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1.1 Objectives of the study
To know about Treasury functions of a bank in India.
To learn about different types of financial instruments which bank deals on a day
to basis.
This study enabled to have a greater exposure about the practicality of treasury
functions which I could study in contrast with the theoretical context.

1.2 Overview
Treasury refers to the funds and revenue at the possession of the bank and day to day
management of the same. Idle funds are usually source of loss, real or opportune, and,
thereby need to be managed, invested, and deployed with intent to improve profitability.
There is no profit or reward without attendant risk. Thus treasury functions seek to
maximize profit and earning by investing available funds at an acceptable level of risks.
Returns and risks both need to be managed. If we examine the balance sheets of
commercial banks (Public Sector Bank, typically), we find investment/deposit ratio has
by far overtaken credit/deposit ratio. Interest income from investments has overtaken
interest income from loans/advances. The special feature of such bloated portfolio is that
more than 85% of it is invested in government securities.

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.
Governments 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 sizably a book entry.
In this context, treasury functions 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.


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 functions 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

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.

3.1 Cash Reserve Ratio / Statutory Liquidity Ratio Management
RBI having regard to the needs of securing monetary stability in the country has
mandated Banks to deposit the portion of their money with RBI. CRR, or cash reserve
ratio, refers to the portion of NDTL i.e. Net Demand and Time liabilities that banks have
to maintain with RBI. This serves two purposes. First, it ensures that a portion of NDTL
is totally risk-free. Second, it enables RBI control liquidity in the system, and thereby,
inflation. Besides CRR, banks are required to invest a portion (21.5 per cent now) of their
NDTL in government securities as a part of their statutory liquidity ratio (SLR)
requirements. The government securities (also known as gilt - edged securities or gilts)
are bonds issued by the Central government to meet its revenue requirements. Although
the bonds are long-term in nature, they are liquid as they have a ready secondary market.

For calculation of CRR and SLR, it is taken as a percentage of Net demand and Time
liabilities of the Bank.
Demand Liabilities:It includes all liabilities which are payable on demand such as current deposits, margins
held against LOC / guarantees, recurring deposits, demand drafts, etc.
Time Liabilities:It includes all liabilities which are payable otherwise than on demand such as fixed
deposits, recurring deposits, margins held against LOC / guarantees, cash certificates, etc.

Other Demand and Time Liabilities: Interest accrued on deposits, Bills payable, unpaid dividends, etc. SCBs are not required
to include inter-bank term deposits / term borrowing liabilities of original maturities of 15
days & above and up to one year for calculation of NDTL in case of CRR. But in case of
SLR it needs to include inter-bank term deposits / term borrowing liabilities of original
maturities of 15 days & above and up to one year. Banks need to maintain prescribed
CRR & SLR as on last Friday of fortnight. All SCBs are required to maintain minimum
CRR balance up to 95% of total CRR requirement on all days of fortnight. CRR can be
kept in form of cash, gold or approved securities.
On daily basis: Interest of 3% p.a. above the bank rate will be recovered from bank. If it
continues, 5% p.a. above bank rate will be recovered.

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 NDTL. Banks are now
required to maintain 4 per cent of their NDTL with RBI. 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. This 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 21.5 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 program. 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 functions 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 in government securities has gone up
tremendously and trading in these securities has been quite active. They are not generally
in the form of securities but in the form of entries in RBI's Subsidiary General Ledger
The investors in government securities are mainly banks, FIs, insurance companies,
provident funds and trusts. These investors are required to hold a certain part of their
investments or liabilities in government paper. 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. Till recently, a few of the domestic players used to trade in these
securities with a majority investing in these instruments for the full term. This has been
changing of late, with a good number of banks setting up active treasuries to trade in
these securities.Perhaps the most liquid of the long term instruments, liquidity in gilts is
also aided by the primary dealer network set up by RBI and RBI's own open market

3.3 Money Market Functions

Money Market is for short term assets that are very close substitute of money. Money
market instruments are liquid and can be turned into cash quickly. 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.
A. Call Money Market
Call/Notice money is an amount borrowed or lent on demand for a very short period. 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'. Intervening holidays and/or Sundays are excluded
for this purpose. No collateral security is required to cover these transactions.

The call market enables the banks and institutions to even out their day-to-day
deficits and surpluses of money.

Banks (excluding RRBs) and primary dealers are allowed to borrow and lend in
this market for adjusting their cash reserve requirements.

Interest rates in the call and notice money markets are market determined.

In view of the short tenure of such transactions, both the borrowers and the
lenders are required to have current accounts with the Reserve Bank of India.

It serves as an outlet for deploying funds on short-term basis to the lenders having
steady inflow of funds.

B. Treasury Bills Market

Treasury bills (T-bills) offer short-term investment opportunities, generally up to one
year. They are thus useful in managing short-term liquidity. In the short term, the lowest
risk category instruments are the treasury bills. RBI issues these at a prefixed day and a
fixed amount.
There are three types of treasury bills;

91-day T-bill - maturity is in 91 days. Its auction is on every Wednesday of every

week. The notified amount for this auction is Rs.100 cr.

182-day T-bill - maturity is in 182 days. Its auction is on every alternate

Wednesday (which is not a reporting week). The notified amount for this auction is
Rs.100 cr.

364-Day T-bill - maturity is in 364 days. Its auction is on every alternate

Wednesday (which is a reporting week). The notified amount for this auction is Rs.500 cr.
Treasury bills are available for a minimum amount of Rs.25000 and in multiples of
Rs.25000. Treasury bills are issued at a discount and are redeemed at par. Treasury bills
are also issued under the Market Stabilization Scheme (MSS).

While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364-day Tbills are auctioned every alternate week on Wednesdays. The Reserve Bank of India
issues a quarterly calendar of T-bill auctions which is available at the website. It also
announces the exact dates of auction, the amount to be auctioned and payment dates by
issuing press releases prior to every auction.

Auction of T-bills

* If the day of payment falls on a holiday, the payment is made on the day after the

C. Ready Forward Contracts

It refers to a transaction in which two parties agree to sell and repurchase the same
security. 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. Similarly, 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 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. Thus, whether a
given agreement is termed as Repo or a Reverse Repo depends on which party initiated
the transaction.

The lender or buyer in a Repo is entitled to receive compensation for use of funds
provided to the counter party. Effectively the seller of the security borrows money for a
period of time (Repo period) at a particular rate of interest mutually agreed with the
buyer of the security who has lent the funds to the seller. The rate of interest agreed upon
is called the Repo rate.

The Repo rate is negotiated by the counter parties independently of the coupon
rate or rates of the underlying securities and is influenced by overall money market

Purchase & Sale price should be in alignment with the ongoing market rates.

Treasury Bills, State & Central Government Securities are eligible. PSU bonds

Private corporate instruments are also permitted if they are in demat form.

Further it can be undertaken only in securities that are in excess of SLR


The minimum period for Reverse Repo by listed companies is 7 days. However,
period for Repo is for shorter time including fortnight.

The counterparty should be either bank or Primary Dealer maintaining SGL with
Reserve Bank

Banks or PDs can enter in REPO transactions among themselves subject to

a) Its not between SGL a/c holder and its constituents.
b) Its not between 2 gilt a/c holders having their account with the same

Securities purchased under Reverse repo should not be classified under HTM

In repo transaction, it should be sold at market price & re-purchased at the derived
The motivation for the banks and other organizations to enter into a ready forward
transaction is that it can finance the purchase of securities or otherwise fund its
requirements at relatively competitive rates. On account of this reason the ready forward
transaction is purely a money lending operation. Under ready forward deal the seller of
the security is the borrower and the buyer is the lender of funds. Such a transaction offers
benefits both to the seller and the buyer. Seller gets the funds at a specified interest rate
and thus hedges himself against volatile rates without parting with his security
permanently (thereby avoiding any distressed sale) and the buyer gets the security to
meet his SLR requirements. In addition to pure funding reasons, the ready forward
transactions are often also resorted to manage short term SLR mismatches.
Apart from inter-bank repos RBI has been using this instrument effectively for its
liquidity management, both for absorbing liquidity and also for injecting funds into the
system. Thus, Repos and Reverse Repo are resorted to by the RBI as a tool of liquidity
control in the system. With a view to absorbing surplus liquidity from the system in a
flexible way and to prevent interest rate arbitraging, RBI introduced a system of daily
fixed rate repos from November 29, 1997.
For any additional liquidity requirements Primary Dealers are allowed to participate in
the reverse repo auction under the Liquidity Adjustment Facility along with Banks,
introduced by RBI in June 2000(Details given below). The major players in the repo and

reverse repurchase market tend to be banks that have substantially huge portfolios of
government securities. Besides these players, primary dealers who often hold large
inventories of tradable government securities are also active players in the repo and
reverse repo market.
The Repo/Reverse Repo transaction can only be done between parties approved by RBI
and in securities as approved by RBI (Treasury Bills, Central/State Govt securities).
Uses of Repo

It helps banks to invest surplus cash

It helps investor achieve money market returns with sovereign risk.

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.

RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the

After the second leg is over of the transaction:-

Difference between clean price of 1st leg and 2nd leg is interest income / expenditure.

Difference between the accrued interests paid between the two legs.

3.4 Collateralized Borrowing and Lending Obligation

Collateralized Borrowing and Lending Obligation (CBLO)", a money market Instrument
as approved by RBI, is a product developed by CCIL for the benefit of the entities who
have either been phased out from interbank call money market or have been given
restricted participation in terms of ceiling on call borrowing and lending transactions and

who do not have access to the call money market. CBLO is a discounted instrument
available in electronic book entry form for the maturity period ranging from one day to
ninety Days (can be made available up to one year as per RBI guidelines). In order to
enable the market participants to borrow and lend funds.
CCIL provides the Dealing System through:
- Indian Financial Network (INFINET), a closed user group to the Members of the
Negotiated Dealing System (NDS) who maintain Current account with RBI.
- Internet gateway for other entities who do not maintain Current account with RBI.
CBLO is explained as under:
An obligation by the borrower to return the money borrowed, at a specified
future date;
An authority to the lender to receive money lent, at a specified future date with
an option/privilege to transfer the authority to another person for value received;
An underlying charge on securities held in custody (with CCIL) for the amount
Membership to CBLO segment is extended to entities that are RBI- NDS members viz.
Nationalized Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial
Institutions, Insurance Companies, Mutual Funds, Primary Dealers etc. Associate
Membership to CBLO segment is extended to entities who are not members of RBI- NDS
viz. Co-operative Banks, Mutual Funds, Insurance companies, NBFC's, Corporates,
Provident/ Pension Funds etc.
Eligible Securities:
Eligible securities are Central Government securities including Treasury Bills, as
specified by CCIL from time to time.

Borrowing Limit and Initial Margin:

Borrowing limit for the members is fixed every day after marking to market and applying
appropriate hair-cuts on the securities deposited in the CSGL account. The post hair-cut
Mark-to-Market value after adjusting for the amounts already borrowed by the members
is the borrowing limit, which, in effect, denotes the drawing power up to which the
members can borrow funds. Members are required to deposit initial margin generally in
the form of Cash (minimum Rs.1 lac) and Government Securities. Initial margin is
computed at the rate of 0.50% on the total amount borrowed/lent by the members.
Intraday BL/IM enhancements facility is also provided to CBLO members. Members can
also withdraw unencumbered portion of BL intraday. However, intraday cash withdrawal
is not possible.

3.5 Short Selling

Short Selling refers to selling of securities that one does not own. A bank can also
undertake Notional short sale of securities i.e. selling a security from HFT category even
if it is held under HTM / AFS category of investments of the bank. Short sale transaction
has to be covered within maximum period of 5 days i.e. T + 4 days. Short Sale
transactions should be executed only on NDS-OM.
Failure to settle the short sell transaction is considered as SGL bouncing and Bank will be
liable to action. Total Short sale transaction of a bank should not exceed 0.5% of the total
outstanding stock. SCBs (other than RRB and LAB) & Primary Dealers are permitted.
Selling of securities that one does not own and the same being covered by outright
purchase within the same trading day.

3.6 When Issued Market

When, As and If issued is commonly known as When Issued. It refers to the security that
has been authorized for issuance but not yet actually issued. In this market, trading takes
place between the period of new issue announced and actually issued. It is settled on the
date of issue. Only Primary Dealers are allowed to short sell in When Issued Market.

Issue announced ----------- When Issued Market ---------- day preceding the date of issue

Limits for transaction in When Issued Market

Non PDs Long position should not exceed 5% of the notified amount.
PDs Long position or Short position should not exceed 10% of notified amount
(Reissued Security)
* Short Position not exceeding 6% of notified amount (New Issue)
* Long Position should not exceed 10% of notified amount (New Issue)

3.7 Non-SLR Investments

Banks investment in Non-SLR securities issued by corporate, banks, FIs and State
& Central Government sponsored institutions, etc. including capital gains bonds.

Banks should not invest in Non-SLR securities which have maturity of less than 1
year other than Commercial Paper and Certificate of Deposits.

It should not invest in unrated Non-SLR.

It should ensure that it makes investment only in listed securities.

Investment by the Bank in unlisted Non-SLR securities should not exceed 10% of
its total Non-SLR investments.

Banks investment in Unlisted Non-SLR can exceed by additional 10% provided

the further investment is in securitization of papers issued for infrastructure projects and
bonds issued by reconstruction companies.


No Bank shall offer any Portfolio Management Service or other such type of
schemes in future without obtaining specific prior approval from RBI.

Non-Banking Financial Companies are allowed to undertake PMS.

If Banks are offering PMS, then

- It should be entirely at customers risk without guaranteeing any return.

Funds should be for period more than 1 year.

Funds should not be used for lending in call / notice money, inter-bank
deposits, bill rediscounting markets and lending to corporate bodies.

Client wise account should be maintained.

Banks own investment and PMS investment should be distinct.

Clients portfolio should be maintained at market rates.

3.9 Banks exposure to Capital Markets

Direct Exposure
It refers to direct investment in equity shares, convertible bonds, convertible debentures
and units of equity oriented mutual funds.
Indirect Exposure
1. Advances against securities to individuals for investment in
securities 20 lakhs per individual Physical form 20 lakhs per
individual - Demat form 10 lakhs per individual IPO
2. Advances against securities for any other purpose.

3. Advances to stockbrokers and guarantees issued

4. Loans sanctioned to corporate against securities for raising funds.
5. And, all exposures to Venture capital funds.

3.10 Classification of Investment Portfolio

Banks investment portfolio is classified into 3 categories:-

Banks should decide the category of investment at the time of acquisition.

(A) Held to Maturity (HTM)
Investments under Held to Maturity category are the securities held by the bank with
the objective to hold them up to maturity. For example, 11.40% GOI Bond 2011. This
security under HTM category will be held till the year 2011. Only 25% of the total
investments can be included in this category.

Following investments fall under HTM category but are not counted for the purpose of
limit of 25%:a) Investment in Subsidiaries and Joint Venture.
b) Debentures/Bonds deemed to be advance.

Re-capitalization Bonds received from GOI towards their re-capitalization

requirement and held in their investment portfolio.

It can exceed the limit of 25% provided
a) The excess comprises only of SLR securities
b) The total SLR held under HTM category is not more than 25% of their NDTL
No fresh Non-SLR securities are permitted to be included in the HTM category.
(B) Held for Trading (HFT)
Securities acquired by the Banks with the intention to trade by taking advantage of shortterm price/interest rate movement comes under Held for Trading category. These
securities are to be sold within 90 days. There is no limit on the extent of holdings.
(C) Available for Sale (AFS)
Securities which do not fall under HFT & HTM will come under Available for Sale
category. There is no limit on the extent of holdings.

3.11 Non-Performing Investments

Non Performing investment is one where:
(a) Interest / Installment is due and remains unpaid for more than 90 days.

(b) Fixed dividend of Preference Shares is not paid.

If any credit facility availed by the issuer is NPA in books of Bank, investment in any
securities issued by the same issuer would be treated as NPI and vice versa.

4.1 Instruments
A financial instrument settled at a future date which requires little or no investment
compared to other types of contracts.

(1) Forward Rate Agreement

It is a contract between 2 parties for the exchange of the interest payments for a principal
amount on settlement date. It is a contract in which one party pays fixed interest rate and
receives floating interest rate. It is for a period from start date to maturity date.
(2) Interest Rate Swaps
An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or
swapping a stream of interest payments for a notional principal amount on multiple
occasions during a specified period. Such contracts generally involve exchange of fixed
to floating or floating to floating rates of interest.

(3) Interest Rate Futures

Exchange traded future.
(4) Foreign Currency Forward
In this contract, purchaser and seller agrees to buy & sell a specified amount of specified
currency on a certain date in future.
(5) Currency Swaps
A foreign exchange agreement between two parties where they agree to exchange the two
currencies at the prevailing spot exchange rate with an agreement to reverse the exchange
of currencies at the same spot exchange rate.
(6) Currency Options
A contract where purchase has the right but not the obligation to purchase (call) or sell
(put) and the seller agrees to sell or purchase an agreed amount of specified currency at a
price agreed and denominated in another currency in future.
All this instruments serve a useful risk-management purpose. It enables transfer of
various financial risks to entities who are more willing or better suited to manage them.
Users can hedge specifically reduce or extinguish an existing identified risk on an
ongoing basis during the life of transaction or for transformation of risk exposure.

4.2 Risks Associated

There are various risks to which Market Makers are exposed in their Derivatives

Risk of loss due to counterpartys failure to perform on an obligation of the institution.
There are two types of Credit Risk:
(a) Pre-Settlement Risk
The risk that one party of a contract will fail to meet the terms of the contract and default
before the contract's settlement date, prematurely ending the contract.
(b) Settlement Risk
The risk that one party will fail to deliver the terms of a contract with another party at the
time of settlement. Its the risk that one party will not perform his part of obligation even
if the other party has already performed his obligation.
This is a risk of loss due to adverse changes in the market value of instruments. The
change in the market value of the instruments is due to changes in market factors such as
interest rates, exchange rates, equity prices, commodity prices.
Risk of loss due to failure of an institution to meet its funding requirements or to execute
a transaction at a reasonable price. In other words, the risk that a bank cannot meet or
generate sufficient cash resources to meet its payment obligations in full as they fall due,
or can only do so at materially disadvantageous terms.
An operational risk is a risk arising from a company's business functions and from the
practical implementation of the management's strategy. As such, it is a very broad
concept including e.g. information risks, fraud risks, physical or environmental risks, etc.
The Risk Principle is an area of law closely tied to legal causation in negligence. It
provides limits on negligence for harm caused unforeseeably.

4.3 Market Risk Limits

This refers to setting the limits in terms of transaction volumes.
To avoid unrealized loss if exceeded specified level. Positions are either liquidated or
hedged at this limit.
This is an addition to Stop Loss limit. This limit is for early warning for the traders.
This is designed to restrict the total potential loss from derivative products to levels
approved by the board. Management calculates the current market value of positions and
then uses statistical modeling techniques to assess the probable loss. VAR is related
directly to amount of capital or earnings which are at risk. VAR reflects the maximum
exposure authorized by the Board.

5.1 Stress Testing
There are many statistical models that are available to measure & manage the financial
risks. These models provide a framework for identifying, analyzing, measuring,
communicating and managing their risks. These models are not capable of capturing
sudden and dramatic changes. In order to deal with the changes, Banks supplements these
models with Stress Tests. It has become an integral part of Banks Risk Management

Sensitivity Tests: - Normally used to assess the impact of change in one variable such as
significant movement in the foreign exchange rates, equity index, etc. on the banks
financial position.
Scenario Tests: - simultaneous moves in a number of variables such as equity prices, oil
prices, foreign exchange rates, interest rates, etc. based on single event experienced in
past or an event that has not yet happened. Stress testing framework helps banks to be
better equipped to meet the stress situations as & when they arise and also overcome
them so that they do not become a serious threat.


Banks understanding of its risk profile.

Assessing the adequacy of internal capital.

Supplementing the models which have a drawback of predictive power.

Introducing a forward looking element.

Stress Tests results may be used:

For setting risk limits.

Allocating capital for various risks.

Managing risk exposures.

Putting in place appropriate contingency plans.

Stress test only indicates the likely impact and not the likelihood of the stress events.

5.2 CRAR
It indicates the amount of capital that is backing up risk weighted assets. Banks adopt
standardized approach for credit risk which requires all counterparties to be assigned risk
weight basis external credit ratings. Minimum CRAR of 9% is to be maintained by the
Banks. The fundamental objective behind the norms is to strengthen the soundness and
stability of the banking system. Tier I Capital should at no point of time be less than 50%
of the total capital. This implies that Tier II cannot be more than 50% of the total capital.
Capital fund:
Capital Fund has two tiers
Tier I capital include


*other disclosed free reserves
*capital reserves representing surplus arising out of sale proceeds of assets.



subsidiaries, *intangible assets, and

*losses in the current period and those brought forward from previous periods to
work out the Tier I capital.

Tier II capital consists of:

*Un-disclosed reserves and cumulative perpetual preference shares:
*Revaluation Reserves (at a discount of 55 percent while determining their value for
inclusion in Tier II capital)
*General Provisions and Loss Reserves up to a maximum of 1.25% of weighted
risk Assets:
*Investment fluctuation reserve not subject to 1.25% restrictions
*Hybrid debt capital Instruments (say bonds):
*Subordinated debt (long term unsecured loans:

5.3 Asset Liability Management

In banking, asset liability management is the practice of managing risks that arise due to
mismatches between the assets and liabilities (debts and assets) of the bank. Banks face
several risks such as the liquidity risk, interest rate risk, credit risk and operational risk.
Asset Liability management (ALM) is a strategic management tool to manage interest
rate risk and liquidity risk faced by banks, other financial services companies and
Banks manage the risks of Asset liability mismatch by matching the assets and liabilities
according to the maturity pattern or the matching the duration, by hedging and by
securitization. Modern risk management now takes place from an integrated approach to
enterprise risk management that reflects the fact that interest rate risk, credit risk, market
risk, and liquidity risk are all interrelated.

Asset-Liability Management (ALM) can be termed as a risk management technique

designed to earn an adequate return while maintaining a comfortable surplus of assets
beyond liabilities. It takes into consideration interest rates, earning power, and degree of
willingness to take on debt and hence is also known as Surplus Management.
But in the last decade the meaning of ALM has evolved. It is now used in many different
ways under different contexts. ALM, which was actually pioneered by financial
institutions and banks, are now widely being used in industries too. The Society of
Actuaries Task Force on ALM Principles, Canada, offers the following definition for

ALM: "Asset Liability Management is the on-going process of formulating,

implementing, monitoring, and revising strategies related to assets and liabilities in an
attempt to achieve financial objectives for a given set of risk tolerances and constraints."
Basis of Asset-Liability Management
Traditionally, banks and insurance companies used accrual system of accounting for all
their assets and liabilities. They would take on liabilities - such as deposits, life insurance
policies or annuities. They would then invest the proceeds from these liabilities in assets
such as loans, bonds or real estate. All these assets and liabilities were held at book value.
Doing so disguised possible risks arising from how the assets and liabilities were
Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same
money at 7 % to a highly rated borrower for 5 years. The net transaction appears
profitable-the bank is earning a 100 basis point spread - but it entails considerable risk. At
the end of a year, the bank will have to find new financing for the loan, which will have 4
more years before it matures. If interest rates have risen, the bank may have to pay a
higher rate of interest on the new financing than the fixed 7 % it is earning on its loan.
Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in
serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its
financing. Accrual accounting does not recognize this problem. Based upon accrual
accounting, the bank would earn Rs 100,000 in the first year although in the preceding
years it is going to incur a loss.
The problem in this example was caused by a mismatch between assets and liabilities.
Prior to the 1970's, such mismatches tended not to be a significant problem. Interest rates
in developed countries experienced only modest fluctuations, so losses due to asset
liability mismatches were small or trivial. Many firms intentionally mismatched their
balance sheets and as yield curves were generally upward sloping, banks could earn a
spread by borrowing short and lending long.
Things started to change in the 1970s, which ushered in a period of volatile interest rates
that continued till the early 1980s. US regulations which had capped the interest rates so
that banks could pay depositors, was abandoned which led to a migration of dollar

deposit overseas. Managers of many firms, who were accustomed to thinking in terms of
accrual accounting, were slow to recognize this emerging risk. Some firms suffered
staggering losses. Because the firms used accrual accounting, it resulted in more of
crippled balance sheets than bankruptcies. Firms had no options but to accrue the losses
over a subsequent period of 5 to 10 years.
One example, which drew attention, was that of US mutual life insurance company "The
Equitable." During the early 1980s, as the USD yield curve was inverted with short-term
interest rates sky rocketing, the company sold a number of long-term Guaranteed Interest
Contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. Equitable
then invested the assets short-term to earn the high interest rates guaranteed on the
contracts. But short-term interest rates soon came down. When the Equitable had to
reinvest, it couldn't get even close to the interest rates it was paying on the GICs. The
firm was crippled. Eventually, it had to demutualize and was acquired by the Axa Group.
Increasingly banks and asset management companies started to focus on Asset- Liability
Risk. The problem was not that the value of assets might fall or that the value of
liabilities might rise. It was that capital might be depleted by narrowing of the difference
between assets and liabilities and that the values of assets and liabilities might fail to
move in tandem. Asset-liability risk is predominantly a leveraged form of risk.
The capital of most financial institutions is small relative to the firm's assets or liabilities,
and so small percentage changes in assets or liabilities can translate into large percentage
changes in capital. Accrual accounting could disguise the problem by deferring losses
into the future, but it could not solve the problem. Firms responded by forming assetliability management (ALM) departments to assess these asset-liability risk.

5.4 Interest Rate Risk

Due to the very nature of its business, a bank should accept interest rate risk not by
chance but by choice. And when the bank has to take a risk as a choice, then it should
ensure that the risk taken is firstly manageable and secondly it does not get transformed
into yet another undesirable risk. As stated earlier, the focal point in managing any risk
will 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
interest income/interest expenditure or values of assets/liabilities to the interest rate

5.5 Contingency Funding Plan

The Reserve Bank of India working group on "market risk management" has suggested
that all commercial banks should put in place contingency funding plans, which quantify
the likely impact of an event on their balance sheet and also evaluate their ability to
withstand a prolonged adverse liquidity environment.
As part of the detailed guidance note on MRM, the working group said if the contingency
funding plans, which are liquidity stress tests, result in a funding gap within a threemonth time frame, the asset liability committee must establish an action plan to address
the situation.
MRM for a bank involves management of interest rate risk, foreign exchange risk,
commodity price risk and equity price risk. Besides, it is equally concerned about the
bank's ability to meet its obligations as and when they fall due.
At a minimum, the CFPs under each scenario must consider the impact of accelerated
runoff of large funds providers and they must take into account the impact of a
progressive, tiered deterioration, as well as sudden, drastic events. The note called upon
all banks to establish specific policies, which should represent minimum requirements for
them including approval levels and requirements for any exceptions, deviations or
waivers, on MRM.
The policies should among others, cover the responsibilities of the risk management

committee/ risk taking unit/ market risk manager; identify risks, limits and triggers.
Further the risk reporting should enhance risk communication across different levels of
the bank, from the trading desk to the CEO. Successful implementation of any risk
management process has to emanate from the top management and its strong
commitment to integrate basic functions and strategic decision making with risk
management. Measuring and managing liquidity risk, which is the potential inability of
banks to meet liabilities as they become due, are vital for effective operation of the banks.
Banks should track the impact of pre-payments of loans, premature closure of deposits
and exercise options built in certain instruments which offer put/call options after
specified times. They should evolve a system for monitoring high value deposits (other
than inter-bank deposits) say Rs.10 million or more to track volatile liabilities. The
working group pointed out that management of the interest rate risk should be one of the
critical components of MRM in banks as deregulation of the interest rates has exposed
them to the adverse impacts of interest rate risk.

The foreign exchange (currency or forex or FX) market exists wherever one currency is
traded for another. It is the largest financial market in the world, and includes trading
between large banks, central banks, currency speculators, multinational corporations,
governments, and other financial markets and institutions. The average daily trade in the
global forex and related markets currently is over US$ 3 trillion. Although exchange rates
are affected by many factors, in the end, currency prices are a result of supply and
demand forces. The world's currency markets can be viewed as a huge melting pot: in a
large and ever-changing mix of current events, supply and demand factors are constantly
shifting, and the price of one currency in relation to another shifts accordingly. No other
market encompasses (and distills) as much of what is going on in the world at any given
time as foreign exchange.
Supply and demand for any given currency and thus its value, are not influenced by any
single element, but rather by several. These elements generally fall into three categories:
economic factors, political conditions and market psychology.

6.1 Exchange Rate Applications

An Exporter will be happy with the depreciation in the value of the domestic
currency as he will get more of domestic currency in exchange of given foreign currency.

An Importer will be unhappy with the depreciation in the value of the domestic
currency as he will get less of domestic currency in exchange of given foreign currency.

Hike in oil prices impacts the exchange rates. Data of the last few years show that
the Indian Rupee depreciated against all the major currencies of the world.

Value of the Rupee is determined on daily basis by linking it to a basket of

currencies with different weightages.

Under direct quotation, the foreign currency is constant and domestic currency differs.
1$ = 50.50 51.25
This quote shows that when a customer wants to buy 1 dollar he will have to pay 51.25


Authorized Dealers in FX

Exchange Brokers

Foreign / Overseas Market i.e. Banks & Brokers abroad

Customers needing / disposing foreign exchange

6.2 Financial instruments

A spot transaction is a two-day delivery transaction (except in the case of the Canadian
dollar, which settles the next day), as opposed to the futures contracts, which are usually

three months. This trade represents a direct exchange between two currencies, has
the shortest time frame, involves cash rather than a contract; and interest is not included
in the agreed-upon transaction. The data for this study come from the spot market. Spot
has the largest share by volume in FX transactions among all instruments.
One way to deal with the forex risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A
buyer and seller agree on an exchange rate for any date in the future, and the transaction
occurs on that date, regardless of what the market rates are then. The duration of the trade
can be a few days, months or years.

Foreign currency futures are forward transactions with standard contract sizes and
maturity dates for example, 500,000 British pounds for next November at an agreed
rate. Futures are standardized and are usually traded on an exchange created for this
purpose. The average contract length is roughly 3 months. Futures contracts are usually
inclusive of any interest amounts.
The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded through
an exchange.
A foreign exchange option (commonly shortened to just FX option) is a derivative where
the owner has the right but not the obligation to exchange money denominated in one
currency into another currency at a pre-agreed exchange rate on a specified date. The FX

options market is the deepest, largest and most liquid market for options of any kind in
the world.

6.3 Processing Corporate FX Deals

All the corporate deals are written by traders in serially numbered corporate worksheets.
The back office work is to ensure that any corrections on the worksheet are duly
authenticated by the trader. If there is a break in the serial number order of the worksheet,
it should be investigated and reasons should be obtained from the trader. It should be
brought to the attention of the Head-Corporate Advisory Services by way of a memo.

The next morning contract confirmations are printed for all the deals booked the previous
day. On the reverse side of the confirmation the back office mentions the underlying
exposure as indicated by the trader on the worksheets. Every corporate confirmation has
to be affixed with Rs. 100 agreement stamps and defaced. The franking of stamps is done
on the second copy of the confirmation. This is the copy, which is signed by the customer
and returned as deal confirmation. All contract confirmations should be sent to customers
latest by T+1 date. Confirmations not received from the counterparty duly signed by their
authorized signatories or confirmations received with discrepancies which are not
resolved within 10 days from the trade date, will be reported in the month-end exception
When the trader receives intimation from the customer to cancel a deal, the cancellation
worksheet is completed which is a serially numbered worksheet. The trader retrieves the
deal which has to be cancelled in T2 and compensated the deal in T2 to the extent of the
cancellation amount, which means a reverse deal is booked by the system for the
cancellation amount and the cancellation rate is keyed in by the trader. If it is a cross
currency cancellation, the trader will have to book one more deal in addition to the
compensating deal, which is the compensation deal i.e. for conveying the variable
currency in the compensating deal into local currency (INR). Compensation deals can be
identified in T2 as they are booked.

The compensating deals and compensation deals flow into the system.

The contract utilizations are reported to the trader by the departments concerned. The
trader confirms the same along with their comments on Early Delivery charges (if any).
The processing of utilizations done by the back office is as follows:

6.4 Rate scan

This report is reviewed by the back-office. This reflects deals which have been executed
at rates which fall outside the tolerance limit approved by the Country Treasurer. They
will appear with a single asterisk or double asterisk depending on a 0.5% or 1% variance
respectively, from the days reval rate. A second level check is done by comparing the
deal rate to the high and low rates reflected. If it is within this range, a remark will be
written on the report that it is within the days range. If it is outside this range, an
explanation should be sought from the trader concerned. The appropriate remarks are
written on the Rate Scan Report.


Treasury refers to the fund and revenue at the possession of the bank and day-to-day
management of the same. The Treasury Functions Department is responsible for
Treasury's middle and back office functions, all systems services, and provides Cash
Management and Banking Relations services as a whole.

Bank managements are highly sensitive to Treasury risks, as they arise out of the high
leverage of the treasury business. The risk of losing capital is much higher than, say, in
the credit business. The second reason for managements concern is the large size of the
transaction done, at the sole discretion of the treasurers.

Treasury investments are categorized into government securities, other approved

securities, shares, debentures and bonds, commercial papers, and mutual funds. In line
with international best practices, the investments are classified into three categories

There are too many norms and regulation that the Banks have to comply with while
making all such treasury transactions. And, inspite of RBI imposing SLR of 25%, banks
investment in SLR securities continue to be more than required. This shows that banks
are also keen towards investing in the Government securities rather than anywhere else.

There are various risks to which banks are exposed to while dealing in securities, forex
market, derivative products. Risk management is very important element that are need
to be considered while taking any decision or even while framing the investment policy.

Treasury Functions are considered to be the heart of Indian Banks without which the
financial system would have been incomplete.

Books Referred

Name of Book


Guidance Note on Audit of Banks

Vijay Kapur, ICAI

Foreign Exchange A Practical Approach

P. Balachandaran

RBI Master Circulars


Websites Accessed