Rs 13 cr arising at the end of .pril !ill be invested for the ne"t five months and to meet the deficit arising at the beginning of may the bank !ill borro!s Rs : cr for 2 months i e May and Iune. the bank !ill have to go for asset management and the time the interest rates stabili#e and revert back to the liability management Thus. the bank !ould prefer to maintain higher li1uidity position by utili#ing the cash balances for investments loan disbursals This further improves its profitability levels $onsidering these factors.

The second important 1uestion that the bank !ill have to face is. e"pectations theory !hich e"plains the relation bet!een the interest rates and the investment period does not hold good in reality These occurrences e"plain the fact that the long-term investments do give higher yields than short-term investments The firm !ill also have to consider the transaction cost involved !hile converting its marketable securities Aeficit Balance. the bank has the option of either maintaining cash balances or investing these e"cess funds in securities(loans Though holding ade1uate cash reserves can eliminate the li1uidity risk completely. consider(understand the behavior of the yield curves on the long(short-term investments ?ield curves often are sloping up!ards since higher interest rates are associated !ith long term and relatively less li1uid assets 7or the. ho!ever. especially for a bank Bence the bank should make optimum use of its idle funds by investing in such a !ay that the yields earned are greater There are generally 2 options available to the ban !hile it makes its investment decisions It can invest either for a short term and roll over until the funds are re1uired for some other purpose of. invest for a longer period after properly assessing the cash re1uirements through the forecasting process In this decision making process one has to. the cost involved in doing so could be prohibitive. In case of a surplus balance.Treasury Management In Banks Surplus Balance. the aim of the bank should be to keep its cost of raising such short-term funds as lo! as possible The bank also has an option of meeting its deficit by internal sources by ad9usting against surplus balances obtained earlier In this option. ho! to meet the deficit cash balances The only alternative available to meet its deficit is by borro!ing funds from the market 6hile doing this. the number of forecasting periods plays a vital role Internal funds can be effectively used !hen the cost of borro!ing is relatively high There are various models that discuss the suitable ratio that can be maintained bet!een the cash balances and the investments T!o models. are the Baumol Model and the Miller and =rr Model The cash management model given by Baumol e"tends the Economic =rder Muantity concept used in inventory management Thakur Institute of Management Studies and Research 5< . !hich have been commonly used.

against the transaction costs incurred !hen the marketable securities are converted into cash The Miller and =rr model considers that there !ill 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 Thus. !hich resort to a sale of securities(borro!ings as and !hen the need for funds arises. a remarkable difference in this strategy used in this approach !hen compared to the earlier models Aistinguishing itself from the earlier methods. !hich influences the average cash holding of the firm This model analyses the income foregone !hen the firm holds cash balances %rather than investing the same in the marketable securities'. management can have a policy !hich has a relatively large(small amount of li1uidity 0. the criteria !hile taking such decisions !ill be to increase yields on investments and lo!er the costs of borro!ings Thus there should be optimi#ation 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 This trade off decision of the bank depends upon its attitude to!ards the li1uidity policy i e aggressive(conservative Aepending on the li1uidity position to be maintained. ho!ever. securitisation can impart li1uidity on a continuous basis and has little or no relation to be surplus deficit balances Thakur Institute of Management Studies and Research 5) .Treasury Management In Banks to discuss the dNcash conversion si#e. SE 6!ITIE*TION ?et another method of imparting li1uidity into the system by !ay of securitisation There is. the risk preferences and risk factors.

contributing to a ma9or chunk of the total turnover in the money and fore" markets Through a net!ork of state-of-the-art dealing rooms in India and abroad. *SE ST6#8 State . securitisation also reduces the interest rate e"posure for the bank since risk associated to the risk fluctuations !ill also be eliminated Securitisation can in fact be taken up on a continuous basis to supplement the other approaches 2.arge volumes of funds get blocked in pro9ect financing and asset financing activities of the institution Securitisation is an effective !ay to release these funds for further investments In securitisation the future cash flo!s from the advances made by the bank are repackaged into negotiable securities and issued to the investors This arrangement induces li1uidity into the system by imparting li1uidity to the highly illi1uid asset In the process of enhancing li1uidity.Treasury Management In Banks The loan profile of the bank !ill generally be long term in nature .an& of India T!E*S6!8 Profile &rofile India/s largest bank is also home to the country/s biggest and most po!erful Treasury. the SBI e"tends round-the-clock support to clients in managing their fore" and interest rate e"posures Thakur Institute of Management Studies and Research 53 . backed by the assured e"pertise of informed professionals.

maturity profiles of assets and liabilities and interest rate risks O Investments.Treasury Management In Banks SBI/s relationships !ith over <44 correspondent banks are also leveraged in e"tracting ma"imum value from treasury operations SBI/s treasury operations are channeled through the Rupee Treasury. preference shares. SBI offers financial support through a !ide spectrum of investment products that can substitute the traditional credit avenues of a corporate like commercial papers. the 7ore" Treasury and the Treasury Management 0roup The Rupee Treasury deals in the domestic money and debt markets !hile the 7ore" Treasury deals mainly in the local foreign e"change market The TM0 monitors the investment.R'. fi"ed and floating rate products SBI invests in primary and secondary market e1uity as per its o!n discretion These products allo! you to leverage the fle"ibility of financial markets.iability Management %.. investments and trading The Rupee Treasury also manages the bank>s position regarding statutory re1uirements like the cash reserve ratio %$RR' and the statutory li1uidity ratio %S. non-convertible debentures. as per the norms of the Reserve Bank of India Products and Ser%ices O . securiti#ed paper.sset . enable efficient interest risk management and optimi#e the cost of funds They can also be customi#ed in terms of tenors and li1uidity options Thakur Institute of Management Studies and Research :4 . risk and asset-liability management aspects of the Bank/s overseas offices !u'ee Treasury The Rupee Treasury carries out the bank>s rupee-based treasury functions in the domestic market Broadly..M'. these include asset liability management. The .M function comprises management of li1uidity.

and deals !ith all the ma9or corporates and institutions in all the financial centers in India and abroad The bank>s team of seasoned. rupee-foreign currency interest rate s!aps and cross currency s!aps ODE!SE*S T!E*S6!8 OPE!*TION Treasury Management $rou' The Treasury Management 0roup %TM0' is a part of the International Banking 0roup %IB0' and functions under the $hief 0eneral Manager %7oreign =ffices' .Treasury Management In Banks SBI invests in these instruments issued by your company. both in the Interbank and $orporate 7oreign E"change markets. corporate bonds.s the name implies the department monitors the management of treasury functions at SBI>s foreign offices including asset liability management. investments and fore" operations Thakur Institute of Management Studies and Research :1 . thus providing you a dynamic substitute for traditional credit options The Rupee Treasury handles the bank>s domestic investments Trading The bank>s trading operations are unmatched in si#e and value in the domestic market and cover government securities. skilled and professional dealers can tailor customi#ed solutions that meet your specific re1uirements and e"tract ma"imum value out of each market situation The bank>s dealing rooms provide 2:-hour trading facilities and employs state-of-the-art technology and information systems SBI>s relationships !ith over <44 correspondent banks and institutions across the globe enhance the strength of the 7ore" treasury The 7P Treasury can also structure and facilitate e"ecution of derivatives including long term rupee-foreign currency s!aps. call money and other instruments SBI is the biggest lender in call Fore@ Treasury >FF? The SBI is the country>s biggest and most important 7ore" Treasury.

M function comprises management of li1uidity. facilitating e"ecution of foreign currency derivatives including currency options.foreign currency s!aps.. composition and si#e of the portfolio. The . are %a' safety of the funds invested. TM0 also plays an important role in structuring.sset . maturity profiles of assets and liabilities and interest rate risks at the foreign offices O Investments.Treasury Management In Banks Products and Ser%ices O . apart from compliance !ith the regulatory re1uirements of the host country. %b' optimisation of profits from investment operations and %c' maintenance of li1uidity Investment operations are conducted in accordance !ith the investment policy for foreign offices formulated by TM0 The activites include appraisal of the performance of the foreign offices broad parameters such as income earned from investment operations.. cross currency s!aps and for!ard rate agreements $ommodity hedging is one of the recent activities taken up by TM0 O Reciprocal . Monitoring of investment operations of the foreign offices of the bank is one of the principal activities of TM0 The main ob9ectives of investment operations at our foreign offices.M'. marketing. Monitoring of fore" operations of our foreign offices is done !ith the ob9ective of optimising of returns !hile managing the attendant risks O 7ore" and Interest rate %7oreign $urrency' derivatives. performance vis-Q-vis the budgeted targets and the market value of the portfolio O 7ore" monitoring. and is based at Mumbai Thakur Institute of Management Studies and Research :2 .ines. The department is also responsible for maintenance of reciprocal lines !ith international banks Portfolio Management G ustodial Ser%ices The &ortfolio Management Services Section %&MS' 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 The &MS forms part of the Treasury Aept of State Bank of India. foreign currency interest rate s!aps.iability Management %. long term rupee .

even the most sophisticated investors are finding it difficult to address day to day investment concerns.dherence to stated investment ob9ectives O Security selection 1uality considerations O $onformity to policy constraints O Investment returns The team manning the &MS Section consists of highly e"perienced officers of State Bank of India.Treasury Management In Banks &MS !as set up e"clusively for management of investments of Social Security funds and custody of the securities related thereto In the increasingly comple" regulatory and investment environment of today. such as O . !ho have the re1uired depth of kno!ledge to handle large investment portfolios and address the concern of large investors The capabilities of the team range from Investment Management and $ustody to Information Reporting Thakur Institute of Management Studies and Research :5 .

has definitely led to Treasury management assuming a center stage But to have a proper Treasury Management process in place. ON "6SION To sum up. the paradigm shift in the risk e"posure levels of the Banks.Treasury Management In Banks 4. it has helped banks to effectively manage its Treasury and enhance it profitability !ith limiting its risk Thakur Institute of Management Studies and Research :: . a thorough understanding of the various operations on its assets liabilities becomes essential Such an understanding !ill enable the banks to identify and unbundled the risks and further aid in adopting and developing appropriate risk management models to manage risks 7urther !ith advancement in technology.

Ir Maga1ines G ne)s'a'ers<  Business !orld  Banking  .Treasury Management In Banks -.I. .rticles from economic times :e+ Sites<  !!! investopedia com  !!! treasury-management com  !!! financiale"press com Thakur Institute of Management Studies and Research :* ."IO$!*P78 .oo&s<  $ommercial banking by 7raserR0upRSolari  Treasury management by A $ 0ardner  $ommercial bank financial management by Ioseph 7 Sinkey.