Banking Audit Practice Guide II

kpmg
Bank Practice Guide

Volume II
International Audit &

Accounting Department
October 1996
Bank Practice Guide
kpmg
Contents
Contents
Volume 1
1 Using the bank practice guide
2 Audit strategy and other planning considerations
3 Effective audit evidence
Glossary
Index
Volume 2
1 The business of banking
2 Risk management and limits
3 Lending
4 Allowance for credit losses
5 Money market and foreign exchange
6 Dealing and investment securities
7 Financial futures
8 Interest rate swaps
9 Options
10 Interest rate caps, floors and collars
11 Forward rate agreements
12 Deposits
13 Documentary credits and acceptances
14 Leasing
15 Other banking activities
16 Analytical procedures
17 Substantive sampling
18 Confirmations
19 IT and banking
20 Regulation
Index
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Contents
Foreign exchange........................... 3.23

Volume 1 Swaps ............................................. 3.31
Options .......................................... 3.39
1 Using the bank practice guide Futures ........................................... 3.47
Forward rate agreements................3.55
Introduction ..................................... 1.1 Capital markets .............................. 3.63
Scope of the KPMG bank practice Lending and direct credit
guide ................................................ 1.2 substitutes ...................................... 3.71
Structure of the KPMG bank Allowance for credit losses............3.79
practice guide .................................. 1.5 Profit and loss account and
business overview .......................... 3.87
2 Audit strategy and other planning
considerations Glossary
Introduction ..................................... 2.1
Understanding the client’s Index
business ........................................... 2.3
Identification of the risks facing
the client’s business ........................ 2.6
Critical audit objectives in a
bank or financial institution .......... 2.23 Volume 2
Obtaining an overview of
internal control .............................. 2.26 1 The business of banking
Assessment of inherent risk,
control risk and the risk of Introduction..................................... 1.1
significant misstatement................ 2.31 Domestic and international
Classes of transactions .................. 2.38 banking ........................................... 1.8
Role of internal audit .................... 2.43 Retail and wholesale banking ........1.10
Planned audit precision ................. 2.47 International financial centres........1.14
Appendix 1: Treasury control
environment 2 Risk management and limits
Appendix 2: Guidance on inherent Introduction..................................... 2.1
risk considerations for banks and Asset - liability management .......... 2.2
other financial institutions Other risk management
Appendix 3: Indicative relative techniques ...................................... 2.16
assessment of inherent risk for each Banking risks by activity ............... 2.17
assertion in banks and other financial Limits ............................................. 2.18
institutions Credit limits ................................... 2.19
Liquidity limits .............................. 2.22
3 Effective audit evidence Interest rate position limits ............2.26
Introduction ..................................... 3.1 Foreign exchange position
Nostro accounts and payment limits .............................................. 2.32
systems ............................................ 3.5
Money market assets and 3 Lending
liabilities ........................................ 3.15 Introduction..................................... 3.1
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Types of lending ............................. 3.7

Types of security (collateral) ........ 3.31 7 Financial futures
Organisation, operations,
Introduction to derivatives .............. 7.1
and records .................................... 3.34
Financial futures ............................. 7.2
Accounting matters ....................... 3.45
Mechanics of financial futures
Auditing guidance ......................... 3.60
trading ............................................7.15
Accounting matters ........................7.25
Other matters ................................. 7.36
Introduction ..................................... 4.1 Auditing guidance ......................... 7.39
Substantive credit file reviews ...... 4.30 8 Interest rate swaps
Assessing the adequacy of the
Introduction..................................... 8.1
allowance for loan loss .................. 4.58
General definitions ......................... 8.7
Example commercial credit
Valuation of interest rate
review working paper ................... 4.70
swaps ............................................. 8.26
Other credit evaluation
Other matters ................................. 8.58
considerations ............................... 4.72
Appendix: Valuation formula for
5 Money market and foreign
interest rate swaps
exchange
Introduction ..................................... 5.1 9 Options
Money market transactions ............. 5.9
Introduction..................................... 9.1
Foreign exchange transactions ...... 5.11
Mechanics of trading currency
Organisation, operations and
options through an exchange ......... 9.21
records ........................................... 5.28
Accounting matters - currency
options............................................9.26
Other matters ................................. 9.34
Appendix: Foreign exchange
accounting
Appendix: Valuation formula for off-
balance sheet instruments
Introduction and types of 10 Interest rate caps, collars and
securities and transactions............... 6.1 floors
Organisation, operations,
Introduction....................................10.1
limits and records .......................... 6.16
Accounting matters ..................... 10.11
Risk considerations and
Other matters .............................. 10.13
controls .......................................... 6.27
Auditing guidance ...................... 10.16
Short sales, wash sales and
"unseasoned" bond transactions .... 6.60 11 Forward rate agreements
Auditing guidance ......................... 6.68 Introduction....................................11.1
Mechanics of FRAs ....................... 11.4
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Other matters............................... 11.19

Auditing guidance ....................... 11.22 17 Substantive sampling
Introduction....................................17.1
12 Deposits
Sampling off-balance sheet
Introduction ................................... 12.1 instruments..................................... 17.3
Types of deposits .......................... 12.2
Auditing guidance ......................... 12.9 18 Confirmations
Introduction....................................18.1
13 Documentary credits and
Types of confirmations .................. 18.3
acceptances
Sample letters ................................18.8
Introduction ................................... 13.1
Organisation, operations and 19 IT and banking
records ......................................... 13.20
Introduction....................................19.1
The banking environment .............. 19.2
Auditing guidance ....................... 13.45
Characteristics of the IT
environment ................................ 19.12
14 Leasing
Risks associated with the
Introduction and types of use of IT in the banking
leasing transactions ....................... 14.1 industry ....................................... 19.43
Organisation, operations and How clients manage (control)
records ........................................... 14.5 these risks in the banking
Accounting matters ....................... 14.6 industry ....................................... 19.50
Auditing guidance ....................... 14.15 Implications for our audit
approach...................................... 19.55
15 Other banking activities The future - emerging
technologies in banking .............. 19.73
Introduction ................................... 15.1
Trustee and related activities ........ 15.2
20 Regulation
Bond and loan syndication ............ 15.4
Money transfer systems .............. 15.19
Bullion trading ............................ 15.22 Glossary
Policies, key controls and
records ......................................... 15.32
Index
Introduction ................................... 16.1
Use of analytical procedures
in the planning stage...................... 16.3
Obtaining effective audit
evidence using analytical
procedures ..................................... 16.5
Sources of information for
analysis ........................................ 16.11
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Introduction
1.1 Banks are financial intermediaries. In simplest terms, they buy the use of funds from those
willing to sell, in order to sell them to those wanting to buy. Banks profit by their ability to
control and price the risks associated with the movement of money, and process transactions
efficiently and effectively. Profits are derived primarily from interest margin, supplemented by
fee income.
1.2 Banks thus broker funds, and in doing so help to avoid the inefficiencies that would result
were it necessary for the ultimate buyers and sellers of funds to find each other and conduct
their transactions face-to-face. Banks, however, are not the only financial intermediaries
broking funds. A variety of institutions, such as insurance companies, securities firms engaged
in trading or underwriting, investment or finance companies, as well as the treasury function
within any well-managed corporation, are all involved, to one degree or another, in the business
of acquiring funds to be able to resell them and to do so profitably. What distinguishes banks as
institutions from these other enterprises, though such distinctions have grown dramatically less-
pronounced in the past decade, is the extent to which they function as market makers for a wide
variety of financial products to serve the needs of both those buying and those selling funds.
1.3 Banks acquire the use of funds primarily through deposits and sell their use in the form of
loans or investments. Banks normally have a unique balance sheet structure in that they borrow
short and lend long. For other commercial enterprises, this would be considered imprudent.
For banks, it is essentially the only way to do business and is the principal reason why
maintenance of confidence among the deposit base is vital to their stability.
1.4 The banks use liquid deposits, or other extremely short-term liabilities that are often
withdrawable on demand, to build an asset base that principally comprises highly illiquid loans,
which normally cannot be sold quickly without a loss in value. This financing structure means
that liquidity management is key and will be achieved by techniques rarely encountered in other
commercial enterprises, and results in some unique exposures.
1.5 The activities of banks are more complex than would be normal for most other commercial
enterprises. The volume of transactions is usually much higher, with much greater use of
computer processing (indeed, banks tend to be at the leading edge of computer technology).
There is often a high degree of inter-dependence between a range of transactions impacting
treasury, lending and the trading desk. As will be discussed in later chapters, these factors
combine to produce a complex array of risks.
1.6 As market makers, banks specialise in the transfer of funds, enabling customers to make
same or next-day payments virtually anywhere in the world. To facilitate such funds transfers,
banks have come together to form a community: establishing networks of correspondent banks,
participating in automated systems for interbank communication, developing systems for
interbank credit extension in the form of documentary credits and acceptances, and engaging in
interbank trading mostly in the form of foreign exchange delivery commitments and deposits
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placed with other banks. Through these means the banking community offers its markets
comparatively high liquidity, ready access to credit, and substantial protection for their deposits.
1.7 The banking community is made up of a variety of institutions engaged in offering
prospective customers every kind of banking service and facility. The emphasis of their
business varies from bank to bank as each seeks to find a place in a competitive market, both
nationally and internationally.
Domestic and international banking

1.8 Domestic banking is the provision of banking services to companies and persons resident in
the country where the bank is situated. The variety of services required by domestic users will
generally be less than the services required by international users. The need to finance
international trade has led to a wealth of services and techniques being developed to meet the
specialised requirements of both importers and exporters. An example of this would be
documentary credits - banks act as intermediaries between importers and exporters and
eliminate or accept some of the risks associated with international trade.
1.9 Communications assume far greater importance when national boundaries are crossed and
new methods of communicating and transferring funds, such as SWIFT, have evolved to
overcome the problems of international operations.
Retail and wholesale banking

1.10 Retail banking is primarily the provision of the following services:
■ current (chequing) and deposit accounts;
■ cheque clearing;
■ overdrafts, personal loans, fixed loans and mortgages;
■ credit cards;
■ trusteeship and investment management;
■ trade related foreign exchange;
■ insurance and advisory.
1.11 Wholesale banking is primarily the provision of the following services:
■ loans to all types of borrower;
■ cash management;
■ documentary credits;
■ discounting, forfaiting and acceptances;
■ export-import finance;
■ interbank foreign exchange trading;
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■ financial futures, interest rate swaps, forward rate agreements, options and other
“derivative” financial instruments;
■ leasing;
■ factoring;
■ new capital issues.
1.12 It is evident from the above that retail banking is closely related to domestic banking and
wholesale banking to international banking.
1.13 The different types of services listed above each carry with them different risks in varying
degrees. The level of risk to which a bank is exposed is directly affected by the type and level
of services provided. The management of these risks is discussed further in chapter 2 of this
volume.
International financial centres

1.14 International financial centres are of two types: those through which foreign borrowers or
lenders gain access to the domestic markets of the financial centre and those "entrepot" centres
through which foreign borrowers obtain funds invested by foreign lenders without entering the
local markets of the financial centre. Principal financial centres of the first type are located in
the world's major industrial countries: Germany, Japan, France, Australia, the United States and
the United Kingdom. Entrepot centres have developed in countries where government
regulation, adequate technology, and politico-economic stability have combined to encourage
their growth. Some, such as Switzerland and Luxembourg, have benefited from their proximity
to the industrial giants, while Bahrain has benefited from its proximity to the petroleum
exporters. So-called “off-shore” centres, such as the Bahamas and the Cayman and the Channel
Islands, have benefited especially from favourable taxation and regulatory environments. In the
Far East, Hong Kong and Singapore are not only major regional centres but also, by their time
zone position, provide a link among the financial markets of the Far East, Australasia, and the
west coast of the United States and those of Europe.
1.15 The Eurocurrency markets, markets for trading financial instruments outside the country
in whose currency the instruments are denominated, are the principal markets for entrepot
financial centres and are of major importance to such financial centres as London. The
attractiveness of these markets is that they operate virtually free of control by either individual
governments, governments in concert, or even self-policing associations among the participants.
As a result, the markets are generally free from exchange and capital controls and from taxes
and deposit insurance; they generally have no limits on deposit interest rates nor any credit
allocation or reserve requirements. These factors combine to eliminate significant cost factors
present in domestic financial markets, enabling banks to pay higher interest on deposits and to
charge lower interest on loans, thus reducing the nominal spread but still maintaining the same
real spread, as compared with domestic bank transactions in the same currency.
1.16 Banks expand their international operations to gain access to financial centres and to
penetrate the local financial markets in the areas to which they expand. Technological
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sophistication, especially in international communications has made such expansion

manageable. Reasons for this expansion include the following:
■ To gain access to alternative sources of funding : Through internationalisation banks
obtain more efficient access to the funding sources available outside their home countries,
enabling them to avoid having to pay premiums to middlemen importing those funds.
■ To diversify risk: Internationalisation enables banks to spread their risks across a number
of political and economic environments, thus reducing the extent to which disruptions in
any one location will disrupt its earnings.
■ To serve, and so attract and retain, customers: Customers, themselves engaged in
international business, with significant operations outside their home countries, expect their
banks to service their needs wherever they operate and will give their business to those
banks able to do so.
■ To exploit local market advantages: Banks open offices outside their home countries to
realise competitive advantages available to them in these foreign markets. For example, the
foreign country may host a large home country ethnic community which would be
favourably disposed to bringing its business to a bank of the home country.
■ To achieve greater flexibility in money management: Through internationalisation banks
can participate in money markets and foreign exchange markets around the world and
around the clock, thus giving them greater flexibility to satisfy customers' or their own
needs in one market while obtaining the funding to do so in another.
1.17 An attractive financial centre will have some or all of the following features:
■ a relatively stable financial system which commands trust and confidence;
■ expertise of its institutions in international business;
■ a concentration of the offices of the world's leading financial institutions;
■ a large pool of skilled international bankers and availability of trained staff at all levels;
■ leading world markets, e.g.; Stock Exchange, insurance, shipping, commodities and money
markets;
■ relative political stability;
■ a convenient time zone;
■ convenient geographical location;
■ an excellent communications network;
■ a large pool of experienced professional advisers e.g., lawyers and accountants.
1.18 To the extent local regulations allow, banks can open offices in foreign countries in a
variety of forms. Some countries restrict what foreign banks can do, either across the board or
on the basis of reciprocity agreements. Particularly in countries severely limiting foreign
banking activities, foreign banks can still gain some access to those local markets through
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purchasing an equity interest in a local "financial company", that, as regulatory restrictions are
eased, may then be converted to a full-scale banking office.
1.19 The basic forms most frequently used to establish foreign offices are as follows:
Office type Banking function Other functions
Representative office None Serves as liaison between
local customers or local
segments of international
customers and the Head
Office
Branch Full banking services Not incorporated and with no
capital stock (though certain
countries do require branches
of foreign banks to maintain
permanently invested
donation capital from the
parent), serves as an
extension of the Head Office
Agency (US only) Full banking services - except Same as for branches
that agencies may be prohibited
from accepting certain forms of
deposits
Subsidiary Full banking services and other Incorporated with capital
financial services as allowed by stock outstanding, serves to
law develop local business under
Head Office direction while
retaining its own corporate
identity
Consortium Full banking services and other Incorporated with capital
financial services as allowed by stock owned by a group of
law banks (rather than by one as
is usually the case with
subsidiaries), serves to enable
the owner banks to establish
foreign offices when they are
too small to do so
individually or when they
achieve special advantages
through merging their
particular strengths or
services into one unit
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Introduction
2.1 Chapter 2 of volume 1 introduced the basic kinds of banking risk. In this chapter we
expand our discussion in this area to focus on:
■ the concept of asset - liability management;
■ banking risks by activity; and
■ the use of limits by banks and financial institutions to control their exposure to banking
risks.
Asset - liability management

2.2 Managing banking risks while aiming to maximise net interest margin requires some
anticipation of what future economic conditions will be like and what their impact will be on
the bank or financial institution’s funding and investment alternatives. Doing so may take the
form of detailed forecasting or of some less-structured analyses. Banks and financial
institutions cannot retain complete flexibility to respond to economic changes, any more than
can other enterprises -- the choices made today will limit the range of choices available in the
future. Thus, prudent bank and financial institution management will often sacrifice potential
profits that could be realised on a particular strategy should one set of circumstances occur in
order to avoid the adverse consequences of adopting that same strategy in quite different
circumstances. But at the same time, a too cautious strategy could well allow others, who have
taken more risk but have better anticipated the resulting economic climate, to penetrate its
markets and undermine its ability to operate profitably.
2.3 A simple example will illustrate the benefits and dangers arising when a bank or financial
institution opts for a specific strategy. Suppose the current environment exhibits comparatively
high interest rates, though the bank or financial institution’s management is reasonably
confident that rates will soon fall and then persist at levels well below the current ones. In these
circumstances, the bank or financial institution could well elect to pursue short-term funding,
assured that it will be able to replace maturing liabilities at lower cost, while investing the
proceeds so obtained in longer-term fixed-rate assets. In this scenario, the bank or financial
institution will increase its net interest margin from this asset - liability mix as lower-cost funds,
purchased at then prevailing market rates, are brought in to fund assets still earning the higher
rates of the earlier period.
2.4 Such a strategy, though, exposes the bank or financial institution to increased interest rate
risk in that it accentuates the bank or financial institution’s vulnerability to the adverse
consequences of future interest rate patterns different from the one expected. So, should rates
rise rather than fall, the bank or financial institution purchasing shorter-term liabilities to fund
longer-term assets could find itself paying more, at the then current market prices, than it earns
on those assets still paying the now lower rates of the earlier period. Further, the bank or
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financial institution would be unable to liquidate those assets to forego the need for replacing
maturing liabilities without incurring losses reflecting their below-market yields.
2.5 This example shows the effect of a deliberate mismatching of assets and the liabilities
funding them -- mismatching in the sense that the exchange through which funds are invested
differs from the exchange in which they were acquired in at least one essential regard, in this
case their respective sensitivity to interest rate changes as a result of their differing maturities.
While it may seem desirable, on superficial analysis, for banks and financial institutions to
match the terms and conditions of their assets and liabilities to the extent possible, it is only
through some such mismatching that they can hope to earn any profit at all through their
intermediation of funds. A perfect match would require a bank or financial institution to enter
into simultaneous exchanges to acquire funds and invest them with the same customer, for the
same term and in the same currency -- transactions in which the bank or financial institution
would be hard pressed to charge any kind of premium for its “service”. Rather, it is because
banks and financial institutions enter into exchanges to invest and acquire funds at different
times, with different customers, for different terms and in different currencies that they
accomplish their intermediary function and so open the opportunity for profit. At the same
time, however, they also increase their risks.
2.6 Successful asset - liability management is thus perhaps best understood as a controlled
mismatching of funds acquired and invested. The parameters mismatched include the
following: the classes of customers involved, the maturities offered, the variability of interest
rates paid or earned during the term to maturity, and the currencies in which the funds are
denominated. The extent to which a bank or financial institution mismatches within or across
these parameters provides a measure of both its potential for profit and its exposure to risk and
are a reflection of the bank or financial institution’s philosophy to both taking and managing
risk.
2.7 A bank or financial institution’s philosophy towards taking risk, its risk profile, is
concerned with management’s propensity or willingness to assume or reject varying degrees of
risk. In some instances, management may be timid or risk-averse (that is, protect the depositors
by investing conservatively). In other cases, management may adopt an aggressive investment
strategy (maximise profits while assuming greater risk). Each of the extreme cases is not, by
definition, good or bad. For example, a very conservative investment strategy may be perceived
as good for protecting depositors. However, such a strategy can result in a declining market
share (and profit) due to more aggressive competitors. In the long run this may not protect
depositors.
2.8 While the degree to which management is willing to assume risk may be indicative of profit
and growth potential, it is also indicative of the potential for volatility and losses.
2.9 A bank or financial institution’s philosophy towards managing risk can range from one that
is inactive and reactionary (that is, reacting only to changes in risks that present themselves) to
one that involves actively seeking, identifying, and managing risks within established limits. A
bank or financial institution’s risk management philosophy at either end of the spectrum can
have varying implications. For example, a bank or financial institution that actively seeks to
identify and manage risk will not necessarily make successful business judgements.
Conversely, a bank or financial institution that reacts only to changes in risks associated with
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previous business judgements will not necessarily be unsuccessful if its previous judgements
about uncertainties were correct and accurate .
2.10 Awareness of the bank or financial institution’s risk management process (or lack thereof)
can alert you to the potential for business and financial exposures which are going undetected
by management. It may also present opportunities to suggest improvements or provide value-
added services in the area of risk management.
2.11 The mismatches in a bank or financial institution’s portfolio of assets, liabilities, and
commitments define its position. A bank or financial institution’s position is, ultimately, the net
flow of cash as of, or cumulative to, any future date, that its current portfolio promises. As
such, a bank or financial institution’s position locates the gaps in its portfolio: those days at
which, or cumulative to which, it has a net outflow of cash. Since no entity can pay out what it
does not have, these gaps represent amounts that the bank or financial institution, in one way or
another, will have to obtain in future transactions not already included in its present portfolio.
The uncertainties attending to the transactions or their terms that will be available when they are
in fact made constitutes the bank or financial institution’s position exposure: its vulnerability to
future market conditions resulting from its need to cover the mismatches among the assets,
liabilities, and commitments contained in its present portfolio.
2.12 The following table shows the components of a bank or financial institution’s position and
the related resulting gaps.
Risk Factor Inflow of Cash - Outflow of Cash = Position and
Related Gap
Liquidity ■ Realisation of ■ Realisation of Maturity gap
commitments to commitments to sell,
purchase or borrow lend, or invest funds (5)
funds (1)
■ Customers’ ■ Repayment to customers
repayment of funds of funds purchased or
sold, loaned or borrowed
invested (2)
■ Secondary market ■ Secondary market
sale of claims to purchase of claims to
future customer future customer
repayments (3) (4) repayments (3) (4)
■ Customers’ payment ■ Payment to customers of
of interest earned (2) interest owed
■ Other cash receipts ■ Other cash
(e.g., payment of fees disbursements (e.g.,
for services) (2) payment of overhead
costs)
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Risk Factor Inflow of Cash - Outflow of Cash = Position and

Related Gap
Interest rate ■ All of the above ■ All of the above Interest rate gap
■ Loans and other assets ■ Deposits and other
for which an interest liabilities for which an
rate change may occur interest rate change may
occur
Foreign ■ All of the above by ■ All of the above by Currency gap
exchange rate currency currency
Notes:
(1) Supported by standby facilities from other lenders.
(2) Subject to credit risk.
(3) Priced to reflect the credit risk of the customer.
(4) Priced to reflect market interest rates and the time value of money.
(5) Includes standby facilities available to borrowers.
2.13 Asset - liability management is thus perhaps better called “position management”, since it
is only through an analysis of a bank or financial institution’s total position that its risks are
identifiable -- the uncertainties attending to the future inflow of funds the current portfolio
promises (credit risk) and to the future transactions required to cover the gaps the current
portfolio contains (liquidity, interest rate and foreign exchange rate risks) -- and that its
potential for profit is measurable.
2.14 Investment and lending alternatives (the bank or financial institution’s placing out of
funds) must be priced to reflect both credit and position risk factors. To remain profitable a
bank or financial institution must price its investments not only to provide sufficient protection
against monies invested that are not repaid but also to yield positive spreads relative to those
future transactions that will cover the gap such investments create in its overall position.
Included within its position risk are those future cash outflows that relate to the bank or
financial institution’s overheads: such things as employee, occupancy, communications, taxes,
and related costs.
2.15 In selecting the deals they enter into, whether to acquire funds or to invest them, bankers
typically have four basic objectives which, if attained, ensure both the bank or financial
institution’s profitability and its protection against risks. These are as follows:
■ Limit exposures: whether with respect to credit risk or position risk, limits on exposures
control the extent to which the bank or financial institution is vulnerable at or to any given
day, in any given currency, and with respect to the vagaries of its customers. Limits are
considered in paragraph 2.18;
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■ Diversify exposures: through diversification a bank or financial institution can accomplish

controlled growth without violating exposure limits so as to reduce the extent to which it is
vulnerable to any one set of future economic circumstances;
■ Maintain flexibility: by maintaining flexibility, having more than one possible response
available to new economic conditions (e.g., purchasing additional liquidity on any of a
number of markets or selling easy-to-liquidate assets), a bank or financial institution can
reduce the extent to which future economic circumstances will have a negative impact on its
positions;
■ Maintain a privileged access in a broader range of financial markets than its customers
enjoy: such privileged market access -- a bank or financial institution’s competitive
advantage as a financial intermediary -- enables a bank or financial institution to charge
more for selling the use of its funds than it needs to pay to acquire them, so enabling it to
recover its overhead costs and earn profits.
The last three of these objectives, carried to their logical extension, provide more than ample
motivation for banks and financial institutions to expand their business to international markets.
Other risk management techniques

2.16 Institutions also use a number of other techniques to assist them in managing the risks
they face. These are briefly discussed below. It is beyond the scope of this guide to detail the
mechanics of these techniques, however, you should be aware that institutions are increasingly
using them.
■ Value at risk. This technique allows management, through the use of internal models, to
estimate, for each product or position, the maximum amount of loss at a point in time which
may occur within a certain degree of statistical confidence. Management can then monitor
exposure levels using this “value at risk” amount.
■ Stress tests. This technique involves using internal models to perform sensitivity analyses
on an institution’s market risk exposures by changing key variables.
Banking risks by activity

2.17 Chapter 2 of volume 1 introduced the basic kinds of banking risk. As a prelude to the
more specific discussion of banking and finance activities operations in later chapters, the
following table identifies the primary and secondary risks associated with the principal
activities of international banking and finance.
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Line of Volume 2 Primary banking Business Primary risks Secondary

business chapter activities operations risks
Trading 5 Money market Short term Liquidity; Credit

liquidity
5 Foreign exchange Interest rate;
management;
6 Dealing securities and
Risk management
15 Bullion (hedging); and Foreign
Arbitrage exchange rate
7,8,9,10,11 Off balance sheet
transactions
Lending / 6 Investment securities Revenue Credit; and Liquidity; and
Investing management; and
3 Commercial lending Interest rate Foreign
Portfolio exchange rate
13 Documentary credits
diversification
and acceptances
14 Leasing
3 Consumer lending
Funding 12 Non-money market Intermediate and Interest rate; Foreign
deposits long-term liquidity and exchange rate
management
Not Intermediate and Liquidity
presented long-term debt
Not Equity
presented
Particular consideration should be given to the use of derivative instruments. In recent years
derivatives have received extensive publicity and there have been many calls for an increase in
regulation in this area. The principal derivative instruments and the related risks are discussed
in chapter 3 of volume 1 and chapters 7 to 11 of volume 2.
Limits
2.18 Paragraph 2.15 identified limiting exposures as a primary objective of bank and financial
institution management in its efforts to control the bank or financial institution’s vulnerability to
risk. The table on the following page identifies the primary and secondary limits banks and
financial institutions will typically set to control their exposures, as well as key management
reports used to monitor compliance with those limits. These risks and limits are discussed in
more detail in the paragraphs that follow.
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Exposure Risk type Primary limits Secondary limits Key reports

type
Customer Credit risk Customer limits Country exposure limits Consolidated
exposure ■ Settlement ■ By transaction type customer liability
Currency exposure
risk (1) ■ In total ledger
limits
■ Transfer ■ By country
Limits relating to
risk (2) Industry exposure limits ■ By industry
authority granted to
■ Country risk
commit the bank or
(3)
financial institution’s
resources
■ Loan officer limits
■ Credit committee
limits
■ Regulatory lending
limits
Position Liquidity risk Maximum contracted Maximum contracted Consolidated
exposure cumulative cash outflow cumulative cash outflow cumulative cash
(gross) for all currencies (net) for all currencies outflow:
combined ■ Per currency
Maximum cash outflow - Gross
(gross) per currency outflow
- Net
Maximum cash outflow outflow
(net) per currency
Interest risk Total interest rate gap Cumulative interest rate Consolidated
(per currency) gaps by period interest rate gaps
■ By period
Total interest rate gap ■ By currency
(all currencies ■ All currencies
combined) combined
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Exposure Risk type Primary limits Secondary limits Key reports

type
Foreign Net open position per Overall net open Net position per
exchange rate currency position, all currencies currency
risk combined
Limits on gaps in
maturity dates of Intraday net open
forward contracts position, per currency
(if feasible)
Limits relating to
authority to commit the
bank or financial
institution’s resources
■ Trader position
limits:
- Gross
- Net
■ Trader deal limits
(1) Discussed in paragraph 2.20.
(2) The risk that a borrower which conducts its operations in one currency but has debt
denominated in another currency will be unable, because of local currency restrictions or
adverse exchange rates, to obtain the currency required to satisfy the debt.
(3) Discussed in paragraph 2.21.
Credit limits
2.19 Credit limits should be set for each customer/counterparty with regard to both the kinds of
transactions that can be made (e.g., loans or deposits placed, or foreign exchange transactions)
and for the customer’s/counterparty’s total potential liability to the bank or financial institution,
including its guarantees issued on the behalf of other borrowers. The size of the limits should
be based not only on the bank or financial institution’s assessment of the size and
creditworthiness of the customer/counterparty, but also on expected usage. Any substantial
increase in volume of dealing or in credit line usage with a particular customer/counterparty
should be of interest, and possibly of concern, to senior management, and would be highlighted
by the request from the loan officers or dealers for an increased limit.
2.20 Foreign exchange dealing is normally allowed a higher limit than loans or placings
because a foreign exchange deal involves the receipt as well as the payment of money (although
of different currencies) on the same day. If the bank or financial institution receives notice
before the value date that the customer/counterparty will be unable to complete the deal, it can
cover the resulting foreign exchange exposure in the market. Thus, as regards future maturities,
the potential loss is restricted to the cost of covering the foreign exchange deal, which of course
varies according to exchange rate movements. However, as regards settlements of foreign
exchange deals on any particular day, the credit exposure is equal to the gross value of the
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currency purchased; the bank or financial institution is at risk in that it might pay away the sold
currency, but the customer/counterparty would fail to deliver the purchased currency
(settlement risk). Settlement limits should therefore be specified for each
customer/counterparty to limit the value of settlements on any one day of foreign exchange
deals.
2.21 Country limits should also be established for loans made, deposits placed, and foreign
exchange deals. Such country limits are often less than the total of limits available to the
individual customers/counterparties within the particular country. Separate settlement limits for
each country could also be introduced if the bank or financial institution’s information system
allows this to be done, but these are regarded as less important. Customers/counterparties
should be classified by country of risk as well as by country of domicile. Branches of banks or
financial institutions are usually classified according to the country of their head office, as are
certain subsidiary companies supported by a standby agreement from their parent companies.
As with country exposures, banks or financial institutions may wish to place limits on certain
industry exposures.
Liquidity limits
2.22 Liquidity limits should be established to restrict the net cash outflow (and the funding
requirement) on, and cumulative to, any one day, in each currency. Because surplus liquidity
on one day can be rolled over to meet an illiquid position on a subsequent day, the daily limit
need not be very restrictive. The limit on the cumulative net cash outflow will be more
restrictive - for instance, some banks and financial institutions insist that they should have a
positive cumulative cash position for the next 15 days.
2.23 An illiquid position more than one month ahead normally allows the bank or financial
institution sufficient time to arrange its funding to cover such a position, and so limits are only
essential for the short-term liquidity position, say up to one month. Excessive maturity gaps
more than one month ahead would be to some extent restricted by the interest rate gap limits.
2.24 An illiquid position in one currency may generally be covered by swapping from a surplus
liquidity position in another currency (albeit possibly at an extra cost). Consequently, the
liquidity limits for all currencies combined are the most important liquidity limits and will be
less than the sum of the individual liquidity limits for each currency.
2.25 Of particular importance in determining the bank or financial institution’s liquidity
position is the treatment of money at call or notice. Call or notice assets should properly be
included at call or at the applicable notice period from the date of determination of the liquidity
position. However, if a bank or financial institution has significant call or notice liabilities (e.g.,
retail deposits), it may be misleading to include such liabilities at their earliest repayment date
for liquidity purposes. To do so would be to show perhaps an unrealistic “worst case” position
and might show permanent short-term illiquidity. A statement showing permanent illiquidity
could obscure real movements in the bank or financial institution’s underlying liquidity position
and, therefore, a bank or financial institution would normally include only a portion of its call
and notice liabilities at the earliest repayment date in a liquidity position. It is important that
management be aware, however, of the potential significant impact on the bank or financial
institution’s liquidity position of significant call or notice liabilities.
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Interest rate position limits

2.26 A change in prevailing interest rates which produces a loss from a short interest-rate
position in one time period may produce a corresponding gain from a long position in another
time period. Certainly the risk of loss is less than where the position is in the same direction for
all time periods. To reflect this, an important measure of the exposure to interest rate
movements is the “total interest rate gap”. This is computed by the arithmetic addition of the
interest rate gap on each day (long positions counted as positive and short positions as
negative), divided by 360 to arrive at an annualised figure. A limit should be applied to this
position for each currency, and an overall limit applied on the consolidated gap for all
currencies.
2.27 However, interest rates for different maturities and different currencies do not always
move by the same amount or even in the same direction. Accordingly, in addition, limits should
be placed on various cumulative interest rate gaps in each currency. Separate limits may be
placed on, say, the gap up to six months and the gap up to 12 months.
2.28 The amount of risk of an interest rate mismatch is held to increase with the length of the
period of the exposure (that is, the period between the present day and the day on which the
mismatch arises) and so, the amount of the limit should vary with time; for example, the limit
for an elapse of time of one week may be twice the limit for one month and limits for longer
periods would be correspondingly less. Limits set for each currency should not always
represent the same proportion of the respective currency portfolio as certain currencies may
present more severe funding problems than others due to the relatively limited market available.
2.29 The following example shows how a bank or financial institution may compute total
interest rate gap:
■ Assume a bank or financial institution carries out the following deals on day 1:
Borrow $2.5 million for five months to next interest rate fixing
Borrow $1.5 million for six months to next interest rate fixing
Lend $3.5 million for four months to next interest rate fixing
Lend $0.5 million for eleven months to next interest rate fixing
(In this example gaps are calculated by reference to 30 day months rather than by day, for
simplicity).
■ The cumulative interest rate gaps are as follows:
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Monthly products:
Month Movement Cumulative Cumulative Cumulative gap
$m gap gap limit
x 30
$m
$m
0 - - X -
1 - - X -
2 - - X -
3 - - X -
4 - - X -
5 +3.5 +3.5 X 105
6 -2.5 +1.0 X 30
7 -1.5 -0.5 Y -15
8 - -0.5 Y -15
9 - -0.5 Y -15
10 - -0.5 Y -15
11 - -0.5 Y -15
12 +0.5 - Y -
60
Cumulative gap limits: X = 6 month limit

Y =12 month limit
The total interest rate gap is then computed as follows:
Sum of monthly products 60
360 = 360 = $0.167m/year
The monthly and the total interest rate gaps would need to be compared against the limits
appropriate for the individual institution. In this example, the total interest rate gap indicates
that a uniform 1% movement up/down in all interest rates would mean the institution would
incur a gain/loss of $1,670. However, consideration must also be given to limits in various time
bands. In the example, a short term limit of X and a longer term limit of Y are used. The short
term limit goes out to six months. The total gain or loss from a 1% interest rate change in
relation to this period is:
$105m + $30m
360 x 1% = $3,750
Similarly for the longer term (i.e. excluding the first six months) the total gain or loss from a
1% interest rate change in relation to this period is:
5 x $15m
360 x 1% = $2,083
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2.30 Duration. Duration is another commonly used indicator of interest rate risk in a bank, or
financial institution’s portfolio of assets and liabilities. It is a more sophisticated risk
measurement methodology than the simple gap analysis described above. The duration of a
portfolio is the mean term of all future cash flows, weighted by their present value. As an
indicator of risk, duration is useful as it provides a means of assessing the degree of mismatch
between the assets and liabilities of a portfolio. Further, use of a measure known as “modified
duration”, allows you to measure the sensitivity of the portfolio to a movement in interest rates
(assuming a parallel shift in the yield curve).
2.31 A detailed analysis of the calculations involved in duration is beyond the scope of this
Guide. If more information is required, reference should be made to one of the many textbooks
dealing with financial mathematics.
Foreign exchange position limits

2.32 For each currency, a limit should be placed on the end-of-day net open position. The net
open position in a currency is principally the sum of assets denominated in that currency and
commitments to purchase the currency less liabilities denominated in that currency and
commitments to sell the currency. The size of each currency limit will depend on the volume of
trading in that currency and the bank or financial institution’s perception of the volatility of the
currency’s exchange rate against its base currency.
2.33 The overall open position is computed by the simple addition of all open positions,
whether short or long (i.e., ignoring sign), excluding the base currency. The overall open
position limit should be less than the total of the open position limits for each currency, to
ensure that the bank or financial institution does not utilise all its currency position limits at the
same time, and to limit the bank or financial institution’s total exposure to exchange rate
movements.
2.34 Although it would be desirable for there also to be limits on the net open positions which
may be run during working hours, in the absence of “state of the art” systems enhancements it is
not generally feasible to monitor such “intraday” limits because to do so would require accurate
timing of deals to establish the sequence of dealing.
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3 Lending
Introduction
3.1 Lending activities normally represent the largest source of bank and financial institution
revenue (interest income) and the most significant component of bank and financial institution
assets. Lending transactions cover a range from overnight money market loans (refer chapter 5
of this volume) to long term project linked loans. Lending and its inherent risks are critical to
bank and financial institution performance and stability. Funding loans with liabilities of
comparable maturity and rate sensitivity, together with monitoring credit concentrations in
specific industries or economies are key strategies to control risk and so are usually primary
areas of management attention.
3.2 The art of good lending and sound banking implies that the bank or financial institution
must strike an acceptable balance between the potentially conflicting principles of the need to
make a reasonable return on its advances and to ensure that it maintains the high duty of skill
and care it owes its depositors whose monies fund its lending activities. The bank or financial
institution will consider the following factors in seeking to achieve this compromise:
■ quality of borrower and security;
■ purpose of loan;
■ amount and duration of loan;
■ industrial and geographical sector of the borrower;
■ regulatory constraints (e.g., capital adequacy and large exposure requirements); and
■ government and management policy constraints.
3.3 Lending activity is also limited by the availability of funds, credit demand and profitability
(interest spread). The structure of a bank or financial institution’s loan portfolio should reflect
its funding sources and the credit needs of its customers.
3.4 Funding considerations which affect lending activities include the following:
■ scheduled maturities of deposits and borrowed funds;
■ stability of deposit base;
■ availability of funding sources other than deposits; and
■ cost of additional funding.
3.5 The possibility that a borrower may not be able to fulfil the terms of its obligation to the
bank or financial institution represents the principal risk inherent in lending. A bank or
financial institution’s exposure to this risk can be minimised through controls over the extension
of credit, the close monitoring of loans already recorded, and obtaining security (for example,
collateral, guarantees, or liens on assets). The estimation of probable loan losses is significant
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(often critical) to the valuation of loans for financial reporting purposes. The provision for loan
loss, the charge to earnings necessary to reduce recorded amounts to their realisable value, and
the loss of earnings from the inability of borrowers to pay interest can be significant and are
usually subject to considerable management attention and judgement.
3.6 In addition to interest, banks and financial institutions generally earn income on their
lending activities through charging a variety of fees. Fees earned in connection with lending
can be considerable, contributing significantly to bank and financial institution earnings. The
principal fees generated through lending are the following:
■ loan origination fees which represent reimbursement to the bank or financial institution for
its expenses in granting credit.
■ servicing/agency fees which represent service income for collecting payment of principal
and interest required by the loan agreement; administration of the loan, including
monitoring the protection of collateral (e.g., maintaining loan documentation files and the
payment of taxes and insurance on property collateralising the loan); and maintaining
records for other institutions participating in the loan.
■ standby/commitment fees which are charged for maintaining the availability of credit.
■ interest related fees which represent yield adjustments to compensate for a contractual
interest rate below the market rate.
Types of lending
3.7 A bank or financial institution may engage in a wide variety of lending or may restrict its
activities to those in which it believes to have cultivated a particular expertise. The products a
bank or financial institution makes available will depend on many factors, including the needs
of its customers, products offered by its competition, regulatory restrictions, and management’s
objectives, limits and strategies. There are a number of ways to categorise loans, the most
common being according to the nature of the borrower, the purpose of the loan, presence or
nature of collateral, and method or nature of repayment.
3.8 All loans can be divided into two broad categories:
■ Secured loans are supported by the pledge of specific assets (collateral), e.g., real estate,
securities, warehouse receipts, cash deposits or savings accounts, inventories, equipment or
accounts receivable.
Generally the reason for requesting collateral is to reduce the bank or financial institution’s
risk of loss in the event of default. However, the mere presence of collateral does not
ensure that the loan will be repaid (e.g., the collateral could prove to be unmarketable or to
have depreciated in value from the time it was pledged). For fully secured loans the value
of the collateral should be well in excess of the amounts loaned. It should be mentioned
that in most countries loans which are guaranteed by a third party are regarded as unsecured
loans.
■ Unsecured loans are based exclusively on the financial condition of the borrower and/or
guarantor since there is no security to rely upon in the event of default.
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The financial stability and future prospects of the borrower and/or guarantor are the most
important factors to be considered before a loan decision is made.
3.9 Loans are categorised by interest terms as follows:
■ Fixed rate loans carry the same rate of interest from inception until maturity;
■ Floating rate loans carry interest rates which fluctuate directly with the prime, LIBOR, or
other prevailing market rate.
■ Variable rate loans (generally real estate loans) carry interest rates that are subject to
periodic adjustments tied to prevailing market rates, often subject to specified maximum
rates. Rate adjustments on variable rate loans are typically less frequent than floating rate
loans and do not necessarily move directly with market rates. For example, the rate on a
variable rate mortgage may undergo an incremental semi-annual adjustment to close the gap
between the then existing rate on the loan to the bank or financial institution’s prevailing
mortgage lending rate at the adjustment date, with increases limited to an increment (e.g., 2
percent for a specified period) or an overall (e.g., 5 percent) maximum over the life of the
loan.
3.10 Types of loans with respect to maturities are the following:
■ Demand loans have no fixed maturity date, are payable on demand of the lender, and
generally have floating interest rates (adjusted daily or monthly). Demand loans are used by
borrowers to provide working capital for operations. Although payable on demand, they are
often required to be repaid in accordance with a schedule such as 90 to 180 days from the
date the loan was granted. Demand loans offer the bank or financial institution greater
flexibility in getting out of potentially adverse situations. Effectively, the loan is for the
shorter of the demand of the lender or the specified period of time.
■ Instalment loans require periodic payments, usually over 6 to 48 months. Constant
amounts are to be repaid which consist of fixed principal and interest components.
■ Time loans are made for a specific period of time, generally for 30, 60, 90, 120, 180, or 360
days. Often such loans are renewed for further periods in what is known as a roll-over.
Interest rates are fixed for the initial period and for each roll-over period. These loans are
often used to finance inventories or receivables for seasonal business needs. Repayment is
usually the result of the liquidation of inventories, receivables, or other assets. The
specified periods offer the lender the opportunity to reassess the borrower’s situation before
renewing and also allow for rate adjustments.
■ Term loans are made for a specified term in excess of one year and are usually made at a
fixed rate or at a fixed margin over a floating rate of interest and adjusted periodically,
usually at 3 or 6 month intervals. Repayment schedules are structured in various ways,
including agreements which call for:
- escalating periodic payments over the life of the loan;
- moderate periodic payments over the life of the loan with a large payment (“balloon”)
due as final payment;
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- grace periods (agreements under which no repayment has to be made for a period of
time;
- equal periodic payments over the life of the loan;
- specific number of years, after which the loan is repaid over the remaining number of
years, usually in equal instalments).
Instalment loans, time loans, and term loans are sometimes granted on a discount basis or on a
combination of discount and interest.
3.11 Direct loans, syndicated loans, and participated loans. Direct loans originate in those
situations where the bank or financial institution lends funds directly to a borrower. The bank
or financial institution carries the credit risk of the loan and is responsible for its proper
administration. At times a borrower may need funds in excess of the maximum amount an
individual institution can provide, in accordance with its lending limits. In such cases,
assuming the borrower has the financial background to sustain such a large borrowing, the bank
or financial institution can serve the borrower’s needs through the co-operative lending
arrangements discussed below.
Syndicated loans are arrangements wherein several banks or financial institutions may each
lend a portion of the total amount advanced to the borrower and share the risk proportionally.
One or more banks or financial institutions are authorised by the borrower to serve as the agent
institution or management group, arranging the syndication of a specified amount of money at a
specified interest rate or interest margin in return for an agreed management fee. The
management group will normally provide the largest individual amounts of funds and will
circulate details to other institutions, inviting them to participate in the loan. Syndications
generally involve large commercial enterprises.
In order to make participation in the syndication attractive to other banks and financial
institutions, the lead managers may offer a participation fee payable from the management fee
they receive. Expenses of the loan syndication, such as legal fees and costs of preparing the
loan agreement are generally met by the borrower. For additional information see paragraph
15.4 of this volume.
Participations also represent situations in which banks or financial institutions share portions in
loans originated by other lenders. Participations, however, may be negotiated without the
knowledge of the borrower and may give the participating bank or financial institution recourse
to the original lender should the borrower be unable to repay. Also, a loan participation may be
sold on terms that differ from the original loan terms. All documentation of the loan is drafted
in the name of the selling bank or financial institution. Generally, the purchaser’s share of the
participated loan is evidenced by a certificate that assigns an interest in the loan and any related
collateral. Similar to syndications, participation loan origination and administration are the
primary responsibility of the appointed lead bank or financial institution, which is also
responsible for communication, distribution of pro rata amounts, and other administration
activities with respect to the purchasing bank or financial institution/companies. From the lead
bank or financial institution’s perspective, this transaction is referred to as a participation sold,
the corresponding bank or financial institution’s transaction is referred to as a participation
purchased.
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3.12 Overdrafts are initiated when the bank or financial institution customer draws a cheque
on its current account in excess of funds it has available resulting in a debit balance. At that
time the bank or financial institution transfers to the customer's current account an amount
equivalent to the overdraft or an appropriate rounded amount and concurrently establishes a
loan balance for the amount of the transfer. Alternatively, an overdraft limit may be established
for the current account which enables the customer to draw funds up to that limit. Overdrafts
are loans and should be subject to an appropriate authorisation process and credit evaluation.
3.13 Facilities. A common business arrangement is the granting of lending facilities, often
known as a line of credit, which may be extended for a specific period, thus providing the
borrower with available credit at stated terms up to a set limit. In many cases banks and
financial institutions distinguish between advised and unadvised lines of credit. The advised
lines are known to the potential borrower, while unadvised lines represent only internal lending
limits the banks and financial institutions have set for each individual borrower.
Borrowers may establish global multi-purpose facilities or specific lines of credit with varying
limits for several of the various loan types.
Special types of facility are so-called revolving credit agreements which contain the provision
that repaid amounts previously borrowed under the given credit line are available for
subsequent borrowing up to the agreed maturity of the facility.
The agreement negotiating advised lending facilities usually provides for the payment of
origination and commitment fees. In some countries it is common practice for the borrower to
maintain deposit balances in order to compensate the bank or financial institution for holding
the line available.
3.14 Types of loans as to borrowers and purpose. Loans can be divided into the following
groups according to the different types of borrowers:
■ Commercial and industrial loans. This type of loan is made to domestic and
multinational corporate borrowers, generally for business purposes such as:
- financing working capital requirements;
- purchase of inventory;
- purchase of plant and equipment;
- purchase of other business assets;
- financing of business acquisitions; and
- financing of overseas subsidiaries.
■ Consumer loans. Such loans represent typical retail bank or financial institution
transactions and are discussed in paragraphs 3.16 -3.19;
■ Real estate loans. Real estate loans are secured by mortgages or other liens on real
property. Real estate loans are generally made on the following types of property:
- residential property loans;
- commercial property loans (e.g., hotels, shopping centres, schools, industrial property);
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- improved land loans (land that generally has infrastructure in place);

- unimproved land loans (nonfarm);
- construction loans (financing provided during the construction period only); and
- farmland (includes soil and water conservation, as well as farm ownership loans).
■ Loans to finance companies. Loans to finance companies are primarily granted to finance
their receivables from customers. Banks and financial institutions thus provide in this case
a portion of finance companies' lendable funds;
■ Loans to banks and financial institutions. Banks and financial institutions also make
loans to other banks and financial institutions. Such loans may be secured (for example by
marketable securities) or not secured and may range in terms from outright loans to
permanent credit facilities.
In addition to outright lending to other banks and financial institutions, banks and financial
institutions grant or take loans in the form of money market transactions; for further details
refer to chapter 5 of this volume;
■ Sovereign risk lending. Sovereign risk lending involves lending to central or state
governments, governmental agencies and central banks. Decisions to make such loans will
take into account the economic resources of the region in which the borrower is located as
well as its specific economic characteristics. Factors affecting the ability to repay on
sovereign risk lending include the borrowing country's basic economic strength including its
work force, natural resources, political stability and infrastructure, as well as its ability to
generate foreign currency (liquidity).
Similar to sovereign lending is quasi-governmental lending. Often commercial or
individual borrowers request a loan which is guaranteed by the government or a
governmental institution. These loans usually are considered to have the same degree of
risk as lending directly to the respective central or state government.
3.15 Special types of lending. In addition to the various types of loans mentioned before,
special types of lending have been developed, of which the most common types are the
following:
■ Project financing. Project financing involves providing funds to a borrower so that the
borrower can complete the construction or acquisition of assets which are expected to be,
but as of yet are not, income producing. Examples include building or ship construction.
Project financing can also involve the financing of the sale of the project after its
completion. Project financing usually bears greater risks due to the uncertainty of
successful completion of the project and therefore, it often commands higher interest rates
than other types of lending.
In project financing a bank or financial institution’s involvement usually begins as the
guarantor under a bid bond or performance bond on behalf of the construction company
bidding for the project. Such a bond, usually for 5 to 10 percent of the bid price, provides
security to the buyer of the project that the construction company whose bid is accepted will
complete the project in accordance with the contract. During construction the bank or
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financial institution provides funds for materials and other construction costs. After
completion of the project the construction loan is often followed by a mortgage loan to
provide so-called permanent financing for the asset constructed. Usually the buyer of the
asset is then the borrower and the respective loan is secured by mortgages or other liens on
the property.
■ Invoice discounting (or accounts receivable financing) and factoring. Invoice
discounting, sometimes known as “accounts receivable financing”, involves situations in
which a bank or financial institution advances funds to a borrower based on the borrower
assigning, on a continuing basis, selected parts of its accounts receivable to the bank or
financial institution as security for the loan. In theory, the bank or financial institution takes
possession of the accounts receivable pledged. Factoring is a method of financing similar to
invoice discounting except that the bank or financial institution will generally be assigned,
on a continuing basis, the complete debtors ledger. Borrowers enter these arrangements to
accelerate cash flow by eliminating the time lag between their shipment of merchandise and
their customer's payment of the invoice. Borrowers generally pay commission on
receivables discounted or factored, based upon volume, and interest on advances before the
scheduled maturity dates of the receivables.
“Non-notification” arrangements are those in which the debtors are unaware that the invoice
discounting or factoring arrangements are in place and they continue to deal with the
company in the normal way. In these cases, the borrower generally continues to administer
the sales accounting function (ie duties such as credit checking, bookkeeping and
collection). Payments received from the debtors are then forwarded on to the bank or
financial institution.
“Notification” arrangements are those in which the debtors are aware that the invoice
discounting or factoring arrangements are in place. In such cases, the bank or financial
institution may assume the sales accounting function. If this is so, the debtors may make
their payments directly to the bank or financial institution or to a trust account under which
the bank or financial institution is the beneficiary.
The borrower may assign the accounts pledged to the bank or financial institution with
recourse; that is, if the account proves uncollectible, the bank or financial institution may
look to the borrower for payment. Alternatively, a non-recourse arrangement may be
entered into whereby the bank or financial institution assumes the credit risk (sometimes
within agreed limits) associated with debts.
■ Forfaiting. Forfaiting is the purchase of bills of exchange resulting from an export
transaction without recourse to the exporter. It is similar to factoring in that the forfaiter
assumes the risk inherent in the transaction and the exporter receives immediate cash flow;
however, forfaiting should be distinguished from factoring for several reasons. First, a
typical forfaiting transaction calls for a guarantee. Since it is quite difficult to rate a foreign
borrower, forfaiters demand, essentially as a means of security, a guarantee by a bank
located in the country of the importer. Secondly, additional risks are assumed by the
forfaiter which are generally not of concern to the typical factor. In addition to the risk that
the debtor may be unwilling or unable to pay the debt, a forfaiter must also be concerned
with the inherent political and economic country risk as well as currency risks.
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Furthermore, the typical forfaiting transaction is generally long term in nature (i.e., more
than one year) and subject to specific contractual arrangements.
■ Back-to-back/washable loans. Back-to-back or washable loan arrangements arise where a
bank or financial institution makes a loan to a customer or bank and receives a deposit from
another or the same party with the deposit pledged to guarantee repayment of the loan.
Generally, borrower and depositor, if not the same party, are related in that they are
members of the same group.
Where the loan and the deposit are identical as to amount, interest rate and currency and
there is a legal right of set-off between the two amounts, the washable loan is risk free and
this is reflected in the low level of margin charged to the customer.
■ Parallel loans. Parallel loans arise where one entity (branch or subsidiary) within a
banking or financial institution group makes a loan and another entity within that same
group takes a deposit from the borrower or a related third party, generally another entity in
the group of which the borrower is a member. The deposit is pledged to guarantee
repayment of the loan.
Where the entities are branches of the same bank or financial institution within the same
country, the arrangements may be structured as a washable loan. Where the branches are in
different countries, the practical ability to apply the deposit against the loan may be
inhibited, in which case the arrangement will be that of a parallel loan.
The risk inherent in a parallel loan is the same as in any other secured loan exposure.
■ Guarantee/standby letters of credit. Banks and financial institutions frequently issue
guarantees/standby letters of credit on behalf of their customers to third-party beneficiaries.
Such guarantees give the third-party beneficiary security that, if the bank or financial
institution’s customer is unable to pay on its commitment under a contract, the bank or
financial institution will make good the obligation. The procedures a bank or financial
institution will use to evaluate the risks of guarantees/standby letters of credit are similar to
those used in evaluating a loan.
Examples of specific needs for guarantees issued by banks or financial institutions are as
follows:
- Bid bonds. The bank or financial institution guarantees that its customer, who has
participated in a tender offer, will be able to fulfil all conditions of the bid made.
- Delivery or performance bonds. The guarantee covers the possibility that the selling
or performing company might not be able to fulfil its obligations under its contract.
- Advance payment guarantee. These guarantees cover the risk that a purchaser who
has made advance payments to a supplier will have its advances returned should the
supplier not be able to deliver the goods purchased in accordance with the contract.
- Bills discounted. Bills discounted are drafts purchased by the bank or financial
institution from the borrower (payee), whereby the bank or financial institution deducts
in advance its fee or interest for lending the money. In this way the payee receives the
net proceeds (face amount of draft less fees and interest) immediately and does not have
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to wait for the due date of the draft. The payee is also relieved of the need to present the
draft to the payer for payment. When the draft becomes due, the bank or financial
institution can claim the money from the drawee, or in the case of the drawee's inability
to make payment, from each endorser or from the drawer. For more details see Chapter
13 of this volume.
Consumer loans
3.16 In a retail banking environment, banks and financial institutions provide financing to
individuals for household, family, and other personal expenditures. Examples may include
loans for such purposes as:
■ consumer goods (e.g., personal automobiles, household appliances and furniture, boats,
clothing, etc);
■ purchase and/or construction of residential dwellings;
■ repairs and improvements to the borrower's residence (not secured by property);
■ educational expenses, including student loans;
■ medical expenses;
■ personal taxes;
■ vacations; and
■ other personal expenditures.
Consumer loans may be secured or unsecured. Where appropriate, the bank or financial
institution often monitors the existence and adequacy of insurance coverage in order to
safeguard pledged collateral.
3.17 Instalment loans. Consumer loans may be payable on demand, single payment, or other
repayment schedule; however, most are payable in monthly instalments. Most instalment loans
are issued on either a discounted basis or a simple interest basis. For discounted loans, the
interest, life insurance premiums, and other charges are added to the amount to be advanced to
arrive at the total, and instalment payments include both principal and interest components.
Instalment loan maturities depend upon the collateral or nature of the loan but typically do not
exceed five years. The gross yield on consumer loans is greater than most commercial or
property loans, but the risk is generally greater, and since they are relatively small loans, the
handling costs per amount loaned are higher.
3.18 In some countries, consumer laws require that the bank or financial institution disclose to
the borrower the effective rate of interest on consumer loans. Recognition of interest income
should normally commence at the end of the first month of the borrower's repayment schedule.
As a practical matter, however, some banks or financial institutions immediately recognise one
month's interest on the date the loan is granted.
3.19 Consumer instalment loans generally originate from:
■ Direct loans. Customers that approach the bank or financial institution directly;
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■ Dealer loans (retail contracts or sales financing). Loans generally originating with a dealer
(e.g., auto, mobile home, appliance, furniture dealers) in the form of an instalment sales
contract, which is:
- discounted with the bank or financial institution;
- conveyed to the bank or financial institution under a dealer participation agreement
where part of the finance charge becomes the income of the dealer and part becomes the
income of the bank or financial institution.
The bank or financial institution will generally hold back from the dealer a portion of the
proceeds as a "dealer reserve" (or "dealer hold-back"). This reserve offers the bank or financial
institution limited protection as it may, depending on the agreement with the dealer, be charged
with the losses incurred on the loans. When a bank or financial institution engages in dealer
lending, it must exercise the same care in selecting its dealers as it would in determining the
creditworthiness of a borrower in a direct type of lending.
3.20 Rebates. Occasionally, a borrower may liquidate a loan before it is due. If interest has
been paid in advance (discount), the borrower may be due a refund (rebate) for the interest
charge associated with the cancelled remaining term of the loan. The "refund method" may
permit the institution to recover out-of-pocket expenses at the time the loan was made.
3.21 One of the most common methods for computing rebates is based on the "rule of 78".
Under this method, the rebate due is the result of multiplying the finance charge after
adjustments (if any) by a factor. The factor is computed by the formula, S(S + 1)/N(N + 1),
where S is the number of months prepaid (months remaining in original terms of loan) and N is
the number of months in the original loan agreement. Many banks or financial institutions use a
rebate schedule (based on the above formula), which gives the percentage of the finance charge
to be refunded.
Credit card financing

3.22 Credit card financing is a form of direct consumer lending. In some countries, banks and
financial institutions may issue customers with prenumbered credit cards under approved lines
of credit, which can be used to purchase goods or services from a participating merchant. Most
such banks and financial institutions charge an annual fee, in addition to interest (finance
charges) and other fees (e.g., cash advance fees).
3.23 The primary international credit card plans are MasterCard (Eurocard) and Visa. In the
USA, a number of banks also sponsor independent plans. Some banks and financial institutions
have formed service companies to centralise card issuance, processing of transactions, and
maintenance of customer accounts.
3.24 Not all institutions that sponsor credit card plans carry the loans that results from use of
the cards. The institution may be affiliated with another institution, usually a commercial bank,
that processes transactions and assumes the loan and credit risk. Several institutions may enter
into a co-operative agreement to provide a credit card program under which each institution
issues its own credit card, provides for its own promotion, signs up merchants, but the principal
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institution in the group provides the computer and accounting facilities. The associate
members pay a fee for these services.
3.25 After a customer has been issued a credit card, thereby, establishing a line of credit, loan
transactions are initiated by the customer’s purchase of goods or services from a participating
merchant.
3.26 Credit card operations. For a discussion of credit card operations, it may be convenient
to classify banks and financial institutions into two categories:
■ card-issuing banks and financial institutions that issue their own cards or another
institution's card; and
■ noncard-issuing banks and financial institutions.
3.27 A card-issuing bank or financial institution performs the following functions:
■ accepts credit card applications and obtains credit reports on applications;
■ embosses and issues cards to acceptable applicants;
■ negotiates with retail merchants, service organisations, and others to accept the credit card
in lieu of cash or other credit for sales or services rendered. Vendors usually pay a one-time
membership fee and an annual maintenance fee. The bank or financial institution maintains
a contract file containing the current agreements signed by vendors. Vendor membership
may usually be terminated according to contract provisions upon written notice of the
vendor or the bank or financial institution. Affiliation with a credit card programme may
reduce vendor accounting and record-keeping costs. It may also reduce credit losses and
collection expenses provided procedures set forth in the contract with the bank or financial
institution are followed. Membership in a credit card programme may permit the vendor to
offer credit card facilities that are competitive with department stores and other large retail
outlets, and may increase sales volume;
■ issues charge slip imprinters (controlled by serial numbers) and maintains or replaces
imprinters;
■ furnishes vendors with all applicable materials and supplies;
■ accepts charge slips from vendors and credits each vendor's account for the face value of the
charge less a negotiated discount (called the merchant discount). The discount rate may be
fixed (e.g., 3 percent) or may be on a sliding scale based on the volume generated;
■ updates the cardholder's account for charges or credits;
■ charges each vendor's account for rejected charge slips. Some charge slips may be rejected
because the card has expired, the transaction vendor did not obtain a required authorisation
for the transaction, or the card used was a lost, stolen, or counterfeit card. The vendor is
usually responsible for:
- verification of the validity of the card at the time of the transaction through reference to
a listing of invalid cards furnished periodically to them, usually by national sponsors on
behalf of all participating institutions;
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- obtaining prior authorisation on charges over a specified amount. National sponsors

maintain authorisation centres on behalf of all participating institutions that can be
accessed by telephone or using on-line systems.
■ makes cash advances to valid cardholder upon request and charges the cardholder's account.
These cash advances are made by cashiers after they have received telephone authorisation
from the credit card department. When a bank or financial institution’s credit card plan is
part of a national or international plan, the bank or financial institution’s cardholders may
obtain cash advances at any institution participating in the plan. In return, the bank or
financial institution will honour requests from cardholders of other institutions after
obtaining approval by telephone from an authorisation centre;
■ renders monthly statements to the cardholder, detailing charges and payments made by the
cardholder, interest (finance) charges, or other charges on the account (if any). The
cardholder usually can pay the entire balance due without incurring a finance charge or pay
in monthly instalments with a finance charge on the outstanding balance;
■ maintains and distributes a list of stolen, lost and cancelled cards. For national plans, this
function is generally administered by the national sponsor;
■ monitors accounts with high balances, excess activity and delinquency to reduce the risk of
loss.
3.28 A noncard-issuing bank or financial institution may act as an agent for a card-issuing
institution. Depending on the agreement, the noncard-issuing institution accepts applications,
enrols vendors, credits vendors' accounts for charge slips deposited, furnishes imprinters and
supplies, charges vendors' accounts for rejected charge slips, and makes cash advances. The
noncard-issuing bank or financial institution does not ordinarily assume any credit risk. The
charge slips, credit slips, and cash advance advices are forwarded to the card-issuing institution
for processing and billing. The noncard-issuing bank or financial institution generally retains
the vendors' membership fees, vendors' annual maintenance fees, a portion of the discount on
charge slips deposited, and a discount on cash advances as compensation for participation in the
card plan.
Overdraft facilities
3.29 Personal overdraft facilities are another form of consumer credit that typically ensure that
cheques written upon the customer's current or checking account will clear even if there are
insufficient funds in the account.
Education loans
3.30 Education loans may be under a government programme or under the bank or financial
institution’s own specialised lending programme. (As a practical matter, a borrower may
finance his or her children's education by using one or more of the other available forms of
credit at the bank or financial institution).
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Types of security (collateral)

3.31 Taking security (or collateral) for a loan is a method by which the bank or financial
institution can reduce the effective risk of loss in the event of default. The ideal form of
security is one that has the following features:
■ has a stable and ascertainable value;
■ is readily realisable;
■ provides adequate cover;
■ gives valid title.
3.32 Security may be categorised on the basis of:
■ who provides the security;
- direct: provided by the borrower;
- indirect: provided by a third party
■ the title it gives the bank or financial institution:
- legal: bank or financial institution has right to sell the security in the event of default by
the customer;
- equitable: bank or financial institution can obtain right to sell the security by application
to the legal authorities.
3.33 The more common forms of security are the following:
■ Debenture. A direct and legal form of security that can take the form of either a fixed
charge over specific assets and/or a floating charge over all assets of the borrower. In some
countries, the enforceability and strength of such security may be affected by the timing of
its creation. For example, in the UK:
- for both fixed and floating charges, the charge may be challenged as a fraudulent
preference if it was created in the six months prior to the commencement of liquidation;
- a floating charge created within a year prior to the commencement of liquidation is
invalid unless the borrower was solvent immediately after its creation.
■ Mortgage. A direct and legal or equitable security over the assets referred to in the deed of
mortgage. Common examples of assets mortgaged as security are: land, buildings, ships
and stocks or shares;
■ Lien. A bank or financial institution has a general lien over a borrower's property coming
into its possession in its capacity as a banker and not for some purpose inconsistent with the
lien. A lien is a direct and equitable form of security and rights to a lien depend upon
continued possession of the property or documents in question;
■ Assignment. This involves the transfer by a borrower to the bank or financial institution of
the right to receive a monetary benefit from a third party debtor. Banks and financial
institutions usually insist on the legal assignment of debts although an equitable
arrangement is sometimes possible;
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■ Guarantee/Indemnity. These are usually forms of indirect securities commonly used by

parent companies to secure bank and financial institution loans made to subsidiaries.
Organisation, operations, and records

3.34 Organisation. Typically, the following departments are involved in lending activities:
■ Lending department(s). Lending activities are initiated by lending officers, who negotiate
with potential new customers, maintain contacts with existing customers, and represent the
bank or financial institution in general to its customers.
The lending activities are usually under control of a senior credit committee, or, in the case
of small banks and financial institutions, of top management. The committee or institution
management is responsible for defining the bank or financial institution’s lending policies,
establishing lending limits, supervising the lending officers' adherence to established
policies and limits, and approving loans which are in excess of the lending officers' limits.
In some countries, lendings exceeding the bank or financial institution’s legal lending limit
must be reported to and/or authorised by the regulatory authorities.
■ Credit and loan administration department. The credit and loan administration
department is responsible for the following:
- receiving and controlling the loan documentation;
- maintaining relevant information about the borrowers;
- initiating the payment of funds;
- monitoring the timely receipt of principal, interest, and fees;
- monitoring of excesses against limits; and
- monitoring of movements in the market values of the assets securing the loans.
An important group within the credit administration department is the credit analysis group.
Its major task is to provide the credit assessment function for new borrowers and for
preparing periodic credit reviews for each loan and commitment to lend outstanding. For
further discussion on the credit review and evaluation process, refer paragraph 3.36. Many
banks and financial institutions use standardised spread sheets which are prepared using
financial data culled from borrower’s financial statements on a comparative basis for a
number of years. Significant relationships, key amounts and ratios are also shown on those
spread sheets. After the initial evaluation of the financial situation of the borrowers, the
analysts develop a first recommendation about the credit worthiness of the borrowers and
suggest an appropriate credit facility.
The loan administration department maintain a credit file for each borrower, obtain the
required loan documentation and keep records of interest, commitment fees, management
and other fees, principal repayments and participations sold. The department also ensure
that all payments of interest and repayments of principal are received by the bank or
financial institution on the due dates. The credit and loan administration department liaises
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with the dealing room in respect of the receipt and payment of funds and with the
accounting department, particularly as regards accruals for interest and fees.
■ Accounting department. The accounting department in conjunction with the EDP
department is responsible for maintaining the bank or financial institution’s accounting
records, which should reflect, in addition to all current outstandings per borrower, any
unused amounts of advised credit lines.
■ Legal department. A number of banks and financial institutions now have separate legal
departments which ensure that the legal aspects (such as documentation, security, intra vires
considerations etc.) of their activities, particularly lending, are in order.
■ Safekeeping department. Some banks and financial institutions also have a separate
safekeeping department, which is responsible for the physical custody of notes and other
loan documents received as well as any collateral kept in the bank or financial institution’s
possession.
3.35 A summary of the basic responsibilities of the various functional activities is set out in the
following table:
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Responsibilities Credit Committee Credit and Loan

Chief Lending Officer Loan Officers Administration Accounting/EDP Paying and receiving Safekeeping
General : Supervise lending Transact lending Maintain credit Process loans and loan Effect disbursements/ Maintain custody of loan
operations operations information and monitor facilities transacted receipts of loan notes and related docu-
disbursements/receipts proceeds and related mentation and, if applicable
under loan facilities interest and fees of related collateral
Specific : • Formulate lending • Commit the bank's • Collect and analyse • Maintain accounting • Execute appropriate • Receive and maintain
strategy resources to lending data on potential records payment instructions custody for loan
• Monitor profit transactions borrowers' credit Generate management through: • Release loan
performance • Execute lending worthiness, including information reports, (i) customer's account documentation and
• Establish/monitor strategy obtaining other bank including: with the bank collateral on
compliance with the • Manage the bank's loan references and i) customer liability (ii) correspondent borrower's
bank's lending portfolio to maximise verifying data reported ledger (including banks satisfaction of their
policies, including profits while by the applicant, and commitments) • Receive customer commitments under the
adherence to loan complying with recommend appropriate ii) interest accruals repayments through: facility
officer, customer, policies to control facility iii) summaries of i) charges to
country and industry risk including those • Establish and maintain country and customer's account
concentration limits regarding interest disbursements, receipts industry with the bank
• Review portfolio for rate sensitivity and and interest accruals concentration (allowing
collectibility and maturity distribution • Prepare accounting exposure overdrafts only on
establish appropriate as well as adhering to entries iv) summaries of maturity appropriate
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reserves for possible loan officer, • Reconcile accounting authorisation)
distribution and
losses customer, country and data to customer files interest rate ii) correspondent
industry concentration • Maintain current data on sensitivity banks
limits borrowers' credit worthiness
• Promote new business and recommend appropriate
• changes in credit facilities
Review of and, if needed, reserves
accounts for
collectibility and for possible losses
recommend • Review covenants on a
provisions and regular basis to ensure
gradings ensure continued compliance
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Lending Department Operations/Accounting
Responsibilities Credit Committee Credit and Loan

kpmg
Chief Lending Officer Loan Officers Administration Accounting/EDP Paying and receiving Safekeeping
Transaction related: • Authorise loan • Authorise (within • On notification of • Process accounting • Receive paying/ • Receive delivery
facilities in excess receipt of appropriate entries prepared by receiving instructions instructions from
limits) and commit to
of loan officers' transaction documentation/ credit administration, from credit credit administration
limits • Prepare and arrange collateral initiate including: administration • Take/make delivery of
for customer to disbursement of loan i) memo record of • Match incoming documents/collateral
deliver signed proceeds undrawn commitments receipts to receive specified in Credit
documentation • Monitor interest to lend instructions Administration
including: accruals ii) disbursements of • Make payment on pay
i) loan agreement • Allocate receipts loan proceeds instructions
ii) loan note between interest and iii) allocation of cash
iii) corporate principal repayments receipts
resolution • Prepare accounting • Calculate and record
• Arrange for customer entries for interest accruals
to assign/deliver disbursements/receipts
appropriate security • Notify the customer of
• Take appropriate payments past due or
corrective action for of changes in its
borrowers unable to credit facility with
meet loan terms, the bank
including:
i) realise collateral
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ii) legal recourse
iii) renegotiate terms
Accounting Controls: Authorisation Authorisation Completeness, Existence Completeness, Existence

Accuracy Accuracy
Segregation of Authorises Authorise and Commit Enter exchange data to Receive consideration Receive consideration
Duties: accounting system for the exchange for the exchange (loan
note)
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3.36 Credit review and evaluation. When a potential borrower approaches the bank or
financial institution for a loan, a credit analysis is performed to determine the ability of the
borrower to repay the requested loan in accordance with the terms of the proposed loan
agreement. A bank or financial institution must determine the degree of risk it is willing to
assume in each case and the amount and type (e.g., secured versus unsecured) of credit that can
be prudently extended in view of the risks involved. Moreover, if a loan is to be made it is
necessary to determine the conditions and terms under which it will be granted. Some of the
factors that affect the ability of a borrower to repay a loan are difficult to evaluate but must be
dealt with. Generally, this involves reviewing the current financial position and the past record
of the prospective borrower and up to date valuations of any assets securing the loans. In a
number of cases, institutions may utilise “credit scoring” to assist in the evaluation of
prospective borrowers. While loans are contracted today, they must be repaid in the future.
Accordingly, loans are not based entirely on a borrower’s history and reputation. In certain
types of loans, financial projections must be prepared, involving economic forecasting.
Financial projections attempt to forecast the borrower’s future ability to repay the loan in the
normal course of business or from personal finances.
3.37 The degree of delegation and specialisation in the credit review area depends on the size
of the bank or financial institution and the composition of its loan portfolio. In smaller banks
and financial institutions, each loan officer may secure the necessary credit information and
maintain his/her own credit files. In large banks and financial institutions, there is usually a
separate credit department, and personnel will normally specialise in certain types of loans or
industries.
3.38 The type of information gathered in the credit review and evaluation function and the
depth of analysis performed will depend on the type of the loan, amount requested, and the
nature of the potential borrower. For example, the work performed in connection with a
consumer loan application differs from a mortgage loan. It would differ further if the
application were for a mortgage on a single-family residence as opposed to an apartment
complex. While the extent of work performed by the credit function varies, the objective
remains the same (i.e., gathering and analysing sufficient information to enable an informed
decision to be made on whether the customer should be granted the credit request, based on risk
considerations).
3.39 There are many sources of credit information available to the bank or financial institution.
Some of the more common sources include (as appropriate):
■ interview with applicant;
■ financial statements and related information of the borrower and any guarantors. These
include not only current statements, but statements for several prior years and schedules of
future projections. These statements and schedules might include:
- balance sheet;
- income statement;
- funds flow statement;
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- bank or financial institution’s own records. An institution may maintain a central file of
all its depositors and borrowers from which credit information can be obtained. A
liability ledger, for example, will show the payment record on previous loans as well as
current indebtedness;
- credit reporting agencies;
- retail credit bureaus. Consumer rating agencies supply credit information on
individuals;
- other institutions. Institutions that have relationships with the applicant can supply
information;
- applicant’s customers and suppliers (or employer). They can supply information on the
financial reliability of the applicant;
- internally and externally prepared appraisals and inspection reports; and
- tax returns or tax searches prepared by tax search companies.
Having obtained the information and made the decision to lend to the borrower, institutions may
rate the loan according to their internal grading system. Rating the loan upon commencement
will assist management in monitoring the loan during its life relative to its original rating. In
addition, the migration of loans between ratings provides useful information on portfolio trends.
3.40 Records and reports. All information on the borrower is filed in a credit file and/or a
loan documentation file. Typically, such file(s) should include the following documentation
which should normally be available where appropriate, prior to the disbursement of funds:
■ loan application;
■ loan summary sheet;
■ evidence of loan committee approval and date approval was granted;
■ signed loan agreement;
■ financial statements of borrower and guarantor;
■ spreadsheets and other analyses on the financial situation of the borrower;
■ legal opinion (e.g., on power to borrow);
■ board resolution (if applicable);
■ legal constitution of borrower;
■ signed guarantee;
■ evidence of security and its location;
■ promissory notes;
■ participation certificates relating to loan syndications;
■ credit agency reports and bank reports;
■ newspaper clippings;
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■ various other pertinent data, including history of the borrower, future projections and the
industry involved, etc.;
■ re-approval date for advised and unadvised lines;
■ internal memoranda; and
■ correspondence.
3.41 The loan summary sheet (sometimes referred to as loan record card) should contain the
following information:
■ lending committee approval date;
■ total amount of facilities (advised and unadvised) and dates to which available;
■ drawdown amounts and dates;
■ any currency options;
■ rate of interest and adjustment dates;
■ rate of interest withholding tax;
■ amount of undrawn commitment;
■ rate of commitment fee and respective dates due;
■ date commitment fee received;
■ repayment terms;
■ domicile of country risk;
■ name and country of any guarantor;
■ amount of participation fee; and
■ indication of overdue payments of interest, fees, or instalments.
3.42 In addition to the records kept in the credit files and the loan documentation files, banks
and financial institutions maintain such usual accounting records as general ledger, subledgers,
and central liability ledgers (a summary report of total customer outstandings).
3 . 4 3 A collateral ledger is used to record the instruments which secure a borrowers'
indebtedness. The items in the collateral ledger should be cross-referenced to the specific
collateralised indebtedness.
3.44 To enable management to exercise control over the bank or financial institution’s loan
portfolio and credit risks sufficient information regarding the portfolio must be available and
must be properly presented. Reports are often produced in which credit risks and contents of
the total loan volume are condensed and analysed. Examples of such reports are as follows:
■ summary of country exposures (outstandings and commitments) in comparison to
established limits;
■ loan diversification summaries (governments, quasi-government bodies, banks,
multinational companies, local companies);
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■ industry diversification summaries;

■ weighted average spread by country exposure reports;
■ classified loan reports (i.e. those loans in need of close supervision);
■ rollover/maturity analyses compared with maturity analyses of deposits accepted (i.e.,
funding report);
■ average life of portfolio summaries.
Accounting matters
3.45 The following guidance is general in nature. Consideration should be given to any local
practice and accounting regulations.
3.46 Balance sheet. Loans are recorded at their estimated realisable value, which is normally
the outstanding principal amount (face value) less the allowance for loan losses.
Loans held for Sale (e.g. portions of syndications not yet sold) are recorded at the lower of cost
or market.
3.47 When loans are made at a discount the difference, called the discount, between the face
value of a loan and the (lower) amount paid to the borrower represents the equivalent of interest
and other fees. Banks and financial institutions usually record discount loans at their face
amounts, crediting the discount to a liability account (deferred income account). However, in
some countries it is required that unearned discount should be deducted from the related asset
for financial statement presentation.
3.48 A washable loan arrangement may (depending on any local restrictions e.g., United
Kingdom FRS 5) qualify for elimination from a bank or financial institution’s balance sheet if
the following conditions apply:
■ the bank or financial institution holds an irrevocable authority from the depositor that the
deposit can be applied at any time in satisfaction of the amount outstanding on the loan and
there is no legal impediment to enforcing that right;
■ the amount of the loan and of the deposit are the same. However, if the deposit is less or
more than the loan, then the arrangement may still be construed a washable to the lower of
the two amounts;
■ the period of the loan and of the deposit are the same. However, if the period of the deposit
and of the loan are not identical, a washable arrangement may only exist up to the earlier of
the repayment of the deposit or the loan;
■ the currency of the loan and of the deposit are the same. A cross currency arrangement
normally provides for any shortfall in the amount of the deposit as against the amount of the
loan being topped up on demand or as may be otherwise provided as the rate of exchange
between the two currencies varies adversely; subject thereto a washable arrangement may
be deemed to subsist up to the lower of the two amounts, translated to a common currency.
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The significance of washable arrangements is that deposit and loan are set off and are off
balance sheet. Where the amounts do not match exactly (as in some of the circumstances set
out above) the difference would generally be dealt with on balance sheet as a loan or deposit as
the case may be. A note to the balance sheet would generally be appended stating that there are
assets and liabilities not included in the balance sheet which represent related transactions
where the bank or financial institution has no overall exposure; such a note may quantify the
amount involved.
3.49 The loan and the deposit arising out of a parallel loan arrangement are recorded on the
balance sheet of each entity in the normal way unless it is a washable arrangement in which
case the guidelines in paragraph 3.50 apply.
3.50 Off-balance sheet. Undrawn committed facilities, guarantees, standby letters of credit,
etc. should be recorded in contingent or memoranda accounts. The extent to which such
obligations are disclosed in the financial statements is a matter of local practice and regulations.
3.51 Profit and loss. Interest is normally accounted for on an accrual basis.
3.52 Loan fees are commonly accounted for as follows:
■ Management/origination fees - such fees generally represent reimbursement of indirect costs
incurred in arranging the loan and as such should be credited to income on the date of
signing the agreement or when received;
■ Commitment fees - such fees represent compensation for holding a credit line available over
a specified period of time (the commitment period) and as such should be credited to
income evenly over the commitment period;
■ Interest-related fees - some loan agreements provide for a high front-end fee as
compensation for a contractual interest rate below the market rate; in such circumstances,
the interest-related portion of the front-end fee should be credited to income over the life of
the loan (in a manner similar to unearned discounts);
■ Rescheduling fees - it is becoming common practice for borrowers rescheduling their loans
to pay additional fees to creditor banks or financial institutions; the timing of recognition in
income of such fees will vary depending upon individual circumstances, primarily the
purpose for which the fee is paid (e.g., reimbursement of costs, penalty for rescheduling the
loan, interest adjustment for extending the maturity) and the overall credit assessment of the
borrower.
3.53 Guarantee fees should be credited to income over the life of the guarantee.
3.54 Non-accrual loans. Loans are normally accounted for on a non-accrual basis when it is
expected that interest is probably not collectable. In some countries an arbitrary length of time
that payments are past due has been established after which a loan is to be classified as non-
accrual (e.g., 60 or 90 days). In reading the following, consideration should also be given to
requirements or best practice or regulatory direction in individual countries.
Previously accrued but uncollected interest should be reversed from income. When the accrual
of interest has been suspended and interest is subsequently collected, consideration should be
given to the following in evaluating the proper accounting procedure:
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■ if principal repayment is overdue and/or considered doubtful of collection, such payments

should be recorded as a reduction of the outstanding loan balance;
■ in cases where amounts subsequently collected are treated as interest income, this amount,
under the accounting conventions of some countries, should be allocated between interest
income from current operations and interest income relating to previous periods;
■ in cases where cash receipts have been recorded as a reduction of principal and where such
a loan is subsequently determined beyond a reasonable doubt to be fully collectable, it is
considered appropriate under the generally accepted accounting principles of many
countries to record as interest income the amount by which the stated principal balance of
the loan exceeds the book balance of the loan on the date of such determination. In some
countries the excess amount is to be recorded as extraordinary income. In other Countries
such amounts are recorded as a yield adjustment over the remaining term of the loan.
3.55 Provisions for probable loan losses. Laws, regulatory bodies, and/or generally accepted
accounting principles in many countries require use of the reserve method of accounting for
loan losses. Under this method, a provision is periodically charged to earnings in an amount
sufficient to maintain the balance of the allowance for probable loan losses at a level
appropriate to absorb anticipated losses in the then existing loan portfolio, including undrawn
commitments. Subsequent loan losses are deducted from the allowance and recoveries added.
3.56 Management periodically performs a review of the loan portfolio to assess the credit
standing of borrowers in order to form a view of whether loans outstanding and contingent
assets will be fully collectable at maturity and, if not, the amount of provision for loss that
should be made.
3.57 Management's evaluation is based on a continuing review of the loan portfolio which
considers many factors, including identification and review of individual problem situations
which may affect the borrower's ability to repay; review of overall portfolio quality through
analytical review of current charge-offs, delinquency and non-performing loan data; an assess-
ment of current economic conditions; and changes in the size and character of the loan
portfolio.
3.58 For financial statement purposes the allowance for loan losses is usually either shown as a
separate line item deducted from the total of the respective asset account (i.e., contra asset
account) or deducted directly from the respective assets, with appropriate footnote disclosure.
3.59 For additional discussion see chapter 4 of this volume.
Auditing guidance
3.60 For auditing guidance on a bank or financial institution’s lending activities reference
should be made to chapter 3 of volume 1.
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Introduction
4.1 General. The disbursements of funds through investments, loans and other credit facilities
entails the risk that the bank or financial institution will fail to recover such funds. The
allowance for credit losses is an estimate as of the date of the balance sheet of investments,
loans and other credit facilities that will eventually be uncollectable based on all information
available. For the purposes of the above, other loans and credit facilities include:
■ loans, leases and standby arrangements;
■ money market instruments and/or amounts due from other banks or financial institutions;
■ other credits including guarantees and documentary credits issued;
■ undrawn commitments and other off-balance sheet credit risks;
■ recourse provisions on whole loans or participations sold;
■ off balance sheet transactions (swaps, foreign exchange, FRAs and options);
■ accrued interest.
4.2 In general, management should periodically perform a review of the investment, loan and
credit portfolios (collectively, "the credit portfolio") to assess the credit standing of borrowers
and other creditors in order to form a view of whether investments, loans or other credits will be
fully collectable and, if not, the amount of provision for loss or diminution in value that should
be made as a result thereof.
4.3 Management's review of the credit portfolio should consider many factors in addition to
identification and review of individual problem situations that may affect the borrower's ability
to repay. Such other factors include review of overall portfolio quality through analytical
review of current and historical write-offs; delinquency and non-performing loan data; an
assessment of current economic conditions; and changes in the size and character of the credit
portfolio. More fundamentally, management must consider its credit initiation, monitoring and
collection processes, and the underwriting standards inherent in this process. This process
serves as an important basis for management's determination of a reasonable allowance for
credit losses.
4.4 There are generally two components of the allowance for credit losses:
■ Allocated (specific) portion. That portion of the allowance that is allocated to separately
identified and evaluated credits or pools (or types) of credits in which exposure is calculable
(e.g., delinquent loans, instalment loans, etc);
■ Unallocated (general) portion. That portion of the allowance required to cover loss
contingencies associated with risks for credits not separately identified and evaluated in
determining the allocated portion. This amount should be based on judgements regarding
risk of error in the amount of the allocated portion, other exposures existing in the bank or
financial institution's credit portfolio, and other relevant factors consistently applied.
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4.5 The determination of precisely what constitutes an adequate allowance for credit losses is
highly subjective. Thus, careful consideration and judgement is required. Each market tends to
have its own practices and where possible you should seek to ensure that the institution follows
practices for allowance for loan losses which are not inconsistent with its competitors.
However, primary consideration must be given to the loss characteristics in the institutions loan
portfolio.
4.6 Loss contingencies can occur from activities other than investments, loans and other credits
referred to above. This can be the case in such areas as foreign exchange transactions,
securities trading, etc., and is an evaluation that needs to be made apart from the evaluation of
the allowance for credit losses.
4.7 Non-accrual loans. Where collectibility of interest on loans is not probable, interest
accruals are normally suspended. Previously accrued interest receivable should be evaluated for
collectibility. Accrued interest that is not protected by sound collateral values or, otherwise
collectable, should be written off against current-period interest income.
4.8 If principal repayment is overdue and/or considered doubtful of collection, interest
collections on non-accrual loans may generally be recorded as a reduction, first, of any
outstanding interest receivable on the loan, and second, of the outstanding loan balance. In
cases where cash receipts have been recorded as a reduction of principal and where such a loan
is subsequently determined to be fully collectable, interest income may be recognised on the
difference between the stated principal balance and the book balance of the loan at the date of
such determination. Certain banks and financial institutions may prefer to recognise this
difference as a yield adjustment over the remaining life of the loan. In determining the
appropriate treatment, consideration should also be given to requirements or best practice in
individual countries, e.g., United Kingdom: British Bankers’ Association’s Statement of
Recommended Accounting Practice on Advances.
4.9 A non-accrual loan may be restored to an accruing status when principal and interest are no
longer due and unpaid, or it otherwise becomes both well secured and in the process of
collection. Prior to restoring a loan to accrual status, management should consider the
borrower's prospects for continuing future contractual payments. If reasonable doubt exists,
reinstatement may not be appropriate.
4.10 In an attempt to ensure compliance with the non-accrual policy referred to above, certain
banks and financial institutions and/or regulators have required suspension of interest accruals
for loans that are delinquent as to principal or interest for a period of ninety days or more,
unless the loan is well secured as to principal and interest and is in the process of collection.
4.11 Troubled debt restructurings. Troubled debt restructurings occur when a bank or
financial institution, for economic or legal reasons, grants a concession to the borrower which
the bank or financial institution would normally not consider, including loans where:
■ cash, property, or other assets, whose combined fair value does not equal or exceed the bank
or financial institution's carrying amount of the loan, are received in full or partial
satisfaction of the loan;
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■ certain equity interests in the borrower are granted to the bank or financial institution in full
or partial satisfaction of the loan;
■ certain terms of the debt are modified.
4.12 Financial statement presentation . The allowance for loan losses is generally presented
in the balance sheet or notes thereto as a reduction of loans receivable (i.e., contra asset
account).
4.13 In some countries, the accounting bodies and regulators encourage banks and financial
institutions to provide full disclosures on their problem ("nonperforming") loans. Such
disclosures are especially important when levels of such loans are considerably above industry
norm, the allowance is marginally adequate or such loans are expected to be a problem for an
extended period; and where the loss in revenue has not been clearly reflected in the most recent
income performance of the bank or financial institution.
4.14 Internal control considerations. Internal control considerations for lending activities in
general are addressed in chapter 3 of volume 1.
Auditing guidance
4.15 The provision and allowance for credit losses is usually one of the most significant
elements of a bank or financial institution's financial statements. Also, matters are often highly
judgemental and subject to the possibility of management override. If excessive management
emphasis exists to maintain or attain a particular trend or level performance in the financial
reporting of the bank or financial institution, this must be considered in determining the level of
reliance that can be placed on specific controls. Carried to an extreme, management override in
this area can make all of the controls over the credit loss allowance ineffective.
4.16 The allowance for credit losses must reflect the client's business. In establishing the
approach to auditing the allowance the auditor should consider the following factors:
■ composition of loan portfolio and other credit exposures;
■ credit policies and process including the experience and depth of lending management;
■ reporting process;
■ nature and extent of the credit evaluation process including the identification of problem
loans, loans to be charged-off, as well as the adequacy of the documentation of
management’s evaluation of the adequacy of the allowance for credit losses;
■ local, national, and environmental conditions; and
■ latest regulatory reports.
4.17 When auditing the allowance for credit losses, we are primarily concerned with the
valuation assertion in the financial statements. It is essential that the audit team gain an
understanding of the specialised financial instruments utilised by management and an
understanding of the bank or financial institution's lending environment, including credit
strategy, credit risk and the bank or financial institution's lending policies, procedures and
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control environment. These key areas are addressed more specifically to the audit process in
the paragraphs that follow.
4.18 Planning analysis. Planning analysis is the use of analytical procedures designed to aid
in the identification of critical areas and segments and enhance our understanding of the client’s
business. Examples of the types of analysis that should be considered include:
■ composition of the lending portfolio and other credit exposures (e.g., off balance sheet
activities). The objective of this analysis is to identify the type of credit exposures
including nature of the lending, customer profile, industry concentration and geographic
spread;
■ analysis of non-accrual loans;
■ analysis of allowances for credit losses by type of credit;
■ composition of lending portfolio by grading (where applicable);
■ management attitude toward recognising credit losses.
4.19 Assessment of inherent risk. In planning an examination of allowances for credit losses,
we should assess the risk that the financial statements contain a material misstatement (ignoring
the effect of internal controls) as a result of an incorrect valuation of the bank or financial
institution’s assets resulting from credit losses. The paragraphs below provide a number of
matters that should be considered when evaluating the inherent risk associated with the
evaluation of allowances for credit losses. These should be considered in conjunction with the
general matters contained at 2.32 of volume 1.
4.20 An institution's credit strategy includes defined goals and objectives regarding investments
and loans and the use of on and off balance sheet capital markets instruments as well as credit
policies written to achieve those goals and objectives. A guiding principle in credit strategy is
to achieve profitable returns while managing risk. The objectives of a sound credit plan are to
identify profitable markets, set goals for portfolio growth or contraction and establish limits on
industry, instrument and geographical concentrations. A further objective would be to ensure
that procedures and controls are in place to monitor credit performance through periodic
reporting and review and to identify and monitor problem credit situations.
4.21 Several factors relating to the composition of the credit portfolio should be considered in
evaluating the risk of loss in that portfolio. The primary areas that might be considered, with an
emphasis on risk considerations, are described below in the form of questions:
■ What are the primary lending/investing markets?
■ To what industries or consumers does the bank or financial institution extend credit? Are
they in areas in which the bank or financial institution is experienced? Are the industries
growing or depressed? Are they capital, labour or technology intensive? Are they
particularly susceptible to environmental risk (eg chemicals)? Is the consumer outlook of
employment and cash flow secure?
■ Does the bank or financial institution actively manage the portfolio? If so, how?
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■ What geographic areas are significant to the credit portfolio? Are they areas in which the
bank or financial institution is experienced? Are they in areas that are dependent on one
industry (e.g., agricultural, energy, automobiles, high technology). Are they areas that are
economically depressed?
■ To what size and type of borrower does the bank or financial institution extend credit? For
example:
- One-industry companies, diversified companies, conglomerates;
- Large multinationals, middle-market companies, small companies;
- Start up companies - are the credits actually venture capital investments;
- High net worth individuals, low income individuals;
- Persons (companies, individuals, developers, contractors) with strong success reputation,
financial position;
■ Have there been significant changes in the credit portfolio? This analysis should focus on
the trends in the portfolio (e.g., increased or decreased concentration in particular industries,
geographic areas, new versus established companies, types of consumers);
■ How has the credit portfolio grown in relation to the business and consumer economies in
which the bank or financial institution operates? We should be attentive to credit portfolios
(or segments of a portfolio) that are growing or declining at a rate significantly different
from the rate of growth of the economy;
■ What is the dispersion of risk in the portfolio and how has it changed? We should be
attentive to the composition of the bank or financial institution's loans. The greater the
diversity in a portfolio (in terms of size of borrower, industry, location, etc), the less likely it
is that a single event or small number of events can cause significant losses.
4.22 Changes in the portfolio and management thereof may indicate either a greater or lesser
concern about the inherent risk of loss.
4.23 The overriding factor in the credit extension process is the amount of credit risk associated
with both the lending process and the use of various financial instruments. Credit risk pertains
to the borrower's ability and willingness to perform under credit extension agreements and
should be assessed before credit is granted or renewed and periodically throughout the term of
the credit extension.
4.24 Additional risks, however, are involved in the overall credit process, and should be
assessed when developing credit strategy, defining target markets and designing proper controls
over the credit initiation and credit monitoring processes. These risks (including inherent risks
and control risk considerations), which should be addressed by the audit team in assessing the
adequacy of the allowance for credit losses, include the following:
■ Collateral risk - The bank or financial institution may be exposed to loss on collateralised
transactions if the bank or financial institution's security interest is not perfected or the
collateral is not otherwise under the bank or financial institution's control, or if the value of
the collateral declines;
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■ Concentration risk - Inadequate diversification of investment assets in terms of different

industries, geographic regions, or number of borrowers may result in significant losses. For
example, a high concentration of loans to companies in an industry experiencing economic
problems would constitute a concentration risk;
■ Country or transfer risk - Economic, social, legal and political conditions of a foreign
country may unfavourably affect a borrower's ability to repay in the currency of a credit
extension or loan. Cross border loans are those where borrowers must repay in a currency
other than their local currency or to a lender in a different country. Losses may result if a
country's foreign exchange reserves are insufficient to permit timely repayment of cross
border loans by borrowers domiciled in that country, even if borrowers possess sufficient
local currency. In addition, foreign government decisions and associated events can affect
business activities in a country as well as a borrower's ability to repay its loans;
■ Environmental risk - The possible erosion of security values as a result of clean up costs
and the question of lender’s liability are issues which are of increasing concern to lenders;
■ Foreign exchange risk - Changes in foreign exchange rates may affect lenders
unfavourably;
■ Fraud risk - Credit extensions may expose the bank or financial institution to loss by not
being either bona fide or arms-length transactions;
■ Insider risk - Credit extensions to executive officers, directors and principal shareholders
of a bank or financial institution and related interests of such insiders may expose the bank
or financial institution to loss due to the possibility of management override and/or fraud;
■ Legal and regulatory risk - Credit extensions that are granted illegally, with exorbitant
interest rates or on terms that are not adequately disclosed to the borrower may expose the
bank or financial institution to loss. In addition, the institution may also be exposed to loss
for other legal or regulatory reasons such as if it does not adequately comply with regulatory
requirements and codes of conduct, if it lends to enterprises which are acting ultra vires or it
lends with inadequate or legally ineffective documentation;
■ Management risk - Management's competence, judgement and integrity in originating,
disbursing, supervising, collecting and reviewing credit extension agreements could
substantially expose the bank or financial institution to credit risk;
■ Operations risk - Funds might be disbursed without proper authorisation or collateral
documentation. Failure to evaluate and monitor a borrowers potential inability to perform
also constitutes an operations risk.
4.25 Select substantive audit procedures. Example procedures for performing substantive
tests for evaluating the measurement of the allowance for credit losses are discussed in chapter
3 of volume 1. Credit files reviewed as part of test of control procedures are largely performed
for the purpose of obtaining evidence with respect to controls on which we intend to rely. The
substantive procedures discussed are general in nature and allow for flexibility on the part of the
audit engagement team in designing suitable procedures for evaluating the bank or financial
institution’s allowance for credit losses based on the engagement team’s understanding and
evaluation of the credit risk strategy and credit risk position of the bank or financial institution.
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4.26 Most portfolios contain various categories of credits that represent greater or lesser risk
factors. With respect to substantive tests of specific credits, therefore, sampling is generally not
appropriate. One approach is, therefore, to judgementally segregate the portfolio into two
populations:
■ minimal exposure credits; and
■ higher exposure credits (all other credits).
4.27 Substantive tests on minimal exposure credits will largely be analytical procedures,
including:
■ a review of current and historical credit loss statistics (e.g., losses, level of the allowance,
write-offs, delinquency statistics, trends in credits classified, non-accrual loans, or other
problem credits, etc) including, where appropriate, a comparison to industry and peer group
statistics.
■ a consideration of changes in lending polices and economic factors; and
■ a review of current changes in the size, maturity, and character of the portfolio.
Historical analyses should generally cover three to five years, at a minimum, and include
appropriate ratios, segregated by type of credit/borrower, industry, and other special
characteristics, such as energy, property, consumer, and foreign credits with further breakdowns
(e.g., construction, auto, commercial/residential property etc) depending on the nature of the
credit portfolio.
4.28 Substantive tests on higher exposure credits will often consist largely of detailed credit
review of borrowers, including collateral values, guarantors, and the industries in which they
operate. These procedures are often supplemented with analytical procedures such as:
■ ratio and trend analysis of the allowance for loan losses as a percentage of loans;
■ ratio and trend analysis of charge offs to average loan balances; and
■ aging analysis.
4.29 Credit review procedures are typically performed as of an interim date (e.g., for banks or
financial institutions with a calendar year-end, credit reviews will often be performed as of the
end of September, October, or November). Interim reviews should be supplemented with year-
end updates on selected credits reviewed at interim (especially problem or marginal credits) and
reviews on new "large" credits or credits that meet the parameters for unusual credits
subsequent to the interim examination. General guidelines on the timing of substantive
procedures are provided in chapter 60 of the KPMG Audit Service Manual.
Substantive credit file reviews

4.30 Selection criterion. The number of credits included in the population of "higher exposure
credits" subject to detailed credit reviews will be a matter of judgement. Risk considerations
and other factors to be considered include those already discussed in this chapter, the
composition of the credit portfolio, economic conditions, and the results of analytical
procedures conducted during the planning and field work stages. Generally, large and/or
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unusual credits that have higher risk should be included. Selection of items from the remainder
of the population is a matter of judgment having regard to the inherent risk associated with that
class of credits and results of our assessment of the control risk.
4.31 Large credits. Generally, a "100 percent condition" should be established based on risk
considerations (including degree of reliance on internal review function), such that all credits
equal to or exceeding the 100 percent condition are included in the population of "higher
exposure credits" subject to detailed credit reviews. The 100 percent condition should be
determined using audit judgement for individual banks or financial institutions based on
inherent risk and control risk considerations.
4.32 Unusual credits. Unusual credits below the amount of "large" credits, that are, based on
risk considerations, to be included in the population of "higher exposure credits" subject to
detailed credit reviews usually include certain of the following credits that might be considered
to be of significance:
■ Identified by us in prior examinations as a having unusual or greater than the normal
amount of risk;
■ Classified by regulatory agencies in their latest examination;
■ In currently known problem industries, geographic locations, etc;
■ Identified as past due or non-accrual. Where client-prepared listings (computer or manual)
are relied upon in identifying past due or non-accrual credits, we should perform tests to
determine that such listings are accurate and complete;
■ Identified by the client as a problem - these credits can be obtained from minutes and
reports of the board of directors or credit committees and client-prepared listings of problem
credits, "watch" credits, modified credits, renegotiated credits, credits for which specific
reserves have been provided, credits written off, credits with excessive renewals and
extensions, etc;
■ Insider credits or other related-party credits;
■ Construction credits with delays or cost overruns; and
■ Credits identified in tests of controls or other substantive procedures to have inadequate
documentation or other unusual risk.
4.33 The determination of which credits are significant, as well as the specification of the 100
percent condition discussed above, is a matter of audit judgement based on the results of the
evaluation of internal controls, the satisfaction obtained from other substantive procedures, and
other risk considerations in the context of the financial statements taken as a whole. Also, the
definition of significant credits may not be universal among credit categories enumerated above.
In some cases, a review of client reports, rating agency reports for publicly held companies, or
other evidence, may also impact our determination of unusual credits to be selected for detailed
credit review.
4.34 Some banks and financial institutions employ very limited practices in assessing the level
of the allowance, depending upon regulatory examiners or external auditors to a significant
degree. In this case the number of "higher exposure credits" is necessarily high, and
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accordingly, the coverage of detailed substantive credit reviews should be extensive. On the
other hand, some banks and financial institutions have very effective review processes whereby
line management is encouraged to classify credits promptly, based on a competent independent
credit review function, and those classifications and their effect on the allowance are reviewed
by credit committees, senior management, and internal auditors. In these cases (assuming the
tests of controls indicated an effective system) the number of "higher exposure credits"
subjected to a detailed credit review should be relatively small. Most clients will probably fall
somewhere between these two situations, and the extent of related substantive tests, including
individual credit reviews, will be judgemental.
4.35 For commercial and consumer credits, in evaluating the adequacy of the allowance, it is
important to understand the procedures the bank or financial institution follows in writing off
credits. One factor in evaluating the adequacy of the allowance as a percentage of total credits
outstanding is the timeliness of credit write-offs. For example, assume two commercial banks,
each of which has a total commercial credit portfolio of $10 million and an allowance of
$100,000 (100 basis points). If both banks have a credit of $100,000 to the same enterprise that
is in financial difficulty, the evaluation is different if one bank charges off this credit while the
other bank does not. While subjective credit judgement will vary, we should be alert to banks
and financial institutions that are slow to charge off uncollectible credits.
4.36 The extent of individual credit review will also vary from credit to credit. For example, a
credit that has been recently subjected to an effective management review, an effective internal
independent review, and a regulatory review will usually require less audit time for review that
a credit that has not undergone some or all of these reviews. Also, standard first mortgage
credits typically require less time than an acquisition, development, and construction lending
arrangement.
4.37 We should evaluate the factors outlined above to select a sufficient number of credits for
detailed review so as to bring the population of credits not reviewed (taking into account levels
of inherent risk, control risk, and detection risk based on other substantive procedures) to a
sufficiently small level to reduce the risk of a cumulative material loss or other adverse financial
statement impact (the ultimate risk) to an acceptable level.
4.38 Evaluation criteria. When performing a credit review, the borrower's total indebtedness
should be considered. Some commercial banks have a liability ledger that serves as a good
source from which aggregate credit by borrower can be obtained. We can also:
■ ask the bank or financial institution to prepare a schedule of the related indebtedness of
major borrowers;
■ check the latest regulatory report under the section on concentration of credit; and
■ be alert for recurring names as credit files or subsidiary listings are reviewed.
4.39 The contents of the credit file are summarised in paragraph 3.40 of this volume. An
example credit review working paper for commercial credits is included after paragraph 4.71 of
this volume. We should normally look first to the information that is most relevant to assessing
collectibility, including:
■ financial data of the borrower, including the purpose of credit and source of repayment;
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■ financial data of the guarantor for guaranteed credits;

■ information regarding the value of collateral for secured credits;
■ information to evaluate country risk considerations.
4.40 In addition to a review of the credit file, we should consider including discussions with the
credit officer(s) involved with the borrower to provide a source of information to supplement
the credit file information. This is particularly important for problem or marginal credits. For
commercial, construction, problem credits, and certain other credits, credit officers generally are
responsible for the daily monitoring, including customer contact. Therefore, they are often
familiar with background information, the borrower's reputation, the bank or financial
institution's future plans, and other intangibles not always found in the credit file with respect to
credits assigned to them. While the credit officer's estimate of a specific loss allowance may be
obtained during this preliminary review, we should not discuss his/her preliminary evaluation of
any specific reserves until the engagement manager and partner have concluded their review, at
which time a meeting should be arranged to discuss the results of the review with the client.
4.41 Credits supported by the financial condition of borrowers or guarantors . When the
prospects for credit repayment are based solely on the ability of the borrower to repay, we
should review the borrower's background and financial history (including quality of credit
history with the institution and others), financial resources, short-term liquidity, future financial
expectations, and long-term risks. Such a review should include an assessment of financial
data, internal memoranda, correspondence, and other documentation maintained in the credit
files.
4.42 These credits often represent a greater degree of risk than secured credits. The institution
must look to future profitability, primarily cash generated from the borrower's business, for
liquidation of the credit. While seasonal reductions in asset levels result in related credit
reductions, the continuing viability of the credit depends on positive cash generation.
4.43 For guaranteed credits we should generally perform an initial review of the borrower and
then review any collateral. A review of the guarantor (and the bank or financial institution's
access and contingency conditions relating to the assets or other current and projected resources
of the guarantor, and the condition of such) should then be performed to the extent considered
necessary. We should recognise that collecting from a guarantor can be a difficult and lengthy
process. It is also difficult to evaluate a guarantee unless all guarantees issued by the guarantor
are known. Personal guarantees can be a particularly difficult matter to enforce because of
complicated legal issues. However, if it is obvious that expectations for repayment are based
primarily on the credit worthiness of a guarantor, a detailed analysis of the financial condition
of a borrower is not necessary. The review of the credit worthiness of a guarantor should be
carried out as if it were the borrower.
4.44 Financial data relating to a borrower or guarantor should include:
■ interim and year-end financial statements of the current year and prior years;
■ financial forecasts for the current year and following years;
■ budget, cash flow, and liquidity plans and analyses;
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■ key measures of performance (e.g., sales volume, cost of sales, earnings before and after
extraordinary items).
4.45 An understanding of the borrower's history, the industry in which it operates, products,
markets, and business cycles is crucial in credit evaluation. The background and effectiveness
of management should be reviewed, including production, financial, and marketing functions.
This information should be evident from the loan files or from discussions with loan officers.
4.46 Ratios Analysis of financial statements and forecasts (and for individuals, salary and
other employment data, income from self-employment, or other sources of cash, and
outstanding obligations) is the primary basis on which to evaluate a borrower's or guarantor's
ability to repay a credit. Our emphasis should be to look beyond the numbers to obtain an
understanding of the underlying business activity. For example, borrowers that are reliant on
one or a few products/services are generally more risky than a multiproduct/service company.
We should evaluate the reliability of financial information. More weight, for example, should
be placed on audited financial statements than on unaudited statements. Various financial ratios
may be calculated to measure a borrower's condition and performance in terms easily
comparable with other borrowers. Such ratios should be measured against the trends and
norms, both historical and projected, for both the borrower being reviewed and the industry in
which the borrower operates. The most commonly used ratios are as follows (these should only
be used to the extent they are appropriate to the particular borrower or credit):
Category Ratio How calculated Significance
Liquidity Current ratio Current assets (CA) Ability to pay interest
Current liabilities (CL) and principal on debt
Quick ratio (acid CA - Inventory More demanding
test) CL measure of ability to
pay on debt
Working capital ratio CA - CL Measure of net
Total assets liquidity relative to size
of firm
Cash-flow and Times interest earned Pretax income Measure of margin of
fixed charge (or interest cover) + interest cost safety to cover interest
cover Interest cost expenses
Debt service ratio Operating cash flow (net Measure of margin of
income + debt service safety to cover debt
+ interest costs - dep’n) service
Debt service (principal +
interest)
Fixed charge cover Income available to Measure of margin of
meet fixed charges safety to cover interest
Fixed charges and other fixed charges
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Category Ratio How calculated Significance

Asset turnover Inventory turnover Cost of sales Measure of efficiency
Inventory of inventory investment
Average collection Receivables Measure of efficiency
period Sales per day in receivable
management
Fixed asset turnover Sales Measure of efficiency
Fixed Assets of fixed asset
investment
Total asset turnover Sales Measure of efficiency
Total assets of total asset
investment
Profitability Profit margin Net profit after tax Measure of profitability
Sales
Return on assets Net profit after tax Measure of profitability
Total Assets
Return on net worth Net profit after tax Measure of
Net worth stockholders' return
Financial Debt to total assets Total debt Measure of financial
leverage and Total assets leverage
solvency
Net worth to debt Net worth Measure of solvency
Total debt protection
Debt as percent of Long-term debt Measure of
capital funds Capital funds management's use of
debt to provide long-
term funds
Notes:
■ Average balances, if available, tend to provide more reliable information than point-in-time
balances which are subject to isolated and short-lived fluctuations.
■ In assessing the financial statements of the borrower (or the guarantors), regard should also
be had to, amongst other matters:
- revaluations of assets (whether incorporated in the balance sheet or not);
- whether any part of the net worth can be considered as representing non-trading assets,
whether current or not, which could be realised without harming the business;
- post balance sheet events indicated by published comment, etc.
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■ It should be noted that ratios may be misleading when considering capital intensive
industries (such as power supply) where huge initial expenditure financed by borrowings
may be recouped over several years from income generated. In addition, the generally
accepted level of gearing within an industry may vary from country to country.
■ When considering a highly leveraged lending transaction, traditional standards and ratios
applicable to the acquired company may not be applicable, especially when considering
financial gearing, solvency, interest cover and other related ratios. Instead what will
normally be relevant are ratios which compare the company’s cash flow from operations
before interest to future commitments the company has other than the repayment of the
principal debt. We should also carefully assess the acquired company’s ability to sell parts
of the business, especially where the leveraged lending has been based on asset sales to
secure repayment of the loans.
■ Ideally, only recent information (up to six months old) should be used for review purposes.
In some cases, however, there may be considerable delays on the part of the borrowers (or
guarantors) in filing financial statements, although most credit agreements now specify the
period after an entity's year end within which audited accounts are to be provided to the
lender. "Old" financial statements may provide some comfort where the borrowers (or
guarantors) have low gearing and substantial net worth and a substantial deterioration in the
intervening period is considered unlikely given economic conditions generally and the
absence of adverse press comment, or where the primary security is provided by fixed asset
charges. Other useful sources of information on the latest published financial information
on the borrowers will be press cuttings (which may be available via commercial press
extract services, which collate comments on both industries and individual companies from
a variety of sources and sends copies of the extracts to subscribers), and stock brokers
reports; and
■ In addition to assessing financial data and ratios, the evaluator should also take into account
any information about the borrower contained in the credit file that may be indicative of
internal strife, weakness in management or marketing, or production problems. These
matters and similar non-quantifiable items can often best be obtained through discussions
with the credit officer.
4.47 Credits supported by collateral. For secured credits, we should generally perform a
preliminary review of the borrower to determine whether it is likely that the bank or financial
institution will be required to look to the collateral to recover the credit. In general, the
preferable means of repayment and the primary reason for making a credit is the borrower's
ability to repay from its cash flow. The collateral should be generally viewed as an "alternate
way out". Collateral values and liquidity often tend to decline in periods when they are most
needed to protect against loan losses. In some circumstances, however, the cash flow may be
generated from the assets collateralising the credit or assets to be acquired with the credit
proceeds. The source of such cash flow may be from operations of the asset (e.g., commercial
property), from the disposal of the asset in the ordinary course of business (e.g., property under
construction, certain marketable securities, and pledged deposit accounts), or from the depletion
of the asset (e.g. oil and gas reserves, minerals).
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4.48 In addition to the quality, condition, and value of collateral, we are concerned with the
access and contingency conditions associated therewith. The types of collateral used to secure a
credit represent varying degrees of risk. For example, credits secured by the following types of
collateral generally involve more risk as the list progresses:
■ a deposit account in the bank;
■ marketable securities;
■ property;
■ stocks/inventories.
4.49 Secured credits may indicate that the borrower's credit worthiness has been judged to be
insufficient to warrant extending an unsecured credit. In many cases, therefore, it will be
necessary to determine the net realisable value of the collateral.
4.50 The net realisable value of collateral to fully secure a credit should at least equal the sum
of the outstanding principal on the credit, interest, and the costs that would be incurred in
converting the collateral to cash (e.g., legal fees, sales commissions, taxes, etc). Cash, deposit
accounts, and marketable securities listed on stock exchanges are the forms of collateral easiest
to measure reliably. In evaluating marketable securities, the current quoted bid price (or in the
absence of a quoted bid price, the last sale price) should be used. Valuation of other forms of
collateral should give effect to the priority of the bank or financial institution's claim to the
collateral and to the collateral's marketability. Valuations performed by outside appraisers
generally provide better evidence than valuations supplied by internal appraisers or
management, especially if such internal sources have only limited experience with the type of
property serving as collateral. Appraisals should be recent and particular care should be
exercised in reviewing assumptions as to market conditions, especially if property that has been
subject to significant market fluctuation is involved (e.g., commercial and residential property,
oil and gas properties, ships).
4.51 We should ascertain the priority of liens on property by examining title deeds, land
registry certificates, etc. It is also essential to ensure that any security interest has been
perfected through up-to-date filing with the applicable authority. Liens that other lenders have
against the property must also be considered to determine if they rank ahead of the bank or
financial institution's claim.
4.52 For credits secured by negotiable collateral held by the institution, related negotiable
collateral should be inspected in the presence of bank or financial institution personnel.
4.53 Many credit agreements require regular expert valuations to be obtained for the benefit of
lenders. If such valuations are not available, "information valuations" may be made with
reference to trade journals. Where the security for an advance is provided by an assignment of
income earned by an asset under a long term fixed price contract then the value of the security
may be calculated as the net present value of the future income flows less estimated expenditure
plus the discounted residual value of the asset. The discount rate used should reflect the
element of risk involved. Whether or not assets should be valued on a continuing basis or a
break up basis will depend on whether in the opinion of the reviewer the business of the
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borrowers could be sold as a going concern in the event of the bank or financial institution
calling its security.
4.54 Country risk considerations. In addition to evaluating the creditworthiness of individual
borrowers, we should also assess country risk for the bank or financial institution's exposure
within various countries to determine the impact of such risk on the ultimate collectibility of its
credits. Accordingly, borrowers should be grouped by the country in which they are domiciled
or subject to currency restrictions and an evaluation of country risk upon the ultimate
collectibility of these loans in aggregate should be made. Country risk consists of three
components: sovereign risk, currency (liquidity) risk, and political risk.
■ Sovereign risk is involved in cases where either the borrower or guarantor of a credit is a
sovereign state or government agency supported by the credit of the state (public sector
borrower). Such debt is comparatively more secure than private sector debt within any
particular country. Private sector borrowers can seek protection from creditors in
bankruptcy but public sector borrowers cannot. In a few cases, countries have indeed
renounced their foreign debt, however, at the price of being barred from international credit
markets for an extended period of time. Thus, instances of actual loss on credits to public
sector borrowers will be quite rare. Nevertheless, political instability, economic collapse,
and severe inflation, among other factors, can all result in a country's being unable to
service its public sector debt and its requiring protracted restructuring of that debt;
■ Currency risk, which encompasses both public and private sector debt, involves situations in
which credits are repayable in a currency other than either the bank or financial institution's
reporting currency or the borrower's functional currency. If the former, the bank or
financial institution runs the risk that, as a result of unfavourable changes in currency
exchange rates, it may realise from the cash repaid by the borrower less than it disbursed in
making the credit. If the latter, the borrower may find it economically unfeasible to obtain
the currency it needs to repay the credit;
■ Political risk stems from much the same conditions as sovereign risk but also affects both
public and private sector debt. This kind of risk encompasses all political matters ranging
from minor regulations imposed on a bank or financial institution or borrower that may
impair its profitability to the expropriation of property and expulsion from the country.
Factors to be considered in evaluating political risk include such items as the country's
internal and external debt, inflation rates, social and political climate, etc. Political risk
exists regardless of whether a credit is repayable in domestic or in foreign currency.
4.55 Other evidence. Satisfactory credit evaluation information may exist for certain
borrowers even if the credit file is not complete. Commercial paper ratings, bond ratings,
investment bankers' analyses, and recent SEC filings, for example, may be acceptable
substitutes for formal credit files. In addition, we may be able to perform alternate procedures
in lieu of missing credit file information (e.g., direct inspection of collateral, premises,
confirmation, etc).
4.56 Suggested stages for an efficient credit file review. Suggested (but by no means
prescriptive) stages in the performance of an efficient credit file review are as follows:
■ determination of the review approach for various types of credits;
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■ classification of loans according to risk;

■ assessment of credit and determination of adequacy of credit loss provision.
The determination of the review approach can be summarised in the chart set out as follows:
Critical features
when evaluating a
Types of credits
credit
Unsecured Guaranteed Secured by Sovereign
collateral lending
Financial detailed overview* overview* overview*
statements of review and
borrower analysis
Financial n/a detailed n/a n/a
statements of review and
guarantor analysis*
Realisable value n/a n/a detailed n/a
of collateral investigation of
the realisable
value*
Country risk review review review review
considerations
Notes:
n/a not applicable
* assumes the credit was granted primarily upon the basis of the guarantee/collateral and
not on the credit worthiness of the borrower.
In some countries, statutory regulations may require an auditor to examine the financial
statements of borrowers, even if their credits are guaranteed or secured. In such situations a
mere overview of borrower's financial statements will not be sufficient.
4.57 Classification of credits. The credit evaluation process involves classifying credits
according to their risk for the purpose of assessing collectibility. Classification systems may
vary and special considerations will apply where the borrower is considered a sovereign risk or
operates in a market where there are several suppliers of similar goods or services and a review
of the economy or industry generally may be necessary. One system commonly used by banks
and financial institutions, regulators, and many auditors is as follows:
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Classification Description Provision

Loss All or a portion of a credit considered Specific based on calculation
uncollectible or worthless of loss. Interest/fees
recognised on cash basis.
Doubtful All or a portion of a credit, the ultimate Specific - often percentage of
collection of which is doubtful and in balance calculated on
which a substantial loss is probable, but is consistent basis.
not as yet definitely ascertainable in Interest/fees recognised on
amount. cash basis.
Substandard All or a portion of a credit not classified Possible "allocation" of
as doubtful or loss and which involves general provision.
more than a normal risk due to the Interest/fees may be
financial condition and unfavourable recognised on cash basis.
record of the borrower, insufficiency of
security, or other factors.
Special mention Credits not warranting classification as None
substandard, doubtful or loss but which
fall outside the bank or financial
institution's normal lending policy or are
of an unusual nature carrying more than
the usual risk, and which warrant the
careful attention of management.
Good Credits which do not carry more than the None
usual risk/no doubt as to recovery.
Assessing the adequacy of the allowance for loan loss

4.58 In evaluating loans, individually and collectively, it is important to bear in mind that
historical conventions and guidelines may not have current validity and should not be used
mechanically. For example, an allowance of 1 percent of outstanding commercial loans, or
another percentage that "compares favourably" with industry averages, has no basis unless the
underlying portfolio risks support it. Similarly, the projected losses on substandard or doubtful
loans need to be evaluated individually and should not be automatically allocated a 10 percent
or 50 percent allowance, unless such percentages appropriately measure the credit risk for those
loans so classified.
4.59 Understanding and reviewing management's method of assessing the needed allowance is
a key factor in forming an audit conclusion. If management has used a reasonable approach, we
should determine that they have appropriately applied the method. Where practicable, we
should then compare the bank or financial institution's allowance for loan losses with the results
of the audit approach in order to form a conclusion. If the conclusion indicates an allowance of
approximately the same size as that established by management, it is reasonable to accept
management's allowance as adequate.
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4.60 In practice, banks and financial institutions use a variety of methods to estimate an
allowance for loan losses. No single method is considered preferable or ideal. The method
used must be logical, fit the bank or financial institution's circumstances, and the basis for
calculating the allowance must be comprehensive and take into consideration the range of risks
and the range of the various types of lending. The objective of all methods should be to
estimate the amount of uncollectible loans based on conditions at the balance sheet date.
4.61 Some of the approaches used by banks and financial institutions that have proved to be
effective are summarised below:
■ Review of all individual loans in excess of a designated amount and identification of those
loans that require a specific reserve allocation in light of the probability of loss.
■ Classification of loans into various risk categories and assigning loss percentages to such
categories based on experience, adjusted for changes in the character of the portfolio,
current economic conditions, and the average remaining life of the loans (ie., turnover
period).
■ Analysis of loans below a designated amount in light of loss experience, current conditions,
and the estimated turnover rate of this category of loans. (Turnover for a demand loan
could be defined as that point in time when the loan must be renewed or when management
reviews and reapproves continuation of the loan. Such action may often be viewed as
collection and granting of a loan).
4.62 After performing analyses on selected loans, the conclusions drawn need to be projected
to the loans not reviewed in some appropriate fashion. Exactly how this is done will depend
upon the extent of the individual credit reviews and the types of loans reviewed. If the audit
approach focuses on high-risk loans, it would be inappropriate to simply use a mathematical
extrapolation, since the loans not reviewed presumably have a lower risk.
4.63 "Normal circumstances" rarely exist. Thus, consideration needs to be given to subjective
matters for each client before arriving at a final evaluation of the adequacy of the allowance for
commercial loan losses. These special situations might indicate a need for a higher reserve, but
this is not necessarily the case.
4.64 Key historical statistical data (e.g., charge-off ratios and other key ratios, by type of credit)
should be maintained in the permanent file to facilitate trend analysis.
4.65 It is important that the bank or financial institution applies a consistent policy not only
when setting up allowances but also when releasing them if reported results are not to be subject
to manipulation. For instance, a bank or financial institution may set up a specific loan loss
provision on a subjective estimate of loss but only release it upon repayment of principal or
restructuring of security. A consistent policy should also be applied to write-offs of
irrecoverable provided debts: while this may not have an impact on published accounts where
loans are shown net of loan loss provision, it may affect reporting of gross claims to supervisory
authorities.
4.66 Some supervisory authorities have developed a framework within which they can view the
adequacy of levels of a bank's provision against sovereign and other country risk debts. For
example, in the UK, the Bank of England has published a list of several criteria (which are
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weighted to reflect their relative significance) to assist in the process of deciding an appropriate
level of provision. Some of the criteria are:
■ whether a country has unilaterally acted to limit its debt servicing payments, either totally or
partially, and the period such moratorium has been in effect;
■ the number of times a country has rescheduled its external obligations in a given period;
■ the extent to which a country is currently in arrears on either interest or principal to
international financing agencies (e.g., World Bank, IMF) over a given threshold:
- the ratio of interest payable on external debt to the value of exports of goods and
services;
- the ratio of value of imports to available monetary reserves;
- the ratio of total external debt to gross domestic product;
- the shortfall caused by prospective payment outflows exceeding prospective inflows
after taking into account all presently available sources of finance;
- over dependence on a single commodity or natural resource for export revenues.
The consideration of the above or similar criteria by lenders should provide an indication of the
extent to which provisions are required to be made against credits to troubled debtor countries.
4.67 Subjective considerations . Some of the subjective factors to be considered are discussed
below. This is not an all inclusive list. Each bank or financial institution must be viewed
separately to determine the unique characteristics of its portfolio.
■ Relationship of write-offs to allowance (relates primarily to commercial credits). It is
important to review what annual write-offs have been in the past few years in relation to the
opening balance of the allowance. A commercial loan portfolio usually turns over less than
once each year. Thus, the opening balance in the allowance generally would be expected to
exceed the following year's write-offs. This relationship should be examined, and if write-
offs have exceeded, or have been high in relation to the opening balance, this may indicate
that in the past the allowance has been less than adequate to cover losses inherent in the
portfolio or that prior expectations failed to occur.
■ Information risk. The files reviewed may not contain current borrower information,
likewise, they may omit information that would lead us to a different conclusion. This
information relied on as a basis for audit judgements should be sufficient and current.
Much of this originates from a borrower who may not necessarily be motivated to promptly
advise the institution of adversity;
■ Changes in portfolio mix. A bank or financial institution’s portfolio will normally change
over time in several aspects. Some of the characteristics to observe include:
- types of loans (short-term versus long-term, secured versus unsecured, asset-based
lending, financing leveraged buy-outs, property lending, foreign lending, etc);
- geographic areas; and
- industries.
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■ Consideration of the bank or financial institution’s particular environment - for example:

- Concentration in depressed industries. If a bank or financial institution has loans
concentrated in troubled industries it is reasonable to expect that higher than normal
credit losses will result, and this should be built into our analysis. For example, a bank
or financial institution may have fully secured loans to a number of agricultural entities.
While each one individually might seem safe (considering the value of the farm land), if
a few default within a short time, the resulting excess supply of land may reduce the
collateral value of all the loans;
- Concentration in depressed areas. The considerations here are similar to those just
discussed for depressed industries. Geographic areas can have similar problems
resulting from mature industries, weather factors, general economic recession,
oversupply of housing etc;
- Out-of-area lending. Banks and financial institutions may make loans outside their usual
market area to take advantage of what appear to be good opportunities because of
booming industries, good interest rate environments etc. However, this can sometimes
cause problems because of the lack of knowledge of the area or inability to devote
sufficient attention to the loans in remote areas. This has to be considered in the
evaluation of the bank or financial institution’s allowance.
■ Regulatory examiners' reports. Regulatory examiners have a somewhat different focus from
that of an independent auditor - they are usually primarily interested in the safety of
depositors' funds. However, their review of the collectibility of credits is similar to a review
performed by independent auditors. It is critical that all regulatory examiners' reports issued
since the last audit be reviewed as part of the examination (this is important for all areas -
not just credit evaluation). We should have support for any credit classifications where our
review indicates a different classification from that of the regulators. If the regulatory
examination is conducted concurrently with our audit of the financial statements,
appropriate discussions prior to finalising our conclusions on the financial statements and
the allowances for loan losses should be conducted.
4.68 Conclusions and documentation thereof. Having followed a logical process in
examining a commercial credit portfolio, such that we understand the bank or financial
institution’s business, its approach to granting credits and subsequently evaluating them, and
having evaluated the processes and reviewed certain of the credits, we are in a position to
evaluate the reasonableness of the allowance for credit losses. Inevitably the credit allowance
estimated by us from the objective and subjective considerations will not be exactly the same as
the allowance recorded by the bank or financial institution. The final evaluation of the
allowance is based on an assessment of whether it represents a valuation account that results in
net credits being stated at approximately the amount the bank or financial institution can
reasonably expect to realise as of the balance sheet date, based on information available prior to
issuance of the financial statements.
4.69 The evaluation of the credit portfolio is one of the most important areas in the audit of a
bank. Often it is also the area involving the most judgement. Because of these factors, we must
ensure that the documentation of procedures and conclusions is complete. Working papers
should generally include the following documentation, depending on the specific circumstances:
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■ a description of the characteristics of the bank or financial institution’s credit portfolio;

■ a description of the bank or financial institution's credit control process;
■ a description of the bank or financial institution’s procedures for identifying and accounting
for problem credits;
■ a description of the internal independent evaluation process (if applicable);
■ the plans for and results of tests of controls of the bank or financial institution’s processes;
■ a description of the bank or financial institution's write-off procedures and procedures for
determining adequacy of the allowance for credit losses;
■ an outline of the plan for credits (and other credits) selected for review;
■ individual credit reviews;
■ consideration of necessary allowance for credits not specifically reviewed;
■ calculations of loss averages, and estimated allowance based on quantitative characteristics;
■ consideration and quantification of applicable subjective factors;
■ our conclusion as to the reasonableness of the bank or financial institution’s allowance for
credit losses.
Example commercial credit review working paper

4.70 An example credit review working paper is included after the following paragraph. This
working paper is designed to present in a concise form the type of information we should gather
regarding a borrower's credit worthiness. It is not intended to give a detailed picture of every
financial aspect of the borrower. There may be cases where other facts should be considered to
form an opinion as to collectibility. In such instances it will be necessary to summarise the
relevant additional information on a separate schedule and attach it to the review working paper.
The working paper is included as an example only, and certain sections may be superseded by
schedules or attachments already prepared by the client.
4.71 The procedures to be followed in carrying out a review of a particular credit are as
follows:
■ ascertain from the lending officer that the credit file and credit documentation file to be
examined are complete and up-to-date;
■ examine the credit file and credit documentation file and complete relevant sections of
credit review sheet;
■ prepare conclusions and assessment of the borrower's creditworthiness and discuss with
relevant lending officer noting any areas of disagreement;
■ enter results on the credit review summary sheet;
■ initial and date the credit review sheet for review by the manager/partner; and
■ discuss the overall results of the credits review with senior bank or financial institution
management/directors.
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Credit review sheet

Client:
Period:
1 Credit details
Borrower:
Country:
Industry:
Reason for borrowing:
Original date of loan:
Client's last review on:
Type of Total amount Current Period / Interest rate Fees
facility outstanding maturity
Interest payments current? - yes/no

Principal payments current? - yes/no
2 Critical features
3 Collateral/security
Type Assessed value Comments
_______________
Total
4 Assessment
KPMG Client's opinion
Good
Special mention
Substandard
Doubtful
Loss
Total
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5 Reasons for assessment
Assessment discussed with:

Name -
Position -
Preparer Manager Partner

Date Date Date
6 Drawdown/repayment schedule
Date Drawdowns Date Repayments
7 Financial information
Auditors: Currency: Exchange rate to local
currency
Report qualified - Yes/No

Borrower/Guarantor: Year: Year:
Turnover/sales/revenues
Net profit after tax
Net profit percentage
Total assets
Total shareholders' equity
Equity to assets ratio
Net current assets
Current ratio
Profit plus depn. (cash flow)
* Capital commitments:
* Other borrowings:
* Contingent liabilities/guarantees
Comments
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8 Credit file
Evidence of borrower's compliance with conditions precedent -
Required Inspected
Comments
Credit agreement
Legal opinion on agreement
Board minute
Credit approval
Evidence of security
Evidence of guarantee
Participation certificate
Condition of credit file - Inadequate/poor/good
9 Most recent circularisation

Date: Result:
The following comments apply to the specific sections on the credit review sheet:
1 Credit details
Information regarding the details of the credit, should be compiled from the client's credit
summary schedule and cross-checked to the underlying credit documentation to ensure
completeness and accuracy (this may have already been done as part of a test of control of
the credit summary schedule).
2 Critical features
This section should include those critical features of the credit upon which the estimate of
collectibility is to be made and should include for example the name of the guarantor, value
of security and status of borrower. It is essential that these critical features be identified at
an early stage to avoid detailed review of any unnecessary financial information. Further, it
may be that the financial position of the borrower is sound, but political or economic factors
in the borrower's country may cast doubt on ultimate repayment and, consequently, the risk
may be one of country more so than borrower. If the loan being reviewed were a real estate
loan, we would discuss the significant appraisal assumptions and our evaluations of them.
3 Collateral/Security
Security details for the loan should be summarised in this section. This should clearly
identify the type of security (Registered mortgage, Mortgage debenture, Guarantee etc.) and
our assessment of the value of the security should the bank seek to utilise/realise the
security. Narrative comments should be added as the basis of the valuation; for example,
"latest audited accounts discounted to 60%" or "Independent 199X property valuation".
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4 Assessment
Where credits are classified as good the total per the assessment should equal the total
outstandings in section 1. Where a credit is classified other than good consideration must
be given to undrawn commitments as the bank or financial institution may be legally
committed to advance further funds.
5 Reasons for assessment
This section should be completed, even for credits classified as good, to summarise the
principal reasons for the assessment. The name of the lending officer with whom the credit
was discussed should also be noted. Where the lending officer disagrees with our
assessment, the reasons for that disagreement should be noted (on a separate schedule if
necessary). The reviewer's initial assessment should not be altered following a discussion
with the lending officer unless additional information provided is substantiated.
6 Drawdown/repayment schedule
This section should show total drawings to date plus individual details of future drawings
and total repayments to date plus individual details of remaining payments.
7 Financial information
This section should be completed only where the financial standing of the borrower or
guarantor is a critical feature of the credit.
The following basic financial information should be presented. Preferably it should be
extracted from a current set of audited accounts. Care should be taken in reviewing the
accounts of overseas borrowers as these may not be prepared in accordance with generally
accepted accounting principles or audited in accordance with generally accepted auditing
standards.
Sales or revenues: Key indicators of volume and revenue generating capacity
Net profit after tax: Profit after tax and before any distributions. A note
should be made of any extraordinary items.
Total assets: A note should be made of any items included which
consist of intangibles or, for example, inventories that
appear excessive in relation to total assets or turnover.
Equity to assets ratio: The ratio of shareholders' funds to total assets. This
shows the margin of coverage available to creditors in a
liquidation.
Net current assets: Current assets less current liabilities. This shows the
borrower's immediate capacity to repay.
Current ratio: The ratio of current assets to current liabilities.
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Cash flow: Net profit plus depreciation and any other non-cash items.
This indicates the extent to which funds are growing
internally and, therefore, the ability of the borrower to
repay credits without further borrowing.
Capital commitments: Amounts due to be spent by the borrower to acquire fixed
assets (including the acquisition of other companies). The
objective of this is to measure any potential decrease in
liquidity.
Other borrowings: A note should be made of all other utilised facilities with
the bank or financial institution and other material
borrowings and debt repayments coming due during the
period of the bank or financial institution's commitment -
and thus affecting the borrower's capacity to repay the
bank or financial institution.
The object of extracting such financial information is to form an opinion on the collectibility
of the credit. Obviously there are many factors which could bear on this that are not
necessarily covered by the standard information. Any such additional information, e.g.,
guarantees issued, secured or subordinated credits, pending sales of fixed assets, should all
be noted.
8 Credit file
The purpose of this section is to document that the legal and other required credit
documentation is in fact present. Credit documentation should be examined to ensure that it
is current, e.g., guarantees have not expired, and that the proper signatures are evident, e.g.,
borrowers, credit approvals, lawyers legal opinion. The credit agreement should also be
examined to confirm details of the credit (see section 1 - Credit details) and to identify any
other relevant information e.g., restrictions on further borrowings, withholding taxes.
Where the credit has been made on the basis that the borrower is to adhere to certain
conditions, we should determine whether these conditions are met and how the bank or
financial institution monitors compliance. Time should not be spent reading out of date and
irrelevant correspondence, financial information etc.
Where original documentation is not available and only copies are seen, this should be
noted in the column under "Comments".
Where credit documentation has been subject to tests of control as part of the credits audit,
it should not normally be necessary to re-examine/examine credit documentation as part of
the credit review. However, consideration should be given to re-examining/examining
credit documentation for credits classified other than good.
Other credit evaluation considerations

4.72 Listed below by type of loan are considerations that will assist us in evaluating various
types of commercial loans:
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■ Demand loans should generally be to companies that have sufficient liquidity to repay on a
short-term basis, with either cash or receivables sufficient to effect prompt repayment.
■ Time loans are often renewed and should not necessarily be considered on the basis that the
borrower has either a cash balance or sufficient current earnings to repay the credit. The
key factor in evaluating the degree of risk associated with time loans is usually the
relationship of the debt and the assets financed to the borrower's working capital. The level
of working capital should increase as the liquidity of inventories/stocks and
receivables/debtors declines.
■ Term loans are generally repaid from cash generated from operations. Historical and
projected cash flow are of primary importance in evaluating the risk associated with a term
loan. We should determine the cash flow (principally earnings plus depreciation) to service
the debt and other cash flow requirements, including capital expenditures, and the
borrower's overall financial strength to ensure continued operation during the term of the
loan.
■ Agricultural loans are made to various types of agricultural producers, including grain,
livestock, vegetable, dairy products, and fruit producers. These loans may also extend to
farm equipment manufacturers and dealers, seed suppliers and contractors. Consequently,
the operations of agricultural borrowers vary significantly.
Agricultural loans can be generally categorised in the following groups:
- Crop loans - generally one-year maturity lines of credit to finance crop production;
- Multi-year loans - longer-term loans to finance orchards, vineyards, livestock etc. Such
farming operations often require two to three years for gross sales to equal invested
capital;
- Land, equipment and facilities loans - generally longer-term loans.
As a result of adverse conditions, risks inherent in agricultural lending may increase
dramatically. In making agricultural credit evaluations, as in other commercial loans, we
must evaluate the reasonable expectations of recovery through operations and collateral
values. To the extent loans are for production purposes, economic outlook for crop sales
and government assistance (e.g., price supports, other farming guarantees, etc) should be
evaluated. For many farmers, however, collateral values have become increasingly
important in this evaluation.
4.73 Property or Real Estate Loans. Credit review procedures for property loans vary greatly
depending on the type of property involved. For standard mortgage loans, the emphasis is on
reviewing compliance with the bank or financial institution’s loan-to-value ratio policy
combined with statistical analyses (considering both historical and current economic factors),
with detailed credit reviews being performed on large or unusual credits. In performing detailed
credit reviews on income-producing property, a key element is a review of the financial
statements of the property.
4.74 Appraisals are of key importance in most property loans. Several factors may contribute
to a faulty appraisal, including the following:
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■ inadequate qualifications of the appraiser;

■ pressures placed on appraisers to satisfy originators, sellers, insurers, etc (i.e., lack of
appraiser independence);
■ inadequate appraisal fees;
■ excessive reliance on the prices paid for comparable properties when preparing appraisals
and the replacement value;
■ over optimistic assumptions on use or marketing of properties.
4.75 Independent appraisals generally provide stronger evidence than in-house appraisals.
Some factors to consider when relying on an in-house appraisal include:
■ Competence, relevant professional qualifications, and experience of the in-house staff.
While certification is only one consideration in evaluating the appraiser, it does indicate a
level of training, experience, and awareness of ethics and standards of professional practice;
■ Type and physical condition of the property. Some property (e.g., income-producing
property, raw land) is more difficult to evaluate and requires greater expertise;
■ Location of property. To properly evaluate property, the appraiser must be familiar with the
peculiarities of the location. In-house appraisers may not be familiar with distant locations;
■ Environmental considerations. In some circumstances, an environmental audit may be
necessary in order to properly determine the value of property security;
■ Significance of the property to the institution's operations;
■ Other cost-benefit considerations.
4.76 In performing detailed credit reviews, when an independent appraisal is used, we should
evaluate, at a minimum, the appraiser's reputation and expertise. Reference is made to chapter
58 of the KPMG Audit Service Manual for further guidance on evaluating the work of
specialists outside KPMG.
4.77 An appraisal should be read in-depth, and we should understand the appraiser's approach
to formulating his/her opinion of value and be satisfied as to its reasonableness. The most
common approaches used in evaluating property are summarised below:
■ Cost. This approach attempts to estimate the replacement cost of a project based on current
cost of materials, labour etc., and adjusts the current cost for any loss in value because of
deterioration and functional and economic obsolescence. The estimate may or may not
contain a factor for developer's profit. If it does, the results is often used as a ceiling in the
valuation process under the theory that no one would pay more for a project than it would
cost to build a similar one.
■ Market. This approach is based on an analysis of recent sales of properties that are
comparable to the property being appraised. The logic of this approach is that the value of a
given property can be determined by analysing what similar properties can be sold for in the
same general marketplace. The usefulness of this approach is lessened when a
representative number of genuinely comparable sales is not available. Invariably, the
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appraiser makes some adjustments in an effort to compensate for specific areas of non-
comparability.
■ Income capitalisation. This approach is most commonly used in valuing income-
producing property. Under the income capitalisation approach, projected annual operating
income is capitalised, using a capitalisation rate that is generally a function of the cash
required to meet conventional debt service and the prospective purchaser's desired return on
his/her cash investment. Once a capitalisation rate is determined, it is divided into the
operating cash flow (cash flow after operating expenses but before debt service) to
determine the maximum investment (combination of debt and equity) the projected cash
operating income would support.
4.78 Where practicable, we should evaluate the information the appraiser uses and the
reasonableness of his/her assumptions and conclusions. The propriety of income, expense, and
cash flow amounts used in the appraisal should be compared to information in the file and
current economic conditions. For example:
■ occupancy rates departing from current rates should be investigated;
■ capitalisation rates departing from current market rates for similar properties should be
investigated.
4.79 Construction loans. Based on inherent risk, control risk, and other detection risk
considerations, we should consider the following procedures for credits selected for detailed
credit review:
■ Physical inspection of construction work in progress. This procedure would normally be
limited to very large loans and large concentrations with one builder. A general assessment
should be made of the degree of completion of the building under construction. These
observations should be compared with the bank or financial institution inspection and
completion reports submitted by the builders. The need to obtain the opinions of outside
appraisers should also be considered;
■ Evaluation of take-out lender. In cases where another party is to provide the long-term
financing, and depending on the provisions of the take-out agreement, it may be necessary
to evaluate the general creditworthiness of the take-out lender in considering the ultimate
collectibility of the construction credit;
■ Review of the unused commitment. The unused commitment amount (undisbursed portion
of credits in process) should be reviewed to evaluate the adequacy of the unused
commitment in relationship to the remaining costs to complete construction.
■ Prospects for successful completion and sale of project under construction. For income
producing properties committed leases and status of similar projects or available space in
geographic area should be considered. For residential housing projects where construction
loan is expected to be repaid with proceeds from house or unit sales a review of recent sales
data, including, discount from list price, expected sell-out date, recent sales in area,
availability of similar type housing, etc. should be considered in evaluating collectability.
4.80 LDC Loans. Loans to Lesser Developed Countries (LDC loans) have attracted
considerable attention from financial institution management, regulators, media and the external
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auditors of financial institutions. While a LDC loan portfolio should be looked at using the
criteria for evaluating any other loan in the particular industry concerned, there are additional
unique considerations applicable to LDC loans which we should be aware of in evaluating the
allowance for credit losses as follows:
■ LDC debtor nations will normally negotiate their foreign debt on a combined debt basis.
Consequently the auditor should be aware of any current negotiations or agreements which
may affect the recoverability of the financial institution’s LDC loan portfolio;
■ Agreements with creditor banks may involve complex arrangements such as debt/equity
swaps or other similar arrangements. If the financial institution’s LDC portfolio is affected
by any of these agreements, the auditor should ensure that he/she understands the agreement
and the effect it may have on the recoverability of the underlying loans;
■ The ultimate recovery of LDC loans is related to a country’s present debt load and the
stance taken by such institutions as The World Bank or IMF in determining whether to take
a hard or soft line in advancing further loans to enable the debtor country to service its
existing debt load; and
■ Unilateral decisions by LDC countries to suspend interest and/or principal payments on its
foreign debt should be taken into consideration where these announcements are made prior
to finalisation of financial statements. This is valid even where the particular country’s
debts have been serviced in a timely manner up to the date of preparation of the financial
statements concerned.
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Introduction
5.1 In order to maintain ready access to liquid funds in any of the world's major currencies, the
international banking and finance community has cultivated large wholesale markets in which
to broker the use of funds. These markets; the money and foreign exchange markets; enable
banks and other market participants to manage their cash flows more efficiently, whether in the
currencies of their home countries or in other currencies. They provide a ready means to lay off
surplus funds in unwanted currencies and to acquire needed funds in desired currencies.
5.2 The money markets encompass transactions in which funds are sold, packaged in a variety
of instruments, typically for short periods of time, from overnight to a year. Such sales involve
a borrowing (to the purchaser) and a lending (to the seller) for which interest is charged. These
sales originate with the issuer of the instrument, who is the primary borrower. The instruments
thus created are generally negotiable and thus available for secondary market resale.
5.3 The foreign exchange markets encompass transactions in which funds of one currency are
sold for funds in another currency. These transactions take the form of contracts calling for the
parties in the contract each to deliver to the other on a fixed date a specified sum in a given
currency. The exchange, the delivery of one currency on receipt of another, can take place at
the time the contract is negotiated or at some future date, as stated in the contract.
5.4 The money and foreign exchange markets serve a purpose because any enterprise will
experience differences in the timing of its outflow and inflow of funds and, if engaged in
international trade, between the currencies it pays out and those it receives. Activity in the
money and foreign exchange markets is a vital element of liquidity management and an
important aspect of an overall plan for asset-liability management. The money and foreign
exchange markets enable these enterprises to overcome the liquidity limitations such
differences entail. By purchasing the use of funds in money market transactions, enterprises
can fund current disbursements in anticipation of near-term receipts. By selling the use of
funds, enterprises can avoid holding idle cash in anticipation of near-term disbursements.
Similarly, by trading in the foreign exchange markets, an enterprise can convert one currency it
has, or expects to receive, to any other currency it lacks, or expects to disburse.
5.5 While large commercial organisations, nonbank financial institutions, and governments or
their agencies also participate in the money and foreign exchange markets, banks are their
prime market-makers. Thus, banks trade in these markets to maintain their market position as
well as to service their own immediate needs or those of their customers. Much of the trading
is bank-to-bank and most of the products developed for trade are bankers' instruments:
instruments initially issued by banks (e.g., certificates of deposit), or typically held by banks in
their portfolios (e.g., short-term government securities), or put together as secondary market
"packagings" of bank assets (e.g., repurchase agreements).
5.6 Banks trade in the money and foreign exchange markets for three basic reasons:
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■ To meet their own liquidity needs: to fund disbursements as they come due or to place
receipts;
■ To meet the liquidity needs of their customers, whether corporations or correspondent
banks; and
■ To earn trading profits.
5.7 As market makers, which enjoy greater market access than most of their customers, banks
can earn trading profits in essentially two ways:
■ Their favoured market status allows them to command higher rates to sell funds, or to lend
the use of them, than they need to pay to purchase or borrow them.
■ Their greater liquidity enables them to mismatch their purchases and sales (borrowings or
lendings) to exploit interest rate differentials among the types or maturities of the
instruments traded and among the various currency markets on which these instruments
trade.
5.8 Banks conduct their money market and foreign exchange trading through traders (or
dealers) located in the banks' trading rooms who staff the so-called Money Desks or Foreign
Exchange Desks depending on the market in which they specialise. These traders are in
telephone or on line dealing system communication with their counterparties, whether traders
for other banks, brokers or nonbank enterprises. And they have the authority, delegated under
limits set by senior bank officials, to commit the bank's resources to the transactions they
negotiate.
Money market transactions

5.9 Money market transactions encompass a wide variety of borrowing/lending arrangements.
Most are unsecured; the lender has recourse only to the general financial resources of the
borrower, whether it be a bank or financial institution, corporate enterprise, or government.
Unsecured transactions are acceptable because of their short-term tenor and the typically high-
credit quality of most money market participants. Some transactions, however, are secured,
thus opening the advantages of money market participation to borrowers unable to do so on an
unsecured basis.
5.10 Money market instruments include:
Bank issued obligations

■ Interbank placements and takings. These are the simplest forms of money market
transactions, consisting of contracts between banks for placing (lending) or taking
(borrowing) of money, usually for a fixed period of time and paying a fixed rate of interest.
Less commonly, such transactions may be at call or at a specified number of days notice, at
the option of the placing bank. Placements are usually for amounts of at least U.S.
$250,000, though the common dealing amounts are in multiples of U.S. $1 million.
Placements may be denominated in the currencies of many countries, either as the domestic
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currency or as a Eurocurrency. The largest market exists in U.S. dollars, including

Eurodollars.
Eurocurrencies are funds denominated in the currency of one country, placed with and
traded among entities located outside that country. So, Eurodollars are U.S. dollar
placements in banks located outside the U.S. and their subsequent tradings prior to their
repatriation to the U.S.
■ Federal funds. These funds represent deposits, (at an agreed rate of interest), with the U.S.
Federal Reserve Bank. U.S. banks purchase (borrow) these funds or sell (lend) them,
usually overnight, to meet their minimum reserve requirements and to dispose of excess
reserves.
■ Certificates of deposit (CDs). Banks issue certificates that evidence a deposit, of the
amount stated, has been made with the issuing bank. The certificate also specifies the
maturity date and rate of interest for the deposit. Such CDs are negotiable instruments; so
the depositor can recover its funds before maturity by selling the certificate in the secondary
market. Because of this additional liquidity, CDs usually carry lower rates of interest than
comparable placements.
In addition to issuing CDs, banks purchase those issued by other banks, doing so either
directly from the issuing bank (a "primary" CD) or in the secondary market. Secondary
market purchases will be at a premium or discount from face value if market interest rates
to the CD maturity have changed subsequent to its issue.
■ Bankers' acceptances. Acceptances are bank obligations arising from letter of credit or
similar trade financing arrangements (see chapter 13 of this volume). Acceptances are
created when a bank receives a bill of exchange (demand for payment) drawn under terms
of a letter of credit it has issued or confirmed or under terms of a clean acceptance facility
granted to the customer. On receipt of the bill, and satisfied that the terms have been met,
the bank accepts the bill, then called a bankers' acceptance, acknowledging its obligation to
pay the amount stated on the acceptance at a specified date. These acceptances are
negotiable instruments and are actively traded on secondary markets. Because they are
non-interest bearing liabilities, they are traded prior to maturity at a discount from face
value, reflecting the early recovery of the seller's interest in the instrument.
Many banks purchase, prior to maturity, acceptances they themselves have issued, to hold
in their portfolios or for subsequent resale. While holding their own acceptances, these
banks effectively earn interest (the accretion of the discount given to purchase the
instrument) on funds advanced on behalf of the customers for whose benefit the
acceptances were originally issued. When resold, the acceptances effectively carry an
interest cost (the discount taken at resale) thus enabling the issuing bank to determine a
fixed spread on the funding provided its customer.
Non-bank obligations
■ Short-term government obligations. Many governments issue short-term paper, typically
for three to six months, both as a means to meet cash requirements and to implement
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monetary policy. Such paper does not usually carry interest but is issued at a discount and
repayable on maturity at par. Banks may purchase government paper either at issue or in
secondary market trading.
■ Commercial paper. Commercial paper consists of short-term, unsecured debt instruments
with maturities not exceeding 270 days issued by commercial (non-bank) corporations,
though including bank holding companies. The paper functions much like a bank CD and
can be resold on secondary markets. The commercial paper market exists primarily in the
United States, where the paper is rated by recognised agencies, and traded at prices based in
part upon those ratings.
Repurchase and reverse repurchase agreements

■ Banks, among other financial institutions, can participate in the money market on a secured
basis, either as borrower or lender through repurchase or reverse repurchase agreements. In
such transactions, the lender advances funds to the borrower in exchange for title to
securities owned by the borrower. The borrower, however, commits to repurchase these
securities, or substantially the same securities, at a fixed price, which represents a return of
the funds received plus interest. Thus, though title to the securities passes to the lender, the
risks of ownership still belong to the borrower, and the transaction accordingly is, in
substance, a secured borrowing rather than a sale of assets.
These transactions are commonly known as repurchase agreements (reverse repurchase
agreements to the lender). They enable borrowers to obtain additional liquidity from their
longer-term assets at a cost fixed when the borrowing is transacted. Lenders obtain the
benefits of security for their shorter-term lending.
Foreign exchange transactions

5.11 Description of transactions. Foreign exchange transactions, to be distinguished from
transactions in foreign currencies, consist of contracts in which each party is committed to
deliver one currency while, at the same time, receive another. Until the time of delivery, when
settlement is to be made on the contract, the contract represents a future commitment of the
enterprise's resources. Thus, the maturity of a contract culminates in the realisation of the
transaction envisaged in the contract, at which time the counterparties are given value for the
currencies the contract says they are to receive. In foreign exchange contracts, the value date is
the date on which the contract matures, that is the date on which settlement is to be made. For
loans and borrowings, including those in the money markets, on the other hand, the value date
is that date on which the borrower receives constructive use of the funds loaned, while the
maturity date is that future date on which it will repay the funds it has borrowed.
5.12 There are four basic types of foreign exchange contracts:
■ Spot contracts. These are contracts to deliver one currency in exchange for another for
value within two days of the trade date. The two-day margin results from the industry
practice to allow time for communicating payment instructions to the paying agents for the
parties to the deal, so that contracts can settle on their value dates. Paragraph 5A.10 gives
an example of how to account for a spot contract.
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■ Forward contracts. These are contracts to deliver one currency in exchange for another
for value more than two days from trade date. Paragraph 5A.10 gives an example of how to
account for a forward contract.
■ Swap transactions. These transactions combine spot and forward contracts, often with the
same counterparty, so that the currency delivered under the spot contract is returned at a
later date under the forward contract. The effect of the combination of the two deals is to
provide funds in the currency bought spot for the period between the spot value date and the
forward value date rather than funds in the currency sold. The difference in the prevailing
interest rates in the two currencies is adjusted for in the forward exchange rate. Two types
of swap transactions may be distinguished:
- Exchange swaps. Transactions wherein the currency delivered spot comes from a
general pool of funds and the currency received spot goes into a pool of funds:
- Deposit swaps. Transactions wherein the currency delivered spot comes from a specific
transaction (e.g., taking a deposit) which requires returning that currency at a future date
(e.g., repaying on a matured deposit), the funds for which will be received under the
forward contract in the swap.
Paragraph 5A.10 gives an example of how to account for a deposit swap. Other swaps
(e.g., interest rate swaps) are discussed in chapter 8 of this volume.
■ Options. These are rights to enter into forward foreign exchange contracts with value to
occur at an agreed date or within an agreed upon period, the precise date to be set at a later
date by the purchaser of the option. These are discussed in more detail in chapter 9 of this
volume.
5.13 Each foreign exchange contract involves a simultaneous purchase of one currency and
sale of another. Banks that deal primarily in their home currencies in exchange for other
currencies will sometimes classify foreign exchange transactions as:
■ Purchase contracts, if the contracts are to purchase a foreign currency against the sale of the
home currency;
■ Sales contracts, if they are to sell a foreign currency against the purchase of the home
currency;
■ Cross-currency contracts, if they are to purchase one foreign currency against the sale of
another.
5.14 Since foreign exchange contracts call for the exchange of fixed amounts of two
currencies, they define exchange rates for the transaction (the ratio of the amount in one
currency to the amount in the other). These exchange rates -- for spot contracts -- are the prices
traders quote when soliciting a deal. Trading practice is to quote the smaller value currency
against the larger, that is the number of units (greater than one) of a currency that are equivalent
to one unit of another. Traders quote two rates, first the lower which is their selling price, then
the higher or their buying price. So, a quote for Deutsche Marks against U.S. dollars might be
2.4140/45, which means that the counterparty would receive only 2.4140 Deutsche Marks for
each dollar it gave up but would have to give up 2.4145 Deutsche Marks for each dollar it
would receive.
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5.15 To illustrate, suppose a bank contracts to deliver Deutsche Marks to a customer in

exchange for U.S. dollars, value 30 days from trade date. To determine the appropriate
exchange rate, the trader in principle analyses his cost to fund the transaction, which requires
that in 30 days he be in a position to pay out Deutsche Marks and to receive dollars. Three
funding options are available:
■ Enter into another forward contract that reverses the movement of funds (the bank to
receive Deutsche Marks and pay out dollars);
■ Postpone funding until the value date of the contract and then purchase Deutsche Marks
against dollars in the value date spot market;
■ Fund the transaction at the contract trade date by purchasing Deutsche Marks against
dollars in the trade date spot market, investing the Deutsche Marks received in an interest
earning asset and borrowing the dollars paid out, both the investment and the borrowing to
mature at the value date of the forward contract.
Regardless of the funding method a trader actually employs, only the third gives a conceptual
basis for pricing a forward deal. The first method (which hedges the forward contract) has no
parameters on which to determine a price; the second is speculative, requiring an estimate of
future spot rates. The third, on the other hand, does supply parameters to determine a forward
price: the current spot exchange rates and the currently available interest rates on money
market borrowings and lendings in each currency. This method effectively treats the forward
contract as part of a swap transaction.
5.16 To demonstrate this method for determining a forward price, suppose the following:
At trade date:
U.S. $ interest rate for 30-day deposits 12% per annum
DM interest rate for 30-day deposits 6% per annum
Spot DM/$ rate 2.4140/45
and the customer wishes to purchase 30-days forward DM 1,000,000.
To price the forward deal, then:
1) Deposit at 6% p.a. yielding DM 1,000,000 in 30 days DM 995,025
2) $ to purchase DM 995,025 at spot (2.4140) $412,189
3) Deposit at 12% p.a. $412,189 for 30 days would yield $416,311
Therefore the bank would have to pay $416,311 to fund a forward purchase of DM 1,000,000
which gives a break-even exchange rate of:
30-day forward DM/$ break-even rate 2.4021
30-day forward premium (2.4021 - 2.4140) (.0119)
Thus, to conclude the trade profitably, the trader might quote the following:
Spot DM/$ rate 2.4140/45
30-day forward premium (125/115)
30-day forward DM/$ rate 2.4015/30
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5.17 Had the spot rate at trade date been 2.3900/05, a similar calculation shows the 30 day
forward breakeven rate to be 2.3782, resulting in a premium of 118 which still falls within its
quoted market range of 125/115. It is because these forward premiums (or discounts) need not
change significantly even though spot rates do change (so long as the interest rates available in
the currencies remain stable), that traders quote forward premiums or discounts, rather than
outright forward rates. In this manner, traders can continue to quote the same premium or
discount even while adjusting spot rates to respond to market conditions.
5.18 Though forward exchange rates are, thus, conceptually determinable in terms of the
interest rates available in the respective currencies, discrepancies can arise between forward
exchange rate differentials and interest rate differentials. Currency exchange rates and interest
rates are determined in different markets by different classes of market participants. Thus, these
markets will process information and react to actual or foreseen economic events at a different
pace. Put another way, either market may anticipate a change in the other before the other in
fact exhibits the change. So, forward exchange rates may move to reflect an increase in the
differential between the interest rates in two currencies before there has been any change in
interest rates. In such circumstances, traders have arbitrage opportunities: the occasion to
realise profits by obtaining funds on the market in which they are comparatively cheap (because
under priced in terms of the other market) and placing them on the market on which they are
expensive. Such arbitrage, though, is precisely that process through which the two markets will
be restored to equilibrium as bidding for funds on one market will tend to raise their price on
that market while selling them on another correspondingly lowers their price on that market.
5.19 Position management. Chapter 2 of this volume introduces a means of analysing the
transactions a bank or financial institution makes in terms of their overall effect on the bank or
financial institution’s condition and its exposure to risk. The theory of asset-liability
management requires interpreting a bank or financial institution's activities as contributing in
one way or another to its present portfolio of future cash flows -- its positions. Chapter 2 also
discusses some of the general ways in which bank or financial institution management can
monitor and control the risks inherent in those positions, particularly through administering
limits. Money market transactions, as borrowings or lendings, affect a bank or financial
institution's position with respect to liquidity, credit, and interest rate risk. Foreign exchange
transactions though, particularly for market makers, affect primarily interest rate and, of course,
foreign currency exchange rate risk.
5.20 Credit risk is of less significance in foreign exchange transactions because of the feature
of foreign exchange contracts that both the bank or financial institution's delivery of funds to its
counterparty and receipt of funds from that counterparty are to occur on the same day. Thus, if
its counterparty fails and so cannot deliver, the bank or financial institution is equally in a
position not to make its delivery under the contract. Credit risk is not eliminated because one
party may meet its obligations under one side of the transaction but the other party may fail to
meet its obligations. This risk is particularly relevant where the counterparties are based in
different time zones. Further, if a trade simply fails and no funds are transferred, the bank or
financial institution is exposed in the then current spot market to the risk inherent in covering its
position: obtaining and disposing of the funds it would have obtained and disposed of in the
terminated contract.
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5.21 Since a bank or financial institution's position is its total current portfolio of future cash
flows, all transactions denominated in a foreign currency affect the bank or financial
institution's position in that currency. Such transactions include income and expense items --
such as the payment of fees for loan origination or letter of credit financing and of interest on
deposits taken or placed -- as well as purchases or sales of assets and forward commitments to
purchase or sell. To the extent income and expense items are accrued, rather than paid, the
bank or financial institution will recognise the item at exchange rates different from those in
which the transaction will settle, unless the bank or financial institution takes on additional
contracts, matched to the actual flow of funds paid, to dispose of or acquire the foreign currency
it earns or expenses.
5.22 Swap transactions also generate changes in a bank or financial institution's foreign
currency position. A swap, involving a spot purchase of a currency and the forward sale of the
same currency, creates no foreign exchange position as regards the "principal" of the swap.
However, it does result in a currency mismatch of income and expense. Interest expense on
deposits taken will arise in the currency sold spot, while corresponding income will arise in the
currency purchased spot. There is a further component of income/expense, namely the discount
or premium on the forward deal, which may arise in either currency. Whether the swap results
in a profit or loss will depend on whether the value of future income in one currency will
exceed or fall short of the value of the future expense in the other currency. There is thus an
exposure to movements in exchange rates. Accordingly future income and expense associated
with swap transactions is normally included in forward positions. Obviously the income and
expense is in this case not also included in positions as it accrues, as to do so would result in
double counting.
5.23 Future income and expense in a foreign currency may also be mismatched as to maturity.
For example a bank may borrow $1,000,000 for one month at 10%, and lend $1,000,000 for
three months at 10%. There is a mismatch of $1,000,000 for two months at 10%. However it
would not normally be regarded as correct to include this future income in the forward
positions, because the bank will in due course need to arrange funding for the last two months,
leading to a commitment to future expense in the same currency. Of course this may not equal
the future income, but this reflects an exposure which is primarily related to interest rate risk
rather than to exchange rate risk.
5.24 Reference is commonly made to the following different types of currency positions:
■ Spot. Assets less liabilities in a currency, plus net unmatured foreign exchange purchases
due for settlement within two days. It is usual to exclude the effect of swap transactions
from the spot position;
■ Forward. Net of unmatured foreign exchange deals due for settlement more than two days
hence. Again it is usual to exclude the effect of swap transactions, but to include future
income/expense flows which are not matched as to currency;
■ Net open. Net of spot and forward positions;
■ Overall. Sum of the home currency equivalents of the net open positions in all other
currencies.
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5.25 In each case, a surplus of assets or purchases over liabilities or sales in a currency is called
a "long" position, and the converse is a "short" position. Because forward exchange rate
differentials are determined primarily by interest rate differentials, a "spot against forward"
position (long spot covered by short forward, or vice versa), represents an exposure to interest
rate movements rather than to exchange rate movements. Accordingly the net open position is
regarded as the most important measure of exposure to exchange rate risk.
5.26 Banks and financial institutions manage their exposure to exchange rate risk in essentially
three ways:
■ Hedges through which contracts of (roughly) the same value date, effectively cancel out the
movement of funds in a currency, the resulting differential in funds of the other currency
representing the gain or loss on the hedge. The bank or financial institution’s foreign
exchange rate exposure is limited to what it would have been had the first contract not been
undertaken;
■ Swaps through which contracts of different value dates offset each other, though because of
the date difference the bank or financial institution has the use of one currency during the
period of the swap while sacrificing the use of the other. The bank or financial institution in
this case has an exchange rate exposure (to the extent it began the swap with a foreign
currency position to which it will return at the value date of the forward contract)
comprising the swap and the resulting mismatch of income and expense;
■ Nostro balance management through which banks and financial institutions manage their
non-earning demand deposits with foreign banks, denominated in the local currencies of
those banks (so-called Nostro accounts). As a strategy, this method focuses on the bank or
financial institution's net open position in a currency where the other two methods focus on
specific transactions comprising that position. Thus, the bank or financial institution's
exposure to foreign exchange rate risk is a function of the timing and the kind of
transactions undertaken to reverse the effect of contracts settling in the Nostro accounts to
restore them to their targeted balances.
5.27 Banks and financial institutions sometimes enter into foreign exchange transactions that
enable their customers (principally less active participants in the foreign exchange markets, e.g.,
corporations) to manage their own exposures more efficiently. Such transactions give customers
the opportunity to lock into gains and losses on their existing contracts and, if they choose, to
settle the net gain or loss prior to the contracts' value date. These transactions include the
following:
■ Assignments in which the bank or financial institution undertakes the customer's forward
foreign exchange contract with another party as its own commitment, enabling the customer
to walk away from the contract, the customer's only remaining obligation being to settle
with the bank or financial institution any net gain or loss on the contract to the time of the
assignment;
■ Cancellations in which the bank or financial institution allows the termination of an
existing contract, again allowing the customer to walk away from the contract, retaining
only the obligation to settle any net differential in value to the date of cancellation;
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■ Compensation in which the customer enters into another contract with the bank or
financial institution so that its net delivery obligation in one currency is reduced to zero,
requiring only the settlement of the net obligation in the other currency. Compensations
have the same economic effect as cancellations; compensations, however, preserve the
commitments (though to settle net) under the existing contracts while cancellations
terminate them.
Additionally, some banks or financial institutions occasionally will enable customers to defer
their obligations under existing contracts, allowing them to roll over those contracts through a
swap in which delivery on the old contract is settled through a spot deal and the rollover to
settle through the forward deal. If such swaps are priced at market, the customer will have an
obligation to settle the net difference in value between the spot deal and the original contract at
the value date of that original contract. Alternatively, the deal may be “rolled over” at the
historical rate adjusted for the appropriate forward points. This form of “historical rate
rollover” gives rise to an element of credit risk in relation to the unrealised loss rolled over and
is not encouraged by many banks.
Organisation, operations and records

5.28 Organisational structure. Trading activities require appropriate segregation of
responsibilities to provide reasonable assurance that all trades transacted will be duly
authorised, recorded on the accounting records accurately, and properly settled. The traders,
who both commit the enterprise to the exchange and authorise (to their trading limits) could
well misappropriate the bank or financial institution's assets if they could control settlement on
their deals. Similarly, were those individuals who effect settlement also empowered to instruct
and account for settlements, they would be in a position to misdirect payments and prevent
detection of their having done so. Thus, the minimal segregation of duties any trading
operation should exhibit are that the following functions be segregated:
■ Trading;
■ Accounting for trades and settlements (including counterparty confirmation and reconciling
activity in cash and custodial accounts to the accounting records);
■ Effecting settlement.
5.29 Typically, the following departments are involved in the money market and foreign
exchange activities:
■ Treasury department - The dealing activities will be under the control of a treasury
manager, who will be a member of the bank/branch's senior management. Reporting to the
treasury manager will be a chief dealer and a number of dealers, who may each specialise in
particular currencies or instruments. The dealers will occupy a room of their own, equipped
with telex machines and information service terminals (e.g., Reuters), and each dealer will
have a dealing board incorporating a telephone and direct telephone lines to money brokers,
through whom many deals will be contracted. The treasury manager may also deal, but he
is primarily responsible for determining market strategy and monitoring the dealers'
activities. He will occupy an office with a dealing board overviewing the dealing room, and
will usually be able to listen in to the dealers' telephone conversations. In most banks and
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financial institutions all dealers' telephone calls are tape recorded, so that any dispute with a
counterparty over the details of a deal can be resolved.
Often there will be a positions clerk in the dealing room, whose job it is to keep up to the
minute manual records so that the dealers can immediately obtain details of their current
positions. If not, then the dealers themselves should maintain their own manual records
(blotters).
The dealers in some financial institutions are also responsible for the effective management
of the bank or financial institution's nostro balances, maintaining minimal balances, and
avoiding overdrafts.
In the typical small bank or financial institution operation, the number of dealers will be
substantially reduced. In fact the bank or financial institution's treasurer may be responsible
for initiating all of the trades and monitoring the day to day position of the bank or financial
institution. In spite of the lesser degree of sophistication and volume of their operations, the
importance of segregation of duties can not be overemphasised.
■ Operations/accounting
- The instructions and settlements department will be located outside the dealing room.
The head of the department reports to the Operations manager, and is thus outside the
control of the Treasury/FX managers;
- Telex instructions to correspondents to pay away funds must be authenticated by means
of a test number. This will be calculated by a testing department (in a large bank or
financial institution) or by the operations manager or assistant and settlements
department in smaller banks and financial institutions;
- The paying and receiving department is responsible for effecting settlement on trades.
In smaller banks and financial institutions, this function may be handled by the
instructions and settlements department;
- The accounting department, or a separate EDP department, will be responsible for
maintaining the bank or financial institution’s accounting records;
- The reconcilements department (or a division of the accounting department) prepares
reconciliations of the bank or financial institution’s nostro accounts. Reconciling items
are notified to the departments responsible for clearance. This function is in principle
the same as that in any other company but, because of the large flows of money, it is
particularly important in banks that reconciliations are prepared on a timely basis,
generally on receipt of statements (which should be daily for the most active nostros),
and that outstanding items are cleared on a timely basis. Reconcilements is a control
function, and the department/division should not be able to initiate accounting entries;
- The investigations function for enquiries and disputes over settlements is normally
performed by the accounting or instructions and settlements department.
5.30 A summary of the basic responsibilities of the various functional activities is:
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Treasury
Money market/
Responsibilities FX Managers Dealers Positions clerk
General Supervise trading operations Conduct trading operations Establish the boundary for
trades transacted
Specific • Formulate trading strategy • Commit the bank's resources to • Record all trades as transacted
• Monitor profit performance trading transactions to reflect their impact on the
• Promote new business • Execute trading strategy bank's trading positions
• Monitor compliance with the • Manage the bank's position
bank's trading policies and exposure to maximise profits
controls, including adherence while complying with policies
to dealer and customer exposure to control risk, including
limits adhering to dealer and
customer exposure limits
Transaction related: None • Authorise (within limits) and • Receive deal ticket from dealer
commit to transaction and number sequentially
• Prepare deal ticket to • Record effect of trade on
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include: position recap sheet
i) deal date
ii) transaction type
iii) counterparty
iv) currency amount/price
v) value date
vi) maturity date
vii) interest rate
viii) total interest
ix) broker name, if used
x) brokerage fee
xi) settlement instructions
• Enter trade to blotter
(individual position record)
Accounting Controls: Authorisation Authorisation Completeness, Existence

Accuracy
Segregation of Duties Authorise and Commit Enter exchange data to

accounting system
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Operations/Accounting
Instructions and
Responsibilities Settlements Cables/Testing Paying and Receiving EDP Reconcilements Investigations
kpmg
General Process trades transacted Authenticate instructions to Effect settlement on trades Provide automated support Prove activity in cash Investigate customer
or from outside parties to Instructions and accounts, etc to the inquiries
Settlements accounting records
Specific • Confirm trades with • Generate appropriate • Execute appropriate • Maintain accounting • Obtain statements from • Control incoming inquiries
counterparties codes for the bank's payment instructions records correspondent banks and • Monitor disposition of
• Arrange settlement instruction to pay through: • Revalue positions for custodians at appropriate inquiries
• Verify accounting input • Verify codes on incoming i) customer's account those marked to market frequencies • Calculate compensation
• Generate management instructions to pay with bank • Generate automated • Reconcile statements to due to and from
information reports ii) correspondent banks management information accounting records counterparties
reports • Monitor disposition of • Prepare MIS reports of
reconciling items queries received and
compensation claimed
Transaction related: • Receive deal ticket from • Receive settlement • Receive paying/receiving • Receive encoded deal • Identify transactions • Determine responsibility
positions clerk instructions instructions from tickets and enter passing through cash and for failed settlements and
• Encode deal tickets for • Encode outgoing Instructions and transaction to up date: custodial accounts not amounts due from/to
EDP input instructions to pay and Settlements i) contract file recorded in the accounting counterparties for failure
• Despatch counterparty verify that the corres- • Match incoming receipts ii) general ledger control records to settle
confirmations and match pondent acknowledges to receive instructions accounts
incoming confirmations • Decode incoming • Make payment on pay • Generate counterparty • Identify transactions in the
• Process settlement instructions to pay, instructions confirmations accounting records not
instructions to appropriate authenticate, and • Maintain tickler file for: passing through cash or
paying and receiving acknowledge to correspondent i) settlements coming due custodial accounts
agents ii) unconfirmed transactions
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• Generate settlement
instructions
Accounting Controls: Completeness, Existence Accuracy Completeness, Existence Completeness, Existence Completeness, Existence Completeness, Existence
Accuracy Accuracy Accuracy Accuracy Accuracy
Segregation of Duties Receive consideration for the

exchange
Note:
In small banking operations, the above noted fun
ctional activities may not be carried out in separate departments but may be combined in one or more departments
or may even be carried out by the same individua
l. In any event, the segregation between treasu ry and operations/accounting activities is essential.
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5.31 Other organisational/operational matters. Because the money and foreign exchange
markets are dynamic and involve large sums of money over comparatively short periods of
time, certain industry-accepted practices have developed to promote the smoother functioning
of these markets:
■ Counterparty confirmation: Each party to the trade, which is usually transacted over the
telephone and may be recorded on tape to provide evidence of the joint understanding of the
terms of the trade, sends an advice to the other specifying its understanding of the trade
(amounts, currencies, dates of delivery, interest rates, and instruments traded). These
advices are normally sent by mail or by telex. This confirmation process is central to
determining the accuracy of the details of transactions and to ensuring that trades made do
not go unrecorded (if incoming confirmations are matched to the bank or financial
institution's record of deals made by personnel not connected with the dealing activity);
■ Value given: To avoid having each party to a money market or foreign exchange
transaction delay performance until obtaining confirmation that its counterparty has
performed, settlement is made as of the value date in anticipation of performance.
5.32 Money market and foreign exchange trades culminate in settlements -- the movement of
funds between the parties to the trade and, if called for, the movement of the paper representing
the claim to the issuers' funds (e.g., CDs, commercial paper, government securities, or bankers'
acceptances) and collateral (e.g., repurchase agreements). Such settlements usually occur
through a network of correspondent banks so that each party to the trade is able to instruct its
correspondent bank to move funds from its account to the account of the counterparty (or to the
account of the counterparty's correspondent bank). Accounts with correspondents can be cash
accounts or custodial accounts. Cash accounts denominated in foreign currencies, held at banks
located in the countries of those currencies, called Nostro accounts (our accounts with them),
are used to settle the foreign currency side of foreign exchange purchases and sales. Vostro
accounts (their accounts with us) are used to settle the local currency side of foreign exchange
purchases and sales with foreign counterparties. Domestic counterparties settle local currency
obligations through various methods which differ between financial centres.
5.33 Instructions to correspondent banks may be communicated in a variety of ways: by telex,
SWIFT (the international telecommunications network), local clearing facilities (such as in the
U.S., CHIPS), or more rarely, by facsimile machine. Most of these mechanisms do not provide
facsimile signatures. So, for the correspondents to determine settlement instructions to be
genuine, each system has a means to authenticate the communication. For telex messages,
authentication is done through testing codes transmitted with the message. The correspondent
issues its customer banks with sets of tables ("test keys") from which each customer calculates
a unique number to apply to its message. The number is the sum of the following:
■ The customer's unique identification number;
■ The next in a sequence of random numbers;
■ Various numbers determined by the terms of the instructions (the date, value etc.).
Appending this number to the telex message tests the message. On receipt of a tested message,
the correspondent recalculates the test number and verifies that the message, as sent by the
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customer, results in the test number appended to the message. Correspondents periodically
change these test keys, particularly the random number to be used. Customer banks, to
safeguard the capability to instruct disbursements, keep these test keys under dual control.
5.34 Correspondents can effect payments or receipts if instructions are received early on the
day funds are to pass. However, in some countries instructions must be received at least a day
prior to the day funds are to pass. To allow time to transmit instructions and for correspondents
to act on them, most money market and foreign exchange transactions are done for value no
earlier than two days after the deal date, that is for value on the spot dealing date. However, it
is possible for correspondents to effect payments and receipts for value on the day instructions
are received, such that deals can be done for same day value. Further, transactions can be done
for next day value. In both these cases (i.e., value today and value tomorrow (“tomnext”)),
instructions must be transmitted early enough to enable the correspondent to respond. Thus, in
environments where instructions to correspondents are generated at end of day, such cases must
be identified for immediate (manual) attention.
5.35 Money market transactions often involve negotiable paper that banks and financial
institutions issue (e.g., CDs) or hold in custody:
■ CDs issued. Blank CD forms are prenumbered and kept under dual control in safe custody.
When a CD is issued, the details are recorded in a register, which should be initialled by the
authorised signatory(ies) signing the CD. The CD is released to the depositor against
receipt of the deposit. If interest payments are due on a CD prior to maturity date, the CD
must be presented to the issuing bank by the current holder, at which time the CD is
endorsed as having had the interest paid. On maturity, the deposit plus interest is paid
against delivery of the CD, which is cancelled and filed.
■ Negotiable instruments held. CDs, commercial paper and bankers' acceptances
purchased, and most collateral taken for secured loans, are negotiable instruments. Some,
such as CDs, are bearer instruments, while bankers' acceptances require endorsement by the
seller to the purchaser (or to bearer). All, however, must be kept in safe custody. Funds are
released only against receipt of the paper and on maturity the paper is returned against
repayment of principal and interest;
■ Other. Banks and financial institutions frequently have separate safe custody departments
responsible for the physical issue and redemption of CDs, and for the receipt and release of
negotiable instruments, in accordance with instructions from the settlements department.
5.36 Records and reports. The basic records for money market and foreign exchange
transactions which should be maintained are as follows:
■ Deal slip originated by the dealer;
■ Deal blotters (transaction sheets maintained by the trader) to record actual deals made;
■ Reconciliations of positions;
■ Daily profit and loss reports;
■ Position sheets to maintain current control over the traders' position in each currency;
■ Bank or financial institution’s copy of the confirmation it has dispatched;
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■ Counterparty confirmation and/or copy of telex confirmation;

■ Evidence of ownership of security (where appropriate).
Details of the deal are maintained in the accounting records either in a deal file or in a
customer/counterparty account maintained on an open item basis. The deal file or account
balances total to appropriate general ledger control account balances. Deal tickets and
confirmations should be filed together by maturity date, deal number, or value date. These
records will be different when dealing in an on-line environment. Reference should be made to
chapter 19 of this volume for the implications of such an environment.
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Money market and foreign exchange activities
Key management information reports
5.37
Principal Minimum
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Report Contents Purpose Recipients frequency
1. Liquidity Cash flow projections summarised, eg by months To moitor liquidity Senior management Monthly
(maturity gap) report
2. Cash flow projections Projections of daily cash flow in each currency To control liquidity Treasury manager, Daily
(including interest and principal for money market dealers
deals and loans, foreign exchange deals, etc)
3. Nostro projections Nostro closing balances and projections of closing Agreement of dealer's Dealers, Settlements Daily
balances for next few days records and control of
nostro balances
4. Diary Diary of payments and receipts due To ensure all Settlements Daily
payment and receipt
instructions are given
Management information reports
5. Interest rate gap Interest rate ladder summarised, eg by months To monitor interest Senior management Monthly
report rate exposure
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6. Interest rate ladder ct
Analysis by day of assets and liablilities subje To control interest Treasury manager, Daily
to interest rate change, in each currency rate exposure dealers
7. Position report Net open position in each currency, with home Control of foreign FX manager/dealers, Daily
currency equivalent, limits and any excesses exchange risk senior management
8. Country exposure Total money market and foreign exchange To monitor country Senior management, Monthly
report outstandings, with limits, by country. exposure money market/FX
Excesses highlighted. managers, dealers
9. Counterparty excess Outstandings, limits and excesses of deposits To monitor/control Senior management Daily
report placed/negotiable instruments purchased and of excesses
foreign exchange deals in excess of total limitsor
settlement limits, for counterparties in excessonly.
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Money market and foreign exchange activities
Key management information reports
Principal Minimum
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Report Contents Purpose Recipients frequency
10. Counterparty Outstanding balances of placings/negotiable To enable dealers to check Money market Daily
outstandings (money instruments held, by counterparty, with projections whether it is possible dealers/positions
market) for next few days, and limits place deposits or purchase clerk
negotiable instruments under
risk of a counterparty, within
the credit line allocated
11. Counterparty Outstanding foreign exchange deals for each value To enable dealers to check FX dealers/positions Daily
outstandings (foreign date, by counterparty in value date order whether it is possible to deal clerk
market) with a counterparty
within the limit for total foreign
exchange deals outstanding
and the settlement limit
12. Unconfirmed deals Details of unconfirmed deals - counterparty To monitor receipt of Settlements Daily
confirmations outstanding confirmations and enable follow
up letters to be sent when
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appropriate
13. Brokers' notes Details of brokers' notes outstanding To monitor receipt Settlements Daily
outstanding of brokers' notes
Note:
The above outlines the minimum information which should be available in respect of a bank's mone
y market and foreign exchange dealing activities (excluding basic
accounting information). Generally, the information will be produced by the computer system, ually
us as part of the end of day run. If the system has real time
update capabilities, these reports should be ava
ilable on display terminals. For a manual syste
m, the information produced wil inevitably be ther
ei less
detailed or less frequent.
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Accounting matters
5.39 Balance sheet
■ General. Money market assets and liabilities may be classified on the balance sheet by
various criteria, as determined by local practice. However, money market instruments
carried at cost whose pre-maturity sale may be required for liquidity reasons, may require a
reduction of their carrying value to realisable value. Accrued interest receivable and
payable may be included in the same caption as the associated principal amounts or in
separate captions, according to local practice. Similarly accreted discounts and amortised
premiums may be included as additions to or deductions from either the principal amounts
or the accrued interest. Assets and liabilities arising from normal banking and finance
operations are generally valued at current mid-market spot rates of exchange, regardless of
their maturity.
■ Repurchase agreements. Where securities are sold under repurchase agreements, the bank
or financial institution is in substance using the securities as collateral for a borrowing.
Since the risk of ownership of the securities has not passed, although title may have, the
securities normally continue to be included as assets (investment securities) in the bank or
financial institution’s books, and the sale proceeds included in liabilities as amounts
borrowed. However, such transactions may have characteristics that require an alternative
accounting treatment (e.g., they may allow substitution of securities, or involve option
repurchase agreements).
■ Reverse repurchase agreements. Securities purchased under reverse repurchase
agreements are included on the asset side of the balance sheet, as secured loans or in their
own caption.
■ Foreign exchange. For foreign exchange transactions, only suspense balances arising from
revaluation and amortisation of swap profits and losses are included in the balance sheet.
5.40 Off-balance sheet. Unmatured foreign exchange deals and future deposits placed and
accepted should be recorded in contingent or memoranda accounts. In some countries however,
unmatured foreign exchange deals are included in the balance sheet, as contra accounts. In
other countries the existence of the unmatured foreign exchange deals is normally disclosed in
notes to the financial statements, and the amount may also be disclosed. In this case each deal
should be counted once only, and not as both a purchase and a sale.
5.41 Profit and loss
■ Interest is accounted for on an accruals basis for the purposes of financial statements. Any
premium or discount to face value taken on the purchase of a negotiable instrument as part
of money market activities is considered to be an adjustment to the yield on the asset.
Therefore such premiums or discounts are normally amortised or accreted on a level yield
basis over the period from purchase to maturity.
■ Interest on the securities that have been sold under repurchase agreement is accounted for as
interest income on investment securities. The cost of the sale and repurchase agreement,
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equalling the interest on the securities received by the purchaser plus a premium payable on
repurchase by the bank, is accounted for as interest on borrowings.
■ Income received by the bank or financial institution from the purchase of securities under
resale agreements is accounted for as interest income on loans, or as interest on resale
agreements.
■ Profits and losses from revaluation of assets and liabilities denominated in other currencies
are generally included in income, as are profits or losses from revaluation of unmatured
foreign exchange deals. Forward deals are revalued at the forward rates applicable to their
maturities at the date of the revaluation. However, profits or losses from swap transactions
are generally taken into income on a straight line basis over the period from the date of the
spot contract to the date of the forward contract, and are included in net interest. Foreign
currency income and expense items are generally translated into the reporting currency at
the exchange rate as of the date that the income is earned or the expense incurred (or at
average rates which have approximately the same effect), although in some countries all
income and expense may be translated at the closing rates.
More detailed discussion of accounting procedures for foreign exchange revaluations and
income recognition is presented in appendix 5A.
Auditing guidance
5.42 For auditing guidance on a bank or financial institution’s money market and foreign
exchange activities reference should be made to chapter 3 of volume 1.
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Appendix: Foreign exchange accounting
Introduction
5A.1 The transactions that comprise a bank and financial institution's international activity are
denominated in currencies additional to its home currency (the reporting currency). Accounting
procedures are therefore required for:
■ Accounting for transactions in foreign currencies, including foreign currency. Loans and
deposits, as well as foreign exchange contracts;
■ Recognising income and expense associated with foreign exchange contracts;
■ Preparing financial information in the reporting currency.
The valuation of transactions and balances denominated in foreign currencies for the purposes
of preparing financial statements for presentation to shareholders or regulatory authorities is, in
some countries, prescribed by law, practice, or recommendations of accounting or supervisory
bodies. When such rules exist, obviously they must be followed; when they conflict with
economic reality, however, banks and financial institutions often adopt different valuation
procedures for the purposes of management assessment of performance and financial position.
5A.2 For banks and financial institutions, the major considerations are:
■ Balance sheet items. Assets and liabilities arising from normal banking and finance
operations are generally valued at current mid-market spot rates of exchange, regardless of
their maturity;
■ Profit and loss items. In principle, foreign currency income and expense accounts are,
generally, translated into the home currency at the exchange rate as of the date the income is
earned or the expense incurred. In practice, however, income and expense is most often
translated at an average rate for the year or at periodic intervals (e.g., monthly), a minority
of banks and financial institutions, though, translate profit and loss account items into the
home currency at year-end rates. To avoid the effective revaluation of income and expense
accounts, it is important that they should be converted, or brought into the foreign exchange
positions, at the date they are translated. This is discussed in more detail in the following
pages;
■ Foreign exchange contracts. Spot foreign exchange contracts are, in principle, valued at
spot, usually mid-market, rates of exchange. For accounting purposes, forward foreign
exchange contracts can be classified into two groups:
- Hedges of foreign currency assets and liabilities (e.g., as part of a swap transaction) or of
a foreign currency commitment (e.g., future interest payments). Accounting for hedging
contracts is a complex area and varies among different countries but, in principle, the
hedging contract is matched with the asset, liability, or commitment hedged;
- Outright contracts undertaken in anticipation of a trading gain. Outright forward foreign
exchange contracts are generally revalued at the appropriate forward exchange rates to
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determine the cost or benefit of covering the outstanding contracts and closing out the
positions at rates available on the valuation date.
5A.3 Bookkeeping systems. There are, essentially, two distinct methods of accounting for
foreign currency transactions:
■ Double currency accounting. In a double currency accounting system, each transaction in
a foreign currency is allocated a home currency equivalent, and accounting entries are
passed in the home currency ledger. A record of the real foreign currency amount of the
transaction is also maintained but on a memorandum basis only. In a manual ledger system,
this might be no more than a portion of the narrative for the home currency ledger entry. It
should be noted that it is extremely rare for a bank or financial institution to use a double
currency system. The use of such systems is almost exclusively restricted to trading
companies;
■ Multi-currency accounting. In a multi-currency accounting system, separate general
ledgers are maintained for each currency in which business transacted is denominated.
Each transaction is recorded in the appropriate currency ledger and double entry is
preserved within each currency, so that each ledger is always balanced. Generally, no home
currency record of a foreign currency transaction is maintained, and because of this feature
the system is sometimes described as a single currency accounting system.
5A.4 In double currency accounting, the home currency equivalent used in simple loan and
deposit transactions not involving the exchange of currencies is fixed at a nominal rate probably
close to the market rate, but with the possibility of only infrequent adjustment. The rate used
affects only the home currency values at which foreign currency assets and liabilities are stated
in the home currency ledger. When one currency is exchanged for another, however, an actual
home currency equivalent is used.
5A.5 A feature of the multi-currency accounting system is the so-called "position account."
Position accounts are kept in each currency and, to identify foreign exchange profits and losses
by currency, in the home currency for each such foreign currency. These position accounts
serve to preserve the double entry format for cross-currency transactions. Entries are passed
over the position account to record all exchange transactions, such as purchases and sales of the
currency, or for the conversion of profits or losses from the foreign currency into the home
currency. With the exception of revaluation entries passed over the position account in the
home currency only, any entry passed over a position account must be matched with an opposite
entry being passed over the position account in another currency.
5A.6 The following example illustrates the accounting entries under each system:
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Deposits of US$ 1,000 and DM5,000 are taken and DM1,500 is placed. The home currency is US Dollars and a rate of DM2.5=$1 is assumed. The entities are as
follows:
Double currency system Multicurrency system
Dr. Cr. Balance
DM $ DM $ DM $ Dr. Cr. Balance
US$ LEDGER
US$ nostro account Nostro account
Deposits accepted 1,000 1,000 Dr Deposits accepted $1,000 $1,000Dr
Deposits accepted-$ Deposits accepted
Nostro account 1,000 1,000 Cr Nostro account $1,000 $1,000Cr
DM Nostro account DM LEDGER

Deposits accepted 5,000 2,000 Nostro account
Deposits placed 1,500 600 3,500 1,400 Cr Deposits accepted DM5,000
Deposits placed DM1,500 DM3,500Cr
Deposits accepted-DM
Nostro account 5,000 2,000 5,000 2,000 Cr Deposits accepted
Nostro account DM5,000 DM5,000Cr
Deposits placed-DM Deposits placed
Nostro account 1,500 600 1,500 600 Dr Nostro account DM1,500 DM1,500Dr
Suppose the bank sells US$ 1,000 for DM 4,200. The accounting entries passed on the value date are then as follows:
Double currency system Multicurrency
Dr. Cr. Balance Dr. Cr.
DM $ DM $ DM $ US$ Ledger
Position account-DM $1,000
US$ nostro 1,000 1,000 Cr US$ nostro $1,000
DM ledger
DM nostro 2,400 1,000 2,400 1,000 Dr DM nostro DM2,400
Position account-US$ DM2,400
Note that while double entry has been preserved in the home currency, there is no balancing in the foreign currencies. Double entry is preserved in all currencies.
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A balance sheet can now be extracted in US dollars (the home currency) directly from the
general ledger as follows:
I. Double currency system
Assets Liabilities
Nostro accounts: Deposits accepted:
Dollar $ - Dollar $1,000
Deutsche marks 2,400 Deutsche marks 2,000
Deposits placed 600
______ ______
$3,000 $3,000
It should be noted that in the above balance sheet, the Deutsche mark denominated assets
and liabilities are not stated at current exchange rates but at a mixture of nominal rates and
actual rates for exchange transactions.
II. Multi-currency system. In order to produce a total balance sheet for the bank it is
necessary to consolidate the various ledgers in each currency, first translating the foreign
currencies into home currency at an appropriate rate. If this is taken to be DM2.4 = $1, the
procedure is as follows:
DM
Translated Total
DM at 2.4 $ $
Assets
Nostro accounts 5,900 $2,458 - 2,458
Deposits placed 1,500 625 625
______ ______ ______ _____
7,400 $3,083 - 3,083
Liabilities
Deposits accepted 5,000 $2,083 1,000 3,083
Position account 2,400 1,000 (1,000) -
______ ______ ______ ______
7,400 $3,083 - 3,083
The position accounts in this case cancel out because the only exchange transaction was at
the same exchange rate used for consolidation.
If exchange rates had changed in the interim, the net difference on consolidating the
position accounts would represent the profit or loss arising on the revaluation, passed to the
profit and loss account.
5A.7 So far, only transactions involving assets and liabilities have been illustrated. Accounting
for income and expense is different, because fluctuations in exchange rates do not alter the
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value of the foreign currency income and expense. Such fluctuations, however, may alter the
home currency equivalent assigned to the income or expense. Additionally, they do alter the
value of the asset or liability arising as a result of the accrual of income or expense.
5A.8 To illustrate with an example:
Suppose the bank receives a commission of DM 250, which is recognised as income on a cash
basis. Current spot rate is DM2.30 = $1.
I. Double currency system. In the double currency system, a home currency equivalent is
established immediately. (Nominal rate is DM2.5 = $1)
Entries may use either nominal rate or current spot rate:
Dr. Cr.
1 Using nominal rate

DM nostro DM250 $100
Commission income $100
2 Using current spot rate

DM nostro DM250 $109
Commission income $109
The rate of exchange used does not affect the total profits of the bank. Were the deutsche
mark asset (in this case the nostro account) to be subsequently revalued at a current spot rate
of DM2.4 = $1, there would be an exchange gain of $4 if the nominal rate had been used, or
an exchange loss of $5 if the earlier spot rate had been used. In either case, the total profit
following revaluation is $104, but the allocation between commissions and foreign
exchange profits or losses differs.
II. Multi-currency system. In the multi-currency system, the commission is initially recorded
only in the currency actually received. A home currency equivalent is established later,
probably at the month-end.
Entries are: Dr. Cr.
DM ledger
DM nostro DM250
Commissions received DM250
At month-end (spot rate is now DM2.4 = $1):
DM ledger
Commissions received DM250

Position account DM250
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US $ ledger Dr. Cr.
DM- Position account $104

Commissions received $104
Until the home currency equivalent is established, any fluctuations in exchange rates affect
the home currency equivalent of the income. Subsequent fluctuations will result in an
exchange profit or loss on revaluation of the position account.
5A.9 The advantages and disadvantages of the two systems are shown in the following table:
Double currency system Multi-currency system
■ A home currency equivalent must be ■ There is no need to compute home
computed for every foreign currency currency equivalents for foreign currency
transaction; transactions (except for cross deals where
exchange profits and losses are identified
by currency);
■ Entries to three or more accounts are ■ Entries are required to only two accounts
required for each foreign currency to record foreign currency transactions
transaction. Changes in nominal rates (except for foreign exchange deals);
involve the adjustment of all home
currency equivalent accounts;
■ No record of foreign currency risk ■ Position accounts are maintained as part
exposure is maintained as part of the of the double entry system, showing the
double entry system; exposure to exchange rate movements;
■ Revaluation profits and losses can only be ■ Revaluation profits and losses can be
computed by revaluing all assets and determined by revaluing the position
liabilities; accounts;
■ Consolidated information is readily ■ Consolidated information requires
available without the need to value and valuing and aggregating the foreign
aggregate foreign currency ledgers currency ledgers;
(although foreign currency items are not
necessarily valued at current exchange
rates);
■ Exchange profits or losses cannot be ■ As there is no need to use nominal
attributed entirely to dealers; exchange rates to record routine
transactions, exchange profits or losses
identified upon revaluation of positions
can be readily interpreted, and associated
with specific profit centres (for example,
the FX dealer's room);
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Double currency system Multi-currency system

■ Double entry provides an effective control ■ Double entry is not an effective control
over the completeness of posting of a over the completeness of postings of a
foreign exchange transaction to the home foreign exchange transaction, as it is
currency ledger. possible to post accounting entries in one
currency only, without breaking double
entry.
In summary
A computerised system can usually eliminate certain of the disadvantages of either system;
however most international banks and financial institutions use a system based on multi-
currency accounting. Thus the subsequent examples are presented in a multi-currency system.
5A.10 Recording basic foreign exchange transactions. The accounting entries used to record
foreign exchange transactions are illustrated in this section with an example utilising a multi-
currency accounting system.
Example
A bank uses US dollars as its home currency. It has the following opening assets and liabilities:
Assets Liabilities
$ Nostros $1,000,000 Share capital $1,000,000

FF Nostros FF3,000,000 Current account FF3,000,000
The rate used to translate to the home currency at the most recent revaluation was FF8 = $1.
Therefore, the bank's opening position is:
Assets Liabilities
$ Nostros $1,375,000 Share capital $1,000,000

_________ Current account 375,000
$1,375,000 $1,375,000
The bank enters into the following transactions on Day 1:

a) Spot purchase/sale
Sell FF 2,000,000 for DM 500,000 for value Day 3. Spot DM/$ rate is DM2 = $1.
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i) Day 1 Dr. Cr.
FF ledger
(1) FF position account FF2,000,000

Unmatured spot sales FF2,000,000
DM ledger
(2) Unmatured spot purchases DM500,000

DM position account DM500,000
US $ ledger
(3) $position account - DM $250,000

$position account - FF $250,000
To record purchase/sale commitment. Note that position accounts are immediately updated.
The bank also maintains the dollar position accounts by currency, in order to compute
exchange profit or loss by currency. Some banks maintain separate contingent or
memorandum position accounts to record unmatured commitments. These accounts,
together with the unmatured sales and purchases accounts, are segregated from other
accounts as they do not appear in the banks' trial balances or balance sheets (see paragraph
5A.15).
ii) Day 3 Dr. Cr.
FF ledger
(4) Unmatured spot sales FF2,000,000

FF nostro account FF2,000,000
DM ledger
(5) DM nostro account DM500,000

Unmatured spot purchases DM500,000
To record transfer of funds in settlement. Where separate memorandum or contingent accounts

are maintained, entries will be passed to reverse out the entries made on Day 1 and the position
account entries shown in (i) above will be made on Day 3.
b) Forward purchase/sale
Sell DM2,100,000 for US $1,000,000 3 months forward, for value Day 94.
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i) Day 1 Dr. Cr.
DM ledger
(6) DM position account DM2,100,000

Unmatured forward sales DM2,100,000
US $ ledger
(7) Unmatured forward purchases $1,000,000

$ position account - DM $1,000,000
To record purchase/sale commitment.
ii) Day 94
DM ledger
(8) Unmatured forward sales DM2,100,000

DM nostro account DM2,100,000
US $ ledger
(9) $nostro account $1,000,000

Unmatured forward purchases $1,000,000
To record transfer of funds in settlement.
c) Deposit swap
Deposit swaps are described in paragraph 5.12. As the aggregate profit from the deposits
placed and accepted, and from the spot and forward exchange contracts is known as soon as
all of the related deals have been made, the exchange contracts should be excluded from
periodic revaluation procedures. Revaluation procedures are discussed in paragraph 5A.13.
Exchange contracts identified with swaps may be easily excluded from revaluation
procedures by the use of separate "swap position accounts." These accounts are used in
exactly the same way as other position accounts (as described in paragraph 5A.6), but
balances on them are not revalued using the procedures described in paragraph 5A.14(II);
the procedure described in sub-paragraph (i) should be followed instead.
Accept deposit: $2,000,000 @ 12% per annum; value day 3; maturity day 94. Total
interest to be paid is $60,667 (360 day year, 91 days outstanding).
Sell spot: US$2,000,000 for £1,250,000 (exchange rate $1.60 = £1); value day 3.
Buy forward: US$2,000,000 for £1,242,236 (exchange rate $1.61 = £1); value day 94.
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Place deposit: £1,250,000 @ 10% per annum; value day 3; maturity day 94; Total interest to
be received is £31,164. (365 day year, 91 days outstanding).
i) Day 1 Dr. Cr.
US $ ledger
(10) Deposits accepted - contra $2,000,000

Deposits accepted - future value $2,000,000
To record commitment to accept deposit in memo accounts (since value does not
occur until day 3).
(11) $swap position account - £ $2,000,000
Unmatured spot sales $2,000,000
To record spot sale commitment.
(12) Unmatured forward purchases $2,000,000

$swap position account - £ $2,000,000
To record forward purchase commitment.
Sterling ledger
(13) Deposits placed - future value £1,250,000
Deposits placed - contra £1,250,000
To record commitment to place deposit in memo accounts (since value does not
occur until day 3).
(14) Unmatured spot purchases - £1,250,000

£ swap position account £1,250,000
To record spot purchase commitment.
(15) £ swap position account £1,242,236

Unmatured forward sales - £ £1,242,236
To record forward sale commitment.
(16) £ swap position account £7,764

Unearned swap profits £ 7,764
To transfer unearned swap profit from swap position account to unearned swap profits
account. The balance in the £ swap position account following this entry is £0 since
1,250,000 - 1,242,236 = 7,764
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Note: At the end of Day 1, the bank has recorded only future commitments, including its
claim to future income i.e, the swap profit to be realised on the deals.
ii) Day 3 Dr. Cr.
US$ ledger
(17) Deposits accepted - future value $2,000,000

Deposits accepted - contra $2,000,000
To reverse entries to memo accounts at value date.
(18) Nostro $2,000,000

Deposits accepted $2,000,000
To record receipt of deposit.
(19) Unmatured spot sales $2,000,000

Nostro $2,000,000
To record settlement of spot sale.
Sterling ledger
(20) Deposits placed - contra £1,250,000

Deposits placed - future value £1,250,000
To reverse entries to memo accounts at value date.
(21) Nostros £1,250,000

Unmatured spot purchases £1,250,000
To record settlement of spot purchase.
(22) Deposits placed £1,250,000

Nostros £1,250,000
To record placing of deposit.
Note: At the end of Day 3, the bank has recorded the realisation of all its future
commitments except for its forward purchase of £ for $. In addition, the bank shows a
deposit accepted of $2,000,000 and a deposit placed of £ 1,250,000.
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iii) Day 94 (assuming no intervening Dr. Cr.

accruals)
US $ ledger
(23) Nostros $2,000,000

Unmatured forward purchases $2,000,000
To record settlement of forward purchase.
(24) Deposits accepted $2,000,000

Interest expense $60,667
Nostro $2,060,667
To record repayment of deposit accepted with interest.
Sterling ledger
(25) Unmatured forward sales £1,242,236

Nostro £1,242,236
To record settlement of forward sale.
(26) Nostros £1,281,164

Interest income £ 31,164
Deposits placed £1,250,000
To record repayment of deposit placed, with interest.
(27) Unearned swap profits £7,764

Swap profits £7,764
To transfer swap profits to income.
Note: At the end of Day 94, the Bank has recorded the realisation of its remaining future
commitment, the repayment of the deposits accepted and placed, and its income and
expense, including its swap profit, from the commitments made on Day 1.
5A.11 The trial balance at Day 31, after the deals described in paragraph 5A.10 parts a), b) and
c), but before any accruals, would be as follows:
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FF DM £ $
ASSETS AND COMMITMENTS
TO PURCHASE
Nostro 1,000,000 500,000 1,000,000

Deposits placed 1,250,000
Position account - FF 2,000,000 -250,000
DM 1,600,000 -750,000
£
Unmatured forward
purchases 3,000,000
3,000,000 2,100,000 1,250,000 3,000,000
LIABILITIES AND
COMMITMENTS TO SELL
Share capital 1,000,000
Current accounts 3,000,000
Deposits accepted 2,000,000
Unearned swap profits 7,764
Unmatured forward sales 2,100,000 1,242,236
3,000,000 2,100,000 1,250,000 3,000,000
5A.12 The changes from the opening trial balance exhibited in paragraph 5A.10 are presented
in the following T-account analysis. ((0) = opening balance; ( ) = entry numbers refer to entries
presented previously in paragraph 5A.10).
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French Franc Ledger
Nostro account Current accounts FF Position account Unmatured spot sales

kpmg
(0) 3,000,000 (4) 2,000,000 (0) 3,000,000 (1) 2,000,000 (4) 2,000,000 (1) 2,000,000
1,000,000 3,000,000 2,000,000 -0-
Deutsch Mark Ledger
Nostro account DM Position account Unmatured forward sales Unmatured spot purchases
(5) 500,000 (6) 2,100,000 (2) 500,000 (6) 2,100,000 (2) 500,000 (5) 500,000
500,000 1,600,000 2,100,000 -0-
Sterling Ledger
Nostro account Deposits placed £ Swap position account

(21) 1,250,000 (22) 1,250,000 (22) 1,250,000 (15) 1,242,236 (14) 1,250,000
(16) 7,764
-0- 1,250,000 -0-
Unmatured forward sales Unearned swap profits Unmatured spot purchases

(15) 1,242,236 (16) 7,764 (14) 1,250,000 (21) 1,250,000
1,242,236 7,764 -0-
Deposits placed
Future value Contra
(13) 1,250,000 (20) 1,250,000 (20) 1,250,000 (13) 1,250,000
-0- -0-
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US $ ledger
but the following matters always need to be considered:

Nostro account Deposits accepted Share capital
(0) 1,000,000 (19) 2,000,000 (18) 2,000,000 (0) 1,000,000
(18) 2,000,000
1,000,000 2,000,000 1,000,000
$ Position account $ Swap position account

FF DM £
(3) 250,000 (3) 250,000 (7) 1,000,000 (11) 2,000,000 (12) 2,000,000
250,000 750,000 -0-
Unmatured forward purchases Unmatured spot sales

(7) 1,000,000 (19) 2,000,000 (11) 2,000,000
(12) 2,000,000
3,000,000 -0-
Deposits accepted
Future value Contra
(17) 2,000,000 (10) 2,000,000 (10) 2,000,000 (17) 2,000,000
-0- -0-
Note: entries (8) and (9) and (23) through (27) are not posted since they will not occur till day 94.
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5A.13 Revaluation and recognition of profit and loss. Periodically, a bank or financial
institution will calculate accruals of income and expense and revalue its foreign exchange
positions. There are a number of possible variations in the method of performing revaluations,
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a) Accrual of swap profits and losses. Swap profits and losses represent compensation for
the differential in interest rates between the two currencies involved in the swap. Interest is
included in profits on an accrual basis, and the swap profit or loss, therefore, is also accrued.
b) Revaluation at spot rates of exchange. No profit or loss is recognised on individual deals,
whether assets, liabilities or exchange contracts. Instead, the profit or loss resulting from
revaluation of assets, liabilities and commitments includes the result of all dealing since the
previous revaluation. Assets and liabilities are revalued at current mid-market rates of
exchange. The two most common approaches in such instances are:
i) To revalue the net open position, thus including all unmatured foreign exchange deals,
spot and forward.
ii) To revalue the spot position only. In this case it is necessary to reverse the effect on the
swap position of the spot side of swap transactions because the assets and liabilities
resulting from the swap transactions have already been sold forward at a determined
exchange rate.
The approach chosen will determine the method of calculation of forward cover, or vice
versa.
c) Calculation of cost of forward cover. All forward deals outstanding at the end of the
month, with the exception of the forward side of swaps and hedges, are revalued at the
current market forward exchange rates applicable to their maturities. On the basis that this
revaluation is the determination of the cost of cover (the cost, at the time of revaluation to
enter into transactions to eliminate the gaps in its position), net forward purchases could be
revalued at the rates applicable to sales, and net forward sales at the rates applicable to
purchases. As forward purchases may cover the forward sales, even where they are not for
the same value date, it is customary to use mid-market rates of exchange. Where there are
small volumes of deals outstanding, these may be grouped by value date and valued at an
average rate (e.g., all deals between two and six weeks forward may be valued at the one
month forward rate). When the volumes of outstanding deals are large, they should be
valued at rates specific to their value dates. As rates are not quoted for all value dates, they
must be calculated by interpolation (e.g., the two month rate as an average of the one month
and three month rates).
There are two principal methods of treating unmatured foreign exchange deals:
- To compute the difference between their value at forward rates and their value at spot
rates (where their value at spot rates has been included in the valuation of the net open
position, as in b(i) above).
- To compute the absolute value of the forward deals (where only the adjusted spot
position (including forward deals) has been revalued at spot rates, as in b(ii) above).
5A.14 Example (Using the transactions in paragraph 5A.10, assuming profits/losses are
recognised at day 31, and using the methods of revaluation set out in paragraphs 5A.13, b and c.
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I. Accrual of interest and swap profits/losses

All interest and swap profits/losses are accrued on a straight line basis (equivalent to a level
yield basis). Accrual entries on day 31 are:
US $ ledger Dr. Cr.
(1) Interest expense $18,667

Accrued interest payable $18,667
To record interest at 12% on $2,000,000 for 28 days (360 day year).
Sterling ledger
(2) Accrued interest receivable £9,589

Interest income £9,589
To record interest at 10% on £1,250,000 for 28 days (365 day year).

To accrue 28/91 of total swap profit.
II. Revaluation at spot rates of exchange

Assume the following spot rates of exchange against US dollars at day 31:
French franc 8.2
Deutsche mark 1.8
Sterling 1.5
The revaluation is computed as follows:
FF DM £
Currency position, per respective ledgers
Dr./(Cr.) 2,000,000 1,600,000 -
US$equivalent at current spot rates $243,902 $888,889 -
$ position account, per US$ ledger Dr./(Cr.) (250,000) (750,000) -
Profit/(loss) $(6,098) $138,889 -
Note: swap position accounts are excluded from the revaluation (paragraph 5A.10).
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Because the dollar position accounts are maintained by currency, it is possible to identify
the foreign exchange profits and losses by currency. Accounting entries to record the
foreign exchange profit or loss on revaluation are passed in the home currency only:
US $ ledger Dr. Cr.
(4) Position account - FF $6,098

Foreign exchange profit/loss $6,098
Position account - DM $138,889
III. Calculation of cost of forward cover

There is only one unmatured outright forward exchange deal: the sale of DM2,100,000 for
US $1,000,000 for value on day 94. Assume the two month forward rate at day 31 is 1.9.
The calculation of forward cover is as follows:
DM 2,100,000 @1.9 $(1,105,263)
less DM 2,100,000 @ 1.8(spot rate) 1,166,667
Profit $61,404
The US dollar equivalent of the future sale (liability) is less at the forward rate than at the
spot rate, and the difference therefore represents a profit (or in this case a reduction in the
loss recognised on the spot revaluation).
The accounting entries to be passed are:
US $ ledger Dr. Cr.
(5) Forward valuation reserve $61,404

IV. Summary
The total income/expense resulting from the accrual and revaluation process is as follows:
Interest income (£9,589 @ 1.5) $14,383
Interest expense (18,667)
Swap profit (£2,389 @ 1.5) 3,584
Net interest loss (700)

Foreign exchange loss:
French franc profit $6,098
Deutsche mark loss -spot $(138,889)
-forward 61,404 (77,485)
(71,387)
Net loss $(72,087)
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Note: The spot revaluation revalues forward deals at spot rates, so the "loss" from the spot
revaluation of the DM position is not in itself meaningful. Overall, the bank shows a loss
on revaluation for the following reasons:
■ Sterling depreciated against the US $ (from 1.6 to 1.5) and the bank did not obtain forward
cover for the £ swap income; thus, the interest income and swap profit are less than would
have been the case at the spot exchange rate when the £/$ swap was negotiated;
■ Deutschemarks have appreciated against the US $ (from DM2 = $1 to DM1.8 = $1); thus,
the DMs acquired through the sale of FFs have appreciated, but the DMs sold forward yield
fewer $ at the contract rate (DM2 = $1) than would be the case had the forward deal been
negotiated at the revaluation rate (DM1.9 = $1);
■ French francs have depreciated against the US $ (from FF8 = $1 to FF8.2 = $1); therefore,
the bank acquired more $ at the contracted rate than it would have done had the FFs been
sold at the revaluation rate.
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$ Equivalent $ Equivalent $ Equivalent

FF @ 8.2 DM @1.8 £ @ 1.5 $ Total
TO PURCHASE
Nostros 1,000,000 121,951 500,000 277,778 1,000,000 1,399,729
Deposits placed 1,250,000 1,875,000 1,875,000
Position account -FF 2,000,000 243,902 (243,902) --

-DM 1,600,000 888,889 (888,889) --
-£
Accrued interest receivable 9,589 14,383 14,383
Forward valuation reserve 61,404 61,404
Unmatured forward purchases 3,000,000 3,000,000

3,000,000 365,853 2,100,000 1,166,667 1,259,589 1,889,383 2,928,613 6,350,516
LIABILITIES AND COMMITMENTS

TO SELL
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V. Trial balance consolidation after revaluation
Share capital 1,000,000 1,000,000
Profit and loss account 11,978 17,967 (90,054) (72,087)
Current accounts 3,000,000 365,853 365,853
Deposits accepted 2,000,000 2,000,000
Accrued interest payable 18,667 18,667
Unearned swap profits 5,375 8,062 8,062
Unmatured forward sales 2,100,000 1,166,667 1,242,236 1,863,354 3,030,021

3,000,000 365,853 2,100,000 1,166,667 1,259,589 1,889,383 2,928,613 6,350,516
of
Note: For balance sheet purposes, the valueunmatured forward purchases and sales (at spot ates)
r would be netted and combined
with the forward revaluation rese
rve and the unearned swap profits, resulting ainnet debit balance of $23,321.
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VI. The changes from the trial balance exhibited in paragraph 5A.11, representing the accruals
to and revaluation at Day 31 are presented in the following T-account analysis. ((0) =
opening balance, (i.e., the final balance shown in section 5A.12); entry numbers refer to
entries presented previously in this paragraph):
Sterling ledger
Accrued interest receivable Profit and loss account
(2) 9,589 (2) 9,589
(3) 2,389
9,589 11,978
Unearned swap profits

(3) 2,389 (0) 7,764
5,375
US $ Ledger
Position accounts
FF DM
(4) 6,098 (0) 250,000 (0) 750,000
(4) 138,889
243,902 888,889
Accrued interest payable Profit and loss account

(1) 18,667 (1) 18,667 (4) 6,098
(4) 138,889 (5) 61,404
18,667 90,054
Forward valuation reserve

(5) 61,404
5A.15 A commonly encountered alternative bookkeeping procedure requires the separate

identification of the spot and forward positions in each currency, which are revalued separately.
In the example used above, a position account, reflecting the net of the spot and forward
positions, was maintained, and the profit or loss from swaps was transferred from the position
account to an unearned income account. When separate spot and forward position accounts are
used this transfer would not be made.
The trial balance at day 31, before any accruals, would be as follows:
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FF DM £ $
Assets
Nostros 1,000,000 500,000 1,000,000
Position account: FF 2,000,000 (250,000)
DM (500,000) 250,000
£ (1,250,000) 2,000,000
3,000,000 - - 3,000,000
Liabilities
3,000,000 - - 3,000,000
Contingencies
Forward position account:
DM 2,100,000 (1,000,000)
£ 1,242,236 (2,000,000)
Unmatured forward purchases 3,000,000
Unmatured forward sales (2,100,000) (1,242,236)
- - - -
I. Accrual of interest and swap profits/losses. All interest and swap profits/losses are
accrued on a straight line basis (equivalent to a level yield basis). Accrual entries on day 31
are:
US $ ledger Dr. Cr.
(1) Interest expense $18,667
Accrued interest payable $18,667
To record interest at 12% on $2,000,000 for 28 days (360 day year).
Sterling ledger
(2) Accrued interest receivable £9,589

To record interest at 10% on £1,250,000 for 28 days (365 day year).

To accrue 28/91 of total swap profit.
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II. Revaluation at spot rates of exchange. In this alternative procedure the spot position is
revalued, after reversing the effect of the spot deals of swap transactions:
FF DM £
Spot position Dr./(Cr.) 2,000,000 (500,000) (1,250,000)

Reverse spot side of swap - - 1,250,000
2,000,000 (500,000) -
US $ equivalent $243,902 $(277,778) -
US $ spot position $250,000 $(250,000) $2,000,000

Reverse spot side of swap - - $(2,000,000)
$250,000 $(250,000) -
Profit/(loss) $6,098 $27,778 -
Accounting entries to record the foreign exchange profit or loss on revaluation are passed in
the home currency only:
US $ ledger Dr. Cr.
Spot position account - FF $6,098

Spot position account - DM $27,778
III. Calculation of cost of forward cover

Outstanding forward deals, excluding forward deals associated with swap transactions, are
revalued at forward rates:
Sale (DM2,100,000 @ 1.9) $(1,105,263)
Purchase 1,000,000
Loss $(105,263)
Accounting entries to be passed are:

US $ ledger Dr. Cr.

Forward valuation reserve $105,263
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IV. Summary
The total income/expense resulting from the accrual and revaluation process is as follows:
Interest income (£9,589 @ 1.5) $14,383
Interest expense (18,667)
Swap profit (£2,389 @ 1.5) 3,584
(700)
French franc profit $6,098

Deutsche mark loss - spot $27,778
- forward (105,263) (77,485) (71,387)
Net loss $(72,087)
It may be noted that the above result is the same as that arrived at by the previous
revaluation procedure, as the two are mathematically equivalent.
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V)
FF @ 8.2 DM @1.8 £ @ 1.5 $ Total
kpmg
TO PURCHASE
Nostros 1,000,000 121,951 500,000 277,778 1,000,000 1,399,729
Deposits placed 1,250,000 1,875,000 1,875,000

-DM (500,000) (277,778) 277,778 --
-£ (1,250,000) (1,875,000) 2,000,000 125,000
Accrued swap profits 2,389 3,584 3,584
3,000,000 365,853 0 0 11,978 17,967 3,033,876 3,417,696

TO SELL
Share capital 1,000,000 1,000,000
Profit and loss account 11,978 17,967 (90,054) (72,087)
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Trial balance consolidation after revaluation
3,000,000 365,853 0 0 11,978 17,967 3,033,876 3,417,696
Forward position account -DM 2,100,000 (1,000,000)

-£ 1,242,236 (2,000,000)
Unmatured forward sales (2,100,000) (1,242,236)

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convert profits or losses arising in foreign currencies into the home currency on a monthly basis.
5A.16 Conversion of profit and loss to home currency. Most banks and financial institutions
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This monthly conversion has the effect of fixing the value in home currency terms of the
month's profits or losses. This would be effected for the example presented in section 5A.14 by
the following entries:
Example
US $ ledger Dr. Cr.
Swap position account £ $17,967

Interest income $14,383
Swap profits $3,584
Sterling ledger
Interest income £ 9,589

Swap profits £ 2,389
Swap position account £11,978
From the dealer's point of view the above entries represent an (internal) exchange deal whereby
the foreign currency (sterling) has been purchased and the home currency (dollars) has been
sold at the current spot exchange rate. This recognises a foreign exchange position, and the
dealer may then sell the foreign currency for the home currency and close (cover) the position.
5A.17 Future income and expense - internal deal systems . The procedures described in
sections 5A.13-.15 for accounting for swaps and revaluations did not address two particular
problems:
■ The need, identified by some banks and financial institutions, to account for swap positions
not associated with specific spot and forward foreign exchange deals;
■ The need to include forward income and expense associated with swap transactions in the
forward positions.
Many banks and financial institutions solve both of these problems through using internal deals
(i.e., deals between their "money market department/book" and the "foreign exchange
department/book"). Internal deals are used to transfer all foreign exchange risk to the foreign
exchange department.
5A.18 If the money market dealers want to lend currency A and to finance the loan by
borrowing currency B, they purchase currency A spot against currency B from the foreign
exchange dealers, selling currency A forward for currency B. Similarly the money market
dealers sell forward the net income arising in currency A (interest and premium/discount) to the
foreign exchange dealers for currency B. The net profit or loss may remain in either currency.
5A.19 Future income and expense - internal deal system. Each internal deal is then
recorded twice, in the money market book and in the foreign exchange book:
■ In the foreign exchange book, both spot and forward deals are treated as outrights, are
entered into the positions, and are revalued as outrights. If the foreign exchange dealers
exactly cover with external deals the positions created by the internal deals, clearly no profit
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or loss arises to them. The foreign exchange dealers have no swap transactions, so no swap
adjustment is required in revaluation of the foreign exchange book;
■ In the money market book neither the spot nor the forward foreign exchange deals are
revalued because they represent hedges of existing assets, liabilities, and commitments.
Thus there is no revaluation, only a swap amortisation. Since the money market dealers
have also agreed to sell income arising in currency A forward, at a fixed rate, the income (or
expense) must be accrued at the exchange rate for which it has been sold (or bought). This
may be done by a "counter-accrual" in the currency in which the income (or expense) arises.
5A.20 The exchange rate at which an internal deal is done is normally that quoted by the
foreign exchange dealer. If the deal is not at a market rate, a profit or loss will be recognised
immediately, when the foreign exchange book is revalued, while the corresponding loss or
profit on the money market book will be recognised over the period of the swap or forward
contact. Where the money market dealers are distinct from the foreign exchange dealers, and are
assessed on their performance, both sets of dealers will normally wish to deal at the rates most
favourable to themselves, a circumstance that would tend to prevent any large deviations from
market rates. However even in these circumstances, there is the possibility of management
override leading to a distortion of results.
5A.21 The following demonstrates the use of internal deals using the example included in
section 5A.10:
I. Money market dealers
External deals:
1. Accept deposit: $2,000,000 @ 12% per annum; value day 3; maturity day 94
2. Place deposit: £1,250,000 @ 10% per annum; value day 3; maturity day 94
Internal deals:
3. Sell spot: $2,000,000 for £1,250,000; value day 3
4. Buy forward: $2,000,000 for £1,242,236; value day 94
5. Buy forward: $60,667 for £37,681; value day 94
Total profit for money market dealers is in £1,247 as analysed in the following example:
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Example
Cash movements
US Dollars Sterling
1 April
Borrow US$2,000,000 for three months at 12% per 2,000,000
annum
Sell US$2,000,000 spot, for sterling, at 1.60 (2,000,000) 1,250,000
*Buy US$2,000,000 three months forward, against
sterling at 1.61 (forward cover of principal)
*Buy US$60,667 three months forward, against sterling
at 1.61 (forward cover of interest)
Place £1,250,000 for three months at 10% per annum (1,250,000)
* Internal deals - -
1 July
Receive repayment of sterling placement 1,250,000
Receive interest
(£1,250,000 x 10% x 91/365) 31,164
*Settle forward cover of principal 2,000,000 (1,242,236)
*Settle forward cost of interest 60,667 (37,681)
Repay dollar deposit (2,000,000)
Pay dollar interest
($2,000,000 x 12% x 91/360) (60,667)
Cash surplus - 1,247
* Internal deals
The cash surplus represents the profit on the deal, which arises as follows:
Interest received £31,164
Interest paid ($60,667 at 1.61 (forward rate when sold) (37,681)

(6,517)
Discount on forward purchase of $ principal

7,764
(£1,250,000 less £1,242,236)
£ 1,247
Note: The profit in sterling terms is determined at the outset, because the interest has been
covered by a forward deal. The actual spot $/£ exchange rate on 1 July is not relevant. Interest
in sterling is calculated on a 365-day-year basis, while interest in US dollars, and most other
currencies, is calculated on a 360-day-year basis.
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II. Foreign exchange dealers

Internal deals:
6. Buy spot: $2,000,000 for £1,250,000; value day 3;
7. Sell forward: $2,000,000 for £1,242,236; value day 94
8. Sell forward: $60,667 for £37,681; value day 94
External deals:
9. Sell spot: $2,000,000 for £1,250,000; value day 3
10. Buy forward: $2,000,000 for £1,242,236; value day 94
III. Additional accounting entries:
Day 1
US $ ledger Dr. Cr.
(1) Money market suspense $2,000,000
Swap position account - £ $2,000,000
To record spot purchase commitment
(2) Swap position account - £ $2,000,000

Swap position account - £ $60,667
Money market suspense $2,000,000
Money market suspense $60,667
To record forward sale commitments
Sterling ledger
(3) Swap position account - £ £1,250,000
Money market suspense £1,250,000
To record spot sale commitment
(4) Money market suspense £1,242,236

Money market suspense £37,681
Swap position account - £ £1,242,236
Swap position account - £ £37,681
To record forward purchase commitments
(5) Unearned swap profits £ 7,764

Swap position account - £ £7,764
To reverse transfer of unearned profit
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IV. Trial balance at day 31, (after the above deals but before any accruals)
FF DM £ $
Assets and Commitments to purchase

Nostros 1,000,000 500,000 1,000,000
Money market suspense 29,917 (60,667)
Position account FF 2,000,000 (250,000)

DM 1,600,000 (750,000)
£ (37,681) 60,667

________ ________ ________ ________
3,000,000 2,100,000 1,242,236 3,000,000
Liabilities and Commitments to sell

Unearned swap profits

Unmatured forward sales 2,100,000 1,242,236
3,000,000 2,100,000 1,242,236 3,000,000
V. The preceding trial balance results from the entries shown in iii) above as analysed in the
following T-account analysis. The entries are in addition to those presented in paragraph
5A.12. (O) = opening balance (closing balance from paragraph 5A.12)):
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Sterling Ledger
Money market suspense

(4) 1,242,236 (3) 1,250,000
(4) 37,681
29,917
£ swap position account Unearned swap profits

(3) 1,250,000 (4) 1,242,236 (5) 7,764 (0) 7,764
(4) 37,681
(5) 7,764 -0-
37,681
US $ Ledger
Money market suspense £ swap position account

(1) 2,000,000 (2) 2,000,000 (2) 2,000,000 (1) 2,000,000
(2) 60,667 (2) 60,667
60,667 60,667
Note: The effect of these entries is to reclassify unearned swap profits as money market
suspense and to include the internal deal number 5 in sub- paragraph (i) (as transacted by money
market) and number 8 in sub-paragraph (ii) (as transacted by foreign exchange) in the £
position.
5A.22 The accrual and revaluation at Day 31 relating to internal deals would be as follows:
I. Accrual (Money Market Book)
In paragraph 5A.14, the swap profit and loss, which is the difference in the principal value
of the forward and spot deals, was accrued on a straight line basis. In the internal deal
system, the money market book must generate the amounts due to and from the foreign
exchange book at maturity. The accruals for the internal deals are therefore as follows:
US $ ledger Dr. Cr.
(6) Foreign exchange suspense $18,667

To accrue 28/91 of total due to money market ($60,667).
Sterling ledger
(7) Interest expense £9,205
Foreign exchange suspense £ 9,205
To accrue 28/91 of total due from money market (£29,917).
Interest on the external placement and deposit are accrued as normal.
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II. Revaluation at spot rate of exchange (Foreign exchange book)

£ swap position account £(37,681)
US$ equivalent at current spot rate (@ $1.5 = £) $(56,521)

$ swap position account - £ 60,667
(Profit)/Loss $4,146
US $ ledger Dr. Cr.
(8) Foreign exchange profit/loss $4,146

Swap position account - £ $4,146
III. Calculation of cost of forward cover of £ (Foreign exchange book)

All external and internal forward deals by foreign exchange dealer must be revalued.
Assume the 2 month forward rate for £ against $ at Day 31 is $1.52 = £1. The calculation
of forward cover is as follows:
Loss on the swap, no hedge of $ interest expense (as analysed in paragraph 5A.14):
£ $
Interest income (£31,164 x 28/91) 9,589
Swap profit (£7,764 x 28/91) 2,389
11,978 @1.5 = 17,967
Interest expense ($60,667 x 28/91) (18,667)
Loss on swap $(700) (A)
Profit on the swap using an internal deal to hedge $

interest expense:
Interest income (£31,164 x 28/91) 9,589
Interest expense (£29,917 x 28/91) (9,205)
384 @1.5 = 575
Loss on £ position (commitment to purchase £ for $):
£37,681 x (1.52 - 1.61)* (3,392)
Loss on swap $(2,817) (B)
Increase in loss (A) minus (B) $2,117
* 1.52 = forward $ rate for £ at revaluation to value date.

1.61 = forward $ rate for £ in the contract.
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$ equivalent $ equivalent
Purchase/ @ 1.52 @ 1.5
Deal (sale) (forward rate) (spot rate) Difference
7* (internal) £1,242,236 $1,888,199 $1,863,354 $24,845

8* (internal) £37,681 $57,275 $56,521 754
10* (external) £(1,242,236) $(1,888,199) $(1,863,354) (24,845)
$754
* Deal number refers to paragraph 5A.21 ii) deals
The accounting entry is:

US $ ledger Dr. Cr.
(9) Forward valuation reserve $754

Foreign exchange profit/loss $754
IV. Summary
Interest income (£9,589 @1.5) $14,383
Interest expense - internal (£9,205 @1.5) (13,808)
- external $(18,667)
- internal counter accrual 18,667 0
Net interest income $575
Foreign exchange loss:

French franc profit 6,098
Deutsche mark loss - spot $(138,889)
- forward 61,404 (77,485)
£ profit or loss - spot (4,146)

- forward 754
Net loss $(74,204)
It may be seen from the above that the internal deal system ensures that the result of the swap is
positive, reflecting the expectation at the outset. In paragraph 5A.13(iv), there was a deficit on
net interest income due to adverse movements in exchange rates. Here that effect is included in
the foreign exchange loss. Had the foreign exchange dealers been able to cover the forward
interest (sold to the money market dealers (deal number 8) to provide them the dollars to pay
interest on the deposit accepted) with an external deal, the foreign exchange loss would have
been the same as in paragraph 5A.14.
Instead, through these internal deals, the foreign exchange dealers have created a hedge of the
money market dealers' exposure to exchange rate fluctuations affecting their swap profits. This
exposure, in the case of the swap analysed in paragraph 5A.14, is interest expense, denominated
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in £. Internal deal 5 effectively denominates interest expense in £. At the same time, the
foreign exchange dealers have created a £ position for themselves, representing the forward
commitment to purchase £ for $ from the money market dealers (deal number 8). The total loss
shown here of $74,204 exceeds the loss of $72,087 calculated in paragraph 5A.14, by $2,117
because of this internal hedge of the $ interest expense and its resulting effect on the £ position.
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FF @ 8.2 DM @1.8 £ @ 1.5 $ Total
TO PURCHASE
Nostros 1,000,000 121,951 500,000 277,778 1,000,000 1,399,729
Deposits placed 1,250,000 1,875,000 1,875,000
Money market suspense 29,617 44,875 (60,667) (15,792)
Foreign exchange suspense (9,205) (13,808) 18,667 4,859

-DM 1,600,000 888,889 (888,889) --
-£ (37,681) (56,521) 56,521 --
Unmatured forward purchases 3,000,000 3,000,000
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3,000,000 365,853 2,100,000 1,166,667 1,242,320 1,863,929 2,943,888 6,340,337
V. Trial balance consolidation after revaluation

TO SELL
Share capital 1,000,000 1,000,000
Profit and loss account 384 575 (74,779) (74,204)
Unmatured forward sales 2,100,000 1,166,667 1,242,236 1,863,354 3,030,021

3,000,000 365,853 2,100,000 1,166,667 1,242,620 1,863,929 2,943,888 6,340,337
Note: For balance sheet purposes, the value of unmatured forward purchases and sales (at spot rates) would be netted and combined
with the forward revaluation rese
rve and the unearned swap profits, resulting in a net debit balance of $23,321.
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VI. The changes from the trial balance exhibited in paragraph 5A.14(v), representing the
accruals to and revaluation at Day 31 are presented in the following T-account analysis.
These entries replace those exhibited in section 5A.14. (0) = opening balance (closing
balances from paragraph 5A.12), adjusted for entries in 5A.21; entry numbers (1), (2), (4)
and (5) refer to the entries in section 5A.14; entry (3) is not used - and entry numbers (6),
(7), (8) and (9) refer to entries presented previously in this paragraph.
Sterling ledger
Accrued interest receivable Profit and loss account
(2) 9,589 (7) 9,205 (2) 9,589
9,589 384
Foreign exchange suspense

(7) 9,205
9,205
US $ Ledger
Position accounts
FF DM
(4) 6,098 (0) 250,000 (0) 750,000
(4) 138,889
243,902 888,889
Swap position account £

(0) 60,667 (8) 4,146
56,521
Forward valuation reserve Accrued interest payable
(5) 61,404 (1) 18,667

(9) 754
62,158
Foreign exchange suspense Profit and loss account

(6) 18,667 (1) 18,667 (4) 6,098
(4) 138,889 (5) 61,404
(8) 4,146 (6) 18,667
(9) 754
90,054
VII. Day 94
Assuming no further accruals or revaluations are made prior to Day 94, the accounting
entries passed on that day would be as follows:
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US $ ledger Dr. Cr.
Money market suspense $60,667

Foreign exchange suspense $18,667
Sterling ledger

Foreign exchange suspense £9,205
Money market suspense £29,917
The suspense balances relating to internal deals created on day 1 and on accrual are thus
eliminated. It should be noted that different internal deal accounting systems may give rise
to additional suspense balances, all of which should be eliminated on the maturity of the
internal deal.
5 A . 2 3 Identification of swaps. If a pair of foreign exchange deals are identified and
accounted for as swaps, then under the accounting treatment described in section 5A.13, the
premium or discount is amortised or accrued evenly over the period from value date of the spot
contract to value date of the forward contract. If the pair of deals is not identified as a swap, the
spot contract, and subsequently its effect on the spot asset and liabilities, will be periodically
revalued at the spot rates at the time of revaluation, while the forward contract will be revalued
at the forward rate of exchange applicable to its value date. If the forward premium or discount
to that value date remains at the same rate per annum as applied to the forward contract at the
time it was made, the amount of profit recognised in each period will be the same as under the
swap accounting method (although the profit/loss will be classified as exchange profit or loss,
not as a swap premium or discount). However, if the rate of forward premium or discount
changes significantly, then the amount of profit recognised in each reporting period will also be
significantly altered. Thus the correct identification of swap transactions can have a significant
effect on the reported profits.
5A.24 In some banks and financial institutions, a pair of spot and forward foreign exchange
transactions can only be treated as a swap if:
■ the amounts bought and sold in one of the two currencies are equal;
■ there is a specific loan in the currency bought spot, or a specific deposit taken in the
currency sold spot, for value on the value date of the spot deal and for maturity on the value
date of the forward deal.
5A.25 In many respects such a rule is too restrictive. Any spot against forward pair of deals
requires using funds borrowed in the currency sold spot to lend in the currency bought spot and
the forward premium/discount compensates for the differential in the market interest rates in the
two currencies. Dealers may also include interest in the forward deal. And, although the
dealers may intend to cover their positions exactly, market opportunities may result in their
mismatching value dates by a few days or by combining the swap of more than one deposit, etc.
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Accordingly many banks and financial institutions permit the dealers to identify (at the outset)
any transactions that they consider to be swaps. Internal deal systems that allow swap
accounting for currency mismatches of loans and deposits simplify such identification even
where there are no external foreign exchange deals directly related to them.
5A.26 The requirement to identify swaps at the time of dealing should prevent the dealers from
manipulating profit recognition. However, a test to determine whether there might be
unidentified swaps is to calculate, for each currency, the spot position excluding the matured
spot side of swaps (the "adjusted spot position"). A large adjusted spot position in a currency
may, in part at least, reflect unmatched deals that do not form part of swaps: deals made, for
instance, to anticipate favourable exchange rate movements in that currency. Insofar as it does
reflect unidentified swaps, there should be a corresponding large "adjusted forward position."
The net open position should then be close to zero.
5A.27 Although an adjusted spot position may not be close to zero for acceptable reasons, such
a position may result in incurring an interest cost in one currency while earning the
corresponding interest income at a different rate in another currency. To correct this currency
mismatch for the purposes of performance measurement, the net interest cost or benefit from
such a position should be included in the foreign exchange trading result. Adjustment would
also be required if the bank or financial institution wished to determine net interest income by
currency.
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Introduction and types of securities and transactions

6.1 Introduction. Funds management allows alternatives in the choice of the assets a bank or
financial institution will hold and acquire having as its objective some optimum balance
between credit quality, liquidity, and income. The investment portfolio represents, typically,
assets with high credit quality and good liquidity, providing a stable income stream. The
dealing or trading portfolio represents assets managed to promote income maximisation through
a combination of interest income and trading profits. Securities held by banks and financial
institutions are usually classified as either investment securities or trading account securities
(often called dealing securities), according to management's respective intentions and
objectives.
6.2 While the term "securities" covers a broad field of instruments of value, it is more generally
used to refer to marketable debt and equity instruments including some which are a mixture of
both. There is a basic distinction between debt securities and equity securities. Debt securities
have a stated value which is to be paid back by the debtor at the maturity date and bear interest
at a fixed or floating rate (e.g; floating rate notes, eurobonds, treasury bonds, floating, zero
coupon bonds and fixed rate certificates of deposit); equity securities encompass any instrument
representing ownership shares (e.g., common, preferred, and other capital stock), or the right to
acquire or dispose of ownership shares (e.g., warrants, rights, and call options) in an enterprise
at fixed or determinable prices.
6.3 Debt securities include the following:
■ Obligations of governments:
- Primary obligations;
- Obligations of political subdivisions;
- Obligations of government agencies;
■ Public utility bonds;
■ Corporate bonds.
6.4 The price or market value of fixed rate debt securities, credit considerations aside, typically
respond in direct opposition to changes in the surrounding interest rate market. Increases in
interest rates normally depress the prices of debt securities, while decreases in rates typically
result in higher market values.
6.5 Equity securities include the following:
■ Securities representing direct ownership:
- Capital stock - common and preferred;
- Preferred stock or bonds convertible into capital stock;
■ Securities representing the right to acquire ownership:
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- Warrants;
- Rights;
- Call options;
■ Securities representing the right to dispose of ownership:
■ Put options.
6.6 The price or market value of an equity security usually responds to the historic and
projected earnings capability of the respective company, as well as to a variety of indirect
factors that can be expected to have an effect on its earnings capability, including changes in
interest rates, technology, industry segment competition, and the regulatory and political
environment.
6.7 Investment securities. Investment securities are securities purchased in the normal course
of business, where bank or financial institution management's intention is to hold the securities
to maturity or, in the case of equity investments, indefinitely, unless market conditions render
alternative investments more attractive. Investment securities, at the time they are bought, are
intended to be held for their investment value over an extended period of time rather than with a
view to short term profit through trading. Most banks and financial institutions concentrate the
major portion of their portfolio in debt securities because of their fixed income stream and
generally less speculative nature. Regulatory authorities may restrict investment to certain types
of securities or classes, or may establish investment guidelines, including minimum and
maximum limits, with respect to a bank or financial institution’s investment policies. The
objectives of such controls are typically to limit investment risks.
6.8 Trading securities. Dealing or trading account securities are those purchased for resale at
a profit, which usually entails that they are held only a short period of time. The bank or
financial institution acts as a dealer and attempts to make a profit by selling the securities at a
price higher than that it paid. Tradings comprise both new issues (primary market) and existing
securities (secondary market). Although banks and financial institutions principally deal in
interest-bearing instruments, trading activities may also include equity shares and other non-
interest bearing securities. As in the case of investment securities, regulatory authorities may
impose restrictions or guidelines on the types, classes or amounts of securities traded.
6.9 Some of the varied characteristics of securities are set out in the table on the following
page:
6-2
Domicile of issuer
and subscription market Issuer Earning conditions Entitlement
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• Domestic bonds • Government obligations • "Straight" issues, which include bonds • "Bearer bonds" are payable to
or debentures with a fixed rate of the bearer. They do not have the
Bond issue placed for public • Quasi-government obligations interest. name of the owner written on them
subscription by a borrower who is (issued by government agencies nor is the owner registered.
domiciled in the country where the issue and federal corporations) • "Floating rate notes", where the Interest is received by marking
is floated interest rate is adjusted the attached coupons as they
• Municipal obligations (issued by periodically, in accordance with mature and presenting them for
• Foreign bonds states, cities and other current market rates. payment.
political subdivisions and
Bond issue placed by a public or private authorities) • "Convertible" bonds with a low fixed • "Registered bonds" have the name
entity outside its country of domicile. interest rate and rights for of the owner on their face and are
The issues are usually denominated in • Development banks and other conversion into shares (common stock) negotiated by endorsement on the
the currency of the country where the supra-national institutions of the issuing company. certificate and transfer on the
issue is offered for subscription records of the transfer agent.
• Corporate entities • "Deep discount" bonds or "Zero coupon" They may be registered according
• Eurobonds bonds which do not carry an interest to principal only or according to
rate but are instead issued at a both principal and interest. When
Bond issue placed outside the country of discount whereby the purchaser pays only the principal is registered,
the issuer's domicile but denominated in less to acquire the bonds than it will coupons are attached. Each coupon
a currency other than that of the receive on redeeming them at maturity. represents a claim for the
country(ies) in which the issue is interest due on the bond for the
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offered for subscription. The interest period noted on the
Euromarket is not limited to coupon and is negotiable by
European countries but is a worldwide delivery. When both principal and
capital market (first placement of new interest are registered interest
bonds by the underwriter and selling payments are made by cheque or
group) and a secondary market (where transfer-order.
bonds already existing are traded).
Eurobonds are denominated in
Eurocurrencies such as Eurodollars,
Euro-D-mark, Eurofranc etc or in
"basket" Eurocurrencies such as European
Units of Account (EUA) or European
Currency Units (ECU)
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6.10 Borrowing and lending of securities. In addition to the normal purchase and sale type
transactions, banks and financial institutions engage in the lending and borrowing of securities
as well as in repurchase/reverse repurchase agreements, which are covered in the discussion of
Money market and foreign exchange activities, paragraph 5.10 and in paragraph 6.13 below.
6.11 A bank or financial institution may borrow securities when it is obligated to deliver
securities which it does not yet own, either because of a pre-existing commitment to purchase
the securities at a later date or because of a failure of a seller to deliver the securities. The
borrowed securities serve to fulfil the bank or financial institution’s obligation until those
bought are actually received by the bank or financial institution. The lender of the securities
usually obtains as collateral other securities with an equivalent market value. A fee, which
usually ranges from 1/4 percent to 1/2 percent per annum of the principal amount of the
securities loaned, is charged by the lender. Since the securities are borrowed or lent usually on
a fully collateralised basis, no effect is given to the transaction in the balance sheets of either
the borrower or lender, though memorandum accounts are used to reflect the transactions.
6.12 Other transactions and securities. Other securities transactions include forward bond
dealing, writing covered call options, and trading in market index securities:
■ In forward bond dealing a bank or financial institution enters into a commitment to buy or
sell a security at a stated price at a future point in time;
■ Call option writing is an arrangement whereby the bank or financial institution agrees to
deliver a specific security at a stated price for a period of time. When such options are
granted on securities held in portfolio (covered call options), the bank or financial
institution is "covered" and protected from the potential market risk of having to acquire the
security. Such transactions partially insulate the grantor of the option from downside
market risk in exchange for potential increases in market value of the underlying security.
Many aspects of such transactions require careful consideration, including management's
intentions and the effectiveness of the contract as a hedge against market risk for securities
held in portfolio or those for which the bank or financial institution has an obligation to
deliver;
■ The price of market index securities is determined by the market value of a specific pool, or
basket, of debt or equity securities. Dealing in such securities is typically of a speculative
nature.
6.13 Repurchase and reverse repurchase agreements. A repurchase agreement ("repo") is
an acquisition of funds through the sale of securities by the borrowing bank or financial
institution together with a simultaneous agreement to return the funds by repurchasing the same
securities (i.e., a straight repo) or similar securities at a specified later date at the same price
plus interest at a predetermined rate.
6.14 When a buyer "purchases" securities under an agreement to resell ("reverse repo"), the
seller commits to repurchase the same or similar securities at an agreed upon price at a mutually
agreed upon future date. The difference between the price the buyer pays for the securities and
the price at which the securities are "re-sold" to the seller represents the income to the buyer on
his/her loan to the seller.
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6.15 Since the sale of securities under a repo is, in substance, a loan to the selling bank or
financial institution collateralised by the securities that are repurchased, it is not unusual for a
bank or financial institution to use this tool for short term financing of earning assets,
depending on prevailing interest rates. Retail repos may also be offered as investments for bank
or financial institution customers. Likewise, banks or financial institutions may enter into
reverse repos as a lending accommodation to their corporate customers.
Organisation, operations, limits and records

6.16 Organisation and operations. As with other areas of a bank or financial institution,
senior management is responsible for determining the investment policy of the bank or financial
institution and its portfolio. Correlating with the size of a bank or financial institution,
responsibility is often delegated to lower management levels. While decisions regarding the
investment portfolio are usually the responsibility of management, decisions concerning trading
securities are usually made by traders within the individual and collective responsibilities and
limits delegated to them. Established policies of most banks and financial institutions stipulate
that various departments are to be involved in securities transactions, as described below.
6.17 Trading department. Once the investment decision has been made or a customer's order
has been received, the security traders try to buy or sell the securities requested. Most securities
dealing is between banks and securities houses with deals made over telephone or telex. Since
there is usually no security for completion of the deal other than the movement of the bonds and
the counterparty's creditworthiness, most banks and financial institutions establish a credit line
for each of the counterparties with whom the bank or financial institution trades regularly to
control the risk that a deal will be made with a counterparty unable to deliver securities
purchased or cash for securities sold. The internal control system should prevent dealings in
excess of these limits and ensure that the limits are regularly reviewed taking into account the
counterparties' credit standing.
6.18 Assuming the transaction does not exceed established limits, the trader will place an order
with a brokerage house or another bank with a trading account. Whenever a trade is made,
some form of transaction ticket (generally called a trading ticket) is prepared, showing all
particulars of the transaction. This ticket usually requires approval by a second party, such as
the chief trader. At the same time, the traders update their trading blotters which indicate their
current security positions.
6.19 Settlement department. Since there is normally little external evidence of an effected
deal, exchange of written confirmations between the parties forms a vital part of the internal
control system. This control must be kept completely separate from the dealers and is
performed in the settlement department. Here, based upon the information contained on the
trading ticket and information obtained over the telephone from the counterparty (principally,
details of funds transfer), a confirmation of the transaction is prepared and sent to the other
party.
6.20 Trade confirmation replies are compared to a file copy of the confirmation request or
some other record of the transaction. As mentioned above, it is important that confirmations be
compared to the bank or financial institution’s records by individuals not involved in the trading
operations to maintain adequate internal control.
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6.21 A transmittal letter, with instructions for delivery or receipt of the securities and method
of receipt or payment of funds is also prepared and sent to the counterparty. Copies of the
transmittal letters (or a form with equivalent information) are sent to the departments within the
bank or financial institution responsible for the physical movement (or transfer of title) of
securities and the receipt or disbursement of funds. This letter or form is usually approved by at
least two individuals not involved in the security movement or custodial functions.
6.22 Accounting department. The accounting department in conjunction with the EDP
department is responsible for maintaining the bank or financial institution’s accounting records
against which the settlement department's records can be checked. The accounting department
provides on-going control by performing periodic reconciliations between the accounting
records, the vault or custodian's records, and the records of the trading department.
6.23 Periodically, the settlements department will forward to the accounting department a list
of the bank or financial institution’s securities positions. The accounting department will obtain
current market prices for the individual bonds making up the positions. The prices can either be
obtained directly from the market or more commonly from the dealers. Whichever source is
used, the prices should be authorised by a senior official prior to the revaluation.
6.24 Physical safeguards. A special group within the bank or financial institution maintains
custody over securities. The group is normally split into two subgroups, one handling the
physical movement of securities and the other responsible for custody in the vault. In smaller
banks or financial institutions the two functions may be merged.
6.25 Many banks and financial institutions maintain all or a portion of their portfolio with an
outside custodian. The outside custodian is usually another bank or financial institution or
independent clearing and custody facility. These custodians will receive or deliver the
securities upon proper authorisation from the owner. With certain types of securities there may
be no physical certificate, thus eliminating the problems of movement and custody. Instead, the
issuer maintains records of ownership.
In addition, international clearing systems have been formed for the collective custody and
book entry transfer of securities, such as "Euro-Clear" and "CEDEL." Banks and dealers
participating in the clearing systems hold their securities and currencies under the same account
number. When two participants have agreed upon a trade and settlement date, the completion of
this transaction is brought about by a security transfer from the seller's to the buyer's account.
These operations are fully computerised, with securities and cash entries processed
simultaneously. The instructions are received from the participants, checked for correctness,
matched with counterparty instructions, and processed. The securities and cash positions are
immediately available for chaining of transactions.
Securities held within the clearing houses are lodged for safe-keeping with depository banks.
All securities of one specific issue may be deposited with one bank, usually a paying agent for
this issue, thus minimising the need for physical movement of securities. A permanent record
is kept of all certificate numbers held on behalf of participants for safe-keeping in the clearing
houses. The certificate numbers of all lost or stolen bonds are also recorded in the system.
Consequently, securities recognised to be of bad delivery are automatically rejected upon
receipt into the system.
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Facilities also exist within the clearing systems for lending/borrowing securities.
6.26 A summary of the basic responsibilities of the various functional activities is:
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Treasury Operations/Accounting
Responsibilities Managers Traders Settlements Accounting/EDP Paying and receiving Movement and custody
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General Supervise trading Conduct trading Establish the boundary Process trades Affect cash settlement Affect securities
operations operations for trades transacted transacted on trades settlement on trades
Specific • Formulate investment • Commit the bank's • Confirm trade with • Maintain accounting • Execute appropriate • Execute appropriate
strategy resources to trading counterparties records payment instructions delivery instructions
• Monitor profit transactions • Arrangement • Revalue investment through: • Maintain
performance • Execute investment settlement portfolio on basis of (i) customer's account vault/custodian
• Promote new business strategy • Verify accounting current market values with the bank ledgers
• Monitor compliance • Manage the bank's input • Generate management (ii) correspondent
with the bank's investment portfolio information reports banks
investment policies to maximise profits
and controls, while complying with
including adherence policies to control
to trader and risk, including
customer exposure adhering to trader,
limits counterparty, and
issuer limits
Transaction related: None • Authorise (within) • Receive trade ticket • Process trade tickets • Receive • Receive delivery
limits) and commit to from traders to update general paying receiving instructions from
transaction • Review trade ticket ledger and subsidiary instructions from Settlements
• Prepare trade ticket data for ledgers settlements Department
to include: completeness, • Reconcile securities department • Take/make delivery of
i) deal date accuracy and positions per book to • Match incoming securities traded,
ii) transaction type adherence to limits the traders' and to receipts to receive verifying type,
iii) counterparty • Despatch counterparty that reported by the instructions quantity,
6-8
iv) issue confirmation and vault or by custodians • Make payment on pay denomination etc
v) settlement date match incoming instructions
vi) purchased confirmations
interest/discount • Process settlement
or premium instructions
vii) settlement
instructions
viii) broker name, if used
ix) brokerage fee
• Enter trade to blotter (individual
position records)
Accounting Controls: Authorisation Authorisation Completeness, Completeness, Completeness, Completeness,

Existence & Accuracy Existence & Accuracy Existence & Accuracy Existence & Accuracy
Segregation of Duties Authorise and Commit Enter exchange data to Receive consideration Receive consideration
accounting system for the exchange for the exchange
Note:
In small banking operations, the above noted fun ctional activities may not be carried out in sep arate departments but may be combined in one ormore departments or may even be
carried out by the same individual. In any event, the segregation between treasury and operatio ns/accounting activities is essential.
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Risk considerations and controls

6.27 Though the investment and trading securities portfolios share the same elements of risk,
the degree to which these elements are significant to each portfolio varies greatly. The normal
risks can be summarised as follows:
■ Position risk: The risk that excess assets or liabilities in a particular type of security will
give rise to losses because of market movements. The bank or financial institution should
set limits, and monitor that they are adhered to, not only on the position in a particular type
of security, but also in terms of currencies, particular industries, countries etc. Where the
securities held are fixed term or have fixed redemption dates, there may also be limits set as
to how much investment is short term and how much is long term;
■ Liquidity risk: If the bank or financial institution has not matched the maturity dates of its
investments, it may be unable to cover its cash outflows. Proper management of the
portfolio is important to ensure adequate liquidity. For managed portfolios, although the
risk may be borne by the clients, the bank or financial institution should apply the same
controls over liquidity;
■ Credit risk: The risk that the counterparty to a trade might either fail to deliver stock
(delivery risk), or fail to pay for stock received must clearly be guarded against. Again the
control should be effected through limits on trading with particular counterparties. The
credit risk of the issuer also needs to be considered;
■ Operational and accounting risks: Risks arise from the speed at which transactions are
made, the complexity of accounting, and from the unmonitored environment in which
dealers operate. There should be strict segregation of duties between front office and back
office, checks to third party evidence (such as direct confirmation of deals and
reconciliation of nostro statements), and a reporting system for management which
confirms to them all exceptions to the rules and limits they have laid down;
■ Fraud: The risk of fraud arises from operational risks outlined above, coupled with the fact
that the values of individual securities traded may be high. Frauds may be committed
against the bank or financial institution itself, or may be committed against the client whose
portfolios are being managed. Specific examples of fraud include:
- Defalcation of funds or negotiable securities upon settlement;
- Dealers undertake trades which they do not record, and take profits directly to their own
account. In doing so the dealers can also book bad deals to the bank or financial
institution and good deals to themselves;
- With inadequate segregation of duties, dealers could be in a position to receive
commissions or fees directly;
- Deals may be transferred from the investment portfolio to the trading portfolio, or vice
versa, at wrong prices, to boost particular dealers' profits (and bonuses);
- Clients may be charged their commission by means of adjusting the price of a
transaction. While this may not be a fraud, it may cause accounting problems in the
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identification of commissions and fees, and should normally happen only with the
client's permission or instruction.
There are also a number of malpractices that could occur when dealing with portfolio
management clients:
■ Churning, which is the generation of spurious transactions to boost commissions and fees.
This is usually difficult to detect.
- Booking good deals to the bank or financial institution’s portfolio but poor deals to
those of clients. From an audit point of view this might be detected by comparing
average returns on the client's portfolios with those on the bank or financial institution’s;
- Clients may be charged wrong prices. Normally the bank or financial institution should
obtain the best possible prices and charge commission for each trade.
The paragraphs below analyse these financial risks in terms of the various types of instruments
traded.
6.28 Investment portfolio. The primary risks inherent in an investment securities portfolio
comprised of other than government-related obligations are related to the quality of the assets
held (credit risk), the marketability of these assets (liquidity risk) and the fluctuations of interest
rates (money-rate risk). These risk factors are interrelated. For example, increases in market
interest rates may affect other risk factors by decreasing marketability (i.e., liquidity) or by
increasing the credit risk of the issuer's obligations. A more complete description of these risk
factors is provided in chapter 2 of this volume.
6.29 Secondary risk rests in the form of settlement or delivery risks vis-a-vis the credit
worthiness of counterparties involved in transactions entered into subsequent to the original
issuance of the securities. However, the risk is of less significance assuming that delivery of
securities is usually made against payment.
6.30 Trading portfolio. The higher volume of transactions in the trading portfolio, usually
involving resales of securities rather than primary issuance, makes settlement or delivery risks
primary to the trading portfolio. The credit worthiness of transaction counterparties establishes
the degree of settlement risk. However, where positions are taken in securities, credit, liquidity,
and money-rate risks must also be regarded as primary risks.
6.31 Repos and reverse repos. Banks and financial institutions entering into both securities
sales and purchase transactions are exposed to risk of loss if the counterparty fails to meet its
obligations:
■ The buyer is at risk for up to the amount advanced to the seller if the collateral is not in the
possession of the buyer or under its control (e.g., in the hands of a third party custodian).
Even if the collateral is secure, if the market value of the collateral falls below the amount
due from the seller there may be a loss for the difference between the market value and the
amount loaned;
■ The seller may be exposed to loss if delivery of securities to the buyer is authorised prior to
receipt of the offsetting cash payment.
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6.32 Limits. In order to limit a bank or financial institution's exposure to risk, the following
limits and controls are normally established by management of the bank or financial institution.
The limits include:
■ overall limit for the investment securities account (often with sub-allocations as to term and
type);
■ overall limit for daily trading activities;
■ country geographic and industry segment risk limits;
■ individual limits for issuers of obligations;
■ individual trading limits for other banks and customers;
■ authorisation limits for individual transactions;
■ limits for individual traders.
6.33 Records and reports. The basic records for securities transactions which should be
maintained are the following:
■ deal slips originated by the dealer;
■ trading sheets to record actual deals made;
■ position sheets to maintain current control over the traders' position in each security;
■ bond trading account to record the positions held in the bonds traded;
■ investment account to record the securities not held for current trading;
■ register of investment securities held by custodians and their locations;
■ broker's advices;
■ bank's copy of confirmation it has dispatched;
■ counterparty confirmations or replies;
■ custodian reports and statements.
Additionally, the following reports are usually prepared by the accounting or EDP-department:
■ rransaction reports (daily);
■ interest income statement and accrued interest reports (monthly);
■ average yield reports (monthly);
■ custody fees and other expense reports (monthly);
■ periodic portfolio evaluations;
■ limit excess report (daily);
■ inventory of securities, including information like maturity dates, par values, market
values, interest rates, and due dates (monthly);
■ maturity distribution (monthly);
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■ unrealised gains and losses (book to market value differences) (monthly).
Accounting matters
6.34 General. The principles for accounting for securities differ from country to country,
often as a result of differing banking regulations and tax treatments. The following paragraphs
are restricted to the most prevalent methods of accounting for securities adopted by
international banks and financial institutions. The guidance in these paragraphs is general in
nature. Consideration should be given to any local practice and accounting regulations.
6.35 Some banks and financial institutions have traditionally recorded the purchase and sale of
securities and the effect of transactions and valuation adjustments as of the settlement date (the
date the security is physically delivered). Others have recorded such transactions as of the trade
date (the date the entity commits to the purchase or sale). Although trade date accounting is
preferred because it more accurately presents transactions and their effects on the accrual basis
of accounting, settlement date accounting is acceptable if the reported operating results and
financial position would not be materially different had trade date accounting been used. In
those cases w ere a bank accounts for securities transactions on a settlement date basis, a
review of purchases and sales on a trade date basis is necessary to determine whether
significant differences exist between the two methods. Note, however, that in some countries
local practice and the guidelines of regulatory authorities require the recording of transactions
on a trade date basis.
6.36 At the time of acquisition, bank or financial institution management should designate
whether the security purchases are for the investment or trading portfolio. Securities may in
exceptional circumstances be transferred between a trading and an investment portfolio if the
intention as to the purpose of the holding the securities changes. However, more than one
transfer in any one direction may indicate that trading securities are at some stage being
incorrectly defined as investment securities.
6.37 In some countries, investment transactions entered into in anticipation of taking gains on
short term price movements are considered to be trading rather than investment transactions.
The following practices in a bank or financial institution’s investment portfolio may indicate
that the underlying transactions were entered into for trading purposes:
■ Gains trading (or active portfolio management) is characterised by the purchase of a
security as an investment and the subsequent sale of that same security at a profit within a
short period. Those securities initially purchased with the intent to resell are sometimes
retained as investment portfolio assets if they cannot be sold at a profit. "Gains trading"
may result in a portfolio of securities with extended maturities, lower credit quality, high
market depreciation and limited liquidity. In some cases, gains trading has involved the
trading of "when issued" securities and "pair-offs" because the extended settlement period
associated with these practices allows speculators the opportunity for substantial price
changes to occur before payment for the securities is due;
■ When issued securities trading is the buying/selling of securities in the interim between the
announcement of an offering and the issuance/payment date of these securities. A
purchaser of a "when issued" security acquires all the risks and rewards of owning a
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security and may sell the "when issued" security at a profit prior to delivery/payment.
Frequent purchases and sales of securities during the "when issued" period generally are
indications of trading activity;
■ A pair off is a security purchase transaction which is closed out or sold at, or prior to, the
settlement date. Profits or losses on the transaction are settled by one party to the
transaction remitting to the counterparty the difference between the purchase and sale price.
Like "when issued" trading, "pair-offs" permit speculation on securities price movements
without paying for the securities;
■ Short sales. See paragraphs 6.60-6.62.
6.38 Investment securities - Balance sheet. If the debt obligations of others are held to
maturity, they will usually be redeemed at face value; therefore investment securities are stated
at amortised cost (i.e., purchase price less amortised premium or purchase price plus accreted
discount, see paragraphs 6.48-.51). This accounting treatment applies even in those instances
where the market value has temporarily declined below cost if there is reasonable assurance of
the debtor's ability to pay his obligations at the maturity date and the bank or financial
institution has the intention and ability to hold the security for the required time. Usually such
temporary declines result from fluctuations in interest rates.
6.39 If there is evidence that the security has suffered a permanent impairment in value,
however, the decline should be charged to income. Similarly, where the bank or financial
institution’s intent or ability to hold the security to maturity is lacking, the carrying value of the
investment security should be adjusted to the lower of amortised cost or market value. Write-
downs of investment securities to reflect permanent impairment are normally included in
securities gains or losses.
6.40 In some countries, accretion of discount is not reflected in the books because it is
considered "unrealised." In these countries the total amount of discount is recognised when the
investment falls due, and the face value is paid. Where trade date accounting is used, forward
securities purchased and sold should be recorded as assets and liabilities respectively in the
forward ledger at trade date; the other side of the double entry being to the securities clearance
account in that ledger. Upon value date these entries should be reversed into equivalent
accounts in the spot ledger. When settlement of a trade is confirmed, the entry to the securities
clearance account is reversed out into the relevant nostro account.
6.41 Investment securities - profit and loss. Securities held as investments are not revalued,
except to reflect a diminution in value that is other than temporary. A permanent diminution in
value may be defined as a reduction in value the reversal of which it would be unreasonable to
anticipate for the foreseeable future. Permanent diminutions in value of debt securities are
likely to be associated with a reassessment of the long-term credit rating of the issuer or of the
general market for that type of security, and not simply with an adjustment in the value of the
security arising from fluctuating interest rates.
6.42 Securities transferred from the trading to the investment portfolio should be recorded in
accordance with the bank or financial institution’s established accounting policy (market value
or lower of cost and market value) at the date of transfer; any gain or loss should be taken to
profit and loss account.
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6.43 Securities transferred from the investment to the trading portfolio should be recorded at
market value at the date of transfer and thereafter treated as trading securities; a loss should be
accounted for through the profit and loss account but any gain should be deferred until final
disposition of the securities. Such gains should be deferred since the particular securities were
not designated as part of the trading account at the original acquisition date.
6.44 Gains and losses on investment securities disposed of prior to maturity, resulting from
differences between the sales price and carrying value, are included when realised in securities
gains and losses, in the profit and loss account. Varying methods are used to determine
amortised cost for purposes of such calculations including the following:
■ specific identification;
■ average cost;
■ last in, first out (LIFO).
6.45 Should there be substantial turnover in the investment portfolio, consideration should be
given to determine whether the portfolio is actually maintained for trading, rather than
investment purposes. If determined to be in fact a trading portfolio, appropriate classification
and valuation methods should be applied (see paragraphs 6.52-.54).
6.46 For accounting purposes interest is accrued regularly on interest bearing securities owned
including those loaned on a contractually settled position. Adjustments of regular accruals
based upon the periodic interest payment date of the security may be required where securities
are purchased or sold between such dates. In these instances the total funds conveyed upon
purchase or sale normally reflect the accrued interest on the security from the previous periodic
interest payment date to the date of transfer. Accrued interest purchased or sold should not be
reflected in the acquisition or disposal price of the conveyed securities.
6.47 Dividends receivable should be credited to profit and loss account on the day upon which
the security becomes ex-dividend or when management are reasonably certain of income
receipt.
6.48 The two most prevalent methods of amortising premiums and accreting discounts are the
straight-line method and the level-yield ("interest") method. While the straight-line method is
easier to apply, the interest method is preferred because it results in a constant yield over the
life of the investment. The interest method is applied by amortising that amount of the
premium or accreting that amount of the discount in each period to so adjust the security's
coupon interest to produce a constant rate of return.
6.49 The premium or discount on acquisition of a floating rate investment security against its
nominal redemption value should be amortised to the profit and loss account evenly over the
period from value date (i.e., the date the purchase is contractually settled) to the next interest
fixing date. The rationale for this treatment is that the prices of floating rate securities tend to
par at interest rate refix dates and, accordingly, premiums or discounts on acquisition are
amortised from value date to the next specific date to reflect compensating interest receipts. If
a security's value is significantly below par on refix date, this is an indication that there may be
a permanent impairment in value as defined above.
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6.50 The premium or discount on acquisition of a fixed rate security should be amortised to the
profit and loss account evenly over the period from value date to maturity date. Where the
security can be redeemed at one of a series of future dates at the option of either the issuer or
the bank or financial institution, "maturity date" should be taken to be the most likely maturity
date given current market and other conditions. Where the "maturity date" changes with a
change in those conditions, the premium or discount remaining to be amortised should be
spread over the new period assessed to be the most likely remaining life of the security.
6.51 Premiums or discounts on the acquisition of perpetual bonds or notes and equities are not
normally amortised to profit and loss account, remaining in the "cost" of the security.
6.52 Trading account securities - balance sheet. Under prevalent accounting principles the
carrying value of trading account securities is usually adjusted so that they are stated at the
lower of cost or current market value; in some countries, trading securities are carried at
market value. Securities purchased and sold are recorded as assets and liabilities respectively in
the forward ledger at trade date; the other side of the double entry should be to the securities
clearance account in that ledger. Upon value date these entries should be reversed out of the
forward ledger into the equivalent accounts in the spot ledger. When settlement of a trade is
confirmed, the entry to the securities clearance account is reversed out into the relevant nostro
account.
6.53 For securities that are not readily marketable, the basis for valuation should be their fair
value as determined by management. Generally, the fair value of securities is the amount
which an owner might reasonably expect to receive for them upon their sale to a willing
unrelated buyer taking into account all appropriate factors relevant to the value of the securities.
Where significant, the cost basis of such securities should be disclosed.
6.54 When valuing trading account securities, the most common method is to compare the
market value of each security as an individual item against its original cost or against the
aggregate cost for individual issues. More rarely, some banks and financial institutions value
trading account securities on an aggregate basis, i.e., the total market value of the portfolio is
compared to the total cost. If market value is below cost, the market value becomes the new
carrying value or basis. If in subsequent periods the market value increases, the basis may be
changed to reflect the increase up to cost.
6.55 Trading account securities - profit and loss. Profits or losses on securities held on a
bank or financial institution’s trading portfolio are usually recognised by the revaluation of
open positions on a mark to market basis.
6.56 Interest income and expense should be accrued to the profit and loss account on a daily
basis for all interest bearing securities on contractually settled positions. The interest income
and expense are calculated using the nominal value of the security position, the current coupon
rate and a 360 day year basis (365 days for certain countries).
■ Interest income is accrued to the profit and loss account on a daily basis between purchase
and sale value dates to match the cost of funding those long spot positions in interest
earning securities. Interest income accrued prior to the sale of a security also forms an
exact part of the sale proceeds over and above the clean price (i.e., price quoted exclusive of
accrued interest) of the security itself;
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■ Interest expense is accrued to the profit and loss account on a daily basis on contractually
settled short positions to match the income from reinvesting the sales proceeds. Interest
accrued on short positions also forms an exact part of the purchase consideration over and
above the quoted clean price of the security itself.
6.57 Dividends receivable are credited to the profit and loss account on the day upon which the
security becomes ex-dividend in order to match the dividend receipt in the profit and loss
account to the fall in value of the security by the amount of the dividend which will be reflected
in that day's revaluation profit or loss.
6.58 Repos and reverse repos - balance sheet. Because the substance of the transaction is a
loan to the seller by the buyer, the securities "sold" are not accounted for as a sale by the seller.
Securities owned that are "sold" subject to a repo are viewed by the seller as securities pledged
in connection with the loan from the buyer. The amount borrowed is therefore normally
reflected as a liability in the seller's books under the caption "Securities sold under agreements
to repurchase": the securities remain on the balance sheet of the seller. Similarly, to the buyer
the transaction is a receivable from the seller collateralised by the security purchased. Such
"loans" are normally reported in the buyer's balance sheet as assets under the caption
"Securities purchased under agreements to resell".
6.59 Repos and reverse repos - profit and loss . In the seller's books, the interest paid to the
buyer (difference between the funds obtained from the "sale" and the total fund paid for the
"repurchase") during the sale and repurchase period is accounted for as interest expense on
borrowed funds. The interest earned by the buyer is reported as income.
Short sales, wash sales and "unseasoned" bond transactions

6.60 Short sales. Short sales, a trading activity, occur when securities not yet owned (at the
time the bank or financial institution commits to the transaction) are sold, with the intention that
substantially the same securities will be acquired at a future date to cover the sale. The bank or
financial institution may actually acquire, or may borrow, the securities to meet its obligation.
6.61 A short sale results in an obligation which is recorded as a liability. The liability is
adjusted to the higher of cost and current market value, or the current market value, of the
respective security at periodic revaluation dates.
6.62 Should the bank or financial institution use a security held in its investment portfolio to
meet its obligation under a short sale created in the trading portfolio, consideration should be
given to determine whether a completed transaction has occurred with respect to the security
previously held, and the resulting gain or loss recognised immediately.
6.63 Wash sales. A determination as to whether a transaction has been completed is required
when securities are sold with the intent to reacquire the same or substantially the same
securities, most often to obtain income tax or other benefits. Such transactions are referred to
as "wash sales" and the period between sale and reacquisition of the securities varies according
to market conditions and the characteristics of the securities involved.
6.64 In a bona-fide sale, the risks and rewards of ownership are transferred, constituting
realisation of gain or loss which should be recognised. When a security is sold and the sales
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proceeds are reinvested in substantially the same security, no sale should be recognised because
the bank or financial institution is essentially in the same position as before, brokerage fees
incurred and tax effects realised notwithstanding. The facts and circumstances of individual
transactions require evaluation to identify and properly classify wash sales.
6.65 "Unseasoned" bond transaction. In order to protect their resident investors from losses
arising from dealings in newly-issued securities for which stable market prices have not yet
been established in the post-issue or "secondary" markets, some countries restrict the ability of
overseas dealers to offer international securities to residents within a specified period of the
issue date. The managers and underwriters to new issues typically give written undertakings to
observe these restrictions and to offer no securities, directly or indirectly to residents of the
countries concerned; they are required to obtain similar undertakings from any dealers to whom
they sell the securities. When the 90 day period has expired the securities are referred to as
"seasoned".
6.66 There have been instances where "unseasoned" eurobonds subject to the above restrictions
are sold by dealers to residents of the countries concerned within the 90 day period. Such deals
may not be recorded in the accounting records in the normal manner if this would automatically
give rise to the production and dispatch of counterparty confirmations and trigger standard
settlement procedures. They are sometimes aggregated in memorandum records, possibly kept
directly by the dealers concerned, and processed at the end of the 90 day period; this is a similar
procedure to that adopted for pre-issue "grey market" trading.
6.67 "Illegal" transactions in unseasoned bonds may not only render an institution liable to any
penalties arising from the breach of the management/underwriting agreement, but will also have
internal control implications for the monitoring of positions and regulation of dealers' activities
where transactions are not recorded in the accounting systems.
Auditing guidance
6.68 For auditing guidance on a bank or financial institution’s dealing and investment
securities activities reference should be made to chapter 3 of volume 1.
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Introduction to derivatives
7.1 Off-balance sheet activities provide a means for banks and financial institutions to retain
their traditional customer bases and boost fee income in the face of increased competitive
pressures in, and diminishing margins from, conventional on balance sheet business. They also
provide useful tools to assist management in managing risk and the balance sheet of the
institution. Derivatives are often an attractive proposition for trading as only a limited (or,
possibly zero) initial cash outlay is required to establish a relatively much greater position in the
market. In effect, they are highly leveraged. This brings with it higher risks as evidenced by
the recent widely publicised significant losses. Therefore it is important that management
attention is focussed to ensure appropriate controls are in place. Chapter 3 of volume 1
discusses the types of controls which may be appropriate for the various derivative products.
The next five chapters provide further background information on the more common derivative
products available in the market.
Financial futures
7.2 The financial futures market. Commodity futures exchanges provide a mechanism
enabling producers and users of commodities to protect themselves from the effects of
fluctuations in prices. Financial "prices" such as interest rates and currency exchange rates
have become more volatile in recent years making financial costs more difficult to predict and
control. The financial futures markets have developed to provide a means of lessening the
impact of price fluctuations in interest rates, currency exchange rates and, more recently, stock
indices.
7.3 Financial futures trading was pioneered in two markets in Chicago. In 1972 the Chicago
Mercantile Exchange, through a subsidiary, the International Monetary Market ("IMM"),
initiated trading in currency futures contracts. These essentially provide an alternative to the
traditional forward foreign exchange contracts which have been a feature of the major financial
centres for many years. This was followed by the Chicago Board of Trade ("CBOT") where
interest rate futures contracts were introduced in 1975. Since then similar markets have been
opened in several other financial centres, including London, New York, Toronto, Tokyo,
Singapore and Sydney.
7.4 Each market determines the contracts to be traded and sets its own rules and practices.
However, most of the principal features are common to all exchanges. The examples given
generally apply to the IMM, the CBOT, and the London International Financial Futures
Exchange ("LIFFE").
7.5 Definition of futures contract. A futures contract may be defined as a transferable
agreement to buy or sell a standardised amount of a commodity of standardised quality at a
fixed price on a specific future date under the terms and conditions of a recognised exchange.
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7.6 Commodity futures contracts. To assist in understanding financial futures it is helpful to

consider how futures contracts in general are operated. Commodity futures contracts fix the
price at the time of the contract for a subsequent delivery of commodities. Their primary
purpose is to enable producers and users of commodities to protect themselves from the effects
of fluctuations in prices. For example, a user of grain (e.g., a baking company) may believe
that prices for that commodity are likely to rise. The company can protect itself from the
effects of rising prices by buying its future grain needs now on the futures market at a fixed
price. The advantage of doing so is that its costs are fixed in advance. The principal drawback
is that if the company is mistaken and grain prices actually fall, it would have been
advantageous not to have entered the futures market because the company would have
benefited from the fall in price as well as avoiding the costs of the futures contract.
7.7 Clearly, there must be two parties to every futures contract. While a user of grain may
wish to protect itself against rising prices, a producer of grain may wish to protect itself against
future price decreases, and can do so by selling grain for future delivery. A futures exchange
brings the two parties together and enables them both to "hedge" against the effects of future
price changes. The two parties have opposite risks which futures trading enables them both to
eliminate. However, as a price for eliminating the effects of future adverse price changes, they
also forego the possible benefits of future advantageous price changes.
7.8 The party selling the commodity for future delivery is said to be "short" in that commodity
and conversely the party buying the commodity for future delivery, "long."
7.9 Characteristics of financial futures contracts. A financial futures contract is a type of
commodity contract in which the underlying commodity is a financial instrument, currency or
equity and the contract price depends upon an interest rate, exchange rate or stock index. The
more important characteristics are considered below.
7.10 Transactions through a broker. The broker is normally a member of an exchange and
handles transactions on its customers' behalf. However, it should be noted that brokers who are
members of the exchange act in the capacity of principal to every contract negotiated on the
exchange and, in turn, their contracts with customers are on a principal-to-principal basis. The
customer is required to pay exchange fees and commission to the broker. The commission
payable is negotiated between the customer and the broker.
7.11 Dealings through a clearing house . While every futures contract negotiated on an
exchange requires a buyer and seller so that on an overall basis the market is always balanced,
their obligations under the contract are not to each other but to the clearing house. In every
transaction, the clearing house substitutes itself for the other party to the contract, becoming
buyer to every seller and seller to every buyer. The clearing house therefore effectively ensures
the performance of every contract made on the floor of the exchange. It should be recognised,
however, that the clearing house does not guarantee members' liabilities to their customers.
Some exchanges have set up compensation funds for the protection of members' customers.
7.12 Types of financial futures contracts. The types of financial futures contracts currently
traded fall into four broad categories, for example:
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Standardised
Amount
■ Short-term interest rate contracts:
Examples:
CBOT: 30-day commercial paper $ 3,000,000
90-day commercial paper $ 1,000,000
IMM: 90-day U.S. Treasury bills $ 1,000,000
1-year U.S. Treasury bills $ 250,000
LIFFE: Sterling 3-month time deposit £ 500,000
Eurodollar 3-month time $ 1,000,000
deposit
■ Long-term interest rate contracts:
Examples:
CBOT U.S. Treasury notes (10 years) $ 100,000
IMM U.S. Treasury notes (4 years) $ 100,000
LIFFE Sterling long gilt based on a notional 20 £ 50,000
year 12 percent government stock
Japanese government bond Y 100,000,000
U.S. Treasury bond based on a notional $ 100,000
15 year 8 per cent Treasury bond
■ Exchange rate contracts (traded against the U.S. dollar):
Examples:
LIFFE and IMM Sterling £ 25,000
Deutsche mark DM 125,000
Swiss franc SF 125,000
Yen Y 12,500,000
IMM only Canadian dollar $ 100,000
French franc FF 25,000
The short interest rate contracts and the exchange rate contracts account for the bulk of
dealing volumes.
■ Stock indices:
Examples:
Financial Times - Stock Exchange 100 £25 per full index point
Standard & Poors 500 $100 per full index point
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7.13 Use of financial futures by banks and financial institutions. Banks and financial
institutions, whether members of exchanges or not, may use financial futures for the following
purposes:
■ Trading: achieving dealing profits on the bank or financial institution's own account;
■ Hedging:
- reducing exposure to interest and exchange rate fluctuations related to specific assets
and liabilities;
- reducing the bank or financial institution's exposure to interest rate movements due to
mismatches between lending and funding portfolios and to cover the bank or financial
institution's net foreign currency positions.
■ Customer deals: executing deals on behalf of customers (both for trading and hedging
purposes).
Examples of banking and finance situations in which hedging or trading contracts may be
appropriate are set out below.
Trading situations
■ Imbalances between physical and futures markets - just as profits may be made by, for
example, deposit swap transactions on the international interbank loan/deposit and
exchange markets through dealers obtaining advantageous rates while "shopping around",
so can they be made where there is a perceived imbalance between physical and futures
markets for similar transactions. In particular, currency futures deals and interbank forward
deals essentially achieve the same ends. In practice, opportunities may be limited in that
individual futures exchange contracts currently available are for maturity on specified dates
unrelated to deal dates whereas the best rates for interbank deals are available only for
amounts maturing after standard periods following the deal date (e.g. 1, 3, 6 months);
■ Interest arbitrage transactions - interest rate futures contracts can provide an alternative to
interbank loans and deposits in closed deposit swap situations. Futures transactions, unlike
the interbank transactions, are 'off-balance sheet' and may place less strain on a bank or
financial institution's capital resources. Most interbank deposit swaps commence at spot
date although 'forward swaps' may be achieved by setting off a loan in a currency with a
shorter deposit running up to the commencement date and vice versa; here the foreign
exchange transactions related to the swap will be at two forward dates. Interest arbitrage
transactions employing interest futures may be likened to forward swaps;
■ Open position trading - this involves taking speculative unmatched futures positions in the
hope of closing out a profit (open position trading) - it is known as 'scalping' where very
short-term. For example, a trader, expecting short-term sterling rates to rise, may sell a 3
month sterling interest rate contract. If, instead, rates fall the price of the contract will rise
and the trader will make a loss, the size of which will depend on when he closes out the
contract;
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■ 'Spread trading' - this involves the simultaneous purchase and sale of related contracts.
Where the spread is expected to widen, the trader would buy a futures contract with an early
maturity date and sell one with a later maturity date; this is known as 'buying the spread'.
Alternatively, where the spread is expected to narrow, the trader would sell an early
maturing futures contract and buy one maturing later.
Hedging opportunities
■ Matching of long-term deposits - an opportunity may arise to accept a customer deposit at a
fixed rate for a long period that can only be matched with fixed loans for shorter periods.
The risk of losses arising from an adverse movement in interest rates on the maturity of
fixed loans matched with the deposit for the first part of its life can be hedged against. This
is achieved by buying interest rate futures contracts dated on or near the maturity dates of
the initial loans to match the remaining life of the deposit. To the extent that the life of the
instrument underlying the contracts is less than the uncovered life of the deposit the contract
volumes may exceed the value of the deposit;
■ Hedging of short-term loans - a bank or financial institution may expect long term fixed rate
lending to be replaced at a future date by investment in short-term securities. Forecast
yields on the securities may be locked into by futures contracts;
■ Making of fixed loans to customers - a bank or financial institution may wish to make a
fixed loan to a customer for, say, a year, and fund it with short-term interbank deposits. It
could:
- quote the customer a rate based on the average of the current 90 day interbank rate and
the current futures rates for contracts covering the last nine months of the loan, plus a
margin;
- lock into the quoted rates by taking out the futures contracts, closing them out and
drawing three month money as the year progresses.
■ Hedging of securities activities - a bank or financial institution may sell futures contracts in
order to protect a long position in securities against falling prices resulting from rising
interest rates. Similarly, where short positions are vulnerable to falling interest rates futures
contracts may be purchased. This can be illustrated by the following simple example:
In July an institution plans a £2 million issue of 90 day commercial bills in December.
The current market rate for commercial bills is 16.5%.
The December 3 month sterling futures contract price is 84.5.
The institution is concerned that interest rates will rise by December so it sells four
December contracts at 84.5 (i.e. a yield of 15.5%)
By December the rate has risen by 1.5% and the institution issues £2 million of
commercial bills at 18%.
It then buys four December contracts at 83.0 (i.e. a yield of 17%). The profit on the
futures contracts is therefore £2 mil x 1.5% x 90/360 = £7,500.
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This profit can then be applied to the cost of funds actually raised to give an effective
interest rate of 16.5%.
■ Hedging of investment account activities - whereas a 'long hedge' protects short positions in
the trading portfolio, in the investment portfolio it can minimise the effect of falling interest
rates on expected future purchases.
There are many other possible applications of futures, the use of which will no doubt increase
as the range of available contracts widens.
7.14 Futures contracts compared to forward contracts. The financial futures markets have
many similarities to long-established forward foreign exchange markets, both markets
providing a means to hedge against the effects of future changes in currency exchange rates.
However there are a number of significant differences, the more important of which are as
follows:
■ Standardisation. Futures contracts are for standardised amounts. Forward contracts may
be negotiated for any amount, although small amounts may result in uneconomic rates;
■ Rate negotiated through market. The rate for a futures contract is the currently quoted
rate on the market, through which all transactions are negotiated. Forward contract rates are
negotiated on an individual basis and vary (i.e., individual banks and financial institutions
quote different rates);
■ Margin. Futures contracts require the deposit of margin to settle for losses as they arise
through changes in market rates. No formally defined margin is required for forward
contracts, and therefore banks or financial institutions must limit the exposure they are
willing to accept to particular customers, and may in some instances require security;
■ Credit risk. The performance of futures contracts is ensured by the clearing house. The
performance of a forward contract is dependent on the financial reliability of the other
party;
■ Liquidity. A futures contract can be closed out at any time against an equal and opposite
contract obtained in the market. No further obligation then exists. A forward contract can
only be terminated by negotiation with the other party. Exposure can be limited by taking
an opposite position in the market, but both positions remain open until maturity.
Mechanics of financial futures trading

7.15 Open outcry. Contracts are made on the trading floor of the exchange by "open outcry".
Traders with contracts to make call out the details, and purchasers and sellers match up. Details
of the contract are given to the exchange, which as explained in paragraph 7.11 above,
substitutes itself for the other party with respect to each party to the contract. The exchange
records the details of the transaction and issues confirmations to both parties.
7.16 Screen trading. Contracts can also be entered into via screen trading. With screen
trading, the bid (buying) and offer (selling) price for various contract amounts are shown on a
computer screen. Trading is conducted between authorised members and deals are
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automatically recorded on the exchange’s computer. To execute a trade, the broker enters the
contract type, the price and the volume he or she wishes to buy or sell.
7.17 Pricing of contracts. The basis upon which prices of financial futures contracts are
quoted varies according to the type of contract, some contracts are quoted as in the cash market
whilst others are quoted as indices.
■ Short-interest-rate contracts are quoted on an index basis. The index price is equal to
100.00 minus the annual rate of interest on the deposit, so that a deposit with a rate of 15%
is quoted at 85.00;
■ Long-interest-rate contracts are quoted at the price per £100/$100 of nominal value, as in
the cash market;
■ Currency contracts are quoted on the basis of U.S. dollars per unit of currency. This is in
contrast to the accepted European system of quoting exchange rates where, for example, a
rate of DM2 to $1 would be quoted, rather than a rate of $0.50 to DM1;
■ The Financial Times - Stock Exchange 100 contract is quoted as the FT-SE Index divided
by 10.
7.18 Price movements. Prices of financial futures contracts change in fixed minimum move-
ments, known in LIFFE as "ticks," which have a constant value for any given contract. For
example, for the Sterling and Eurodollar three-month interest rate contracts, the tick value is
based on a 0.01% change in interest rates (which also represents a .01 change in the index
price), being equivalent to £6.25 and $25 respectively. The way this has been derived can be
seen from the following Sterling example (nominal amount - £250,000; deposit period - three
months):
Tick value = £250,000 x 3/12 x 0.01%
= £6.25
7.19 It should be recognised that the basis of interest calculation implicit in the fixed tick
values for three-month interest rate contracts may not correspond with the basis of interest
calculation on an asset or liability being hedged. The effect of any such price differential has to
be considered in designing appropriate hedging strategies.
7.20 Closing out. The seller of a futures contract may decide, before the contract matures, that
he no longer wishes to continue his position in the futures market. This can be achieved by
purchasing an identical futures contract in the same market so that he now has equal and
opposite obligations to the clearing house (to both buy and sell equal amounts on the same date)
and therefore has no net obligation. He may then require the clearing house to cancel the two
contracts against each other. He will, of course, realise a profit or loss on his future transactions
depending upon interest rate movements and hence the difference between the price of the
bought contract and the price of the sold contract.
7.21 Few financial futures contracts result in actual delivery of the underlying instrument or
currency. The majority of contracts are closed out prior to delivery by means of equal and
opposite transactions in the market. Indeed, the complexities of the delivery procedures are
such that delivery is not attractive to the majority of market participants.
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7.22 Margin. The clearing house ensures the performance of each futures contract. So that
the clearing house is not exposed to financial loss in the event of default by a member of the
exchange, each member with open positions on the exchange is required to deposit "margin"
with the clearing house in the form of cash. In turn, the exchange members call for margin
from their customers with open contracts on the exchange. There are two types of margin:
■ Initial margin, a fixed amount per contract paid at the time a position is opened;
■ Variation margin, a variable amount representing the unrealised profit or loss on the
contract, calculated on a daily basis.
7.23 On LIFFE, all margins must be put up to the clearing house in cash, but members may be
willing to accept bank guarantees, letters of credit, and government securities from their clients.
Margin other than cash, bank guarantees, and letters of credit in the currency of the contract
would be valued at a discount from market prices. This valuation should be performed
periodically and additional margin called or surplus released as appropriate. No interest is paid
on margin deposits.
7.24 Price limits. To ensure an orderly market, some exchanges specify maximum price
fluctuations for each type of contract. If the change in price from the previous day's closing
price reaches the specified amount, no trading beyond this limit is permitted for a specified
period. On LIFFE this is a one-hour period, to enable members of the exchange and their
customers to assess the causes of the price movements and to consider their open positions and
margin requirements. Following the one-hour period, trading continues for the rest of the day
without limits. Price limits do not apply in the last hour of trading each day or when a contract
is within one month of its delivery date.
Accounting matters
7.25 Background. There have been a number of accounting standards issued which are
directly applicable to financial futures including:
■ International Accounting Standard 32 “Presentation and Disclosure of Financial
Instruments”; and
■ In the United States, Statement of Financial Accounting Standards No. 80 (SFAS No. 80)
entitled "Accounting for Futures Contracts".
The treatments outlined by these accounting standards are not inconsistent with the generally
accepted practice discussed below. The guidance below is general in nature and consideration
should be given to any local practice and accounting regulations.
7.26 Treatment of underlying assets and liabilities. The assets and liabilities underlying
financial futures contracts should be accounted for and disclosed according to normal
principles; i.e., they should not be recorded in the balance sheet unless and until actual delivery
takes place. For example, the deposits underlying a three month interest rate contract would not
be recorded in the accounts until delivery; normal requirements for disclosure of material future
commitments will apply. This treatment is consistent with policies for forward foreign
exchange contracts.
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7.27 At the accounting date, the open positions should be valued by reference to the difference
between the contract price and the price to close out. The choice of accounting treatment for
financial futures profits and losses should be narrowed. For this purpose, there are two types of
accounting whereby profits or losses, whether realised or not, are either:
■ dealt with in the profit and loss account: ('mark to market' accounting); or
■ deferred and carried forward in the balance sheet: ('hedge' accounting).
7.28 If the futures positions relate to trading transactions or to hedges of dealing assets (i.e.,
assets which are recorded in the accounts at market value rather than cost, or lower of cost and
market value), both realised and unrealised profits or losses should be dealt with in the profit
and loss account as the contracts are revalued. This is similar to the treatment of outright
forward foreign exchange deals adopted by most banks and financial institutions.
7.29 The above treatment would also apply to other futures positions unless all the specified
criteria for hedge accounting are met. These are as follows:
■ At the time the futures contract was entered into its purpose as a hedge must have been
specifically identified and documented in the accounting records and the asset, liability or
position for which the hedge was intended must have been specified;
■ The price of the futures contract and the hedged asset or liability must have a high degree of
positive correlation, that is, the tendency to move in the same direction with similar
magnitude. A three month interest rate future may not be regarded as hedging a 20 year
loan in this context;
■ For a hedge of an anticipated transaction, the transaction must be reasonably expected to be
fulfilled in the normal course of business.
7.30 When realised, deferred profits and losses should normally be treated as an adjustment to
the book value of the related asset or liability. However, the book value of an asset should not
be adjusted to an amount in excess of its fair market value at the date the hedge is closed out.
An exception is made for loans and deposits. Here the book value would not be adjusted; the
deferred profit/loss would be carried forward in the balance sheet, and taken to the profit and
loss account over the remaining life or holding period of the related items.
7.31 The above guidance does not readily apply to banks or financial institutions using the
futures market to hedge 'gaps' in their loan portfolio funding or to cover net foreign exchange
positions. Apart from the impossibility of identifying the specific assets or liabilities hedged,
the commencement period of the funding gap may not correspond with the maturity and period
of the financial futures contract. Under the above guidance there would be a requirement to
mark to market.
7.32 Disclosure. When applying the accounting treatment for hedges the bank or financial
institution should disclose the following:
■ The nature of the assets, liabilities, firm commitments, or anticipated transactions that are
hedged with futures contracts or the anticipated transactions to which futures contracts
relate;
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■ The method of accounting for the futures contracts. The disclosures of the method should
include a description of the events or transactions that result in recognition in income of the
changes in value of the futures contracts.
7.33 Margin management. One of the principal disciplines of financial futures trading is the
requirement for each trader with an open position to deposit margin with the clearing house or
their broker, as appropriate. The central clearing house revalues its members' net open
positions and makes margin calls on a daily basis. Exchange rules generally require that
members make margin calls on their own customers which are at least as stringent as those
made by the central clearing house.
7.34 Brokers (both members and non members) may make margin calls on their customers
using the same technique of initial and variation margins used by the clearing house, or may
wish to use a maintenance margin technique (see paragraph 7.22).
This latter technique requires the customer to make a deposit with the broker on opening a
position which may be as much as three or four times the amount of the initial margin set by the
clearing house. Maintenance margin is the minimum level to which the sum of the customer's
ledger balance (comprising cash transfers and realised profits and losses) and unrealised profits
and losses on open contracts is allowed to fall. When this level is reached a round sum margin
call will be made to bring the balance plus unrealised profits and losses back up to the original
level agreed with each customer.
7.35 The advantage of the maintenance margin system is that it reduces the incidence of daily
calls and hence administrative time. The disadvantage, from a customer's point of view, is that
a higher level of margin payment may be required. While banks and financial institutions are
likely to operate on a daily variation margin basis with their broker or the clearing house, they
may prefer to operate a maintenance margin system for their customers.
Other matters
7.36 Policies. As with other areas of a bank or financial institution, senior management is
responsible for setting clear policies prior to the commencement of significant futures trading.
The policies should define the circumstances in which futures trading is considered appropriate,
the classes of assets and liabilities which may be hedged and the futures contracts which may be
used. As a general rule the policies should be formally documented and approved by the
highest levels of management. Consideration should also be given to the manner in which such
policies are communicated; this will depend on the size of the bank or financial institution and
its general style of management.
7.37 Limits. The level of activity at which limits are set will vary and procedures should
therefore be established to review and adjust limits on a regular basis as the bank or financial
institution's attitude and assessment towards risk changes over time. Limits should be applied
so as to minimise risks whilst not imposing undue constraints on the abilities of traders to
maximise profits through operation in the market. The following are the usual types of limits
used by banks and financial institutions to control its futures trading risks:
■ Volume limits: as the face value and characteristics of each contract are known and fixed,
limits can be readily expressed in terms of the number of open contracts. These limits can
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be set by contract, by maturity and by dealer - as required. Typically separate limits are
required for trading portfolio and hedging transactions.
■ Overnight and intraday limits: as margin needs to be paid to the clearing house only on
open positions held overnight, there is normally scope for the bank or financial institution to
set less stringent volume limits on trading during the day than is necessary for overnight
positions;
■ Gap limits: limits for straddle and spread trading need to cover offsetting positions for
different delivery dates. It may be possible to set these limits at somewhat higher levels
than those set for overnight open positions because of the generally lower levels of risk
associated with movements in relative rather than absolute levels of prices. The operation
of gap limits is often made more complex by the difficulties associated with identifying
which transactions have been entered into as straddles or spreads;
■ Stop loss limits: limits can be based on market prices or the losses reflected by those prices.
If market prices reach a level where losses on that position equal or are greater than some
predetermined limit then the position is closed out.
Interest rate futures are also relevant to overall interest rate risk management and the limits in
place in relation thereto. These limits are discussed in chapter 2 of this volume. Similarly,
foreign currency futures are relevant to overall foreign currency risk management which is also
discussed in chapter 2 of this volume.
7.38 Records and reports. The accounting system must create and maintain complete records
of all transactions, segregated by customer where appropriate. The following records should
normally be available:
■ Deal slips originated by the dealer;
■ Trading sheets to record actual deals made;
■ Position sheets to maintain current control over the traders' position in each type of contract;
■ Broker's advices;
■ Bank or financial institution's copy of confirmation it has despatched to the customer;
■ Clearing house reports and statements.
Additionally, the following reports are usually prepared by the accounting or EDP department:
■ Daily transaction reports;
■ Profitability reports, by dealer/customer/period/contract;
■ Position reports, by customer and in total;
■ Margin reports, by customer and in total, showing the net variation and deposit margin
requirements;
■ Commissions and other expense reports;
■ Exceptions reports highlighting potential risk situations (e.g. position limit excesses,
contracts nearing delivery date or expiry, customers equity falling below a defined level).
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Auditing guidance
7.39 For auditing guidance on a bank or financial institution’s financial futures activities
reference should be made to chapter 3 of volume 1.
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Introduction
8.1 Background. Interest rate swaps, transactions in which two counterparties agree to
exchange their interest payment obligations, are one of the most frequently used hedging and
speculative instruments in the market today. They represent a mechanism by which corporate
treasurers can actively manage the liability side of the balance sheet, switching from fixed to
floating rate debt or from one currency to another or from debt linked to one floating rate indice
to another floating rate indice e.g., LIBOR to prime. In addition, interest rate swaps provide
arbitrage opportunities because of the different credit ratings and ease of access which
borrowers have in different markets. The interest rate swap market has steadily become more
sophisticated with new interest rate swap permutations mirroring the risk involved in specific
cash flow scenarios.
8.2 Interest rate swaps fall into two distinct categories:
■ Single currency swaps e.g. fixed/floating rate, floating/floating;
■ Cross-currency swaps e.g. floating/floating, fixed/fixed, fixed/floating, etc.
8.3 Single currency swaps do not require any exchange of principal, whereas cross currency
swaps usually require the currency principals to be exchanged at the commencement and
maturity of the swap.
8.4 Where a bank acts as an intermediary between two other counterparties the swap may be
described as “matched”. The bank may fulfil the role of a broker - merely arranging the
transaction and receiving a fee - or may have a principal relationship with each counterparty. In
the latter case, although the bank may have no direct interest rate or exchange rate exposure it
has a credit risk dependent in part on these two factors.
8.5 A bank may alternatively be one of the two ultimate counterparties to a swap - an
unmatched swap. This may arise as part of the bank’s management of its own debt capital or
the swap may be hedged with other financial instruments or taken as a speculative position.
8.6 Frequently capital raising operations may involve the linking together of a number of swaps
and counterparties in order to meet the requirements of all parties.
General definitions
8.7 Single currency swaps. Single currency interest rate swaps are agreements between two
borrowers to exchange the interest payments on their debt obligations, without any transfer of
principal.
8.8 In the simplest case two counterparties agree to swap interest payments on identical
principal amounts of debt with similar maturities. In some cases a bank may act as an
intermediary between the counterparties and process the receipts and payments of interest. In
this case, the bank assumes a credit risk in relation to each counterparty.
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8.9 The rationale for these transactions normally derives from the arbitrage opportunity that
arises as a result of the different perceptions of risk and credit standing in different markets or
as a result of restrictions on access to particular markets. For example, the fixed rate market is
typically more sensitive to credit quality than the floating rate market, and while two
counterparties may have a difference in borrowing rates in the fixed rate market of 2%, in the
floating rate market the variation may be only 1%. Using the mechanism of an interest rate
swap, each party can borrow in the market where it is most accepted, and then exchange interest
payments. The higher credit risk borrower can thus secure fixed rate debt at a lower cost than
would otherwise be possible (or even access a previously inaccessible fixed-rate market) and
the lower credit risk borrower can secure medium term floating rate funds at a cost less than its
normal short-term borrowing cost.
8.10 Example - single currency fixed/floating rate swap. The following is an interest rate
swap between a low credit risk borrower, Borrower A, who requires floating rate funds but has
a comparative advantage in the fixed rate market, and a higher credit risk borrower, Borrower B
who requires fixed rate funds but who is more easily able to borrow floating rate:-
Borrower A raises 7 year fixed rate funds at an 11% annual coupon.
Borrower B raises a 7 year floating rate bank loan with interest paid semi-annually at
LIBOR plus 5/8% with a bullet repayment at maturity.
During the life of the swap, Borrower B pays to Borrower A 11% per annum, and Borrower
A pays to Borrower B semi-annually, LIBOR plus 1/8% per annum.
8.11 The cash flows are as follows:
Borrower A Pays/(Receives)
Semi-annually: interest to borrower B LIBOR + 1/8% pa
Annually: coupon to bondholders 11%
coupon from borrower B (11%)
______________
LIBOR + 1/8% pa
Borrower B
Semi-annually: to service floating rate debt LIBOR + 5/8%
from borrower A (LIBOR + 1/8%)
Annually: coupon to borrower A 11%
__________
Annual cost 11.50% pa
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These flows can be represented diagrammatically as:
Borrows funds Borrows funds

7 years fixed Interest Rate 7 years floating
@ 11% Swap for 7 years @ LIBOR + 5/8%
A Receives 11% fixed

Borrower Borrower
A B
A pays LIBOR + 1/8%
8.12 Cross currency swaps. In a cross currency interest rate swap, each counterparty requires
the use of funds in a different currency from that in which he initially holds or borrows funds.
Accordingly the currency principals are exchanged at the outset of the swap. In order to enable
each counterparty to repay its underlying currency liability at maturity, there is also an
agreement to exchange principals at the maturity date, usually at the same “par” exchange rates.
During the period of the swap, interest obligations are also exchanged, as in a single currency
swap.
8.13 Example - fixed/floating rate cross currency swap. Borrower B wants to raise DM 100
million at a fixed rate for 7 years but is unable to access the DM market on acceptable terms. A
lower credit risk borrower, Borrower A, wants floating rate US dollars for 7 years; if Borrower
A raised the funds in the market directly it would have to pay LIBOR +1/4%.
8.14 A bank arranges for Borrower B to raise a 7 year US$40 million floating rate loan at
LIBOR + 5/8% and also arranges a DM 100 million 7 year bond issue for Borrower A with a
coupon of 5 1/4%. Borrower B receives DM 100 million in exchange for US$ 40 million from
Borrower A and agrees to re-exchange principal amounts after 7 years. Borrower B pays the
interest on the DM 100 million bond issue and Borrower A pays LIBOR less 3/8% to Borrower
B. Borrower A therefore obtains floating rate dollars at LIBOR less 3/8% while Borrower B
accesses an otherwise inaccessible DM market to obtain fixed rate DM at an all-in cost of
6.25%.
Borrower A Pays/(Receives) Currency
Semi-annually: interest to borrower B LIBOR - 3/8% pa US$
Annually: DM coupon to bondholders 5 1/4% DM
DM coupon from borrower B (5 1/4%) DM
______________
LIBOR - 3/8% pa US$
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Borrower B Pays/(Receives) Currency

Semi-annually: interest on floating rate LIBOR + 5/8% US $
debt interest from borrower A (LIBOR - 3/8%) US $
Annually: DM coupon to borrower A 5 1/4% DM
__________
Total periodic cost 6 1/4% pa
These flows can be represented diagrammatically as:
Borrows DM Borrows US$

7 years fixed 7 years floating
@ 51/4% @ LIBOR + 5/8%
DM 100 Million
Borrower US 40 Million Borrower

A 5 1/4% B
LIBOR -3/8%
(Note: Borrower A and Borrower B would normally transact the swap with a bank rather than
dealing directly with each other.)
8.15 Interest rate swap options. These instruments are a refinement of interest rate swaps
sometimes termed swaptions. Interest rate swap options enable a company which would like to
convert its floating rate debt to fixed rate debt but which believes that rates will decrease to take
out an option to enter into a future interest rate swap at a rate linked to the current market rates.
If rates do decline the company would not exercise the option but would go into the market and
fix the rate on the debt through an interest rate swap on the more favourable terms created by
the decline in interest rates. On the other hand if rates increase the company can exercise its
option and fix its floating rate debt on the option terms. Hence, for the cost of the premium paid
for the option a company can leave itself in a position to take advantage of a decline in interest
rates, without running the risk of interest rates increasing.
8.16 Conversely, a company with fixed rate debt which would like to convert its debt into
floating rate debt but which believes that interest rates will increase could take out an interest
rate swap option and then wait to see if interest rates do in fact increase. If interest rates
increase, the company would not exercise its option but would go into the market and enter into
an interest rate swap under which it paid floating rate interest and received fixed interest income
greater than the rate it is paying on its fixed rate debt. If however interest rates decrease the
company would exercise its option and thereby ensure that the fixed interest income from the
swap would cover its interest expenses on the fixed rate debt.
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8.17 The writers of interest rate swap options would normally be banks which seek to make
profits by accepting the option premiums in exchange for accepting interest rate risks. There is
generally only minimal exchange rate risk in writing an interest rate swap option, as a cross-
currency swap normally involves matched spot and forward exchange deals.
8.18 Example - option. Borrower A has raised US$ 10,000,000 5 year floating rate funds at
LIBOR + 1% and wishes to transform this debt into fixed rate debt. At present it could obtain
an interest rate swap to exchange for a fixed rate of 8%. However, Borrower A believes that in
6 months time interest rates may have fallen but wishes to insure against them rising, and
therefore takes out an option on an interest rate swap for a fixed rate of 8% with exercise date
after 6 months, paying a premium of US$ 300,000 for the option.
■ Interest rate fall.
If on the exercise date of the option fixed interest rates for 4-5 years have fallen by 1% then
Borrower A would not exercise the option but would go into the market for an interest rate
swap on what should be more favourable terms due to the lower interest rates. Borrower A
would obtain a swap for a fixed rate of 7% p.a. saving US$ 100,000 p.a. compounded for 5
years. In order to determine the true economic profit on the transactions the interest saving
would have to be discounted back to the date when the premium was paid and compared
with the amount of the premium.
■ Interest rate rise.
If on the exercise date of the option fixed interest rates have risen by 2% then Borrower A
would exercise its option for an interest rate swap at the fixed rate of 8%. The total cost of
the debt would be 8% plus the premium paid to give an effective annual cost of under 9%,
compared with the current rate of 10%.
8.19 Matched swaps. In a matched swap the bank acts as an intermediary or broker between
two counterparties.
■ Principal. In a single currency swap, the notional principal is not exchanged: the only flow
of funds relate to interest on the notional amount. Since the bank is not committed to
exchange the principal no commitment appears in the balance sheet. However, the principal
may appropriately be recorded in memorandum accounts.
In a cross-currency swap an initial exchange of principals will be recorded through the
nostro accounts. The forward commitments to re-exchange principal should be recorded as
forward deals but separately identified. In a matched swap, no profit or loss will arise on
revaluation of the forward deals with two counterparties, but revaluation will quantify the
extent of the bank’s credit risk on the principal with one counterparty at a particular point in
time.
■ Fees. Broker and intermediary banks commonly receive fees. Brokers’ fees, being
remuneration for bringing together the parties, should be recognised on deal date.
Fees received for intermediation services should be reviewed in the light of the overall
profitability of the deal. Generally it is appropriate to recognise part of the fee up front and
to amortise the balance over the life of the swap, reflecting the effort in bringing the parties
together and the ongoing obligations as the intermediary.
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■ Interest. This should generally be recorded on an accruals basis. Where interest payable
and receivable are in the same currency and relate to the same counterparty the accruals
should be netted off for balance sheet reporting purposes.
8.20 Unmatched swaps. In an unmatched swap the bank does not act as an intermediary but is
itself a counterparty.
8.21 As with matched swaps, unmatched swaps do not involve the provision of finance and the
principal amounts should likewise not be recorded in the balance sheet.
■ Hedges - an unmatched swap entered into by a bank as a hedge typically swaps funds
received from the issue of a medium term bond or note into another currency or converts
fixed rate finance into floating rate finance.
To reflect the substance of the transaction, the notional interest payments should be
accounted for, on an accruals basis, as an adjustment to the interest expense on the
borrowings.
In a cross currency swap, the liability should be recorded in its currency of denomination
and (normally) revalued against the reporting currency. The forward commitment, valued at
spot rates, would give rise to a suspense account balance:
Example: hedged currency swap
Assume
US$ million
Bonds issued (DM 100 million) 8.22
==
US dollar assets 8.23
Suspense account (current spot value of DM 100 million
receivable at maturity ($50 million) less $40 million payable) 8.24
__
Total 8.25
==
■ Other unmatched swaps (trading swaps) - should normally be marked to market, even
when a swap is subsequently “matched”, because any deal contracted at a later date, in order
to “match” the existing deal, will have an interest rate based on market interest rates
prevailing at that later date. Consequently, at the contract date a reference rate should be
assigned to the deal. At each revaluation date a current market rate should be determined
and the swap revalued using discounted cash flow techniques.
■ Fees. The accounting treatment of fees paid or received on unmatched swaps will depend
upon whether the swaps are accounted for on an accruals or “mark to market” basis. Fees
on swaps accounted for on an accruals basis should normally be deferred and amortised
over the life of the swaps. Fees on swaps accounted for on a mark to market basis would
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normally be included as another cashflow in the present value calculation. Accordingly fees
paid or received “up front” would effectively be recognised in the profit and loss account as
received/paid.
Valuation of interest rate swaps

8.26 Below is a summary of the principles which are generally adopted in the mark to market
valuation of interest rate swaps. These principles are applicable to trading portfolios of both
single currency interest rate swaps or cross currency interest rate swaps. In the case of the
latter, each currency leg is revalued separately and the resultant profits and losses converted to
the base currency using the spot rate.
8.27 As stated previously, the mark to market revaluation of an interest rate swap involves
calculating the net present value of the future cash flows under the swap discounted at
appropriate market rates of interest. This can be a complex process and there are a variety of
practices used. From an audit perspective the key matters to consider are:
■ the methodology used;
■ determination of the discount rates;
■ allowing for credit risk;
■ allowance for market liquidity; and
■ providing for future administration costs.
Of these matters, determining the appropriate discount rates is the most critical and should
receive particular attention when we are auditing the valuation of a swap portfolio.
8.28 Revaluation methodology. Interest rate swaps involve a stream of interest rate cash flow
receipts and a separate stream of interest rate cash flow payments. These two streams are
generally revalued separately and the results combined to determine the overall mark to market
valuation of the swap. There are two methods used to complete this revaluation and it can be
proven that these are mathematically identical given certain assumptions. Other formulae may
also be used and in any event these should be carefully reviewed to ensure they achieve the
basic objective of discounting the value of future interest rate cash flows. The two methods
described are the Bond Pricing method and the Close out method.
8.29 Bond pricing method. This method views each leg of the swap as being either a coupon
based security issued (i.e., a liability with negative interest cash flow commitments) or a coupon
based security purchased (i.e., an asset with the right to receive future interest cash flows). In
this way, the discounting process includes both the interest and principal commitments or
receivables less the notional principal amount. The full formula is contained in Appendix A to
this chapter.
8.30 When the discount rate is equivalent to the coupon rate, then the leg of the interest rate
swap has no value. However, if the received interest rate under the swap was greater than the
current market rate of interest (i.e., the discount rate) a positive value would result.
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8.31 In the case of fixed rate leg of an interest rate swap, the cash flows are calculated out to
the maturity of the swap. For the floating rate leg, only the interest cash flows to the date of the
next roll are included at which time the principal is also assumed to be nominally repaid. One
exception to this would be where the floating rate leg includes a basis difference in its pricing.
For example, if the interest receivable or payable is based on LIBOR less ten basis points, then
this would result in a difference on each future interest payment date of ten basis points on the
notional principal amount and this would be included in the net present value calculations.
8.32 No attempt is made to forecast future floating rate interest rates. It can be proven that this
is not necessary since the interest rates beyond the next interest payment date will be reset to
market rates on the interest fixing date. Therefore, the difference between the net present value
of the notional principal received in one interest rate period compared to two interest rate
periods should be exactly offset by the net present value of the interest cash flows that will be
received during the second interest rate period. Expressed in other words, this conclusion can
be seen to follow from the statement made previously that the mark to market value of a swap
leg would be zero where the discount rate is exactly equal to the interest rate payable or
receivable under the swap. As the interest rate on the floating rate swap and hence the discount
rate, is reset at the commencement of each interest rate period the result is that the value of the
interest rate cash flows beyond the date of the current interest rate period would be nil.
8.33 It can also be shown that the notional principal amounts included in the fixed leg and
floating leg revaluation offset each other as:
■ the notional principal is deducted in one leg and added on the other; and
■ the net present value of the principal is included in both formulae; one with a negative and
the other a positive cash flow. It can be shown that the net present value of the floating rate
principal to be received one period into the future is identical to the net present value of the
principal at maturity of the swap plus the future floating rate interest cash flows.
8.34 The precise form of the formula used under the Bond pricing method will vary depending
upon whether the discount rates used are based upon coupon interest rates or zero coupon
interest rates. To explain the distinction consider the following. When an interest yield is
calculated for a coupon based security, the yield is that rate of discount that when applied to
discount all the coupon and principal cash flows equates this to the current market price. In this
way, for a security of given maturity, the same rate of discount is used for all cash flows under
that security.
8.35 As such a coupon (or par) yield is in essence a weighted average. It is inappropriate to use
such a yield to discount a single cash flow in isolation. For this reason, the yield on a five year
coupon based bond will generally differ from that of a five year zero coupon bond. In the case
of the former, the yield is calculated assuming cash flows throughout the life of the bond and at
maturity whereas the latter simply involves a single cash flow at maturity. Interest rates which
are appropriate for the discounting of discrete future cash flows are referred to as zero coupon
rates.
8.36 As a traded interest rate swap portfolio consists of a heterogeneous collection of swaps
coupon rates and maturities, it is more accurate to disregard the remaining term of the swap
being revalued and instead to view the portfolio as consisting of a series of cash flows taking
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place at a variety of dates which will then be discounted at an appropriate rate specific for that
date (i.e. zero coupon rate).
8.37 If coupon discount rates are used, the appropriate market rate of interest will be
determined based on the maturity of the swap and applied to all cash flows under that leg of the
swap. That is, an interest rate cash flow in one years time on a five year swap would be
discounted at five year swap rates. In contrast, where the zero coupon method is used, a
different discount rate will be used for each cash flow under each leg of the swap depending
upon the value date of the cash flow.
8.38 The principal advantage of the coupon (or par) yield method over the zero coupon method
is that the par yield method is easier to implement. The disadvantages of this method are that:
■ the coupon (or par) yield discounting method implicitly assumes that there is no
reinvestment risk, in that there is an assumption that all cash flows through the life of the
swap can be reinvested at a constant rate on which the discount factor is based. This is
obviously unlikely to be the case; and
■ it cannot deal easily with swaps where cash flows are not constant through the life of the
swap. Adjustments for funding have to be made to convert any non-generic swaps into
what are termed plain vanilla swap deals (constant cash flows).
As a result the zero coupon method is preferred by many of the larger, more sophisticated
players in the swap market.
8.39 The main advantages of the zero coupon method are summarised as follows:
■ it can easily handle non-generic swaps with complicated cash flows which can be slotted
easily into each maturity band of the portfolio and discounted as above;
■ it is a more realistic method than the coupon (or par) yield method of valuing a cash flow.
As it uses a different discount factor for each maturity band, it recognises that a flow in year
two is not worth the same as an equal flow in year one solely because of the time value of
money, but also because of the relative risk associated with each flow; and
■ it can be argued that the zero coupon method also automatically accounts for reinvestment
risk in that it is implicit in the utilisation of different discount rates for different maturity
bands.
The only disadvantage of the zero coupon method is that it potentially requires more
sophisticated computer models to carry out the revaluation process.
8.40 Zero coupon rates represent the discount factor required to give the swap a net present
value of zero where the fixed side of the swap is the coupon curve rate. The zero coupon curve
is typically derived from swap market rate for 2 to 10 years and interbank deposit rates or
futures rates for nearer maturities. Consider the following example:
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Notional principal: 100

1 year swap rate (annual payments): 15%
2 year swap rate (annual payments): 14%
3 year swap rate (annual payments): 13.5%
In this simple example the one year zero coupon discount rate is derived as follows:
115
4 = 1+i
1+i = 1.15
The two year zero coupon discount rate is derived as follows:
14 114
5 = 1.15 + 1 + i
1+i = 1.29802 (or an annualised rate of 13.39%)
1 1
You can see that discount factors of 1.15 for one year and 1.29802 for 2 years are the values
required to give the swap a net present value of zero. Thus they are the “zero coupon” discount
factors.
The 3 year zero coupon discount rate is:
13.5 13.5 113.5
6 = 1.15 + 1.29802 + 1 + i
1+i = 1.45774 (or an annualised rate of 13.39%)
Note that for Interbank deposits where interest is paid in full at the end at maturity, the zero
factor is calculated as:
1
Zero factor = 1 + Term x Rate
Where, Term is the proportion of the year represented by the term of the deposit.
Whichever method is used, valuations should be done daily, possibly using special software, or
spreadsheets. Derivation of the zero coupon curve involves complex calculations and will
certainly require special software.
8.41 Close out method. This method is based on the concept that the ideal way for a dealer to
eliminate or close out an interest rate swap position is by doing an opposite swap in the market
at current market rates. Therefore, this method involves overlaying an opposite swap at current
market rates and then taking the net present value of the residual interest rate cash flows. The
formula is set out in the appendix to this chapter.
8.42 As with the Bond pricing method, it is only necessary to revalue interest rate cash flows
on the floating leg out to the date of the next interest rate payment as the difference between the
interest on the swap and the interest rate on an offsetting market swap would be identical. If,
however, there is a basis difference on the floating leg, this difference would be recognised and
discounted.
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8.43 For the current interest rate period, the interest cash flow receivable and payable under the
offsetting swap would be calculated based on the applicable market interest rate for the period
from revaluation date to interest payment date. The rates of interest used for the offsetting swap
are based upon current market rates for the remaining term of the swap being revalued. The
discount rates can either make use of these same rates or applicable zero coupon rates.
8.44 Examples of swap revaluations. The following example sets out the calculations of the
estimated market value of a “plain vanilla” interest rate swap under the “bond pricing method”
using “coupon” or “par yield” discount factors and using “zero coupon” discount factors.
Swap details
A agreed on 9 May 19X3 to transact the following interest rate swap agreement with B:
Principal: $10 million
Commencement date: 9 May 1993
Maturity: 5 years
A pays: 6 monthly LIBOR
B pays: 13% semi annually
Payment dates: Semi annually commencing 6 months after commencement
Terms: Standard ISDA terms
At 9 May 19X4 the following interest rates prevail in the interbank market:
Interbank deposit rates:
1 months 15.25
2 months 15.4375
3 months 15.625
Swap rates:
4 years 14.49
5 years 14.16
6 years 14.02
7 years 13.95
8 years 13.78
9 years 13.30
Par Yield Valuation
The actual cash flows arising under the swap, including the notional exchange of principal, are
calculated and discounted at the appropriate rate for the maturity of the swap to arrive at the net
present value and market value of the swap.
The actual interest inflow at the swap rate is $10m x 13.0% x 1/2 = $650,000.
The discount rate will be the 4 year swap rate which is 14.02%.
The cash flows and their present values are as follows:
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Date Cash flow Present Value

09/05/X4 (10,000,000) (10,000,000)
09/11/X4 650,000 607,420
09/05/X5 650,000 567,629
09/11/X5 650,000 530,445
09/05/X6 650,000 495,697
09/11/X6 650,000 463,225
09/05/X7 650,000 432,880
09/11/X7 650,000 404,523†
09/05/X8 10,650,000 6,193,765
Loss (304,416)
0.1402 -7
† Equals 650,000 x (1 + 2 ) where 7 is the number of half yearly periods.
Zero Coupon Valuation

The actual cash flows arising under the swap, including the notional exchange of principal, are
calculated using the swap fixed rate. These cash flows are then discounted using the zero
coupon rate for each cash flow, as at the revaluation date.
The actual interest inflow at the swap rate is $650,000.
The cash flows and their present values are as follows:
Date Cash flow Present Value
09/05/94 (10,000,000) (10,000,000)
09/11/94 650,000 603,421
09/05/95 650,000 562,159
09/11/95 650,000 525,766
09/05/96 650,000 491,829
09/11/96 650,000 460,636
09/05/97 650,000 432,218
09/11/97 650,000 404,773
09/05/98 10,650,000 6,216,299
Loss (302,899)
8.45 Determination of interest rates. Where coupon (or par) yield rates are used for the
purpose of discounting the cash flows under the interest rate swap, deriving appropriate
discount rates is relatively straight forward. These will generally be obtained from independent
market quotations of the following covering the range of interest rate swap maturity dates:
■ cash rates - i.e., for short dated swaps and floating rate legs;
■ quoted swap rates; and
■ quoted long dated government securities coupon (or par) yields.
Rates for dates between quoted dates should be interpolated.
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8.46 As most yields quoted in the market are based upon coupon instruments, zero coupon
rates are generally derived mathematically based upon coupon rates. The formulae used for this
purpose are often highly complex and proprietary to the organisation concerned. Nonetheless,
these should be reviewed for reasonableness to ensure that the resulting zero coupon yield curve
derived is appropriate for the purposes of the revaluation. We should also focus on how
management monitor the appropriateness of the yield curve and assess the reliability and
integrity.
8.47 The normal inputs used for the purpose of deriving a zero coupon yield curve are as
follows:
■ cash rates for the short dated cash flows;
■ a strip of futures prices. As futures rates are in essence forward-forward interest rates, they
can readily be used to derive zero coupon rates;
■ swap rates; and
■ bond coupon rates.
8.48 There are often differences between the zero coupon rates implied by the swap rates and
those derived from the futures price strip. One method adopted in practice is to average the two
sets of derived rates.
8.49 Allowing for credit risk. A swap portfolio exposes a bank to credit risk arising from
default by the counterparty over the period of the deal. Practices for providing for this credit
risk vary widely. When assessing specific provisions, the credit risk on swaps, as with all off
balance sheet transactions, should be included to establish whether any provision is required. In
addition to this, some banks raise a “general provision” against possible future losses based
upon some measure of credit risk, usually based on the BIS conventions.
8.50 In certain circumstances a dealer may alter the pricing of an interest rate swap so as to
reflect a premium for credit risk. Whilst the adjustment is likely to be much smaller, the
concept of the credit risk premiums is analogous to that used when setting interest rates for
lending purposes.
8.51 Where the quoted rates on a swap includes such an adjustment, care is needed to ensure
that the revaluation process correctly recognises any credit premium in the profit and loss for
the period. If the swap is simply revalued by comparing the contracted interest rates to the
current market rate, the result would be the full recognition of the full credit premium on the
day of the deal. This would arise as a difference between the quoted rate and the market rate
and would be seen by the mark to market revaluation as a profit.
8.52 Where such adjustments are material, the credit premium element should be excluded
from the interest rate on the swap in the mark to market revaluation. Instead, as this represents
a premium for bearing credit risk over the term of the swap, it should be amortised and
recognised progressively. As a result, it is necessary to separately identify any credit premium
built into the pricing of the swap at the time of the deal so that an appropriate adjustments can
be subsequently made. Alternatively, the bank’s method of providing for credit risk arising
from the swap portfolio may be considered to provide appropriate allowance for the credit
premium.
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8.53 Allowing for market liquidity. The concept of mark to market is predicated on the
concept that the dealer could sell his swap portfolio in the market at current market prices and
therefore the most appropriate measure of its value is given by current market rates. While this
does not imply a valuation based upon a forced disposal, it is necessary that the market has
reasonable liquidity so that positions could be meaningfully closed out. Where markets are not
liquid, the appropriateness of using market rates to revalue the swap portfolio should be
questioned. Practical solutions are difficult but one alternative where markets are relatively
illiquid is to broaden the spreads used.
8.54 Provision for administration costs. Interest rate swap portfolios can have maturity dates
extending out for many years. As the mark to market method brings to account the net present
value of the expected future profits in the interest rate swap portfolio, it is generally appropriate
to also make provision for the on-going administration costs associated with this portfolio.
These costs include:
■ processing costs and fees associated with settlements;
■ data processing system costs;
■ government charges and taxes; and
■ salaries and associated administrative costs.
8.55 To the extent that a bank has an on-going interest rate swap trading portfolio, the marginal
costs associated with the on-going administration of outstanding swaps may not be readily
identifiable. As a consequence of this uncertainty, there is no clear and widely recognised
method used in practice and generally provisions are somewhat arbitrary. Nonetheless, it is
likely that the amount of the provision should increase in proportion to the number of deals
outstanding and their term. Further, at a minimum the provision should be sufficient to cover
any direct costs such as settlement processing fees or taxes.
8.56 Cross currency swaps. Some care is required in revaluing cross-currency swaps by
reference to market exchange rates and interest rates. Revaluation of the forward commitment
to re-exchange principal at the current forward exchange rate would normally produce a
substantial profit or loss as the forward deal is normally fixed at the current spot rate. However
this profit or loss arises from the interest differential between the two currencies, which is
already compensated by the agreement to exchange interest obligations.
8.57 Accordingly each leg of a cross-currency interest rate swap should be revalued in the
currency in which is denominated, using discount factors derived from interest rates in the
appropriate currency. The present value of each leg is converted to the home currency at the
prevailing spot rate.
Other matters
responsible for setting clear policies prior to the commencement of significant swap trading.
The policies should define the circumstances in which swap trading is considered appropriate
and the classes of assets and liabilities or off balance sheet positions which may be hedged
using swaps. As a general rule the policies should be formally documented and approved by the
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highest levels of management. Consideration should also be given to the manner in which such
used by banks and financial institutions to control its swap trading risks:
be set by currency, by maturity, by counterparty and by dealer - as required. Typically
separate limits are required for the trading portfolio and for hedging transactions.
Interest rate swaps are also relevant to overall interest rate and foreign currency risk
management and the limits in place in relation thereto. These limits are discussed in chapter 2
of this volume.
8.60 Credit risks. Risks such as interest rate risk and foreign exchange risk for swaps are
similar to those for other instruments. However, the credit risks deserve particular
consideration because of the size of the transactions and the long periods for which the risks
run. They can be considered as:
■ Delivery credit risk. For single currency interest rate swaps the potential exposure is
limited to the interest payments due under the deal, but in cross currency interest rate swaps
there are exchanges of principal both at inception and at final maturity date. Delivery credit
risk is reduced if the agreements allow netting of notional interest so that only the net
amount due to or from the bank is payable.
■ Interest rate and foreign exchange credit risks. Each half of a swap transaction gives rise
to an exposure to interest rate and/or foreign exchange rate movements. If a counterparty
were to default before the conclusion of the transaction, the bank’s position would no longer
be matched, and a cost might be incurred in covering the position at the current rates. The
bank therefore has a credit exposure in respect of the value of counterparties’ future
obligations under swap transactions. The exposure increases as the term of the transaction
lengthens because the likely deviation of the current forward exchange rate, at which the
position arising from such a default could be covered, from the original forward rate (or
fixed interest rate) used in the swap increases with time.
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■ position sheets to maintain current control over the traders' position;
■ bank or financial institution's copy of confirmation it has despatched to the customer;
■ confirmation received from the counterparty (if another financial institution).
■ daily transaction reports;
■ profitability reports, by dealer/customer/period/contract;
■ position reports, by customer and in total;
■ commissions and other expense reports;
■ exceptions reports highlighting potential risk situations (e.g. position limit excesses,
contracts nearing delivery date or expiry).
Auditing guidance
8.62 For auditing guidance on a bank or financial institution’s interest rate swap activities
reference should be made to chapter 3 of volume 1.
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Appendix: Valuation formula for interest rate swaps

Bond pricing method. The formula for the revaluation of an interest rate swap using the bond
pricing method is:
n
CFj P
= + -P
(1 + i mj ) (1 + i mj ) n
j
j=1
Where:
P = Notional principal amount of the swap.
CFj = Interest cash flow receivable or payable under the swap in period j.
imj = The market discount rate applicable. If coupon (or par) yields are used, this is
constant for all values of j for a given maturity of swap n. For zero coupon
rates, this varies for each value of j depending on the position on the zero
coupon yield curve.
n = Number of periods to maturity of the swap.
Close out method. The formula for the revaluation of an interest rate swap using the close out
method is:
n
CFj - CFjm
=
(1 + i mj ) j
j=1
Where:
P = Notional principal amount of swap.
CFj = Interest cash flow receivable or payable under the contracted terms of the swap
in period j
CFjm = Interest cash flow that would be payable or receivable under an opposite swap
for the remaining terms of the swap in period j at the current market rate for
such a swap. An opposite swap is one with equivalent notional principal,
interest dates and interest bases but with opposite cash flows and based on
current rates. In principle, the difference between CFj and CFjm would
represent the net cash flow on the swap if it were closed out with an opposite
swap on the revaluation date.
imj = The market discount rate applicable. If coupon (or par) yields are used, this is
constant for all values of j for given maturity of swap n. For zero coupon rates,
this varies for each value of j depending on the position on the zero coupon yield
curve.
n = Number of periods to maturity of the swap.
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9 Options
Introduction
9.1 Options are available on interest rates, foreign exchange, equities and commodities. In this
chapter we set out the principles of options as they relate to currency options. The principles
apply equally to options on other items. In chapter 10 we address interest rate caps floors and
collars which are effectively “strips” of interest rate options.
9.2 Definition of a currency option. A currency option is a contract between a buyer and a
seller giving the buyer of the option the right, but not the obligation, to buy (call) or sell (put) a
specific amount of one currency, on or until a certain date, the exercise date, at a predetermined
price (the exercise or strike price). For the right given by the option contract, the buyer pays a
sum of money (the premium) to the seller (also known as the writer). The option writer retains
the premium irrespective of whether the option is exercised or not.
There are two different types of option:
■ a call option - gives the buyer the right to purchase the currency;
■ a put option - gives the buyer the right to sell the currency.
9.3 Options which can be exercised at any time up to the expiry date are known as "American"
options. Options which can be exercised for delivery on only one date are known as
"European" options.
9.4 Options are available in two basic forms:
■ traded options which are dealt on a recognised exchange; and
■ over the counter (OTC) options individually tailored by international banks to meet the
particular requirements of corporate customers.
Traded options are standardised and this has helped to create strong secondary markets in them.
An option traded on a recognised exchange is guaranteed by that exchange. To protect the
exchange, the option writer is required to maintain a margin with the exchange.
9.5 Types of traded currency options contracts. Some examples of contracts currency
traded on major exchanges (with standard amounts, all traded against the US dollar).
Chicago board options exchange Canadian $ C$ 100,000
Deutschemark DM 125,000
French franc FFr 250,000
Sterling £ 25,000
Swiss franc Sfr 125,000
Yen ¥ 12,500,000
Chicago mercantile exchange Deutschemark DM 125,000

(options on futures) Sterling £ 25,000
Swiss franc Sfr 125,000
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European options exchange Dutch florin $ 10,000

(Amsterdam) Deutschemark $ 10,000
ECUs ECU 10,000
Sterling £ 5,000
Sterling jumbo £ 100,000
LIFFE (cash) Sterling £ 25,000
9.6 The currency option is a useful tool in the management of foreign currency exposure. It
enables companies to hedge such exposures while retaining the potential to profit from
favourable movements in exchange rates. It provides a flexibility not available from futures or
forward contracts. Thus, if a company is tendering for a contract and is uncertain as to winning
it and earning foreign currency income, it could purchase a suitable option which would protect
it in case it was awarded the contract, but would not leave it with an exposure if it failed to do
so, unlike a forward foreign exchange or financial futures contract of similar amount.
9.7 Pricing and option values. The price of a currency option is determined by five main
factors:
■ current spot price of the underlying currency;
■ exercise price;
■ forward exchange rate applicable to the maturity date (i.e., the relative interest rates of the
two currencies);
■ time to maturity of the option;
■ volatility of the underlying currencies.
9.8 These factors are the only quantifiable influences on the option premium. In practice, non
quantifiable factors such as market expectations as to future movements in the spot rate will
also affect the current market price for any option.
9.9 To understand fully the option pricing mechanisms, it is necessary to understand the
relationship between the exercise price of the option and, depending on whether it is a European
option or an American, the current forward exchange rate or current spot rate respectively.
9.10 An option (European) is said to be:
■ "in-the-money" if the current forward rate is less favourable than the strike price;
■ "out-of-the-money" if the current forward rate is more favourable than the strike price;
■ "at-the-money" if the current forward rate equals the strike price.
Where delivery is allowed at any time up to maturity (on American options) the comparison of
the strike price is with the current spot rate.
9.11 The value of an option can be divided into two components: intrinsic value and time
value. The intrinsic value of an in-the-money call is the amount by which the forward rate or
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spot rate exceeds the strike price. If the call option is at or out-of-the-money, the option has
zero intrinsic value. The time value is the amount by which the option premium exceeds its
intrinsic value. The time value of an option decreases with time and declines to reach zero at
maturity.
The rate of decrease of the option's time value is not constant; rather it increases as the time
remaining until maturity falls with the most rapid decay occurring in the last few weeks before
the maturity date.
9.12 The typical relationship between the option premium and the current market rate is
illustrated by the graph below, which demonstrates the "call option pricing curve" for a
currency option:
CALL OPTION PRICING CURVE
The call option pricing curve illustrated above has two main characteristics:
■ the time value premium reaches its maximum when the current exchange rate equals the
strike price of the option; at this and lower prices, the value of the option will be equal to the
time value;
■ when the option is either deep in-the-money or out-of-the-money the option premium tends
towards its intrinsic value.
9.13 The amount by which the currency option price will change for a given change in the
exchange rate is an important measure and is known as the "hedging ratio" or "option delta".
The hedging ratio represents the hedge position which is required to protect the option position
against incremental fluctuations in the spot or current forward exchange rates. In fact, the
hedging ratio is the gradient of the option pricing curve illustrated above. The value of the
hedging ratio will lie between 0 and 1: the hedging ratio of a deep in-the-money call option will
be nearly 1 as any movement in the exchange rate will be largely reflected in the price of the
option, while the hedging ratio of a deep out-of-the-money option is nearly zero.
The delta value can be used to calculate the physical equivalent of an option position (the “delta
equivalent”). The delta equivalent position enables the calculation of the net open position of a
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portfolio of spot, forward and option transactions. The delta equivalent is only fixed at one
particular time and any movement in the exchange rate will affect the delta value and hence the
delta equivalent position.
9.14 The gamma value of an option represents the rate of change of the delta as the exchange
rate fluctuates. The gamma function will lie between -1 and +1 with the magnitude
representing how receptive the option is to changes in exchange rates and the sign representing
whether the option will lose or gain value for a certain rate movement.
9.15 Currency option pricing formulae. The valuation of exchange traded currency options
is relatively simple given that the prices are quoted on the corresponding futures exchange. The
pricing of over-the-counter options, however, is more complex. The price of the option is given
by complex mathematical option pricing models. There are a variety of such models used in
practice, each often a derivative of the other, with refinements to some of the assumptions so as
to derive "better" option prices.
9.16 For European options, most pricing models are a derivative of the Black-Scholes option
pricing model. An example of the Black-Scholes option pricing formulae is contained in the
appendix to this chapter. Pricing of American options requires the use of binomial option
pricing models which are not discussed here. Because American options provide the holder
with the additional benefit of the ability to exercise early, American options will always be
worth at least as much as European options.
9.17 It can be shown that for American style call options on products which do not provide
income during the period to expiry, it is never optimal to exercise early as no payment is
received for the residual time value (and funding costs will be incurred in relation to the
payment of the exercise price). Therefore, the Black-Scholes valuation is equally applicable to
American call options on such assets. However, in all other cases the Black-Scholes model may
undervalue the option.
9.18 Most of the variables which influence the price of an option are readily available either
from the contract itself or from quoted market sources. For example, the exercise price and
time to maturity are set by the contract and the current spot price and forward price are available
for the market. The key unknown variable is the volatility of the underlying instrument
currency or commodity. There are many ways to look at volatility. For example, do you look
at historical volatility over 10 years or just over the past three months? Do you build in a factor
for expectations of future movements? Do you apply a greater weighting to recent history than
to volatilities that are several years old? Despite these problems, an estimate of volatility is
often available from market information services and is generally quoted in its own right.
Alternatively, estimates of volatility may be obtained from analysis of historical information.
9.19 Uses of options are similar to those for financial futures. The principal difference from
futures transactions are:
■ the option buyer can take advantage of movements in exchange rates as the buyer can
always choose between the option or market rate;
■ the maximum cost is limited to the option premium;
■ the buyer can (within limits) set the strike price.
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9.20 Some banks offer their customers 'cylinder options' where instead of paying a premium
the customer buying a call option grants the bank a suitably priced put option (or vice versa).
This has the effect of restricting the customer's loss on a future transaction at the price to him of
restricting his ability to gain from favourable exchange movements.
Mechanics of trading currency options through an exchange

9.21 Currency options are normally quoted against the US dollar. For example, the sterling
option contract which is traded on the London stock exchange has a contract size of £12,500
and the purchase of a sterling September 1.20 call option gives the buyer the right to buy
£12,500 at a rate of 1.20 (i.e., for US$15,000) at any time up to the option expiry date in
September. Premiums are normally quoted in cents per unit of currency. Thus at a premium of
6 cents, a sterling call option would cost $750 (12,500 x $0.06).
9.22 For each option contract a 'tick' (minimum price fluctuation) is specified. For example the
$/SFr contract is quoted in Swiss francs per US dollar and the contract size, or tick, is $100,000.
The minimum price change is SFr 0.0001 per $ which is equivalent to Sfr 10 per contract.
9.23 Clearing houses associated with options exchanges have strict procedures for dealing with
exercises of options. Typically the holder of a contract will deposit an exercise notice with the
clearing house, which will then send an assignment notice to a randomly selected member with
a position as a writer who may then assign it in turn to a client. The writer is not then able to
close his position by means of a purchase transaction but must deliver (or take delivery of) the
underlying currency.
9.24 Margin. As with financial futures the clearing houses ensure the performance of each
options contract, and they obtain shelter from potential losses by calling for margins from
option writers. Margins are calculated in a variety of ways and some examples are set out
below:
■ Chicago Mercantile Exchange DM futures contract:
Premium plus margin applicable to DM futures contract minus half of the out-of-the-money
amount. Minimum margin is premium plus $400.
■ London Stock Exchange £/US dollar contract:
10% of the US dollar value of contract plus or minus amount by which contract is in- or
out-of-the-money. Minimum margin is $250 per contract.
9.25 Margin reductions may sometimes be claimed for off-setting purchased positions.
Accounting matters - currency options

9.26 Background. The following guidance is general in nature. Consideration should be
given to any local practice and accounting regulations.
9.27 Accounting for trading in currency options. The accounting entry which would
normally be generated on writing or selling an option is to debit cash and credit currency option
premium suspense account, with the full amount of the premium received from the
counterparty. Similarly, on purchasing an option the premium paid is debited to the currency
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option premium suspense account and cash is credited. Also to be considered is the margin
payable by the option writer on the sale of an option contract. With tailored options, a customer
who requests to sell a put or call option would normally be asked to make a margin deposit with
the bank which would record the margin as a liability in the balance sheet. Margins payable by
the bank as writer would similarly be recorded as assets.
9.28 Profits or losses arising on open option positions would normally be calculated by
revaluing all open positions to their current market value ("marking to market") and comparing
this to the cost of the option positions. This method determines the current value of the asset or
liability represented by the net currency option premium suspense accounts and the unrealised
profit or loss is the difference between the current market value of the option positions and the
balance on these accounts. Unrealised losses should be recognised immediately; unrealised
profits would also normally be taken up in the profit and loss account.
9.29 Problems can occur in determining the current market value of open option positions.
With traded options no difficulty should arise as reliable market prices for both put and call
options are available with both bid and offer prices quoted. The last traded price on the floor of
the exchange for the relevant day is taken as the market value. Typically OTC options present
more of a problem as market prices may not be quoted. Frequently a bank will use a price
derived from a theoretical model such as Black-Scholes.
9.30 Although it may be more conservative to recognise profits on option trading on a realised
basis, the practice of marking the positions to market and recognising all unrealised profits and
losses (assuming sufficient liquidity in the market) normally reflects more closely the
commercial reality of trading.
9 . 3 1 Accounting for hedges. If currency options have been used to hedge, then the
recognition of the profit/loss on the option should be recognised over the same period as
income/expense arising from the hedged transaction. For the option transaction to be regarded
as a hedge, the following criteria applicable to financial futures would normally have to be met:
■ At the time the option transaction was entered into its purpose as a hedge must have been
specifically identified and documented in the accounting records and the asset, liability or
position for which the hedge was intended must have been specified;
■ The price of the option and the hedged asset or liability must have a high degree of positive
correlation, that is, the tendency to move in the same direction with similar magnitude;
■ For a hedge of an anticipated transaction, the transaction must be reasonably expected to be
fulfilled in the normal course of business.
9.32 Where these hedging criteria are met, recognition of the income/expense from the option
should be matched with the recognition of the income/expense from the hedged asset or
liability. This may be achieved in one of two ways:
■ Amortise the premium paid (remembering that a hedge using options will always involve
purchased options) over the hedge period and recognise any gain on exercise of the option
at the same time as the offsetting loss on the underlying hedged position.
■ Mark the option to market and match the timing of recognition of any resulting gain or loss
with the recognition of the offsetting loss or gain on the underlying hedged position.
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The first of the above alternatives is normally appropriate where the hedge is a simple “static”
hedge, put in place to offset the risk on a specific underlying position. The treatment of the
premium in this case is akin the amortisation of an insurance premium.
The second of the above alternatives is appropriate where the option is acquired as part of a
“delta hedging” strategy. In this situation the hedge will require management (because the
delta, or hedge ratio, will change as the price of the underlying instrument changes and as time
passes) and it may be necessary to adjust the size of the hedge during the period that the hedge
is to be effective. Therefore it is appropriate to regularly revalue the hedge rather than to
simply amortise the option premium. Note that delta hedging is more common in a trading
environment and, accordingly, the underlying hedged position would typically be marked to
market, and gains and losses recognised at the time of revaluation.
9.33 Note that the option delta is always less than 1, and changes with time and with
movements in the value of the underlying instrument. As a result, in some circumstances, it
may be difficult to meet the "correlation" criterion for a hedge. For example a close to maturity
deep out-of-the-money option has little value and does not provide an effective hedge.
However, it is important to recognise that a hedge does not have to eliminate 100% of the risk
inherent in a position before it may be accounted for as a hedge.
Other matters
responsible for setting clear policies prior to the commencement of activities in options. The
policies should set out in what circumstances options may be used and what the institution’s
objectives are in using options. The policies should specifically address the circumstances in
which options may be written/sold.
institution's attitude and assessment towards risk changes over time. The nature of the limits
will depend upon whether the institution is using options for trading or hedging. If hedging, the
limits will vary depending upon whether only simply “static” hedging is to be used or whether
more complex hedging strategies will be adopted. Limits should be applied so as to minimise
risks whilst not imposing undue constraints on the abilities of traders to maximise profits
through operation in the market. The following are the usual types of limits used by banks and
financial institutions to control options trading risks:
■ Volume limits: these limits may be set on total premium or open position (calculated by
reference to the delta function). These limits can be set by currency, by option type, by
maturity and by dealer - as required. Typically separate limits are required for the trading
portfolio and for hedging transactions.
■ Overnight and intraday limits: as margin needs to be paid to the clearing house only on open
positions held overnight, there is normally scope for the bank or financial institution to set
less stringent volume limits on trading during the day than is necessary for overnight
positions;
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■ Gap limits: limits for straddle and spread trading need to cover offsetting positions for
different expiry dates. It may be possible to set these limits at somewhat higher levels than
those set for overnight open positions because of the generally lower levels of risk
associated with movements in relative rather than absolute levels of prices. The operation
of gap limits is often made more complex by the difficulties associated with identifying
which transactions have been entered into as straddles or spreads;
predetermined limit then the position is required to be closed out.
Interest rate options are also relevant to overall interest rate risk management and the limits in
place in relation thereto. These limits are discussed in chapter 2 of this volume. Similarly,
currency options are relevant to overall foreign currency risk management which is also
discussed in chapter 2 of this volume.
■ position sheets to maintain current control over the traders' position in each type of contract;
■ broker's advises;
■ bank or financial institution's copy of confirmation it has despatched to the customer;
■ clearing house reports and statements (for exchange traded options).
■ margin reports, by customer and in total, showing the net variation and deposit margin
requirements;
■ exceptions reports highlighting potential risk situations (eg. position limit excesses,
Auditing guidance - options

9.37 The audit issues associated with an institution’s option operations are discussed in chapter
3 of volume 1.
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Appendix: Valuation formula for off-balance sheet

instruments
Currency options
9A.1 For European options, most pricing models are a derivative of the Black-Scholes option
pricing model. One form of this model for a call option is as follows.
C = e -rf T SN(d + σ T) - e -rd T XN(d)
√
Where:
C = Call premium
S = Spot price (quoted as US$ per unit of foreign currency)
X = Strike price
rf = Applicable foreign interest rate
rd = Applicable domestic interest rate
T = Number of days to expiry divided by number of days in a year
σ = Volatility
N(a) = Cumulative normal distribution. Normal distribution probability that the
standardised normal variate lies between -∞ and a. That is, the probability that the variate is
less than a. A simple approximation formula for the calculation of N(a) for positive values of a
is:
1 a2
= 1- e - 2 (0.4361836 K - 0.1201676 K2 + 0.937298
2π
√
K3 )
1
where, K = 1 + 0.33267a
Where a is negative, use the absolute value of a in the formula and the
true value of N(a) is 1 - N(a) as calculated.
S σ2
ln(X) + [r d - r f - 2 ] T
d =
σ√ T
9A.2 The corresponding value of a put option (P) is:
P = e -rf T S[N(d + σ T) -1] - e-rd T X[N(d) - 1]
√

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Introduction
10.1 Interest rate caps effectively place a ceiling on the interest rate payable on a quantum of
borrowing.
10.2 Caps attached to borrowings. Floating rate notes (FRNs) or variable rate certificates of
deposit (CDs) are often issued with an interest rate cap or ceiling. When the formula in
accordance with which the interest rate is set indicates a rate in excess of the cap rate, only the
cap rate is paid.
10.3 The issuer often sells the benefit of the interest cap to a bank in exchange for
consideration. The benefit of the interest rate cap is transferred to the bank by means of the
note issuer paying directly to the bank the excess, if any, of the formula interest rate over the
cap rate. The coupon paid on the FRN or CD less the payment received for the sale of the
interest rate cap, is often less than the interest cost of issuing a non-capped FRN because of the
exploitation of an arbitrage opportunity: banks and other institutions are generally prepared to
pay more for an interest rate cap - that is, to receive payments if rates rise above a certain level -
than investors demand for providing the cap.
10.5 Caps as options. An interest rate cap has the characteristics of strip of options on interest
rates. The purchaser of the cap effectively has the “option” to choose between the cap rate and
the market interest rate of each of the prescribed interest rate setting dates. In the case of caps
attached to borrowings, the cap is "written" by the investor purchasing the FRN or other
instrument. Caps are also written by other market participants, independent of any borrowing.
10.6 Floors and collars. An interest rate floor places a lower limit on the rate of interest
payable on a borrowing. Thus, a floor is likely to be of interest to an investor who wishes to
ensure that a prescribed level of return is achieved on an investment. However, both caps and
floors are expensive. As a result we have seen the development of the collar - a combination of
a cap and floor - which appeals to a borrower who wishes to retain the cap but obtain it at a
lower price. Because the borrower is effectively writing an option back to the investor/lender,
the cost of a collar is cheaper than the equivalent cap.
10.7 Typical deal. A typical interest rate cap deal is as follows:
■ The borrower issues US$200 million FRNs with a cap of 13 1/16%. To compensate the
noteholders for the interest rate cap the FRN carries a coupon 1/4% above that on an
equivalent non-capped FRN;
■ The borrower sells the right to the interest rate cap to the sponsoring bank for 3/8% pa,
payable on the same dates as the interest payments on the FRN;
■ The bank sells the right to the interest rate cap to another counterparty in exchange for a
consideration which, when invested in Treasury bonds, yields 3/8% pa on the principal
amount plus a spread representing the bank's profit.
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The flow of payments in the case where (a) the FRN interest rate is less than the cap rate (say
12%) and (b) where the FRN interest rate is greater than the cap rate (say 14%) is as follows:
10.8 Interest rate = 12%
3/8% 3/8%+
Spread
Borrower Bank Treasury Bills
0%
12% 0%
Note Holders Buyer of cap
10.9 Interest rate = 14%

3/8% 3/8%+
Spread
Borrower Bank Treasury Bills
15/16%
13 1/16% 15/16%
Note Holders Buyer of cap

The deal benefits each of the parties as follows:-
■ Noteholders: The noteholders earn a coupon 1/4% above the market rate on a non-capped
FRN (in return for accepting the cap) at interest rates below the cap level;
■ Borrower: The borrower's funding cost is 1/8% less than that for a non-capped FRN as it
pays an extra 1/4% to the noteholders but receives 3/8% from the bank;
■ Bank: The bank earns a spread on the deal as its income from the investment of the
consideration received from the buyer of the cap exceeds the 3/8% pa that it pays to the
borrower;
■ Buyer of the cap: The buyer of the cap has acquired the right to the payments under the
interest rate cap in exchange for the consideration paid. Its objective is may be to provide a
hedge against interest rates increasing above 13 1/16%, or alternatively it might be taking a
position.
10.10 Deal variations. The structure of an interest rate cap deal can be subject to many
variations. For example:
■ the intermediary bank could buy the cap at one rate (13 1/16%) and sell it on at a higher rate
(say 13 1/8%). The bank would then retain a "skim" of the first 1/16% over the cap rate
(but would receive a lower price on the sale of the cap)
■ payments for caps may be made either in the form of up-front payments or by means of
periodic payments over the life of the cap.
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Accounting matters
10.11 The possible variations on interest rate cap deals, and the various parties' roles in them,
mean that the accounting implications of each deal need to be considered separately.
Accounting treatments for some of the more common situations encountered in practice are
given below. The following guidance is general in nature. Consideration should be given to
any local practice and accounting regulations.
■ Payments and receipts under caps
Amounts paid and received under caps when the reference interest rates exceed the cap rate
will be treated by both payer and receiver on an accruals basis. In a matched position (e.g.
of an intermediary bank) the payment and receipt may be netted off for profit and loss
account disclosure purpose.
■ A bank holding a capped FRN
Capped FRNs are essentially a hybrid of a fixed rate note (when the cap rate is reached) and
a normal FRN. Consequently, when the cap rate is approached their market value is likely
to be more volatile than an equivalent uncapped FRN. As with other securities, the value at
which capped FRNs are carried will normally depend on whether they are held on trading
account or investment account. Trading account securities would be carried at market (or
sometimes the lower of cost and market) and investment account securities would be
carried at cost with amortisation of any premium of discount on purchase, less provisions
for permanent diminution’s in value.
In both of the above situations interest income should be recognised on an accruals basis.
■ Matched cap positions
A matched cap position is most likely to arise where a bank acts as intermediary. In the
simplest case the bank will merely act as a conduit.
Where the bank acts as principal, profit may be spread over the period of the cap, to
compensate for the credit risk involved, and any up front payments or receipts would
therefore be capitalised and released to profit and loss over the period of the cap.
Alternatively, part of the profit may be deferred to cover the credit risk and the balance,
representing the reward for arranging the transactions, would be taken to profit on a NPV
basis.
Where the bank is not acting as principal, any receipts will normally be recognised as profit
with deferral only of amounts sufficient to cover known outgoings.
■ Unmatched caps
The buyer of a cap receives, in return for a consideration paid up-front or periodically, the
right to receive interest payments when the cap rate is exceeded. He may acquire the cap
either in order to take a position on interest rate movements or in order to partially hedge an
existing interest rate exposure whilst remaining in a position to take advantage of
favourable rate movements.
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■ Non-hedge caps
The value of the buyer's right to receive payments when interest rates exceed the cap rate
will depend on the following factors:
- the remaining period to maturity of the cap;
- the relationship between the cap rate and prevailing market rates;
- market expectations of future rate movements;
- the principal on which the deal is based.
If there were an active and liquid cap market the appropriate accounting treatment would be
to mark the caps to market value with any increases or decreases in market value being
dealt with through the profit and loss account. As the maturity approached there would be a
tendency for the value of the cap to fall to zero.
Where reliable market values are unobtainable banks may be able to develop mathematical
models based on the above factors which provide reasonable simulations of market values.
Otherwise the most appropriate accounting treatment may be to amortise the consideration
paid for the cap on a straight line basis over the period to maturity.
Analogous considerations would apply to a writer of a cap. However, if the writer of a cap
was unable to quantify the value of the cap it may be prudent to defer recognition of any
income in relation to the premium received until expiry of the cap.
■ Caps as hedges
Where the cap has the effect of limiting the interest rate payable on the buyer's borrowing, it
may be appropriate to account for the cap as a hedge. The cost of the cap would then be
amortised over its life and then added to the cost of the borrowing.
10.12 Risks. The risks are similar to those for other interest rate contracts. An interest rate cap
gives rise to an interest rate exposure and to a credit exposure. Both parties to the cap have an
interest rate exposure: a "bare" writer may have to pay out on the cap (an investor in a capped
FRN will have an opportunity cost if prevailing interest rates exceed the cap rate); while the
buyer will make a capital (or periodic) payment for the rights under the cap, the value of which
depends on movements in, and expectations of movements in, interest rates.
The buyer of a cap also has a credit risk being dependent on the seller to make payments if
interest rates exceed the cap rate.
Other matters
responsible for setting clear policies prior to the commencement of significant caps trading.
The policies should define the circumstances in which caps trading is considered appropriate,
the classes of assets and liabilities which may be hedged and the caps contracts which may be
used. As a general rule, the policies should be formally documented and approved by the
highest level of management. Consideration should also be given to the manner in which such
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maximise profits through operation in the market.
The type of limits applicable to option products are discussed in chapter 9 of this volume.
Interest rate caps, floors and collars are also relevant to interest rate risk management limits
which are discussed in chapter 2 of this volume.
10.15 Records and reports. The accounting system must create and maintain complete
records of all transactions, segregated by customer where appropriate. The following records
should normally be available:
■ position sheets to maintain current control over the traders' position in each type of contract;
■ bank or financial institution's copy of confirmation it has despatched to the customer.
■ confirmation received from counterparty (if another financial institution).
■ mark to market reports,;
■ exceptions reports highlighting potential risk situations (e.g. position limit excesses,
Auditing guidance
10.16 The audit issues associated with interest rate cap operations are discussed in chapter 3 of
volume 1.
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Introduction
11.1 Background. Maximising the excess of interest earned over interest paid is a primary
objective of bank or financial institution management. This is accomplished by controlling the
two sets of exchanges contributing to net interest margin through "asset liability management".
This involves co-ordinating investment alternatives with possible sources of funding so as to
maximise the net interest margin of the resulting portfolio, while containing interest rate,
exchange, credit and liquidity risks within tolerable limits.
11.2 Because the maturity dates of deposits and other sources of funds available in the market
do not always sufficiently match the maturity of banks’ or financial institutions’ assets, bankers
make use of interest rate hedging instruments to reduce their interest rate gap exposure to
acceptable limits. Banks have used traded financial futures contracts but, as an alternative,
interbank forward rate agreements (FRAs) have became increasingly popular, as they have
several advantages over futures contracts. Under an FRA the two counterparties agree to
compensate each other for the difference between a mutually agreed interest rate and a
benchmark rate (e.g. LIBOR) ruling on a mutually agreed future date (the "value date") and for
a mutually agreed period.
11.3 For two parties to enter into an FRA for hedging purposes they would have to have
exposed positions which were substantially equal and opposite with regard to amount, period
etc and this is likely to be rather difficult to arrange in practice. Consequently, mechanisms
have developed to facilitate the functioning of an FRA market, including:
■ The intervention of intermediaries. Certain banks and brokers specialise in organising FRAs
and finding a counterparty to match their client's hedging needs. Such FRAs often involve
multiple counterparties and to complete the deal one or more counterparties often takes a
position in its own right.
■ Position taking. Banks and financial institutions may take speculative positions on interest
rate movements by entering to unmatched FRAs either whilst looking for suitable
counterparties or as a pure speculation. Such positions can also be partially hedged by
financial futures contracts.
Mechanics of FRAs
11.4 There are six key elements of a FRA transaction:
■ Value or settlement date. The FRA must specify the forward period over which the rate
agreement is to apply. The start of this forward period is referred to as the value or
settlement date.
■ Maturity date. The end of the forward period over which the rate agreement is to apply is
referred to as the maturity date.
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■ Contract amount. The FRA must specify the contract amount, which is the notional
principal upon which the settlement amount is calculated.
■ Contract reference rate. The contract reference rate is the agreed rate upon which the FRA
is written.
■ Settlement rate. The settlement rate is the current market “contract” rate, on settlement
date.
■ Settlement amount. On the settlement date, the settlement rate is compared to the contract
reference rate. Based on the interest rate differential for the settlement period and the
underlying notional principal amount, the settlement amount is determined.
The settlement amount will be paid by one of the parties to the other (depending upon the
direction of the movement) to compensate for any unfavourable movement in the interest
rates.
If a party buys a FRA (i.e., has an agreement with the seller to pay a fixed interest rate) and
interest rates rise, then the seller must pay the buyer the settlement amount. If interest rates
fall, the buyer would have to pay the seller the appropriate settlement amount.
11.5 The principal advantages of FRAs for banks and financial institutions are as follows:
■ As FRAs are interbank transactions and do not go through a futures exchange there is no
requirement for margin deposits or margin variation calls, with a corresponding saving in
administration costs;
■ Whereas futures contracts are standardised as to amount, settlement day etc., FRAs can be
negotiated to fit precisely the bank or financial institution’s hedging needs;
■ The bank or financial institution’s exposure to credit risk is limited to the interest variation
based on the principal and is not the full principal amount. The perceived credit risk
depends on the interest rate volatility;
■ The FRA is settled on value date by exchange of a cash sum and consequently does not
gross up the balance sheet. This is in contrast to a forward deposit transaction - an
agreement to place or take a deposit for a specified period at a specified value date - where
funds equal to the principal of the deposit will be exchanged on the value date and the
deposit will then be carried on the balance sheet throughout the hedge period;
■ FRAs are available in the interbank market not only in US dollars and Sterling but also in
Swiss francs, Deutschemarks, Australian dollars and other currencies which are not traded
on the financial futures exchanges.
11.6 FRAs do, however, have two disadvantages when compared with financial futures:
■ There are no formal markets in which FRAs can be traded, and secondary market liquidity
is limited. In theory, a FRA can be closed out at any stage by entering into an equal and
opposite FRA at a price which reflects the interest rate for the period at the time of closing
the hedge. However, the lack of a formal secondary market and the difficulty of finding an
equal and opposite FRA (due to their tailored nature) may make closing out difficult or
prohibitively expensive;
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■ FRAs carry the credit risk of the counterparty, whereas for financial futures this is covered
by substitution of the clearing house which is in turn protected by the deposit of margin.
11.7 Settlement. On the value date the fixed rate established in the FRA is compared with
LIBOR for deposits over the agreed period and the counterparties settle between them the value
of the interest rate differential on the agreed principal over the agreed period. As the interest
rate differential is paid in advance at the start of the fixed rate period, the settlement amount is
normally discounted at LIBOR. The following formula can be used to determine the settlement
amount:
LIBOR - FRA rate No.days in fixed rate period
Principal x 100 x 360 x Discount factor
Where:
1
Discount factor = LIBOR No. of days in fixed rate period
1 + 100 x 360
Note that in accordance with market practice the above calculations are based on a 360 day
year for all major currencies except sterling (365 day year).
11.8 Example. An example of the use of a FRA to reduce interest rate gap exposure would be
the case of a bank which has made a loan of $1 million for 12 months at a fixed rate of 15%.
Suppose that the bank has funded this loan for the first 6 months at the current LIBOR of 13%
but does not want to be exposed to the risk of a rate increase when it refunds the loan after 6
months. The bank would enter into an FRA for 6 months at 13% commencing 6 months after
signing (called a 'six against twelve' agreement).
On the value date, six months after signing the contract, the FRA rate of 13% would be
compared with LIBOR for dollar deposits over the agreed period (in this case 6 months) and the
bank would receive from, or pay to, the counterparty the value of the interest rate differential.
If LIBOR on the value date was 15%, the bank would receive $9,302 from the counterparty,
calculated as follows:
15 - 13 180 1
$1,000,000 x 100 x 360 x 15 180 = $9,302
1 + 100 x 360
Conversely, if LIBOR on the value date was 10% the bank would pay $14,286 to the
counterparty, calculated as follows:-
10 - 13 180 1
$1,000,000 x 100 x 360 x 10 180 = $14,286
1 + 100 x 360
In practice the above calculation would be based on the actual number of days in the 6 month
period in question rather than a round 180 days.
11.9 In certain countries, FRAs are based upon an underlying discounted instrument. That is,
the settlement amount is calculated not on the basis of the difference between two interest rates
on a deposit, but on the difference between the purchase price of a short term zero coupon
instrument such as a bank accepted bill. In these cases, the formula used to determine the
settlement amount of the FRA is as follows:
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36500 x A 36500 x A
(D x IC) + 36500 - (D x IS) + 36500
Where:
IS = Reference rate D = No. days in interest period
IC = Contract rate A = Contract amount
This formula is applicable to Australian dollar and New Zealand dollar FRAs.
Accounting matters
11.10 Accounting pronouncements directly attributable to FRAs have been limited and no
country has yet issued accounting standards which cover them. UK and Australian accounting
practice for financial futures broadly corresponds to United States FAS 80 ('Accounting for
Futures Contracts') and similar principles can be used as a guide to accounting for FRAs, as
interest rate futures contracts and FRAs have the same economic substance.
International Accounting Standard 32 “Presentation And Disclosure Of Financial Instruments”
was issued in 1995. The treatments outlined by this accounting standard are not inconsistent
with the generally accepted practice discussed below.
11.11 FRAs as hedges. In general, in order for an FRA to qualify as a hedge the following
conditions would have to be met:-
■ the bank or financial institution must have net assets or liabilities which are subject to
interest rate risk and in determining this condition the bank or financial institution must first
take into account commitments and anticipated transactions which offset or reduce the
exposure; and
■ the FRA must reduce that exposure and be designated as a hedge. The FRA must be
designed in such a way (with regard to maturities etc) that the result of the FRA will
substantially offset the effect of interest rate changes on the exposed item.
11.12 Generally speaking, intention is important in determining whether or not a hedging state
exists. Since it is frequently rather subjective, it is highly desirable that a bank or financial
institution's internal procedures should provide for the identification of hedging transactions at
the outset, and for the documenting of such decisions. Mere existence of positions is not
enough; the accounting should reflect the results of management decisions, and if a conscious
decision was not taken, then the more general accounting rules shall apply. However, as FRAs
are tailored it should often be easier for an FRA to qualify as a hedge than it is for a financial
future.
11.13 When an FRA qualifies as a hedge in accordance with the above criteria, the amount paid
or received by the bank or financial institution on settlement date should be deferred and
appropriated to profit and loss over the fixed rate period on a straight line basis (the discount
element can usually be ignored as immaterial).
11.14 Example of FRAs as a hedge. At 31 December, 19x1 a bank has £100,000,000 in
assets yielding an average of 15% and with rate adjustment after 1 year, funded by
£100,000,000 in liabilities costing 13%, with rate adjustment after 9 months. To eliminate its
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exposure to an increase in LIBOR when its liabilities are subject to rate adjustment on 30
September, 19x2, the bank enters into a 9 against 12 FRA at 13% on £100,000,000. Assume
that at 30 September, 19x2 3 month sterling LIBOR is 17%.
Before recording the FRA transaction, the bank's profit and loss account for the year to 31
December, 19x2 would be as follows:
Interest income
£100,000,000 x 15% = 15,000,000
Interest expense
272
£100,000,000 x 13% x 365 +
93
£100,000,000 x 17% x 365 = (14,019,178)
__________
£ 980,822
On 30 September, 19x2 the bank will receive £976,865 from the counterparty under the FRA,
calculated as follows:
17 - 13 93 1
£100,000,000 x 100 x 365 x 17 93 = £976,865
1 + 100 x 365
This amount should be deferred and released to income over the period 1 October to 31
December, 19x2. Including the FRA transaction, the bank's profit and loss account for the year
to 31 December, 19x2 would be as follows (assuming that the cash received in settlement of the
FRA is invested to yield LIBOR):
£
Interest income 15,000,000
Interest expense (14,019,178)
Settlement income from FRA 976,865
Interest income on FRA settlement 42,313
_________
Net income 2,000,000
Or, in other words, a net spread of 2% for the entire period of one year.
11.15 Non-hedge FRAs. Most FRAs entered into by banks and financial institutions will
probably fall within the criteria for treatment as a hedge. However, some banks and financial
institutions will enter into FRAs as part of their trading and arbitrage activities. In such cases,
the bank or financial institution should at the end of each reporting period estimate the gain or
loss to be incurred under each FRA by revaluation. In order to estimate the gain or loss,
forward LIBOR quotations for the relevant period should be obtained, if possible, from an
independent source. In the absence of such a quotation, the forward LIBOR would need to be
estimated on a conservative basis.
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11.16 Any revaluation losses would need to be provided for. In deciding whether any gains on
revaluation should be recognised as income (as would normally apply to outright forward
foreign exchange and financial futures transactions) regard should be given to:
■ the extent to which such gains can properly be matched with losses;
■ the availability of independent quotations indicating the existence of a market in which such
gains could be "locked in" as at the revaluation date;
■ any correlation with traded financial futures which could be used to cover the position.
11.17 Example on non-hedge FRA. On 31 October, 19x6 a bank sells a 3 against 6 FRA (i.e.,
has an agreement to receive from the seller the fixed rate for 3 months as from 31 January 19x7)
at 15% on £1,000,000. The FRA is not for hedging purposes. How should it be recorded in the
bank's 31 December, 19x6 financial statements?
At 31 December, 19x6 the bank must estimate its probable gain or loss under the FRA and
therefore must estimate 3 month LIBOR on 31 January, 19x7. If the forward 3 month LIBOR
quoted for 31 January, 19x7 was 16% the estimated loss would be £2,346 as follows:
16 - 15 89 1
£1,000,000 x 100 x 365 x 16 89 = £2,346
1 + 100 x 365
This loss would be provided for in the 31 December, 19x6 financial statements.
11.18 Where FRAs are part of a trading portfolio and revalued as demonstrated in the previous
example, the profit or loss (i.e., £2,346) is an estimate of the expected future settlement amount
on the FRA based on current market rates. This cash flow will not take place until 31 January,
19x7 and therefore the amount of profit or loss bought to account should be discounted to a net
present value. The need for this discounting of the revaluation amounts is particularly critical
where the FRAs are part of an interest rate swap portfolio or a component of an arbitrage
transaction. In these cases, the profitability of the transaction typically depends heavily upon
the precise timing of the cash flows and therefore appropriate provision for the future funding
costs or benefits is essential to the proper measurement of the associated profit or loss.
Other matters
responsible for setting clear policies prior to the commencement of significant FRA trading.
The policies should define the circumstances in which FRA trading is considered appropriate
and the classes of assets and liabilities or off balance sheet positions which may be hedged. As
a general rule, the policies should be formally documented and approved by the highest levels
of management. Consideration should also be given to the manner in which such policies are
communicated; this will depend on the size of the bank or financial institution and its general
style of management.
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used by banks and financial institutions to control its FRA trading risks:
be set by currency, by maturity, by counterparty and by dealer - as required. Typically
separate limits are required for the trading portfolios and for hedging transactions.
11.21 Records and reports. The accounting system must create and maintain complete
records of all transactions, segregated by customer where appropriate. The following records
should normally be available:
■ Deal slips originated by the dealer;
■ Trading sheets to record actual deals made;
■ Position sheets to maintain current control over the traders' position;
■ Bank or financial institution's copy of confirmation it has despatched to the customer;
■ Daily transaction reports;
■ Profitability reports, by dealer/customer/period/contract;
■ Position reports, by customer and in total;
■ Commissions and other expense reports;
■ Exceptions reports highlighting potential risk situations (e.g. position limit excesses,
contracts nearing delivery date or expiry).
Auditing guidance
11.22 For auditing guidance on a bank or financial institution’s FRA activities reference should
be made to chapter 3 of volume 1.
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12 Deposits
Introduction
12.1 Deposits represent a bank or financial institution’s primary source of funds and typically
comprise the major liability of these institutions. Deposit activity generally involves a large
volume of deposits and withdrawals. This is particularly true of chequing accounts wherein
activity is high as compared to balances maintained. The composition of these deposit
portfolios has undergone rapid change over the past several years. Deposits are central to the
banking and finance function as a whole. Not only do deposits serve as the primary source of
funds, but in a bank or financial institution they impact or are impacted by most transactions
that occur. In a bank, for example,
■ when a loan is granted, the proceeds are usually credited to the customer’s demand account
or disbursed through an official cheque which is also a bank deposit account;
■ when securities are sold, the proceeds are frequently credited to a deposit account
maintained by the seller; and
■ correspondent banks often maintain deposit (compensating) balances to facilitate transit,
collection, and money market operations.
For financial institutions in general, interest expense on deposit accounts is usually credited to
depositors’ accounts.
Types of deposits
12.2 Deposits are usually classified into two general categories: demand and time. Brief
descriptions of the types of deposits within these categories follows.
■ Demand deposits. Demand deposits may be withdrawn or transferred immediately by the
depositor without advance notice to the bank or financial institution. The major types of
demand deposits are as follows:
- Cheque/current accounts - These accounts provide the greatest volume of activity in a
retail (consumer, branch-oriented) operation. These accounts can be classified by type
of depositor served, which typically include individuals, corporations, other financial
institutions, and partnerships;
- Official drafts - These include cashier's cheques, money orders, payment orders and any
other cheques which the bank draws on itself. These cheques are often used for loan
disbursements, interest payments, withdrawal of account balances, etc.
■ Time deposits. Time deposits are generally interest-bearing and are typically left with the
bank or financial institution for a definite period of time or, in certain circumstances, require
advance notice of withdrawal. Interest penalties may be imposed by the bank or financial
institution if the customer withdraws the funds earlier than the stipulated time period. In
certain countries, time deposits may be withdrawn by cheque.
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Time deposits include the following categories:

- Savings deposit accounts - These accounts are interest-bearing, have no stated maturity
but may require advance notice of withdrawal, and may require a certain minimum
balance to be maintained. In a retail operation these accounts are usually a large
component of time deposits. Transactions are typically recorded in a passbook, although
with the increased use of EDP equipment there has been a tendency to eliminate
passbooks and provide periodic statements of account activity;
- Certificates of deposits - These deposits are interest-bearing and usually have a fixed
maturity date. Depending upon the size of the deposit amount the interest rate may be
subject to negotiation. These types of deposits can be in a form payable to the bearer or
may be subject to negotiation.
For time deposits and certain types of interest-bearing demand deposits, methods of
computing interest and periods for compounding and paying interest will vary by institution
and normally, by type of account.
12.3 Types of deposit systems. Deposit account processing systems can be identified as "off-
line" or "on-line." In an off-line system, transactions are posted to a depositor's account after
the transaction occurs. Evidence of the transaction, such as a paid cheque, a deposit or
withdrawal slip, or a debit or credit advice, is converted to machine readable form before
affecting the depositor's account. In an on-line environment, transactions are processed to the
depositor's account as they occur. In both cases, it is usual practice to differentiate between
cleared and uncleared funds.
12.4 Internal controls. Deposit taking activities such as those described above are generally
conducted through a network of retail branches. Raising of funds from the wholesale inter bank
markets by way of deposits is discussed in chapter 5 of this volume.
12.5 Retail branch networks can range from tens to thousands of branches and a common
characteristic is generally the use of standardised systems and procedures throughout. In this
way, head office management can maintain control over geographically dispersed activities. In
such an environment, the opportunity for material error at any one branch is reduced given its
relatively small share of the total liabilities (or assets). However, the risk of poorly designed,
implemented and enforced systems increases as such systems are used at multiple points and
collectively these points are likely to be material.
12.6 Internal audit has a key role in ensuring the integrity of internal controls in a retail branch
network. Through an on-going program of rotational audits, internal audit can verify that the
controls implemented are effective and being compiled with. Reference should be made to
paragraph 2.43 of volume 1 for guidance on our use of the work performed by internal audit.
1 2 . 7 Electronic funds transfer: Automated teller machines ("ATMs"), automatic
telephone payments ("ATPs"), point-of-sale banking ("POS"). ATMs perform many of the
normal services offered by a teller physically located in a branch. Funds can be deposited,
withdrawn, or transferred, certain bills can be paid, and account balances can be accessed
through these computer terminals. The machine transmits hard-copy evidence of the transaction
to the customer after the completion of the transaction. These machines also typically offer 24-
hour service at many locations. ATPs enable customers to initiate third-party payments by
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telephone. POS banking, through machines located at retail establishments, provide for transfer
of funds from customer to retailers' accounts.
12.8 Dormant accounts. Some customers may make deposit transactions only infrequently.
When a customer has not had any deposit or withdrawal activity from his account over a
specified time period, the bank or financial institution will consider the account "inactive" or
"dormant." The time period required for dormant status will vary from institution to institution,
however, it is usually longer for time deposits than demand deposits. This is due to greater
activity normally associated with demand deposit accounts.
Dormant accounts are more vulnerable to manipulation due to the lack of frequent customer
verification that is normally provided with each transaction or statement in an active account.
Due to the sensitivity of these accounts the auditor should ensure that in addition to the normal
internal controls expected to be found in the deposit area, the following additional controls are
also in effect:
■ separate subledger controls maintained for dormant accounts;
■ signature cards maintained under dual control and transactions processed only after
authorisation received from supervisory employee;
■ timely review and approvals by persons independent of the teller function made of
transactions affecting the dormant accounts; and
■ periodic reviews by responsible personnel performed for notation of unusual transactions in
employee accounts.
Auditing guidance
12.9 Audit risks with respect to deposit activities include:
■ whether the bank or financial institution’s financial statements accurately present its deposit
liabilities in accordance with generally accepted accounting principles;
■ whether the financial statements accurately present the income effect of its depositor
servicing activities, including interest expense incurred and fees earned for services
rendered; and
■ whether the financial statements give appropriate effect to clearing, suspense, and other in-
transit items captured within its deposit servicing activity.
■ analysis of the composition of the deposits portfolio and identification of major trends;
■ analysis of dormant and hold mail accounts;
■ composition of interest expense and comparison to budgets or prior periods;
■ interest yield analysis;
■ identification of material other sources of income - e.g., cancellation fees.
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12.11 Assessment of inherent risk. In planning an examination of deposit taking trading

activities, we should give consideration to the characteristics that distinguish these activities
from other banking and finance operations and assess their impact on the risk that the financial
statements contain a material misstatement (ignoring the effect of internal controls). The table
below summarises some of the additional factors that should be considered when assessing the
inherent risk of misstatement for assertions in the deposit taking area of a bank or financial
institution. These should be read in conjunction with the general guidance provided at
paragraph 2.32 of volume 1.
Indication of:
Factor Lower risk Higher risk
Extent of “hold all mail” Few accounts Significant number of
accounts accounts
Number of accounts Small number of accounts Large number of accounts
Volume of transactions Small volume of transactions Large volume of transactions
Number of dormant accounts Small number of dormant Large number of dormant
accounts accounts
12.12 Evaluation of the control environment. Reference should be made to chapter 52 of the
KPMG Audit Service Manual for our approach to internal controls and the control environment.
Set out below are a number of specific issues that should be considered when assessing the
impact of the control environment upon the control risk for assertions relating to deposit taking
activities.
12.13 As deposit taking activities are generally undertaken through networks of branches, there
should be increased awareness of the following aspects of the control environment:
■ documented accounting and operational procedures;
■ adequate methods to select and train staff;
■ existence of an effective internal audit function;
■ EDP control environment - recognising the dependence by banks and financial institutions
upon data processing systems in retail banking (refer chapter 19 of this volume for further
discussion).
12.14 Evaluation of internal controls. We are required by the KPMG Audit Service Manual
to understand the internal controls even if we were to plan a substantive approach for all audit
objectives. Listed below are typical internal controls that we would expect to be in operation in
a deposit taking activity which may allow us to lower our internal control risk assessment for
the assertion.
General controls
■ All detailed subsidiary ledgers are reconciled to the general ledger on a timely basis;
differences found are appropriately investigated and resolved;
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■ Controls over voucher preparation, batching and suspense account reconciliation

procedures. These controls will generally ensure that an entry is raised to record the deposit
for each deposit or withdrawal of funds;
■ Customer receives transaction receipt for each exchange except cheque cashing;
■ Reconciliation of cash on hand;
■ Statements are forwarded to customers;
■ Payments of interest are appropriately monitored.
Existence, accuracy and authorisation controls

■ Appropriate personnel prepare timely proofs verifying that debits equal credits for all
exchanges submitted;
■ Appropriate officers review and approve cash items held;
■ Transactions relating to deposit accounts (e.g., rates and maturities offered on new accounts
and service charges imposed on existing accounts) receive appropriate officer review and
approval in accordance with formally approved policies;
■ Subsidiary ledgers are maintained and reconciled with the general ledger on a timely basis;
differences found are investigated and resolved;
■ Exception reporting of dormant accounts reactivated and verification of signatures against
customer signature records;
■ Appropriate supervisory personnel review and approve the creation of, or increases in,
overdrafts before funds are released;
■ The adequate protection of ledger cards, cancelled cheques and signature cards;
■ The frequency of customer statement dispatch;
■ The adequacy of controls over the operation of accounts with minimal activity (or dormant
accounts) and "hold mail" accounts;
■ The review of employees' accounts for unusual transactions;
■ The controls over unissued/blank official cheques and drafts, certificates of deposit etc;
■ Adequacy of segregation of duties.
Processing controls
■ Appropriate supervisory personnel review and approve completed reconciliations on a
timely basis;
■ Depositors receive periodic statements for their transaction accounts that individually
identify all transactions therein;
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■ Transaction accounts for which statements are not sent to customers ("hold mail" accounts)
are allowed only on written authorisation from the customer and the customer's written
release is required when contents of the "hold mail" file are released; compliance with these
policies is periodically verified by appropriate independent personnel;
■ Postings of adjustments to interest accruals (e.g., for premature withdrawals) receive
appropriate supervisory review and approval and, in automated systems, are appropriately
flagged and documented;
■ Automated accrual systems incorporate system control features such as limit checks and
checks for negative accruals, and exceptions reported are appropriately investigated and
resolved;
■ Verification procedures are effectively performed to ensure interest is properly accrued,
recorded and paid;
■ New CD listings are compared to actual CD copies, agreeing dates, rates, method of interest
calculation, etc and differences found are investigated and resolved;
■ Verification procedures are effectively performed to determine that appropriate cut-offs are
established, including that the general ledger appropriately reflects work processed and
unprocessed during the day and that holdover items are recorded to suspense accounts for
next day processing;
■ Suspense accounts are used to control holdover items for next day processing; suspense
account balances are appropriately monitored (including ageing of open items) to identify
unusual or potential problem items, and such items are properly investigated and resolved;
■ Personnel not involved in teller or cheque processing functions receive all return items and
establish numeric control over them as received; appropriate independent personnel
periodically verify the effective functioning of such controls, along with determining the
propriety of the disposition of returned items;
■ Personnel independent of teller and accounting functions receive all customer inquiries,
establish numeric control over them as received, and issue appropriate replies, appropriate
independent personnel periodically verify the effective functioning of such controls, along
with determining the propriety of the disposition of inquiries.
Safeguard Controls
■ Cancelled cheques, deposit and withdrawal slips, signature cards, and other original
documentation supporting the propriety of transactions processed are kept in secure
facilities, e.g., fireproof files;
■ Original documentation supporting the propriety of transactions processed are microfilmed
for back-up and research purposes.
12.15 Select audit procedures to test internal controls. Where we conclude that the controls
identified above would be effective in reducing our control risk for the assertion if properly
performed, we will design tests of controls to ensure that the controls are functioning as
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designed. Reference should be made to Chapter 61 of the KPMG Audit Service Manual for
guidance on tests of controls.
12.16 Select substantive audit procedures. Substantive audit procedures include analytical
procedures and tests of details. The extent of audit evidence required from tests of details is
determined by our assessment of risk of significant misstatements and the level of audit
evidence obtained from analytical procedures. For further guidance on the relationship between
the risk of significant misstatements and planned substantive audit procedures, reference should
be made to paragraph 51.103 of the KPMG Audit Service Manual.
12.17 Guidance on the use and assessment of analytical procedures is provided in chapter 16 of
this volume. It is likely that the main application for analytical procedures in deposit taking
activities would be the analysis of interest and fee income. The effectiveness of substantive
analysis on principal balances and related streams is likely to be limited unless adequate
predictive measures can be identified. For example, as a limited assurance technique,
comparison of the bank or financial institution's deposit growth against industry statistics.
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Introduction
13.1 This chapter will discuss the accounting and auditing considerations of the principal
instruments utilised by banks and financial institutions to provide financial services to
customers engaged in import and export activities.
13.2 There are a number of problems facing importers and exporters in the conduct of their
business. The following table illustrates some of these considerations.
Problems of Importer Problems of Exporter
■ How do I know I will get the goods I pay ■ How do I know I will be paid for the
for? goods I ship?
■ How long will it be before I receive the ■ How long will it be before I am paid?
goods?
■ I can't pay for the goods until I receive ■ I can't wait to be paid because I have to
them and resell them to my customers. pay my suppliers
■ How do I know that the goods will ■ I know nothing of the credit standing of
conform to what I ordered? the importer or his bank
■ My business is conducted in my home ■ I am uncomfortable with the political or
currency but the exporter wants payment economic situation in the importer's
in his currency. country so I want to be paid in my
currency.
13.3 As illustrated in the preceding table, both the importer and exporter have serious concerns
about the delivery, financing, and security of the transaction into which they are entering.
There is, therefore, an obvious need for an intermediary between the importer and the exporter,
who has both the resources and the access to the international financial community to be able to
provide the high degree of assurance and, in many cases, financing required for them to conduct
their business.
13.4 The banking and finance community plays a major role in providing international trade
customers with the vehicles they require. The following sections will discuss the principal
types of instruments available to customers for the securing of payment or performance.
13.5 Documentary credits. Documentary credits are instruments by which a bank or financial
institution substitutes its own credit for that of its customers, so that international trade may be
more safely, economically, and expeditiously conducted. They are the most frequently used
method of securing payment in international trade situations.
13.6 More specifically, a documentary credit is an instrument drawn by a bank or financial
institution (the "issuing bank") at the request of and on behalf of a customer (the "principal"),
authorising another bank or financial institution (the "correspondent bank") to make payments
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to or to accept drafts drawn by a fourth party (the "beneficiary") when such beneficiary has
complied with the stipulations contained in the documentary credit.
13.7 In a typical situation in international trade, the principal would be the buyer or importer,
the issuing bank would be the importer's bank or financial institution, the correspondent bank
would be a bank or financial institution situated in the beneficiary's country and the beneficiary
would be the seller or exporter. The major stipulation of the credits is generally the
presentation of documents representing ownership of goods shipped.
13.8 There are a number of different types of documentary credits available which differ
principally in the degree of security and timeliness required in the related payment. A
particular credit will have several of the following characteristics.
Characteristic Description
Sight credit Drafts drawn against this type of credit are payable
immediately upon presentation of draft and required
documents.
Time or acceptance credit Drafts drawn against this type of credit are payable at a
stipulated future date.
Form of currency credit Stipulate the currency against which drafts must be drawn.
Straight credit Relates to a specific transaction or shipment of goods after
which it becomes void.
Revolving credit Automatically renews itself for the original stipulated amount
each time a draft is drawn on it; does not become void until
stipulated expiration date.
Revocable credit Issuing bank reserves the right to revoke its obligation to
honour drafts drawn on it by the beneficiary.
Irrevocable credit Issuing bank waives the right to revoke its obligation to
honour drafts drawn on it prior to the expiration date.
Red clause credit Beneficiary can obtain an advance from the correspondent
bank (intended to finance the manufacture of the goods to be
delivered).
Confirmed credit Correspondent bank adds its own unqualified assurance that
the issuing bank will pay and that, if the latter does not honour
drafts drawn on the credit, the correspondent bank will. (Only
obtainable when the credit is also irrevocable.) Credits which
do not contain a confirmation are considered "Unconfirmed."
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Characteristic Description
Stand-by credit More of a guarantee than a documentary credit. A stand-by is
used to guarantee the satisfaction of a wide variety of
obligations of bank customers including performance of
contractual as well as financial obligations (see paragraph
13.11).
Transferable credit This credit permits an exporter or other middleman to transfer
his right to receive payment from an importer under a
documentary credit directly to his supplier.
Back-to-back credit Used in cases where an exporter wishes to transfer his rights
to a supplier under a credit that is not transferable. The
exporter's bank may open up a second credit for the benefit of
the supplier, using the original credit as security.
Assigned credit An exporter may assign the proceeds of a credit to his supplier
by submitting certain documents to that effect to his bank and
the supplier.
13.9 Regardless of what combination of the above characteristics a particular documentary
credit may have, except for back-to-back credits, the primary function of the instrument is to
secure payment in either cash or an accepted bill of exchange at the time that documents
representing title to the goods are presented.
13.10 Documentary collection. A documentary collection is a service provided by a bank or
financial institution whereby the bank or financial institution receives the documents
representing ownership of the goods from the exporter and collects the payment from the
importer. Documentary collections differ from documentary credits in that the exporter does
not receive payment or the full security that he will be paid until after the documents have been
presented to the buyer. They are generally used in those cases where buyer and seller are
known to each other and the primary concern is to expedite the movement of the documents
between buyer and seller.
13.11 Stand-by letter of credit. A stand-by letter of credit is an instrument guaranteeing some
type of payment or performance. In this type of credit, the bank or financial institution
(guarantor) promises another party (beneficiary) to answer for the debt or default of a customer.
Stand-by letters of credit have a variety of purposes, both debt-related and non-debt-related.
Debt-related stand-by letters of credit are those which back the bank or financial institution
customer's borrowing including commercial paper, promissory notes, municipal or industrial
revenue bonds or similar borrowings. Non-debt-related stand-by letters of credit are issued for
various purposes, including:
■ the guarantee of performance under a bid or contract;
■ to ensure contract performance associated with construction, service or supply contracts;
■ to act as a security deposit;
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■ to guarantee a payment that the account party is expected to make in the normal course of
business;
■ to ensure performance of options or futures contracts involving commodities; and
■ to facilitate the purchase of securities.
As with other documentary credits, stand-by letters of credit represent a contingent liability to
the issuing bank or financial institution and are often recorded, therefore, in a memorandum
account in the general ledger (see paragraph 13.31). A stand-by letter of credit also presents a
collectibility risk to the issuing bank should it be drawn on by the beneficiary. As such, a
review of the creditworthiness of the customer similar to that performed in the lending function
should be performed (see chapter 4 of this volume).
13.12 Acceptances. An acceptance is created when a bank or financial institution agrees to
pay, at a stipulated future date, a draft drawn on it for a specified amount. Such a draft,
commonly known as a banker's acceptance, becomes a negotiable instrument and is actively
traded on the secondary markets (see chapter 5 of this volume). The following example will
highlight the major steps.
13.13 Company A, an importer, negotiates the purchase of goods from Company B, an
exporter. Company A opens a time documentary credit with Bank X, stipulating payment for
the goods to be made 60 days after receipt of required documents. After shipping the goods,
Company B, through its bank, Bank Y, presents the required documents to Bank X. The
required documents include the bill of lading for the shipped goods and the bill for the goods.
Bank X, upon checking the documents, accepts the transaction, thereby agreeing to pay the bill
at maturity. The accepted bill is returned to Company B and can be presented for payment at
maturity.
13.14 Company B may decide that it does not want to wait the 60 days for its payment. Since
Bank X has accepted the bill, and therefore substituted its own credit for the credit of Company
A, the acceptance has become a readily marketable instrument. Company B can ask its own
bank, Bank Y, or another bank to discount the acceptance and obtain payment immediately. If
the bank agrees, the acceptance would be discounted in an amount equivalent to 60 days
interest on the face amount at current rates, and the face amount less the discount would be paid
to Company B. At this point, the transaction is closed with respect to Company B and the bank
or financial institution who discounted the acceptance now holds the instrument for presentation
to Bank X at maturity.
13.15 The discounting of bankers acceptances is a frequently used method of expediting
payment to exporters.
13.16 Upon accepting a draft, the accepting bank is establishing a liability to pay an identified
amount of money regardless of whether it collects payment from its customer; consequently, it
has a credit risk from its customer. To manage and limit this risk, whether for individual
customers or certain industries, banks sell risk participations in acceptances.
13.17 Risk participations. Risk participations are normally sold to other financial institutions.
The participating bank or financial institution accepts a portion of the transaction as its own risk
in return for a portion of the acceptance fee obtained by the accepting bank. In the event of
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default on the part of the accepting bank's customer to pay on the original transaction, the
participating bank or financial institution becomes liable to the accepting bank up to the amount
of the participation. The following example illustrates the sale of a risk participation.
13.18 Assume that in the example in paragraph 13.13 above, Bank X is approaching its credit
risk limit for Company A's industry. In order to avoid exceeding its limit, Bank X, upon
accepting the draft, simultaneously sells a 50 percent risk participation in it to Bank Z for a
portion of the fee received.
13.19 The terms of the risk participation are contained in a separate contract between Bank X
and Bank Z. At maturity, Company A's obligation to settle the acceptance is to Bank X.
However, Bank X has reduced, by half, its risk of loss in the case of a default by Company A
with an enforceable claim against Bank Z for a 50 percent participation.

13.20 The organisation and operations of the documentary credits activity varies by institution.
However, regardless of the functional breakdown, the following procedures are typically
followed:
■ interview between the customer and the issuing bank at which time letter of credit
application is submitted;
■ review of credit information in order to assess risk;
■ decision to extend credit to the customer (customer is usually subjected to the same credit
review and approval process as for loans);
■ letter of credit and letter of credit folder are prepared. The letter of credit folder acts as the
central point where all correspondence and records related to the credit are filed. Folders
usually have printed columns for entry of the original balance of credit, drafts drawn against
the credit, and the remaining unused balance. The folders are filed by letter of credit
number;
■ letter of credit is signed and mailed to the beneficiary. A copy is sent to the customer and a
copy is filed in the letter of credit folder. The bank or financial institution makes an entry
in the memorandum account, increasing the bank or financial institution's liability under
letters of credit and customer's liability under letters of credit. Customer's current account
is usually charged a fee for issuing the letter of credit;
■ the memorandum accounts, which ordinarily are maintained as part of the bank or financial
institution's accounting system, act as a control on the bank or financial institution's and the
customer's liability under letter of credit. These accounts should always equal each other
and the sum of the unused balance on the letter of credit folders. The customer's liability
ledger reflects all of a customer's obligation to the bank or financial institution. Therefore,
the ledger should also contain a notation for the issuance of the letter of credit;
■ review of the letter of credit by the beneficiary. If no errors are noted, the goods are loaded
for shipment and the necessary documents (including a bill of lading) prepared or obtained;
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■ the beneficiary forwards the letter of credit and the documents to the advising bank, a
correspondent of the issuing bank, which presents the same documents to the issuing bank
which reviews them to be sure all terms are complied with. The correspondent's account is
credited for the face of the draft and the customer's account debited;
■ upon receiving the funds from the issuing bank, the correspondent bank credits the
beneficiary's account;
■ debit advice and the documents are forwarded to the customer, which will receive the goods
from the shipper upon presentation of the bill of lading;
■ paid draft is recorded in the letter of credit folder as a reduction in the unissued balance and
the memorandum accounts and the liability ledger are reduced.
13.21 The above transactions include a draft that was due on sight; a time letter of credit
involves additional steps. The procedures for a time draft are the same as above up to the point
where the beneficiary forwards the necessary documentation to the advising bank, at which
point the procedures would be changed as follows:
■ Assuming that the time letter of credit specified the draft is due 30 days after sight, the
beneficiary forwards the letter of credit and the documents to the advising bank, a
correspondent of the issuing bank, with a request that the draft be discounted immediately;
■ Draft, with the documents attached, is sent to the issuing bank which reviews the documents
to be sure all terms are complied with. If the documents are correct, the bank will stamp the
draft "accepted," date and sign it and credit the correspondent's account for the face value of
the draft, less the collection fee and the discount for 30 days. The bank then prepares the
acceptance ticklers. The acceptance tickler is usually a multi-part form prepared whenever
the bank accepts a draft. The copies are usually distributed as follows:
- Original mailed to bank's customer as a notice of his or her liability to bank;
- Copy filed in due date order. The total of all the copies should agree to the general
ledger account;
- Copy filed in letter of credit folder as an indication of the reduction in the unused
balance of the credit;
- Copy sent to clerk posting the liability ledger for entry thereon.
■ Upon receiving the funds from the issuing bank, the correspondent bank credits the
beneficiary's account.
13.22 The memorandum accounts for the bank's and the customer's liability under letters of
credit are decreased. At this point, asset and liability accounts entitled "Customer Liability
under Acceptances" and "Bank Liability under Acceptances", respectively, are posted for the
amount of the draft.
13.23 The customer would usually be required to sign a trust receipt on the goods to be
received. A trust receipt is an agreement by which the party signing the receipt promises to
hold the property received in the name of the bank or financial institution. If the property is
sold under the agreement, the cash must be "earmarked" and identified to the trust receipt.
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Trust receipts are used mostly to permit importers to obtain possession of merchandise for
resale. Arrangements for this financing are usually completed before the issuance of letters of
credit. The trust receipt is used as collateral security for the advance of funds by the bank or
financial institution to meet the acceptances arising out of the letter of credit. Under the terms
of the agreement, the importer is required to pay to the bank or financial institution proceeds
from the sale of merchandise as soon as they are received. The importer is also required to
keep the merchandise insured. The bank or financial institution may take possession of the
merchandise at any time without due process of law.
13.24 After the customer signs the trust receipt, the documents (including the bill of lading) are
turned over by the bank or financial institution allowing the buyer to claim the goods.
13.25 The advising bank may ask the issuing bank to hold the acceptance until maturity. Upon
maturity, the account of the advising bank is credited for the face amount of the acceptance and
the account of the customer is debited for that amount. The general ledger accounts, bank and
customer liability under acceptances, and the liability ledger are reduced by the same amount,
or the advising bank may request that the acceptance be discounted. The account of the
advising bank would be credited for the face of the acceptances, less discount for 30 days, and
the general ledger account, "Own acceptances discounted" (which is included with loans on the
financial statements), would be debited. Upon maturity, the customer's account is debited for
the face amount of the acceptance and "Own acceptances discounted" is credited for the same
amount. (The discount should be accreted to maturity.) At this time, the general ledger
accounts for the bank's and customer's liability under acceptances and the liability ledger are
reduced by the face amount of the acceptances.
13.26 Documentary credit operations are almost always carried out in accordance with the
"Uniform Customs and Practice for Documentary Credits" of the International Chamber of
Commerce, which is recognised by banking authorities world-wide.
13.27 The most important procedure concerning the bank's liability is the checking of
documents because if, for example, an advising bank pays a beneficiary when the documents
are not in accordance with the letter of credit, that bank may be liable to a claim from the
issuing bank. The maximum possible loss is the value of the letter of credit, which can be a
substantial amount for some transactions. Consequently, this procedure should at all times be
carried out exercising care and diligence. Some common discrepancies include:
■ credit expired;
■ late shipment;
■ presentation after permitted time from date of issuance of shipping documents;
■ short shipment;
■ credit amount exceeded;
■ under insurance;
■ description of goods on bill differs from that of the credit marks and numbers differ
between documents;
■ weights differ;
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■ lack of evidence that goods actually shipped on board;

■ documents generally inconsistent with each other.
It is common practice for banks and financial institutions to set up detailed checklists to cover
all of the above, and more, points.
13.28 The areas that are particularly important when considering the controls over
documentary credits are:
■ evaluation of the bank or financial institution’s risk;
■ evaluation of the customer's credit worthiness;
■ safe custody of documents, especially those with negotiability;
■ agreement of bank's and customer's liability ledger with control accounts;
■ checking of documents;
■ independence of custodian, recording and authorisation functions.
13.29 The principal records that should be maintained are:
■ register of negotiable instruments;
■ register of commitments;
■ register of facilities granted;
■ maturity diaries;
■ customer contingent accounts;
■ control accounts;
■ register of unpaid items.
Accounting matters
Off balance sheet

13.31 Documentary credit. When a documentary credit is established, it becomes a
contingent liability to the bank or financial institution, since the bank or financial institution has
agreed to substitute its credit for that of its customer. Although it is necessary to book the
outstanding documentary credit, it is not a balance sheet item and is, therefore, recorded in a
memorandum account in the general ledger. The entry therefore would be:
Dr Documentary credits outstanding - (memo)
Cr Documentary credits outstanding - contra (memo)
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A letter of credit will remain on the books in this fashion until it becomes void either by
expiration or utilisation. When it is removed the reverse entry of the above would apply. The
amounts of documentary credits outstanding in the aggregate should be considered for
disclosure in the footnotes to the financial statements with other contingencies.
Balance sheet
13.32 Acceptance under a documentary credit. When a bank or financial institution accepts
a draft under a documentary credit, it is considered to be a balance sheet event. Although the
bank or financial institution is not technically lending its own funds by accepting the draft, it is
establishing a liability to pay an identified amount of money regardless of whether it collects
the payment from its own customer, and therefore it is generally considered to be an event
reportable on the balance sheet of the bank or financial institution.
13.33 At the time the bank or financial institution accepts a draft, and it should be emphasised
that this event is prior to the exchange of any funds between the parties, the following entry is
made:
Dr Customer liability under acceptances
Cr Acceptances outstanding
"Customer liability under acceptances" is an asset account established to demonstrate that the
bank or financial institution's customer is actually the source of the funds for the settlement of
the acceptance.
13.34 When acceptances mature, the bank or financial institution collects the funds from its
customer and pays off the acceptance which has been presented by a third party. The following
entries apply:
■ Collection from Customer
Dr Cash
Cr Customer liability under acceptance
■ Payment of Acceptance
Dr Acceptances outstanding
Cr Cash
13.35 Own acceptances discounted. A frequently encountered situation in acceptance
financing occurs when an exporter, or other third party, request immediate payment on an
acceptance which has not yet reached maturity. In many cases, the acceptance is a broadly
negotiable instrument which can be sold in a very active market to almost any financial
institution. If the acceptance is sold to a financial institution, no entry is required by the
accepting bank. However, if the acceptance is sold back to the accepting bank, the accepting
bank pays an amount of cash which represents the face value of the acceptance less a discount
for an amount equal to a market rate of interest from discounting date to maturity.
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13.36 There are a number of different ways own acceptances discounted can be recorded. The
method to be utilised by a particular bank or financial institution will usually depend on volume
and intent of the discounting. Theoretically, when a bank or financial institution discounts its
own acceptance it has provided financing to a third party which will be paid back by its own
customer at the maturity of the acceptance.
13.37 The recording of own acceptances discounted is as follows:
Dr Own acceptances discounted (face amount)
Cr Unearned discount
Cr Cash
13.38 Once discounted, the acceptance is no longer outstanding and the customer liability
under acceptance has become a loan. To reflect this, the following entry is made:
Dr Acceptances outstanding
Cr Customer liability under acceptances
13.39 For financial statement purposes, the classification of "Own acceptances discounted"
depends upon whether the acceptance was discounted for investment or trading purposes (see
paragraph 6.1 for distinction). If the acceptance is discounted for investment purposes, "Own
acceptances discounted" should be classified as a loan in the financial statements, otherwise, if
discounted for trading purposes, it should be classified as a trading account asset.
13.40 Upon rediscounting of an acceptance in the secondary market, the face amount of the
acceptance is again reported as a "Customers' acceptance liability" and an "Acceptance
outstanding." Prepayments made by the accepting bank's customer in settlement of its liability
to the accepting bank decrease the bank or financial institution's "Customers’ acceptance
liability," however, the "Acceptances outstanding" is not reduced until the bank or financial
institution has paid the holder of the acceptance. Conversely, if the bank or financial institution
pays the holder of the acceptance but does not receive payment from its customer, the
"Customers’ acceptance liability" is reclassed to loans and begins to accrue interest.
13.41 Risk participation. The sale of risk participation does not reduce the accepting bank's
obligation to honour the full amount of the acceptance at maturity nor change the requirement
for the accepting bank to report the full amount of the acceptance as a liability in the balance
sheet. The purchase of a risk participation presents a contingent liability to the participating
bank, as such, it is not a balance sheet item and is therefore recorded in a memorandum
account. The following entry is made:
Dr Risk participation in acceptances - (memo)
Cr Risk participation in acceptances - contra (memo)
The accounting for risk participations may vary based on local statutory and accounting
regulations.
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Profit and loss

13.42 A commission or fee is charged by the bank or financial institution at the time it issues a
documentary credit, accepts a beneficiary's draft, or examines the documents of a beneficiary
required by the letter of credit. These fees represent compensation for services rendered and are
recognised currently as long as the fees are expected to be collected.
13.43 Unearned discount should be accounted for as follows:
■ discounted acceptances - the resulting unearned discount is accreted into interest income on
loans on an interest method basis over the tenor of the acceptance;
■ rediscounted acceptances - the residual balance remaining in unearned discount is
immediately credited or debited to interest income on loans with the offsetting entry to
unearned discount.
13.44 Acceptances held for trading purposes should be valued to market (see paragraph 6.52).
Auditing guidance
13.45 General. An international bank or financial institution's documentary credits and
acceptances operations typically present us with the risks of error relating to a number of
assertions. These include:
■ Whether the bank or financial institution's financial statements accurately present its
existing receivables, payables, and future commitments arising from documentary credits
and acceptances activities in accordance with generally accepted accounting principles;
■ Whether the bank or financial institution’s financial statements accurately present the
income effect of its documentary credits and acceptances activities, including commissions
and fees, amortisation of purchase premiums and discounts; gains or losses on assets or
liabilities sold; and for trading account acceptances, unrealised gains or losses on mark to
market;
■ Whether the financial statements accurately give effect to the possibility that the bank or
financial institution will be unable to collect its receivables and future commitments.
■ composition of acceptance and related fees and comparison to budgets or prior periods;
■ analysis of income from trading in acceptances;
■ analysis of acceptances discounted held in portfolio.
13.47 Assessment of inherent risk. In planning an examination of documentary credits and
acceptances activities, we should give consideration to the characteristics that distinguish these
activities from other banking and finance operations and assess their impact on the risk that the
financial statements contain a material misstatement (ignoring the effect of internal controls).
Reference should be made to the general guidance provided at paragraph 2.32 of volume 1.
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13.48 Evaluation of the control environment. Reference should be made to chapter 52 of the
KPMG audit service manual for our approach to internal controls and the control environment.
Set out below are a number of specific issues that should be considered when assessing the
impact of the control environment upon the control risk for assertions relating to documentary
credits and acceptances activities:
■ The extent to which the bank or financial institution has established credit policies and to
which senior management monitors adherence to those policies;
■ The degree of segregation of responsibilities for transacting documentary credits and
acceptances, disbursing the proceeds and receiving subsequent payments, and maintaining
the accounting records for the transaction.
13.49 Evaluation of internal controls. We are required by the KPMG audit service manual to
understand the internal controls even if we were to plan a substantive approach for all audit
objectives. The following listing represents typical internal controls that we would expect to be
in operation in documentary credits and acceptances operations which may allow us to lower
our control risk assessment for the assertion.
General controls
■ Vouchers to record documentary credits and acceptances (including associated fees) are
prepared and authorised at the time the documents are signed;
■ Payments due for maturing acceptances are appropriately monitored (including follow-up
with late payers and proper ageing of delinquencies) to their eventual receipt - this
procedure should ensure completeness of recording of settlement amounts;
■ Inventory of required documents including evidence of collateral (if any), is properly
monitored to ensure timely receipt and matching to appropriate customer file;
■ Records are properly maintained and procedures effectively performed to ensure that all
fees due are received;
■ Periodic extraction of acceptances files and comparison to registers and ledger balances.
Existence, accuracy and authorisation controls

■ Documentary credits and acceptances transactions are specifically authorised by appropriate
officers in conformity with formal credit policies and authority limits;
■ Cabled instructions are appropriately authorised/verified;
■ There is appropriate segregation of duties among those who:
- approve credit facilities;
- control acceptances and collateral;
- receive payments;
- post and/or reconcile subsidiary ledgers.
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Processing controls
■ Subsidiary ledgers are maintained and reconciled to the general ledger on a timely basis;
differences found are investigated and resolved; appropriate supervisory personnel review
and approve completed reconciliations on a timely basis;
■ Appropriate officers periodically review outstanding assets and documentary credits for
(potential) collectibility problems and for sufficiency of collateral;
■ Appropriate personnel periodically review collateral valuation;
■ Verification procedures are effectively performed to ensure interest income is properly
accrued and recorded.
Safeguard controls
■ Acceptances and blank documentary credits on hand are kept in secure locations (e.g.,
locked, fireproof compartments).
13.50 Select audit procedures to test internal controls. Where we conclude that the controls
identified above would be effective in reducing our control risk for the assertion if properly
performed, we will design tests of controls to ensure that the controls are functioning as
designed. Reference should be made to chapter 61 of the KPMG audit service manual for
guidance on tests of controls.
13.51 Select substantive audit procedures. Substantive audit procedures include analytical
procedures and tests of details. The extent of audit evidence required from tests of details is
determined by our assessment of risk of significant misstatements and the level of audit
evidence obtained from analytical procedures. For further guidance on the relationship between
the risk of significant misstatements and planned substantive audit procedures, reference should
be made to paragraph 51.103 of the KPMG audit service manual.
13.52 Guidance on the use and assessment of analytical procedures is provided in chapter 16 of
this volume. It is likely that the main application for analytical procedures in documentary
credits and acceptances activities would be the analysis of fees and interest income. Analytical
procedures are unlikely in most cases to be effective on the related principal balances.
13.53 When planning the nature, extent and timing of substantive procedures we should
recognise that the short-term tenor of most documentary credits and acceptances transactions
results in significant portfolio turnover during the year, thus diminishing the extent to which
interim substantive test procedures will have relevance to balances reported in the financial
statements.
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14 Leasing
Introduction and types of leasing transactions

14.1 Lease financed assets range from small items such as office equipment to commercial
aircraft and oil tankers.
14.2 One aspect of lease financing that often makes it favourable to other forms of financing
(e.g., the lessee borrowing to purchase the asset outright) is the possible tax benefits available in
certain countries. If the lessor's tax status and profitability are such that full advantage can be
taken of accelerated depreciation, but the lessee's tax status is such that if it were to borrow and
then buy the asset it would not be able to take full advantage of these benefits (i.e., because it
has insufficient profits against which to offset the tax benefits), there may be an advantage to
both parties in a lease financing arrangement. The lessor can take advantage of the tax benefits,
and pass on a portion of the benefits to the lessee (in the form of lease payments that impute an
interest rate lower than the lessee's normal rate of borrowing).
14.3 Direct lease financing. In direct lease financing, the leased asset is purchased by the
lessor (e.g., a bank) at the request of the lessee, and the lessee assumes virtually all the
responsibilities of ownership, including maintenance of the leased asset and payments of taxes
and insurance. Lease payments usually cover the cost of the equipment and an interest factor
providing a return to the bank. The lease agreement may contain an option providing for
purchase of the leased asset by the lessee at the expiration of the lease at fair value or a
specified price. Such leases entered into by banks and financial institutions are generally
required to be functional equivalents of extensions of credit, and the finance method of
accounting should be followed in the recording of the lease and related income. (In certain
countries, the bank or financial institution may, if the transaction qualifies, record the lease as
an operating lease for tax and/or accounting purposes. As an operating lease, the leased asset
should be recorded as a fixed asset and appropriately depreciated.)
14.4 Leveraged leasing. The primary difference between direct and leveraged lease financing
is that, in leveraged leasing, the lessor (i.e., the bank) "borrows" a substantial portion of the
purchase price of the leased property from one or more long term lenders.

14.5 Because the lease financing activities of banks and financial institutions are in substance a
form of secured lending, the operations of a lease financing department are similar to those of a
loan department in several aspects. The credit checks, official approval, and accounting records
maintained usually conform to the system developed in the loan department (see chapter 3 of
this volume for details). Some significant differences are the following:
■ The agreement between the borrower and the lender is evidenced by a lease. The lease may
be summarised in a brief which is included as one of the first items in a document file;
■ The equipment under lease is legally the property of the bank or financial institution.
Depending on local customs, there may be a required filing of the security interest with
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appropriate regulatory bodies. Evidence of such filings should appear in the document file.
In addition, aircraft, railroad equipment, motor vehicles, and ships may have to be registered
with the respective aviation, commerce, and maritime authorities. There should be a copy
of the vendor's invoice on file to support the purchase price. Both property and, if
applicable, liability insurance should be in effect on the item leased;
■ For leveraged leases, the basis for the accounting entries are normally a set of EDP
generated reports based on a sophisticated leveraged lease model. Such reports are
generated at the inception of the lease and contain the basis for the accounting entries to be
made over the term of the lease. These reports may be re-generated if significant lease
assumptions such as residual values or tax rates change. (See paragraph 14.13 in accounting
matters below.)
Accounting matters
14.6 An example of accounting principles and policies which may be appropriate in recording
leasing transactions is included below. Such example is based upon International Accounting
Standard No. 17, Accounting for Leases. The following guidance is general in nature.
Consideration should be given to any local practice and accounting regulations.
14.7 Direct lease financing. Direct financing leases may be accounted for by banks and
financial institutions as follows:
■ The minimum lease payments (net of amounts, if any, included therein with respect to
executory costs to be paid by the bank or financial institution, together with any profit
thereon) plus the unguaranteed residual value accruing to the benefit of the bank or financial
institution is recorded as the gross investment in the lease;
■ The difference between the gross investment in the lease as computed above and the cost or
carrying amount of the leased property is recorded as unearned income. The net investment
in the lease consists of the gross investment less the unearned income. Initial direct costs
incurred in arranging the lease are charged against income as incurred, and a portion of the
unearned income equal to the initial direct costs may be recognised as income in the same
period. The remaining unearned income should be amortised to income over the lease term,
usually on a method designed to produce a constant periodic rate of return on the net
investment in the lease. Contingent additional rentals should be included in the
determination of income as accruable;
■ The estimated unguaranteed residual value should be reviewed periodically and, if
necessary, adjusted downward, to reflect any permanent reduction in value; future upward
adjustments are permitted but only up to the amount estimated at the inception of the lease.
14.8 When direct lease financing contributes significantly to a bank or financial institution's
revenue, net income, or assets, the following information is generally disclosed in the financial
statements or footnotes:
■ The components of the net investment in direct lease financing:
- Future minimum lease payments to be received, with separate deductions for (i) amounts
representing executory costs, including any profit thereon, included in the minimum
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lease payments and (ii) the accumulated allowance for uncollectible minimum lease
payments receivable;
- The unguaranteed residual values accruing to the benefit of the bank or financial
institution;
- Unearned income.
■ Future minimum lease payments to be received for specified future periods;
■ The amount of unearned income included in income to offset initial direct costs charged
against income;
■ Total contingent additional rentals included in income.
14.9 Leveraged lease. The bank or financial institution records its investment in a leveraged
lease net of the non-recourse debt. The net of the balances of the following accounts represent
the initial and continuing investment in leveraged leases:
■ Minimum lease payments receivable, net of that portion applicable to principal and interest
on the non-recourse debt.
■ A receivable for the amount of any investment tax credit to be realised on the transaction.
■ The estimated residual value of the leased asset. The estimated residual value should not
exceed the amount estimated at the inception of the lease.
■ Unearned and deferred income consisting of
- the estimated pretax lease income (or loss), after deducting initial direct costs, remaining
to be allocated to income over the lease term; and
- the investment tax credit remaining to be allocated to income over the lease term.
14.10 The above calculated investment in leveraged leases less deferred taxes arising from
differences between pretax accounting income and taxable income represents the bank or
financial institution's net investment in leveraged leases for purposes of computing periodic net
income from the lease, as described below.
14.11 The rate of return on the net investment in the years in which such net investment is
positive is computed using the original investment and the projected cash receipts and
disbursements over the term of the lease. The rate is that rate which when applied to the net
investment in the years in which such net investment is positive will distribute the net income
calculated to those years. In each year whether positive or not, the difference between the net
cash flow and the amount of income recognised serves to increase or reduce the net investment
balance. The net income recognised is composed of three elements: two, pretax lease income
(or loss) and investment tax credit, are allocated in proportionate amounts from the unearned
and deferred income included in net investment; the third element is the tax effect of the pretax
lease income (or loss) recognised, which is reflected in tax expense for the year. The tax effect
of the difference between pretax accounting income (or loss) and taxable income (or loss) for
the year is charged or credited to deferred taxes.
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14.12 If the projected net cash receipts over the term of the lease are less than the bank or
financial institution's initial investment, the deficiency is recognised as a loss at the inception of
the lease. Similarly, if at any time during the lease term the application of the method
prescribed above would result in a loss being allocated to future years, that loss should be
recognised immediately. This situation might arise when one of the important assumptions
affecting the determination of net income is revised such as tax rate changes.
14.13 Any estimated residual value and all other important assumptions affecting estimated
total net income from the lease should be reviewed at least annually. If during the lease term
the estimate of the residual value is reduced or if another important assumption is changed so as
to effect the estimated total net income from the lease, the rate of return and the allocation of
income to positive investment years should be recalculated from the inception of the lease
following the method described above and using the revised assumptions. The accounts
constituting the net investment balance should be adjusted to conform to the recalculated
balances, and the change in the net investment recognised as a gain or loss in the year in which
an assumption is changed. An upward adjustment of the estimated residual value is generally
not made.
14.14 For purposes of presenting the investment in a leveraged lease in the bank or financial
institution's balance sheet, the amount of related deferred taxes is presented separately (from the
remainder of the net investment) in liabilities. In the income statement or the notes thereto,
separate presentation is made of pretax income from the leveraged lease, the tax effect of pretax
income, and the amount of investment tax credit recognised as income during the period. When
leveraged leasing contributes significantly to a bank or financial institution's revenue, net
income, or assets, the components of the net investment balance in leveraged leases as set forth
in paragraph 14.9 should be disclosed in the notes to the financial statements.
Auditing guidance
14.15 The internal controls relating to lease financing are generally similar to those for secured
lending activities. Similarly, the audit procedures relating to lease financing are generally
similar to secured lending. Therefore, reference should be made to the auditing guidance in
chapter 3 of volume 1 with respect to lending activities.
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Introduction
15.1 Miscellaneous banking activities, including some that are retail-oriented, are discussed
here, as follows:
■ Trustee and related activities (paragraphs 15.2 - .3);
■ Bond and loan syndication (paragraphs 15.4 - .18);
■ Money transfer systems (paragraphs 15.19 - .21).
■ Bullion trading (paragraphs 15.22 - .46).
Trustee and related activities

15.2 Banks may act as agent or fiduciary in the management of assets for customers and
provision of advice. Examples of such activities are:
■ acting as nominees;
■ share registration;
■ safekeeping, custodial and safe deposit services;
■ money and investment management
■ administration of estates and trustee activities
Banks should maintain appropriate records related to each such activity; for the non-
advisory/administration types of services, this normally involves the use of memorandum
accounts and/or registers to control accountability to its fiduciary customers.
Auditing matters
15.3 The auditor's primary concern is the possibility of contingent liabilities as a result of the
failure of the bank to fulfil its fiduciary responsibilities. The following audit issues are relevant:
■ trustee complies with the responsibilities set out in the trust deed or relevant agreement;
■ the segregation of customers' assets from bank-owned assets;
■ the division of duties between staff managing the bank's own portfolios and staff managing
customer portfolios;
■ controls to ensure that losses on the bank's own transactions are not passed on to customers
via managed portfolios;
■ the regular direct confirmations with customers of assets held by the bank by staff
independent of the safekeeping or custodial functions.
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Bond and loan syndication

15.4 In order to provide major borrowers with large amounts of financing, more than an
individual bank would wish to lend or could place within regulatory constraints, a syndicate will
be formed to provide funds. Borrowers in the syndicated loan and bond markets are principally
sovereign states, quasi-governmental agencies and major international banks and corporations.
Syndicated loans can be for any period but are typically for periods of five to seven years and
generally bear interest at a floating rate. The average life of syndicated bond issues is longer,
generally being between five and twelve years. Bond issues may bear interest at a fixed rate or
a floating rate.
15.5 Loan syndication. In a loan syndication, the borrower authorises one or more banks,
forming the management group, to arrange the syndication of a specified amount of money at a
specified interest margin (e.g., over LIBOR) in return for an agreed management fee. The
management group will normally themselves provide a portion of funds, and will circulate
details to other banks, inviting them to participate in the loan.
15.6 In order to make participation in the syndication attractive to other banks, the lead
managers may offer a participation fee payable from the management fee they receive.
Participation fees are a matter for agreement between the managers and the participating banks.
Expenses of the loan syndication, such as legal fees and costs of preparing the loan agreement
are generally met by the borrower.
15.7 Bond syndication. A bond syndication is generally more complex, and more expensive
than a loan syndication. The participants in the syndicate will include the following:
■ The lead manager - this will usually be a bank specialising in bond syndications, which
obtains a mandate from the borrower to form a syndicate to issue and sell the bond. The
lead manager is responsible for co-ordinating all the arrangements and takes the lead in
pricing the issue.
■ The co-managers - the lead manager, in conjunction with the borrower, will bring in one or
more co-managers who may be chosen because of their ability to place bonds with their
customers or because of an existing connection or common national origin with the
borrower.
■ The underwriters - the management group will solicit other banks and dealers to underwrite
the issue. The managers will normally themselves retain the largest individual underwriting
commitments. The undertaking to provide funds may be a joint commitment by the
management group and the underwriters to the borrower (as is the practice in the U.S.) or a
two-tier commitment, of the management group to the borrower and of the underwriters to
the management group (as is the practice in the eurobond market).
■ The selling group - a larger group of banks and other financial institutions, including the
underwriters, will be invited to join the selling group, which is responsible for placing the
bonds with end investors.
15.8 Sequence of a bond offering. The lead manager circulates details of the proposed issue,
including a draft prospectus and preliminary pricing, to banks and other financial institutions
invited to join the underwriting or selling groups. Underwriters are expected to give acceptance
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of the commitment, subject to agreement of the final terms, within a few days. However, a
longer period, of approximately two weeks, will be allowed for selling group members to
contact potential investors and then indicate the extent of their interest to the lead manager.
15.9 On the pricing day, assuming underwriting has been successfully completed, the
management group decides what issue price to recommend to the borrower. Adjustment of the
issue price alters the effective yield on the bond and is determined according to market
conditions and the level of demand from the selling group. An alternative is to alter the terms
of the issue, such as the size, maturity, or coupon rate, but any such alterations are generally
made well before pricing day.
15.10 Once a decision on price has been made, the underwriting or subscription agreement is
signed, although held in escrow until underwriters have approved the final terms. On the day
after the pricing day (the offering day) allotment telexes are sent to all underwriters and selling
group members indicating the total principal amount of bonds allotted to each bank. The bonds
are allotted at the issue price, less a "selling concession." The selling group members may pass
part or all of this selling concession on to the end investors, although some selling group
agreements may seek to limit the amount which may be passed on.
15.11 Although the intention of the allotment to the selling group is to place the bonds with end
investors, some bonds may be offered in the open market. Alternatively, demand may exceed
supply. Therefore, for a period after the offering day, the lead manager may have to intervene
in the market, buying or selling bonds to stabilise the price. The lead manager will usually
stabilise the position by the "closing date" of the issue, two to three weeks after the offering
date, when the bonds are delivered to purchasers and settlement is made.
15.12 A so-called "grey market" exists in eurobonds prior to the pricing date. In this market,
bonds are traded on an "if and when issued" basis. As the issue price will not have been
determined, such trading is done at a specified discount or premium to the subsequent issue
price.
15.13 Income from bond syndications. The participants in the syndicate receive the
following income:
■ A management fee paid to the lead manager and co-managers. The lead manager will
normally take an initial portion, the "praecipium," with the balance being shared in
proportion to the managers' commitments.
■ An underwriting fee paid to the underwriters pro-rata to their commitments. This may be
paid from the management fee, or paid separately by the borrower. The borrower normally
bears various expenses of the issue including any loss on stabilisation, legal, printing, telex,
and travel costs, etc. up to an agreed limit. Expenses above this limit are borne by the
underwriting group and deducted from the fees distributed by the lead manager.
■ Selling concessions to the selling group.
Accounting matters
15.14 The principal accounting issue relating to loan and bond syndications is the timing of
recognition of fee income. A number of different treatments are found. The following
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guidance is general in nature. Consideration should be given to any local practice and
accounting regulations.
15.15 Loan management fees are normally recognised in profits on signing of the loan
agreement or when received, as compensation for work done. Participation fees may be treated
on the same basis but, if they are considered to be compensation for a low-interest margin, they
should be amortised into profits over the life of the loan.
15.16 Bond syndication management fees are normally recognised in profits on signing of the
subscription agreement or when received, as compensation for work done. Underwriting fees
may be treated on the same basis, but, if recognised on the offer date, appropriate provision
should be made for the expenses expected to be deducted from the fee. Alternatively,
underwriting fees may be amortised into profits over the underwriting period. Selling
concessions received may be treated as a reduction of the costs of the bonds acquired, or as fee
income.
15.17 Potential losses on grey market deals should be provided for, but potential profits would
not normally be anticipated until the offering date, as they are contingent on the bonds being
issued.
Auditing guidance
15.18 The principal audit considerations relating to bond and loan syndications are:
■ whether accounting policies for recognition of income are appropriate, and consistently
applied;
■ whether, as lead manager, the bank has proper procedures for controlling allocations, etc.;
■ whether contingent liabilities and commitments are properly recorded.
It should also be noted that financial institutions within a syndication have significantly less
capacity to influence the exiting of a non-performing loan which is subject to syndication.
Money transfer systems

15.19 The money transfer function of a bank is responsible for the control and execution of
payments and receipts of funds or cash. This function, depending on the size and scope of
operations of the bank, may either be centralised, and interact with all of the bank's business
activities (e.g., money market, foreign exchange, lending or documentary credits), or be
decentralised, and incorporated within the work flow of each of the business lines.
15.20 Payments. The typical payment mechanisms are official cheques or drafts, cable
transfers, CHIPS transfers, and SWIFT transfers. The nature of the transaction as well as the
timing and payment terms will typically determine the payment mechanism used by the branch.
The following is a brief description of these payment mechanisms and their possible uses.
■ Official cheques or drafts. These are instruments that the bank has drawn on itself and
which are generally used for a variety of payments in domestic currency, the most common
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being loan disbursements, interest payments, payments under documentary credits, and
general expense disbursements.
■ Cable transfers. Cable transfers are the most common form of international funds transfer.
This involves the sending of payment instructions to a correspondent bank via telex. For
this payment mechanism, the bank establishes a relationship with each correspondent bank
whereby a system of test keys is determined. The correspondent bank, upon receiving a
message, will read the cable and verify the test key. If the test key matches, the
correspondent bank will process the transaction according to the instructions contained
therein. Often, transfers of this nature, depending upon the amount involved, may also be
confirmed by telephone with both the correspondent bank and the ultimate recipient of the
funds.
■ Clearing house interbank payment systems (CHIPS). A clearing house is an association
of banks organised within a particular region to clear cheques drawn on each other. One of
the largest and best known associations is the clearing house interbank payment system of
New York (CHIPS). CHIPS is a voluntary association of banks organised primarily to
facilitate their paying and receiving functions through the use of terminals (CHIPS
machines) located at each member bank and connected to the CHIPS centralised system.
CHIPS is comprised of two types of banks, members and associate members. Member
banks are the 12 New York clearing house association members. Associate member banks,
including agencies and branches of foreign banks, are banking institutions that participate in
CHIPS through the New York clearing house member banks.
Functionally, the foreign branch selects a correspondent bank, one of the member banks,
with which to settle its net CHIPS position at the end of each day. During each business
day, the branch will enter payment instructions into its CHIPS terminal. Once entered and
approved, preferably by a member of management, the transaction is released into the
system. Additionally, other paying parties can use the system to send payments or funds for
depositors' accounts to the branch. Notification of these payments to the branch are printed
by the CHIPS terminal. Typically, a cable or telephone call from the paying party regarding
the impending transfer of funds will precede the transfer.
At the end of each day, a net position statement will be printed by the system through the
CHIPS terminal. Depending on the branch's system, this statement is generally reconciled
to the general ledger or control ledger that night or on the succeeding day. A settlement in
federal funds will be perfected the same day via either a net debit or credit to the branch's
due from bank account maintained with the corresponding member bank.
This payment mechanism is typically used in settlement of foreign exchange and money
market activities. It provides a direct method for depositing funds in the contracting party's
deposit accounts on exactly the same day as the maturity of the contract, thereby allowing
for the maximum utilisation of cash balances.
■ Society for world-wide interbank financial telecommunication (SWIFT). SWIFT is an
international financial transaction processing network owned by over 1,000 banks in more
than 50 countries with the primary objective of providing a secure and effective
communications system for member banks. Responsibility for security is divided between
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SWIFT and the banks, and there are extensive facilities to ensure that message processing is
controllable and auditable. The system handles many types of international banking
transactions such as transfers, currency operations, collections, securities, documentary
credits, statements, and confirmations.
The system operates 24 hours a day and delivers messages to operational banks within
minutes of transmission. The store and forward processing concept of SWIFT enables
banks in different time zones to transact business conveniently. The use of standard formats
for each message type facilitates the integration of SWIFT processing with banks' main
computer systems.
SWIFT differs significantly from CHIPS in that it operates in multiple currencies rather
than in US dollars and is essentially a communication system.
The SWIFT system comprises three operating centres which are linked to regional
processors in a number of countries. The SWIFT members (over 800 banks) are connected
via national communication facilities to the regional processors. The operating centres
carry out the transaction processing operation between the sending and receiving banks.
The integrity of money transfer instructions is ensured by adding an authenticator to each
message based on unique keys exchanged between banks. International telecommunication
links which are SWIFT responsibility are encrypted. National links between banks and the
SWIFT regional processor are the banks' responsibility; banks are encouraged to arrange for
these links to be encrypted. System generated input sequence numbers (ISN) and output
sequence numbers (OSN) can be used to assist with the detection of missing or duplicate
messages. A system of one time log-in tables controls the connection of a bank to SWIFT.
Payment and receipts controls

15.21 Controls over the payments function should be designed primarily to prevent the
possibility of payments being made without proper authorisation and approval. Examples of
both high level and detailed controls over payments and receipts systems are set out in chapter 3
of volume 1.
Bullion trading
15.22 General. The term "bullion" generally refers to gold and silver, and to claims and
obligations related to these metals.
15.23 Gold has always been a relatively scarce metal and, because of its scarcity, became a
standard of value and possession. The general public and sophisticated investors may prefer to
hold at least part of their wealth in gold, particularly in times of high inflation, or uncertainty
regarding the political or monetary system. In addition, gold and silver offer opportunities for
speculation: holding the metal in anticipation that its value will increase or selling it expecting
its value to decline. Other demands for bullion include the following:
■ manufacture of gold jewellery or silverware;
■ industrial use (e.g., silver in the photographic industry);
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■ dentistry; and
■ as a monetary reserve medium.
On the supply side, the sources of bullion are as follows:
■ newly mined gold or silver;
■ recoveries from industrial processes; and
■ sales of holdings by existing holders.
15.24 The price at which bullion trades is determined, in free markets, by the forces of supply
and demand. The significance of speculative demand can lead to sharp fluctuations in prices
and, therefore, most banks do not normally maintain significant net positions in bullion, but
instead act principally as intermediaries between buyers and sellers.
15.25 Allocated and unallocated bullion. Transactions in bullion may be in either "allocated"
bullion or "unallocated" bullion. A transaction in allocated bullion is a transaction which
identifies specific bars of the metal. Different markets may make their own rules about the
acceptability of bars, but will generally require that they be "assayed" by one of an approved list
of assayers, and conform to certain minimum and maximum weights and degrees of purity
(known as "fineness"). Trading is normally in round amounts and on settlement an adjustment
may be required in respect of actual weight delivered. When a bank holds allocated gold for a
customer, the specific bars will be physically segregated and held in safekeeping for the
customer. The customer is charged insurance and storage fees for this service.
15.26 A transaction in unallocated bullion is a right to a fixed weight but unidentified bars of
bullion.
15.27 Banks may also trade gold and silver in the form of coins, grain, sheet, disc, and wire.
15.28 Types of transactions. The principal types of transactions in bullion are as follows:
■ Spot purchase/sale - for settlement two days from trade date. The transactions may be in
either allocated or unallocated bullion. For a transaction in allocated bullion, the specific
bars are identified on settlement date;
■ Forward purchase/sale - for settlement more than two days after trade date. Again
transactions may be in allocated or unallocated bullion. Customers may be requested to
deposit "margin" against forward deals. Such arrangements are subject to negotiation;
■ Futures - gold futures are traded in various markets, including the New York commodity
exchange ("Comex") and the London gold futures market. Futures can be bought and sold
(unlike rights/obligations under forward deals), and the market characteristics are similar to
those for financial futures (see chapter 7 of this volume);
■ Warrants - silver warrants are issued by members of the London metal exchange upon the
deposit of a quantity of silver bullion. The warrant specifies the details of the bars it
represents. Each warrant represents an exact number of ounces which must be within five
percent of 10,000 ounces of silver. Warrants are traded in units of 10,000 ounces, and on
settlement (delivery of the warrant) an adjustment is made to match the exact number of
ounces specified in the warrant;
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■ Lending - gold may be loaned to or borrowed from a central bank, at a negotiated interest
rate.
Mechanics of trading and settlement

15.29 In most financial centres, a number of market makers trade as principals throughout the
working day quoting a two-way trading price for buying and selling. However, in some centres
such as London and Luxembourg, there is also an opportunity to buy or sell in a "fixing" at a
single quoted price. At the fixing, the chairman announces an opening price, and the
representative of each market member may declare as a buyer or seller. The price is then
adjusted, if necessary, until there are both buyers and sellers. Each representative is then asked
to declare the volume of his interest, resulting in further price adjustments, with consequent
adjustments to volumes, until a balance of buy and sell interests is achieved. Members act as
principals in the fixing, but because purchases and sales are at a single price, a commission is
charged, usually only for sales by a member (purchases by a customer). Purchases by members
are usually free of commission. Each market will have its own rules and conditions.
15.30 Prices are always quoted for local delivery, that is, for delivery at the vault of the market
member. Physical shipment to another location is subject to an extra charge.
15.31 Forward prices for bullion are normally quoted at a premium over the spot price. The
premium reflects the interest cost of holding the non-interest earning asset in a similar
relationship to that governing forward foreign exchange rates. However, a physical shortage of
bullion can result in a spot price which is higher than the forward price.
Policies, key controls and records
Management controls
15.32 Management review. Management reports should be reviewed periodically by
appropriate senior management. These reports should include the following:
■ analysis of open positions;
■ listing of outstanding contracts by customer, at current market value, with details of any
margin deposits;
■ summaries of month-to-date and year-to-date profits and losses by transaction type;
■ reports of any excesses over position limits and, if applicable, customer limits.
15.33 Trading policies. Trading policies should be established with respect to:
■ types of transaction/instruments and markets in which the bank may trade;
■ limits on positions which may be taken;
■ standards for trading with and on behalf of customers, including rules for ascertaining
credentials of new customer and for prescribing trading limits.
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15.34 Segregation of duties. There should be segregation of duties between the following
responsibility units:
■ traders;
■ settlements and instructions ("precious metals desk");
■ vault record keeper;
■ vault custodian;
■ accounting;
■ reconciliations.
15.35 Customer accounts. Customer positions on futures contracts, or forward contracts,
should be revalued regularly and procedures should exist for margin calls where appropriate.
Accounting matters
15.37 Balance sheet. Spot obligations to customers and other banks for unallocated bullion
represent liabilities of the bank and are equivalent to deposits of currency. They are therefore
shown as liabilities in the balance sheet, and may be included in deposit liability accounts
generally or may be distinguished separately. Allocated bullion held on behalf of customers
does not represent a claim on the general assets of the bank, and are not included in the balance
sheet. This is the same treatment as for other items held in safekeeping.
15.38 Physical stocks of bullion (other than those held for customers) and spot claims on other
banks or customers for unallocated bullion are included as assets in the balance sheet. They
may be shown as a separate caption, or, according to the nature of their liquidity and risk, by
showing physical stocks as stock included with cash, spot claims on other banks as bank
balances, and spot claims on customers as advances.
15.39 It is preferable for transactions in bullion to be accounted for on trade date, although it
should be noted that, in some countries, it is conventional to record such transactions on a value
date basis.
15.40 Off balance sheet. Unmatured bullion trades are recorded on trade date in contingent or
memoranda accounts off the balance sheet, and the commitment may be noted although not
necessarily quantified in the financial statements.
15.41 Profit and loss. Physical stocks and spot claims and obligations are revalued at spot
market rates at the balance sheet date.
15.42 Futures contracts and forward purchases and sales are revalued at the future or forward
market rates applicable to their respective maturities at the date of the revaluation.
15.43 Revaluation gains and losses are included in current income.
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Auditing guidance
15.44 The audit issues associated with bullion trading operations are comparable to foreign
exchange trading and reference should be made to the guidance in chapter 3 of volume 1.
15.45 Additional comments on internal controls that should be in place to support a lowered
control risk are:
■ Safeguard controls over physical bullion . The safekeeping function is particularly
important for bullion. The vault or strong room should have adequate physical security. All
movements of bullion should be initiated by stock movement instructions issued by the
precious metals desk, and recorded in a register. On receipt of bullion, the bars should be
individually weighed and the weight and details of the assay recorded in the register. There
should be a periodic agreement of the physical stock to the register;
■ Safeguard controls over warrants. Controls over the issue of warrants should be similar
to those governing the issue of certificates of deposit;
■ Reconciliation controls. The bullion register should be periodically agreed to the physical
stock held as recorded in the accounting records. Confirmation from counterparties of
trades done should be received by the settlements department and checked to the bank's
records.
■ Other. Statements should be sent periodically to all customers of account balances,
including any margin accounts.
15.46 Select substantive audit procedures. The following substantive audit procedures with
respect to bullion trading should be considered. The procedures detailed below are not an
exhaustive list, nor do they form a suggested audit program.
■ Verify outstanding contracts by reference to counterparty confirmations, clearing
house/brokers' statements and use of direct confirmation requests.
■ Verify physical stocks held, both on own account and for customers by inspection (or
confirmation if held by others).
■ Verification by inspection.
■ Verification by direct confirmation of physical stocks held by third parties.
■ Verify allocated gold held in safekeeping for customers by means of direct confirmation
requests.
■ Verify bullion held on an allocated and unallocated basis with other banks or customers by
means of direct confirmation requests.
■ Check market value and recompute amortisation.
■ Analytically review transaction volume and profit/loss statistics.
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Introduction
16.1 Analytical procedures are discussed in detail in chapter 62 of the KPMG Audit Service
Manual.
Analytical procedures may be applied at various stages:
■ to assist in planning the audit;
■ to obtain effective audit evidence;
■ to assist in the review and interpretation of audit findings; and
■ to assist in developing information useful for reports to the client.
The purpose of this chapter is to outline particular factors unique to the banking and finance
environment which should be considered when performing analytical procedures on a banking
and finance engagement.
16.2 A number of analytical procedures are listed by individual product in chapter 3 of volume
1. Paragraphs 16.7 - .9 of this chapter include additional guidance on the application of these
procedures.
Use of analytical procedures in the planning stage

16.3 The objectives and use of analytical procedures in the planning process of an audit
engagement is outlined in paragraph 50.19 of the KPMG Audit Service Manual.
16.4 Analytical techniques employed in this phase should be designed to provide information
regarding the overall operating environment of the banking and finance entity including, but not
limited to, the following:
■ overall and segment/branch operating results;
■ financial position for the bank or financial institution in aggregate and by segment/branch;
■ changes in business mix;
■ new banking and finance products;
■ overall asset quality.
In order to perform the planning analysis which provides us with the above information, the
following may be useful:
■ internally prepared interim financial information, including average balance information;
■ budget information, indicating actual vs. budget figures (on a monthly basis);
■ profitability results by banking and finance product or line of business;
■ volume statistics by product;
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■ information regarding past due loans with regard to commercial loan portfolios and
delinquency trend information with regard to loans to individuals (consumer lending).
Utilising this information we can perform various ratio and trend analyses, comparisons, and
reviews to accomplish the objective of the planning phase.
Obtaining effective audit evidence using analytical procedures

16.5 As outlined in paragraphs 60.43 and 60.45 of the KPMG Audit Service Manual, analytical
procedures are often effective in providing substantive audit evidence. A number of examples
of analytical procedures for individual banking and finance products are listed in chapter 3 of
volume 1.
16.6 The following provides guidance on certain analytical ratios and techniques which may
be considered during an audit. Consideration should also be given to the use of analytical
procedures listed by individual product in chapter 3 of volume 1 which are not detailed below.
The ratios and techniques listed herein and in chapter 3 of volume 1 are not meant to be all
inclusive, and they should be modified or expanded to suit the needs of the particular
engagement.
16.7 Margin/Spread. The margin or spread (also defined as "net interest margin") is the
"gross profit" of the banking and finance industry. It is the difference between the revenue
earned on interest earning assets and the cost of borrowing money. Banks and financial
institutions devote considerable resources to managing the interest rate risk position with a view
to maximising their net interest margin.
A great deal of information regarding the bank or financial institution’s performance can be
derived from an analysis of the net interest margin. For example, an analysis of the changes in
this rate in comparison to general interest rate movement is useful in providing information
regarding the bank or financial institution's funds management. (i.e., funding long-term interest
earning assets with short term interest bearing liabilities in a period of rising interest rates
should result in a lower interest margin.)
16.8 Yield analysis. Yield analysis can provide very strong evidence in relation to both
interest income and expense and the related asset and liability balances. The review should
focus on particular categories of assets and liabilities and their related income streams. When
using these analytical techniques, we should utilise average asset or liability balances, as
fluctuations in point-in-time balances occur frequently. We should compare the yields
calculated through this analysis with relevant market rates.
Where the bank or financial institution deals in multiple currencies, it is important to segregate
the assets and liabilities by currency and calculate separate yields for each pool. The resulting
yield should then be reviewed in light of the foreign exchange fluctuations and market rates for
assets and liabilities denominated in these currencies.
16.9 Asset quality ratios. Although we will perform reviews of all asset categories for
collectibility, the principal focus of a collectibility review is on the bank or financial institution's
loan portfolio. In this regard, the following ratios and analyses information are useful in
determining unusual risk in the portfolio.
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■ Allowances for loan losses to non-performing loans or past-due loans. Banks and
financial institutions typically maintain standards for identifying loans on which the accrual
of interest is either ceased or continued but at a lower rate. These loans are typically referred
to as non-performing loans. An analysis of the ratio of non-performing loans to the
allowance for loan losses historically and in comparison to other banks and financial
institutions' ratios can provide us information regarding the potential adequacy of the
allowance for loan losses in light of potential risk in the portfolio. This analysis is also
useful when performed in conjunction with analysis of the net interest margin.
■ Provision for loan losses to total loans. An analysis of the ratio of the provision for loan
losses to total loans can identify possible changes in risk within the portfolio (i.e., change
from secured lending to unsecured lending) if the ratio shows fluctuation. If it does not, but
we have become aware of changes in lending which typically would require a higher
allowance to loan ratio, the lack of change in this ratio could indicate a possible audit
problem regarding the adequacy of the provision.
■ Risk indicators. It should be noted that some international banks and financial institutions
maintain the consolidated allowance for loan losses at the head office level with no
allocation to the books of the bank or financial institution's branches. Accordingly, analysis
at the branch level should concentrate on identifying changes in risk in the portfolio.
Information which may help identify changes in risk is as follows:
■ analysis of portfolio by type of lending (secured, unsecured, commercial, consumer, etc.);
■ analysis of portfolio by industry diversification;
■ analysis of portfolio by country of risk;
■ gross non-performing or past-due loans;
■ ageing of consumer loan portfolio;
■ management's classifications of the portfolio (e.g., special mention, substandard, doubtful,
and loss);
■ regulatory examiners' classifications.
16.10 Non-financial statistical information
■ Reject statistics. High volume of transactions must be processed through a bank or
financial institution on a daily basis. In many countries these transactions clear overnight or
immediately, e.g., in the case of electronic funds transfer. As a result of the large volumes
processed, input errors do occur and result in rejects. A review of the volume of rejects may
provide us with an indicator of the quality of the internal accounting controls and work flow
efficiency in these areas. Accordingly, we can adjust the approach in the planning stage to
react to potential operational problems.
■ Volume statistics. Volume statistics are indicators of the number and types of transactions
that are processed by a bank or financial institution. Similar to commercial companies,
banks and financial institutions offer "products". In a wholesale banking and finance
environment, the products are the various facilities (loans, documentary credits, etc.) deposit
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accounts (demand, overnight funds, bearer notes, etc) and money market items (foreign
exchange, T-Bill purchases, etc.) available to the corporate customer. The product volumes,
in terms of revenues and costs associated with the products, are typically monitored by the
banks and financial institutions to determine the profitability of services offered. We should
obtain the bank or financial institution's internal profitability analyses and volume statistics
by product category and by geographical region. Analysing this data in light of our
knowledge of the product risks will aid us in determining areas for audit emphasis.
We should be aware that where volume statistics increase significantly and staffing levels
remain the same, internal controls may be compromised to ensure the timely processing of
transactions.
Sources of information for analysis

16.11 The nature of banking and finance activities is such that there should be readily available
sources of information that may be used for analysis purposes. These may come from sources
within the bank or be part of general market knowledge. Particular items of information which
are likely to prove valuable are as follows:
■ Weekly statistics on volumes and outstandings for major banking and finance products.
Generally, the precision of the test will be improved by using data at lower levels of
aggregation, such as statistics by each product and geographic area as appropriate;
■ Daily profitability of each product desk. This is likely to be prepared as a matter of course
and particularly as a control over trading activities;
■ Daily positions in each product e.g., securities, foreign exchange etc.;
■ Market foreign exchange and interest rates throughout the period;
■ Industry statistics such as lending or deposits by class of facility for all banks and financial
institutions;
■ Daily turnover in each product both in terms of number of deals and principal amounts;
■ Budgets for income, expenses and volumes;
■ Dealing strategies throughout the period;
■ Knowledge of any unusual market conditions existing at any time during the period e.g. a
market crash, increases in interest rates, substantial changes in foreign exchange rates etc.;
■ General market knowledge from the financial press.
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Introduction
17.1 Effective audit evidence is obtained through three main types of audit procedures:
■ tests of controls;
■ analytical procedures; and
■ tests of details.
When performing tests of details, substantive sampling may be used when it is necessary to
draw a conclusion about a population without examining all of the items in the population.
However, note that substantive sampling will often not be necessary as sufficient audit evidence
will be able to be obtained from tests of controls and analytical procedures. Further, the
engagement partner may consider that a judgmental sample is more appropriate than the use of
statistical substantive sampling techniques.
17.2 When substantive sampling is undertaken, there are a number of matters to consider and
these are outlined in chapter 63 of the KPMG Audit Service Manual. These matters apply
equally to the banking and finance industry. However, a feature unique to the banking and
finance environment is that of off-balance sheet instruments. When performing representative
sampling of off-balance sheet instruments there are a number of factors to consider and these
are discussed in this chapter.
Sampling off-balance sheet instruments

17.3 For off-balance sheet instruments, the potential misstatement in the financial statements
may be considerably less than the principal amount of the instrument in question. In the case of
off-balance sheet instruments such as interest rate contracts and exchange rate contracts, the
notional asset and liability effectively offset each other except to the extent of any relative
change between the value of the asset (i.e. the right to receive future cash flows) and the
liability (i.e. the obligation to pay future cash flows). Therefore the potential profit and loss
effect is limited to the amount of the relative change.
17.4 The basic balance sheet assertion comprises the total of items representing the profit or
loss on such instruments. For some audit objectives, such as tests of existence, the population
consists of these items at their current valuation. For other tests, such as valuation, the measure
is more wide - effectively comprised of such items at their maximum likely value. In practice
we consider the likely magnitude of the profit and loss effect for our tests. As this is
determined by changes in market price from the date of the transaction until balance sheet date,
we have, by virtue of historic market experience, a reasonable basis on which to assess the
likely magnitude of the profit and loss effect.
17.5 Off-balance sheet items such as guarantees, contingencies and forward asset purchases
generally also carry with them a risk of misstatement to the financial statements which is less
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than their face value. This suggests that some adjustment may also be appropriate in our
sampling of these items to reduce the sample size.
17.6 Measuring the population value. In order to determine the book value of the population
for sampling purposes it is necessary to make some adjustment to the principal amounts in
order to reflect the risk to the bank or financial institution implicit in the transaction. For
purposes of sampling, the population should be redefined as the gross amount of the off-balance
sheet instrument multiplied by the appropriate bank for international settlements (BIS)
weightings as set out in paragraphs 17.8-9. This new population value is referred to as the
"credit equivalent amount". That is:
Credit equivalent amount = Gross amount of the off-balance sheet item x BIS weighting
1 7 . 7 Off-balance sheet weighting factors. In order to make off-balance sheet items
comparable with on balance sheet items, approximate balance sheet equivalents need to be
calculated. The question of equivalency for off-balance sheet items, has been considered by the
Balse supervisors committee which reported in July 1988 with agreed proposals for the
convergence of capital adequacy requirements in the group of 10 countries. For capital
adequacy purposes appropriate risk weightings (BIS weightings) are applied to off-balance
sheet instruments.
17.8 The types of transactions which may require an on balance sheet equivalent to be
calculated include the following, together with their appropriate BIS weightings:
Products Weightings
%
Interest rate contracts See below
- interest rate swaps
- interest rate options
- forward rate agreements
- interest rate caps/floors/collars
Exchange rate contracts See below

- forward foreign exchange contracts
- cross currency swaps
- currency options
Direct credit substitutes (guarantees and acceptances) 100
Transaction related contingent items (performance bonds, bid bonds 50
etc.)
Short-term self-liquidating trade related contingencies 20
Sale and re-purchase agreements and asset sales with recourse 100
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Products Weightings
%
Forward asset purchases, forward deposits, partly paid shares and 100
securities
Note issuance facilities and revolving underwriting facilities 50
Other commitments with original maturity over one year 50
Other commitments with an original maturity of under one year †50
† Adjusted factor as BIS paper gives such items a weighting of nil,
which would exclude them from the population.
17.9 For interest rate and exchange rate contracts, international capital convergence provides
two methods of calculating equivalent amounts, the original exposure and current exposure
methods. Whilst the current exposure method is likely to be used in practice for calculating
capital adequacy, it is likely to be less suitable for calculating the equivalent book value of the
population for substantive sampling purposes. Accordingly, the following factors (applied
under the original exposure method) should be applied to the principal amounts of such
contracts for calculating the equivalent book value of the population:
Original maturity Interest rate contracts Exchange rate contracts
Less than one year 0.5% 2.0%
One year and less than two 1.0% 5.0% (i.e. 2% + 3%)
years
For each additional year 1.0% 3.0%
17.10 Calculating the credit equivalent amount . The total adjusted population value is
calculated by aggregating the credit equivalent amount for each contract in the population; viz:
Gross amount BIS weighting† Credit equivalent amount
30,000,000 2% 600,000
5,000,000 2% 100,000
1,000,000 2% 20,000
… …
____________ __________
4,000,000,000 80,000,000
† For illustrative purposes, the BIS weighting selected is that for exchange rate contracts with
an original term to maturity of less than one year.
17.11 As a practical matter, population values would normally be calculated based upon the
total principal amount of the class of off-balance sheet transactions multiplied by the
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appropriate BIS weighting. For example, in the illustration above, the population value (i.e.;
credit equivalent amount) could be calculated by:
Credit equivalent amount = 4,000,000,000 x 2% = $80,000,000
17.12 It is important to remember that the BIS weightings apply based on the original term and
not the residual term to maturity. The original exposure method measures the possible loss to
an institution due to non-fulfilment of a contract at any time during its currency, not the actual
loss which would arise at a given date. Clearly a 2 year forward contract maturing the day
following balance date (and hence being subject to exchange rate fluctuations over 2 years) has
a greater potential for misstatement than a spot deal maturing on the same day. Therefore, if
credit equivalent amounts are calculated based on population total details, separate totals will be
required for contracts with an original term to maturity of one, two, three etc. years.
17.13 Where this information is not readily available, CAATs may be used to independently
calculate the population totals. If the value of contracts with an original term of greater than
one year is immaterial, as a practical matter, factors for less than one year may be used.
Similarly, where the breakdown is not known, it may be appropriate to estimate the average
maturity of the portfolio and apply the relevant weighting to the total portfolio.
17.14 Appropriateness of BIS weightings . As the BIS weightings are widely accepted as
appropriate risk measures, they provide an independent basis on which to measure the risk and
hence its population value. In cases of serious reservation as to the validity of those weightings
- i.e. in times of exceptional volatility - the sample may be enlarged at the discretion of the
engagement partner.
17.15 Calculating sample sizes. Sample sizes are calculated based on the total credit
equivalent amount as follows:
Sample size = Gauge units x Sample size factor
Total credit equivalent amount
= Gauge x Sample size factor
Assuming that gauge is $5,000,000 and the sample size factor is 4, the maximum sample size
for the population described previously would be:
Sample size † = Gauge units x Sample size factor
80 million
= 5 million x 4
= 64
† Individually significant items have been ignored for purposes of calculating the maximum
sample size.
17.16 Choice of sampling technique. Given that a major concern with interest rate and
currency contracts is completeness, monetary unit sampling is not appropriate.
17.17 Where the risk of significant misstatements is assessed as other than low, or other
substantive procedures to detect understatement are weak, it may not be appropriate to use
stratification under the KPMG sampling plan other than to select individually significant items
(as measured using credit equivalent amounts).
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17.18 It will generally be effective in reducing sample sizes to identify major counterparties
and include these as "individually significant items". The remaining population total to be
subject to sampling would be reduced accordingly.
17.19 Understatement risk . To address the completeness assertion, in addition to tests of
controls, samples should be selected to include major counterparties and incorporate a selection
from customer limits. This may be achieved by:
■ selecting random contracts supplemented by a selection of parties with no outstanding
contracts or large unused limits;
■ selection of counterparties for confirmation from lists of authorised counterparties (limits).
17.20 To ensure that the test is effective in identifying unrecorded transactions, any
confirmation or verification procedures should apply not only to the contracts selected, but also
seek confirmation of all other outstanding contracts with that counterparty. In this way, there is
a greater chance of an omitted transaction being bought to our attention. Usage of limits is
considered to be a powerful technique given that one would generally not expect transactions to
be taking place with a party unless the limit has been established.
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Introduction
18.1 The purpose of this chapter is to provide information related to confirmation procedures.
It should be recognised however, that the use of confirmation procedures, whilst being a highly
effective substantive procedure for verification of existence and accuracy, must be considered
in the light of the control environment in which the balances are recorded and the availability of
effective audit evidence through other means which may be more efficient, such as tests of
controls and analytical procedures. Reference should be made to chapter 3 of volume 1 for
discussion on obtaining effective audit evidence.
18.2 Therefore, professional judgement must be used to determine the nature, timing, and
extent of confirmations. Such matters as the effectiveness of internal accounting controls, the
apparent possibility of disputes, inaccuracies or irregularities in the accounts, the probability
that requests will receive consideration or that the customer will be able to confirm the
information requested, and the materiality of the amounts involved are factors to be considered
by the auditor in selecting the information to be requested and the form of confirmation, as well
as in determining the extent and timing of the confirmation procedures.
Types of confirmations
18.3 Confirmation provides auditors with evidence directly from third parties. Confirmation is
a strong substantive audit procedure for many audit objectives because it provides documented
evidence from an external source. Confirmations are also frequently an efficient procedure to
perform since they provide evidence about existence and accuracy of all information flows that
increase the account balance and about completeness and accuracy of all information flows that
decrease the account balance. The confirmation of receivables (loans) is a required audit proce-
dure in many countries. Confirmations also provide some evidence about matters not
specifically confirmed; for example, confirmation of a balance due from a customer provides
evidence that previous payments from that customer are complete.
18.4 Confirmation should be requested only of matters about which the respondent can
reasonably be expected to be knowledgeable.
18.5 The types of confirmations can be distinguished as between form and content:
Form
■ Positive confirmation requests. Positive requests for confirmation elicit response directly
to the auditor. Positive requests are appropriate for all types of confirmations, and they
permit the auditor to monitor and follow-up non-responses.
■ When positive confirmations are used, it is expected that some customers will not reply.
When no confirmation is received, follow-up/alternative audit procedures should be
employed. Such procedures may include:
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- the sending of second and, possibly, third requests;

- the review of subsequent cash payments made by the counterparty;
- the vouching of the transaction balance by reviewing supporting documentation.
■ Negative confirmation requests. Negative requests elicit response directly to the auditor
only if the respondent does not concur with the data being confirmed. In this case, the
auditor is unable to distinguish between those non-respondents who agree with the
confirmation and those who have ignored it. The use of negative confirmations does not
generally create the same quality of evidence as do positive confirmations. Negative
requests are generally used for confirmation only when all of the following circumstances
apply:
- a large number of smaller balances is involved;
- risk of significant misstatements is low;
- the auditor has no reason to believe the persons receiving the requests are unlikely to
give them consideration.
Content
■ Open confirmation requests. This type of request solicits information from the
respondent rather than providing client data for the respondent's verification and can only
be used as a positive confirmation request. Responses to such requests are independently
prepared by the respondent and are not influenced by client records;
■ Specific item confirmation requests. This type of request elicits response regarding client
data provided and may be used as a positive or negative confirmation request.
Confirmations in an international banking operation should generally be performed on a
transaction-type basis as opposed to an overall customer/counterparty relationship basis.
18.6 Sampling criteria and techniques are discussed in chapter 63 of the KPMG Audit Service
Manual and guidance on the risk assessments for each assertion are provided throughout the
guide. A factor to be considered in determining sample size is the extent to which internal
auditors have already mailed confirmations during the year. Often the external auditors can
place reliance on the internal auditors' work and, thus, reduce their own circularisation scope
provided that:
■ Internal auditors' confirmation procedures compare favourably with external auditors'
procedures (including their monitoring of responses and disposition of replies received with
differences);
■ Timing of circularisation is acceptable;
■ Scope and sample sizes are adequate.
Reliance in the work of internal auditors is discussed further in chapter 59 of the KPMG Audit
Service Manual.
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18.7 The following data are normally subject to confirmation procedures; however, it should be
noted that the following listing is not intended to be complete and should be tailored to
individual engagements, including consideration of risk of error, consequence of error, and
other available effective audit procedures.
Area for confirmation Audit objective Usual type of request
P = positive
N = negative
(subject to para 18.6)
Balance sheet items
Balances with Central Bank To obtain audit evidence about P
existence, accuracy and
ownership of recorded balance.
Lendings to banks To obtain audit evidence about P
(outstanding amounts, existence, accuracy and
maturities, interest rates, ownership of recorded balances
collateral) and conditions.
Securities (from holders of not To obtain audit evidence about P
on hand: description of existence and ownership.
securities, nominal amount,
interest rates)
Lendings to customers To obtain audit evidence about P
(outstanding amounts, existence, accuracy (not
maturities, interest rates overstated) and ownership of
collateral) recorded balances and
conditions.
Demand deposit and current To obtain audit evidence about P/N
accounts completeness, existence and
accuracy (not understated)
Deposits from banks To obtain audit evidence about P
(balances, maturities, interest completeness, existence and
rates, collateral) accuracy (not understated).
Liabilities to customers To obtain audit evidence about P
(balances, maturities, interest completeness, existence and
rates) accuracy (not understated).
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Area for confirmation Audit objective Usual type of request

Savings accounts To obtain audit evidence about P/N
completeness, existence and
accuracy (not understated).
Other assets/other liabilities To obtain audit evidence about P
(balances) completeness, existence and
accuracy.
Off-balance sheet items
Letters of credit and To obtain audit evidence about P
acceptances (total amount, completeness, existence and
unused portion, acceptances accuracy of transaction and
outstanding and collateral memoranda accounts and
held; also, whether letter is collateral.
revocable, confirmed,
revolving, guaranteed, etc)
Unmatured foreign exchange To obtain audit evidence about P/N
contracts (amounts, completeness, existence and
currencies, exchange rate, accuracy of transaction and
transaction date, maturity memoranda accounts.
date), swaps, FRAs etc
Guarantees and collateral To obtain audit evidence about P
given for third party liabilities completeness, existence and
(amounts, type of collateral, accuracy of firm commitments
conditions) and of contingent liability for the
bank.
Safekeeping items To obtain audit evidence about P/N
accuracy of records.
Sample letters
18.8 The following examples illustrate the typical wording used when confirming balances and
other items in the course of a bank examination. The wording should be modified, where
necessary, to the individual circumstances.
■ demand deposit or current accounts -- 1
■ demand deposit or current accounts with other banks (nostro accounts) -- 2
■ certificates of deposit issued -- 3
■ deposits accepted -- 4
■ overdrafts -- 5
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■ loans to individuals, commercial companies, and discount houses -- 6

■ deposits placed -- 7
■ loan participations purchased -- 8
■ loan participations sold -- 9
■ safekeeping items -- 10
■ foreign exchange contracts -- 11
■ treasury options -- 12
■ treasury futures -- 13
■ interest rate swaps -- 14
■ acceptances and guarantees -- 15
■ traveller's cheques held as agent for other banks -- 16
■ reminder where no reply has been received -- 17
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Confirmation letter -- 1
Demand deposit or current accounts
(Client's letterhead)
(Address)
(Date)
A statement showing the balance on your demand deposit (or current) account with us at 31
December, 19XX is included with this letter.
Our auditors, KPMG, (full name and address) wish to confirm this balance as part of their
normal audit procedures. Please check this statement and, if you agree with the balance, certify
it as correct in the space below. If you disagree with the balance shown, please state the
respects in which you disagree at the bottom of this letter.
Kindly complete this letter and return it directly to our auditors, not to us, in the enclosed
envelope.
Yours faithfully,
I confirm that the above balance is correct, subject to any exceptions noted hereunder.
Exceptions noted:
(Authorised signature)
Note: Where a negative confirmation is carried out the second and third paragraphs should be
amended and the following should be printed or stamped on the statement:
PLEASE EXAMINE CAREFULLY
If statement is not in accordance with your records do not communicate with us but
kindly notify our auditors:
KPMG
(full name and address)
giving particulars of difference.
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Demand deposit or current accounts with other banks (nostro accounts)
(Address)
(Date)
In connection with the regular audit of our accounts, please forward to us, for reconciliation
purposes, statements of our demand deposit account with you covering the period from XXX to
31 December, 19XX. At the same time, please send our auditors, KPMG, (full name and
address) a certificate of our balance with you at 31 December, 19XX in the enclosed envelope.
Yours faithfully,
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Certificates of deposit issued
(Address)
(Date)
As part of their normal audit procedures our auditors are confirming selected certificates of
deposit issued by us. Accordingly, please examine the following list of certificates of deposit
outstanding on 31 December, 19XX which, according to our records, were originally issued to
you (although you may have since disposed of some of them).
Certificate No Amount Rate From To Other particulars

(including charges,
if any)
If not already indicated above, please also state whether any of the certificates of deposit are
pledged as security, whether or not formally charged. If formally charged, give details of the
security including the date and type of charge. If the security is limited in amount or to a
specific borrowing, or if there is a prior, equal or subordinate charge please indicate this. If
informally charged, indicate nature of the security interest thereon. Whether or not a formal
charge has been taken, give particulars of any undertaking given to any party relating to the
deposits.
Please certify the accuracy of this list by signing below, noting any exceptions, and return this
letter directly to our auditors, KPMG, (full name and address) in the enclosed envelope.
Yours faithfully,
The above list is hereby confirmed as correct, except as noted hereunder.
Exceptions noted:
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Deposits accepted
(Address)
(Date)
As part of their normal audit procedures our auditors, KPMG, (full name and address) are
confirming selected depositors' accounts outstanding on 31 December, 19XX. We set out
below a list of balances they wish to confirm, which may not necessarily constitute a complete
list of your balances with us. If the information indicated below is not in accordance with your
records, do not communicate with us but kindly notify our auditors giving particulars of
difference.
Deposits Placed by You with Us
Amount Rate From To Other particulars (including charges, if any)
If not already indicated above, please also state whether any of the deposits are pledged as
security, whether or not formally charged. If formally charged, give details of the security
including the date and type of charge. If the security is limited in amount or to a specific
borrowing, or if there is a prior, equal or subordinate charge please indicate this. If informally
charged, indicate nature of the security interest thereon. Whether or not a formal charge has
been taken, give particulars of any undertaking given to any party relating to the deposits.
Yours faithfully,
Exceptions noted:
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Overdrafts
(Address)
(Date)
A statement showing an overdrawn balance of in your demand deposit or current

account with us as at 31 December, 19XX is enclosed with this letter.
Our auditors, KPMG, (full name and address) wish to confirm this balance as part of their
normal audit procedures. Please check the statement and, if you agree with the balance, certify
it as correct in the space below. If you have deposited any collateral in connection with this
overdraft, please describe it briefly. If you disagree with the balance shown, please state the
respects in which you disagree at the bottom of this letter.
Kindly complete the letter and return it directly to our auditors, not to us, in the enclosed
envelope.
Yours faithfully,
I certify that the above balance is correct, subject to any exceptions noted hereunder.
Collateral deposited (If none, please write "none")
Exceptions noted:
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Loans to individuals, commercial companies, and discount houses
(Address)
(Date)
confirming selected loans outstanding at 31 December, 19XX. Please confirm the information
shown below regarding the loan made by us to you, by signing in the space provided and
returning this letter directly to our auditors, not to us, in the enclosed envelope.
Total Facility:
Amount Outstanding:
Final Maturity:
Interest Period:
Rate of Interest:
Fees:
Collateral:
Yours faithfully,
The above loan is confirmed as correct, except as noted hereunder.

Exceptions noted:
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Deposits placed
(Address)
(Date)
confirming selected accounts outstanding on 31 December, 19XX. We set out below a list of
the balances they wish to confirm, which may not necessarily constitute a complete list of our
balances with you. Please certify to them the deposit(s) listed below placed by us with you, by
signing in the space provided and returning this letter directly to our auditors, not to us, in the
enclosed envelope.
Deposits placed by us with you
Amount Rate From To Other particulars,

(including charges, if
any)
If not already indicated above, please also state whether any of the deposits are pledged as
security, whether or not formally charged. If formally charged, give details of the security
including the date and type of charge. If the security is limited in amount or to a specific
borrowing, or if there is a prior, equal or subordinate charge please indicate this. If informally
charged, indicate nature of the security interest thereon. Whether or not a formal charge has
been taken, give particulars of any undertaking given to any party relating to the deposits.
Yours faithfully,
The above list is confirmed as correct, except as noted hereunder.
Exceptions noted:
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Loan participations purchased
(This bank's participation in a loan arranged by another bank)
(Address)
(Date)
(Name of borrower)
confirming selected participations by us in loans arranged by you and outstanding on 31
December, 19XX. Please certify to them the details below of our participation in your loan to
the above, by signing in the space provided and returning this letter directly to our auditors, not
to us, in the enclosed envelope.
Total loan:
Our participation with/without recourse:
Period of loan:
Interest rate:
Fees:
Details of drawings made:
Participation certificate held by:
Collateral:
Yours faithfully,
The above participation is confirmed as correct, except as noted hereunder.

Exceptions noted:
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Loan participations sold
(Another bank's participation in a loan arranged by this bank)
(Address)
(Date)
(Name of borrower)
confirming selected participations of others in loans arranged by us and outstanding on 31
December, 19XX. Please certify to them the details below of your participation in the loan to
the above borrower, by signing in the space provided and returning this letter directly to our
auditors, not to us, in the enclosed envelope.
Total loan:
Your participation with/without recourse:
Interest rate:
Details of drawings made:
Participation certificate held by:
Collateral:
Yours faithfully,
The above participation is confirmed as correct, except as noted hereunder.
Exceptions noted:
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Safekeeping items
(Address)
(Date)
confirming items held by us in safekeeping for you. If the information listed below is not in
accordance with your records do not communicate with us but kindly notify our auditors giving
particulars of difference.
Items held by us in safekeeping for your account on 31 December, 19XX as follows:
Yours faithfully,
The above is confirmed as correct, except as noted hereunder.
Exceptions noted:
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Foreign exchange contracts
(Address)
(Date)
As part of their normal audit procedures our auditors, KPMG, (full name and address) wish to
confirm all foreign exchange contracts outstanding with you on 31 December, 19XX. We
attach to this letter two copies of a schedule of the details. Please return one of these copies
duly certified directly to our auditors, not to us, in the enclosed envelope.
Yours faithfully,
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Schedule of foreign exchange contracts
Foreign exchange contracts outstanding on 31 December, 19XX with (client's name)
Made Value Amount Rate Countervalue
Purchases
Sales
The above is confirmed as a complete list of all foreign exchange contracts outstanding with us
on 31 December, 19xx, except as noted hereunder.
Exceptions noted:
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Treasury options
(Address)
(Date)
confirming all treasury option contracts outstanding with you on 31 December, 19XX. Please
certify that the following treasury option contracts were outstanding with you on that date by
enclosed envelope.
Type Number of contracts Strike price Premium Maturity date
Yours faithfully,
Exceptions noted:
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Treasury futures
(Address)
(Date)
confirming all treasury futures contract outstanding with you on 31 December, 19XX. Please
certify that the following treasury futures contracts were outstanding with you on that date by
enclosed envelope.
Value month Number of contracts Long/short Price
Yours faithfully,
Exceptions noted:
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Interest rate swaps
(Address)
(Date)
confirming interest rate swaps outstanding with you on 31 December, 19XX We attach to this
letter two copies of a schedule of the details. Please return one of these copies duly certified
directly to our auditors, not to us, in the enclosed envelope.
Yours faithfully,
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Schedule of Interest Rate Swaps
Interest Rate Swaps outstanding on 31 December, 19XX with (client's name)
Notional Date of Term Payer of Fixed Frequency Payer of Variable Frequency

principal contract Start fixed interest of payment variable interest of payment
value Maturity interest rate of fixed interest rate of variable
interest interest
The above is confirmed as a complete list of all interest rate swaps outstanding with us on 31
December, 19XX, except as noted below.
Exceptions noted:
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Acceptances and guarantees
(Address)
(Date)
confirming selected accounts. Please certify that our acceptances/guarantees issued on your
behalf, as detailed below, were outstanding at 31 December, 19XX, by signing in the space
provided and returning this letter directly to our auditors, not to us, in the enclosed envelope.
Amount Issued Maturity Date
Yours faithfully,
Exceptions noted:
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Traveller's cheques held as agent for other banks
(Address)
(Date)
As part of their normal audit procedures our auditors, KPMG, (full name and address) wish to
confirm our unissued stock of your traveller's cheques held on 31 December, 19XX. We attach
to this letter two copies of a schedule of the details. Please return one of these copies duly
certified directly to our auditors, not to us, in the enclosed envelope.
Yours faithfully,
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Schedule of traveller's cheques held
Traveller's cheques issued by:

Held by:
Date:
Serial Numbers Unit Value Number Total
The above details are confirmed as correct, except as noted hereunder.
Exceptions noted:
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Confirmation reminder where no reply has been received
(Address)
(Date)
Dear Sirs,
According to their records, our auditors, KPMG (full name and address), do not yet appear to
have had a reply to a letter we sent you in connection with the regular audit of our accounts.
Please reply as soon as possible. We have enclosed a copy of our previous letter in case the
original has not reached you.
Yours faithfully,
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19 IT and banking
Introduction
19.1 This chapter discusses the impact of information technology (IT) on our banking clients
and on our audit of these clients. It is not intended to be a comprehensive guide, but should
provide useful background for auditors or specialists involved in this work. Some knowledge of
IT audit concepts is presumed.
Issues addressed include:
■ The banking environment
Background on the banking environment and in particular the business issues which drive
technology decisions and impact the ability of our clients to effectively manage their
technology risk.
■ Characteristics of the IT environment
The characteristics of the retail and wholesale and the settlement and clearing environments
in terms of the IT systems employed.
■ Risks associated with the use of IT in banking
The risks which arise in banks as a result of the business environment and the technology
they employ and some “red flags” or signs which might indicate a greater potential for these
risks to occur.
■ How clients manage (control) these risks in the banking industry
Discussion of some of the ways in which clients manage any risks associated with the use of
IT and how they may use the features of IT to improve control.
■ Implications for our audit approach
Brief discussion of the issues to be considered in relation to IT in conducting the audit.
■ The future
Emerging technologies in banking and possible implications for auditors.
The banking environment
Background
19.2 Since the 1980s, IT has played a major role in providing a competitive edge for banks to
differentiate themselves in the marketplace and to deliver their services more effectively at a
lower cost. The banking industry is one of the most significant users of technology of all
industries. They also tend to take up new technology at a more rapid rate than most other
industries. This creates both opportunities and risks, which will be discussed in this chapter.
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19.3 There are a number of reasons for the widespread use by banks of technology, including
the following:
■ banks (especially retail banks) process large volumes of information and need to be able to
process these quickly and accurately;
■ customers increasingly expect to be able to have immediate access both to their funds and to
information about funds borrowed or invested;
■ customers are more discerning and require more information about the different options
available to them and the costs and benefits of each, both short and long term;
■ customers, faced with an array of options, are more selective and expect services and
products which meet their own personal needs at a particular time, with the ability to change
as their personal (or corporate) circumstances change; and
■ customers increasingly demand better value and, with increased competition, banks have
needed to reduce their cost base especially in terms of product distribution.
At the same time, technology advances have meant that more information can be recorded at a
lower cost and that information can be retrieved more quickly in a variety of ways and
transmitted greater distances in almost no time. Personal computers (PCs) and sophisticated
development tools, together with networking capabilities, have made it possible for users to
develop their own support systems to complement the core systems.
19.4 Different countries impose different regulatory requirements on banks and others in their
jurisdiction. Banks operating in foreign countries are also subject to specific requirements.
These requirements often impose the need for system modifications to address issues such as:
■ changes in the tax regime, such as the introduction of deposit tax and debit tax;
■ recording and protection of universal identity numbers (social security, tax file numbers);
and
■ specific reporting and control requirements for banks.
Internationally, there is a trend for central banks or regulatory bodies to request external
auditors to report on the level of control within the IT environment. For example, the Bank of
England specifically requests a report from bank auditors as to the controls present in the IT
environment. Similarly, the Reserve Bank of Australia requests auditors to report on the
adequacy of controls over IT where transactions are processed by a service bureau or offshore.
Implications for clients

19.5 This has a number of implications for the use of technology by banking clients:
Paper transactions/documents replaced by electronic records

19.6 Paper input documents have increasingly been replaced by electronic documents.
Examples include:
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■ use of on line dealing systems by treasury dealers to record transactions directly without
using deal slips;
■ immediate negotiation, approval and uploading of loan agreements with customers at the
branch;
■ ability for retail customers to deposit, withdraw and transfer funds via Automatic Teller
Machines (ATMs), pay for goods purchased by direct debit using Point of Sale (POS)
systems and deposit, withdraw and transfer funds by phone (phone banking);
■ customers switching securities or investments directly via various means including via
terminals/booths in the workplace;
■ electronic transfer of funds to pay suppliers, or direct debits from customers using EDI/EFT
or other capabilities; and
■ clearing and netting systems which perform virtually simultaneous switching of securities
and funds between parties based on the net balance derived.
As a result of these changes and the improved speed, reliability and capacity of data
communications, it is possible to transfer information and funds within seconds, anywhere in
the globe. This has reduced the margin for error in these transactions.
Because customers expect immediate or at least overnight transfer of funds, many banks have
had to forego the pool of funds created by slower paper based clearing.
Changes in the marketing and distribution of product

19.7 With the increased availability of ATMs and POS and their rapid acceptance by
customers, the need for large branch networks and associated staff is reduced. Even where
branches remain, staff numbers are reduced. Further, ATMs are now able to process a wide
variety of transactions and enquiries. Some ATMs even provide the capability for share
transfers. Within remaining branches, the focus has moved from transaction processing to
answering enquiries and providing better customer service. It is likely that individual branch
staff will perform a number of functions rather than a single function such as a teller.
PC systems tend to be used in branches as teller terminals and also to provide more user-
friendly systems which can be used by staff to discuss with customers their needs and the
various alternatives for structuring transactions or deals, particularly for lending. For example
the customer can vary the rate and period for their mortgage or have a combination of fixed and
variable rates. The financial implications of the various choices are provided almost
immediately. The deal can then be finalised and transmitted to Head Office. Approval can also
be performed interactively. Sometimes approvals can be completed by the systems according to
specific parameters. This is discussed later.
Constant change in customer demands and products available

19.8 The industry is very competitive with banks in both the retail and corporate markets trying
harder to introduce higher levels of service and flexibility. To gain a competitive edge banks
need new and changed products and information systems which will provide more options and
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flexibility in dealing with the customer. Banks have always been subject to pressure to
continuously change their systems. Now the pressure seems to be even greater. Many front-
end systems such as dealer risk management and branch systems may be largely designed by
user management and sometimes built by users.
Change introduces risk in computer systems especially where deadlines are imposed to meet
marketing imperatives rather than being based on estimates of the time required. User driven
development may not be subject to the same disciplines as formal IT development.
Cost pressures
19.9 Historically banks have found cost allocation/profitability analysis difficult as there has
been no ready means of extracting requisite data from mainframe systems. Increased
competition and focus on cost minimisation has led banks to examine the returns on discrete
business units and this has been facilitated by moves to more open and at the same time more
highly integrated systems.
As banks are driven to reduce administrative costs, there is an expectation that information
technology costs will drop. This is often difficult to achieve with the increasing pressure for
new development in all but the smaller and/or more traditional banks. Banks under pressure to
reduce costs may outsource processing (particularly of the high volume (back-office)
processing) and possibly systems development. Major international banks are also rationalising
their IT operations globally to a few sites which are linked electronically to offices in various
countries. Software packages are increasingly being used.
Need for rapid and focused access to information

19.10 Banks need to obtain and maintain information about existing and potential customers
and the amounts owing by and to these customers and, for borrowers, their payment history. In
order for banks to provide services which meet customers needs and at the same time limit their
exposure to loss, this information must be comprehensive/complete (including demographics),
accurate and current. It must also be able to be accessed in a number of different ways. Banks
are now using relational databases, executive information systems and data warehousing
(discussed later) to obtain and analyse information. They are also progressively dealing with
the need to improve the quality of this information.
Dependence on IT
19.11 All of the above leads to an increasing dependence by the banks on IT. This dependence
is such that:
■ disruption to processing or unavailability of service can have a significant impact on a
bank’s profitability, and indeed, on their ability to continue to operate;
■ with the speed of transfer of funds, the likelihood of major fraud may increase;
■ because of the nature of computer systems, errors are less likely to occur. However, when
they do, they are likely to be more pervasive, and their impact more significant. Further,
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banks rely increasingly on their systems and the number of people involved in handling
(recording, approving and reviewing) information is reduced to save costs. Consequently,
where systematic errors occur, these may be more difficult to detect; and
■ banks make significant investments in hardware and software to compete in the market
place. Often development projects are delayed, cost more than expected, or the anticipated
benefits have to be abandoned. This may have an impact on the bank’s competitiveness or
may even result in significant write-offs of development costs capitalised.
Nonetheless, technology, used effectively, provides banks with the opportunity for more
effective control and management.
Characteristics of the IT environment
Background
19.12 The technology environment within financial institutions tends to vary depending on the
size of the banking institution and the nature of its business. In particular there tend to be
significant differences between the hardware and software employed for retail banking and for
wholesale or corporate banking. This is true even for banks which deal in both the wholesale
and retail markets. The reason for this is the different nature of transactions processed in each
environment. Retail banks tend to have high volume, lower dollar value accounts and
transactions. The processing tends to be systematic and is often less complex than that required
for wholesale banking systems.
Wholesale banking tends to be lower volume but significantly higher dollar value. The
transactions are often complex and deals may involve multiple transactions.
19.13 Large banks tend to have a variety of products, both wholesale and retail. Traditionally,
there has not been a single system to address all of these products. For this reason, banks tend
to use different packages (often tailoring these to their needs) or develop their own systems
inhouse to deal with different aspects of their business.
For example, the following systems may be provided from different sources:
■ financial accounting (general ledger, accounts payable, etc);
■ treasury systems (recording of deals, including exotic derivative style products);
■ valuation of derivatives;
■ corporate lending/leasing;
■ retail banking;
■ customer information;
■ profitability reporting across products, internal rate of return calculations;
■ exposure/limits reporting and/or risk management; and
■ back office broking systems.
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This often creates issues in terms of the interfaces between systems and the ability of the bank
to establish the relationship(s) between information stored in different systems or databases.
For example, some banks still have difficulties in establishing their overall exposure to
particular entities, countries etc.
19.14 Increasingly the head office of a bank will decide on the hardware and/or software that
the bank is going to use and then to roll that decision out to the branches or foreign subsidiaries.
This is more common for wholesale systems, especially treasury and derivatives valuation
systems. In some instances, this software and hardware may not be appropriate for the local
market and in many cases even where it is largely appropriate it will need to be modified for the
local environment.
19.15 There is the potential for overlap between retail and wholesale banking, for example
where large private banking customers are associated with major corporates and/or use
traditionally corporate banking products. There may also be overlaps in funding/revenue.
These areas of overlap can result in exposure to the bank.
Retail banking environment

19.16 The retail environment is essentially high volume/low value. There has tended to be less
flexibility in the product offerings to retail customers, although this is changing as customers
become more demanding and retail banking becomes more competitive. Retail banking tends
to be a significant user of new technology, for example ATMs and POS, imaging, PCs, expert
systems, relational databases and data warehousing. (See the glossary for an explanation of
these terms).
19.17 Retail banks typically operate large IBM or IBM clone mainframes operating either:
■ packages such as HOGAN, tailored to meet individual product requirements and to address
country regulatory issues for example application of payments taxes; or
■ internally developed systems which have been subject to significant change.
Because of the high volumes of data to be processed, the transaction processing systems tend to
be written in third generation languages such as COBOL or even in second generation
languages (ASSEMBLER). This may change with the advent of massively parallel processing
systems which allow a greater volume of transactions to be processed more quickly and give
faster response times. The older retail systems are generally batch processing systems, relying
on transaction entry at the front and back office of the branch during the day, processing
occurring at set intervals during the day or overnight.
System outline
19.18 The system might process products such as interest and non interest bearing cheque
accounts, savings and term deposit accounts (assets), personal investment accounts and
mortgages and loan accounts (liabilities). Major financial institutions may have several hundred
thousand accounts or more and process tens, or hundreds, of thousands or more transactions per
day.
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This system would be linked by one or more networks including for example Branch Teller
systems, Point of Sale systems and ATMs which provide the interface with the customer. The
ATMs may be owned by the bank or by other banks who transmit the bank’s transactions to
them daily. The link or “front end” between these systems and the main system is normally a
highly resilient, fault tolerant computer such as a Tandem. Increasingly the branch teller
systems are on PC and allow for much more than basic recording of customer deposits,
withdrawals, transfers and basic enquiries. These systems may perform functions such as
providing customers with alternatives for investment or borrowing and providing information
about the different long and short term financial impacts of these. Once the customer has
decided on their requirements these can be confirmed (and possibly approved) on the spot and
recorded on the main system, via upload.
19.19 If there are systems holding the day’s transactions at the branch level, these systems will
also generally be used to balance the branch at the end of the day. Information recorded is
transmitted to the main computer at the end of the day and sometimes at interim periods.
Some branch systems transmit information real time (immediately) to the mainframe, although
the account balance may not be updated at that time but a memo account set up to store the new
balance. This reduces the risk of customers going to different branches and withdrawing more
money than they have in their account. With real time transmission, all branches would have up
to date customer account information but this in turn increases their vulnerability to system
disruptions.
19.20 Banks are also making use of imaging technology to store and retrieve information.
Imaging is the electronic recording of document images which can be retrieved in a visual form
using one or more keys. Examples of where this is used are credit card vouchers and personal
cheques as well as securities document records for loans.
Focus on customer service

19.21 As the focus of the banking industry has moved to a more customer service approach, it
has become more critical to ensure timely information meets customer requests. To cope with
these new requirements, many legacy systems have been partially upgraded through the
addition of more “user friendly” interfaces enabling more timely account queries to be
performed. Further, in order to provide customers with convenient access to their funds
anytime anywhere, many banks have developed phone banking and home banking systems.
This is particularly relevant to those countries where personal computers (PCs) have been
widely adopted in the home.
Banks have also had to “socialise” their systems, to meet the cultural needs of the countries in
which they operate. A good example of this is in Japan where ATMs clean and press notes
before dispensing to customers.
System availability
19.22 Availability of the system is a major issue as most banks could not afford to have their
systems off line during normal banking hours. Most retail banks will therefore have relatively
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sophisticated disaster recovery plans and should test these regularly. Normally the client will
have a fallback site and often the branch PCs and the ATM and POS networks can continue to
operate even when not able to communicate with the main system. Transactions recorded at
these remote locations tend to be logged, and whilst it is often possible to establish the current
balance on line at any time, balances are not actually fully updated to the customers account
until the evening. This also improves resilience, as transactions can be retransmitted and
reapplied where necessary.
System security
19.23 Security is also important to protect information both from a consumer protection and
legislative point of view (confidentiality) and to prevent unauthorised manipulation of
information. There are normally very strong controls over the information transferred between
POS, ATMs and branches and the central site. These include encryption and authentication of
the information transmitted. Similar controls are applied over commercial funds transferred.
Access to and availability of customer information

19.24 Because of the increased emphasis on customer service, access to more comprehensive
information about the customer is increasingly important. This information needs to be
accurate and up to date. It must also be readily accessible and by a number of different paths.
Because of the heavy demand on the mainframe transaction processor, information about the
customer is often transferred to a data warehouse to be used for enquiry, analysis and reporting.
It is important that information in both systems is kept up to date and consistent. Much of this
information was previously considered unimportant. However, because of the banks desire to
know more about their customers so they know what products they may be most interested in,
information such as the customer’s name, address etc must be accurate. This has often required
the banks to undergo a major exercise to improve the quality of their data (data cleansing).
Investment in IT
19.25 To maintain important information and access, manipulate and respond to it quickly,
banks have made significant investments in hardware and software. In other cases hardware has
been upgraded to process transactions and enquiries within an acceptable time frame. Most
banks have made huge investments in networks of ATMs, Electronic Fund Transfer and Point
of Sale systems to expand their distribution network and to improve their level of customer
service.
Wholesale banking environment

19.26 Wholesale banking transactions can be complex and are relatively higher value/lower
volume than in the retail market. As a result, any errors in the transactions or parameters
applied to them (eg. interest rate) can have a significant impact. For this reason they tend to be
controlled somewhat differently.
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19.27 The term wholesale banking refers to transactions conducted with corporate, as opposed
to the retail customer market. These transactions tend to fall into two major types. The first is
corporate lending, which relates to large scale leasing or lending, which is normally related to
some sort of security. That is a borrowing, supported by an appropriate security. this type of
lending will normally have its own system and is normally characterised by an agreed payment
schedule from the customer, which allows for regular payment of interest, or a combination of
interest and principal. These transactions may, or may not be, fully paid down at the end of the
deal.
19.28 The other type of transaction is characterised by an either buy or sell type transaction or
deal, where an agreed rate or margin is set up, normally at the beginning of the deal, for the
term of the deal. This type of deal is often referred to as a treasury deal and examples of this
include bonds, securities, swaps, options and futures and foreign exchange deals.
19.29 Banks tend to maintain a separate system for corporate lending. Such systems, because
of their relative complexity, normally are package systems or package systems that have been
tailored by the client. An example would be the SYSGEN system, initially developed by the
Midland Bank. These systems record all details of the payment schedules, the payments made,
the payments billed and the securities held.
19.30 More sophisticated or modern systems of this type will also maintain records of credit
follow-up. Often these systems will also have add-on arrears reporting modules, which may or
may not, include automatically generated letters for late payment.
19.31 Because of the nature of these deals is often driven by commissioned salesmen, and
because often the deals are designed without consideration of the system constraints, they may
result in distorted use of the system, or alternatively, significant system modifications may be
required, often under pressure, to meet ranging demands.
19.32 The straight treasury type deals are often separated from a system perspective from the
broking type deals.
System outline
19.33 The above products often operate on different hardware platforms and may use different
software.
Dealing and broking systems in particular are significant uses of technology both in managing
risk and in recording and processing information. The following is a discussion of the types of
systems we are likely to find associated with the above products.
19.34 Wholesale banking can be split into two main areas, the dealing room or front office and
the back office:
■ The dealing room is characterised by dealing desks or “turrets” equipped with dealing
phones, dealing screen with information feeds and dealers’ calculations (often on
spreadsheets) about deal outcomes. The applications in the back office are more in line with
the other systems that the bank is running. They are used to record and account for the
deals.
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The processing requirements of the front office or dealing room are often met by a high
powered PC or sometimes a UNIX work station. In the majority of dealing rooms these
PCs are networked and have information feeds from various sources. They are often linked
to the mainframe that holds the accounting information to enable them to feed deal
information across to the back office systems and also to obtain information on the bank's
present positions.
■ The back office systems that are used to record the trades are generally on mid range
computers such as IBM AS400s. Historically, deal information was written on deal slips
and then manually entered by the back office personnel. With the increase in paperless
trading and higher levels of automation, deals made are entered directly by dealers and then
transferred to the back-office system.
Ad hoc systems
19.35 As the types of transactions are not repetitive in wholesale banking, the systems for
determining deal profitability are often informal. Deal profitability calculations need to be
processed quickly as dealers require this information before they finalise deals. Deal
calculations are often set up on PCs as a spreadsheet as this is the fastest way to do the
calculation. Further, flexibility is required as “what if” scenarios need to be performed under a
number of assumptions.
Dealers often create their own spreadsheet models. Because of the less disciplined approach
generally adopted in PC development and by users generally, there are more likely to be errors
in these systems than in the back office systems. The systems are often poorly documented
increasing the risk of error and potential for the systems to be unmaintainable. Further, security
and backup of the systems tend to be poor.
19.36 Banks can reduce their exposure requiring a central person (preferably not a dealer) to set
up, document and control the spreadsheet. Spreadsheets can be password protected to stop
changes being made to the formulae. Alternatively a software package can be acquired to
support decision making. These packages are becoming more prevalent as these transactions
become more common and more complex.
Overall risk management

19.37 Automated risk management systems have been implemented in most banks to help
manage global exposure, currency, interest rate, credit and liquidity risks. Global exposure
systems attempt to determine the exposure to a particular customer, company or group, industry
or country by linking information from various subsidiary systems usually on a daily basis.
Interfaces between systems

19.38 Because banks must manage internal and external funding and revenue plans, there must
be a capability to record matching of revenue and funding across portfolios. This needs to be
carefully managed to ensure it is properly handled across the various systems.
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19.39 With the diversity of systems that most banks operate and the different functions that
each of these systems perform, there may be issues with the timing, completeness and accuracy
of interfaces between the applications. In some cases older legacy applications were written in
a third generation language such as COBOL and later applications have been developed in more
modern code generators or fourth generation languages. Manual interfaces may be needed
between some systems. Timely reconciliations are important in ensuring that the interfaces are
properly controlled.
Payment and clearing systems

19.40 The payment and clearing environment is characterised by high value, immediate and
irrecoverable transactions between local and international financial institutions.
Perhaps the most well known of these is SWIFT - essentially a secure payment system. But
others would include CEDEL, EUROCLEAR, the New York Clearing House Association,
Austraclear and CHESS (the latter two systems are available in Australia).
Control features are built into these system to ensure that each party is properly identified and
funds are transferred accurately and completely. Within individual banks, controls include the
use of passwords to restrict access to the system and segregation of duties between data entry
and authorisation of the transaction. Between banks, controls include message
acknowledgement, authentication and encryption.
Impact of real time gross settlement

19.41 In the past, there has been a delay between when a deal took place and the settlement of
that deal. This meant that a bank could have a large position in the market during the day, but
as long as it closed its position it would not have to worry about intra day limits or “daylight
overdraft” because these were in effect unlimited.
With the advent of real time gross settlement (RTGS), transactions must be cleared
immediately. This means that banks must have the funds available to clear each deal as it
happens. The banks will require faster reporting of their position in the market and the funds
that they have at their disposal to clear the deals.
Globalisation of trading
19.42 With the move towards global trading and cross border settlements, issues are arising in
terms of the different regulatory requirements and standards mandated by different countries.
To mitigate these risks, clearing and settlement systems will require the facility to adequately
monitor customer funds and security balances.
Future trends include paperless registries and automated settlement. We are also seeing links
between systems as witnessed by the recent link between SWIFT and the US Depository Trust
Company. This will require standard interfaces.
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Risks associated with the use of IT in the banking industry

19.43 As noted earlier, the way in which technology is used in both the retail and wholesale
banking environment creates some key exposures. These include:
Errors in information or processing

19.44 Errors can be of several types:
■ logic or processing errors caused by underlying errors in program code. Ideally these types
of errors should have been detected during system testing (systemic errors). They may be
very difficult to detect by other means;
■ errors arising from the entry of incorrect parameters such as interest rates. Often system
controls are in place to ensure that interest rates for example can only be entered within a
predefined range; and/or
■ data entry errors (ie. errors in input of individual transactions).
In the retail environment, a processing error is likely to have a greater impact where it is
repeated multiple times. Examples include:
■ incorrect interest calculations. Interest calculations are one of the most complex aspects of
retail banking systems relying upon a number of variables that are constantly changing.
Given the number of transactions bank employees have little choice but to rely upon what
the system tells them. It would have to be a significant error before either a bank employee
or customer was aware of an incorrect interest calculation;
■ incorrect parameters (such as interest rates) can impact both retail and wholesale systems.
In retail systems incorrect interest rates can adversely affect both revenue and expense. In
wholesale systems incorrect interest rates in yield curves can easily turn a profit on a deal
into a loss;
■ accounting errors arising from shortcomings in existing systems which are unable to
properly account for complex derivative style transactions. An international financial
institution recently recorded a US$35 million loss due to bookkeeping problems at its
London operation and another US$14 million after tax charge for improper recording of
interest rate swaps; and
■ system errors in arrears reports. These are often the key control that banks use to monitor
the status of their receivables. Should there be an error in a program that generates these
reports, then bank management may be unaware of the true state of the loan book.
Similarly, banks need to be able to monitor situations in which repayments are not covering
principal and interest.
Fraud
19.45 The banking industry is like any other in that the risk of fraud always exists. However,
cash is a much more desirable and easily transferable commodity and as such more likely to be
abused. For example:
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■ the increasing use of electronic fund transfer systems has resulted in large amounts of cash
being transferred almost instantaneously and in many cases irrevocably. Should funds be
transferred to an incorrect or unauthorised account, bank management would have to act
quickly to minimise their loss; and
■ credit card fraud through counterfeiting is on the increase as a direct result of a reduction in
conventional fraud from stolen cards (due to increased security over card operations through
the use of on line authorisations, “hot card files” and knowledge based systems).
Fraudulent misrepresentation
19.46 The best example of this is the manipulation of arrears reports by management to make a
loan book appear better than it really is. In some cases, this type of manipulation will not be
detected as audit procedures often presume that the arrears report is correct and use this as a
starting point for a review of the adequacy of bad debt provisioning. Another might be the
manipulation of loan parameters so that a loan is able to be automatically rolled over when a
final payment is due rather than requiring a full loan review.
Disruption to processing
19.47 The risk of computer downtime impacting business operations is a risk that all
organisations face but is a much more significant risk for the banking industry. An extended
lack of processing facilities can have extremely adverse effects on market perception, revenue
and ultimately profit. This scenario applies equally to the retail, wholesale and clearing
environments.
Risk of poor return on IT investment

19.48 The size of the IT investment by banks and the pressure to implement new systems in
minimum time frames increases the risk that some systems will prove unsuccessful. In one
recent case a major US bank decided to sell a profitable business line because the cost and
perceived risk of upgrading the business unit’s systems was considered too high to continue.
There is no shortage of examples of banks writing off millions of dollars worth of investment in
IT systems with little or no return.
Red flags
19.49 Often the existence of the above risks is not immediately obvious. There may however
be more subtle signs or “red flags” indicating the existence of deeper and more fundamental
problems. We need to be able to recognise these signs at clients and assess their potential
impact on the audit. The following examples of red flags have been grouped according to the
risk to which they most relate:
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Errors in processing
■ isolated offices and systems - with the growth through merger and acquisition of truly
global financial institutions there is a risk that overseas offices may in some instances
process transactions in isolation from other core systems. The risk from these isolated
systems which do not effectively communicate with head office systems is that management
may not be aware of the bank’s true exposure;
■ extensive rekeying and manual manipulation of data;
■ consistent customer complaints about under or over charging of interest or fees;
■ large number of emergency changes;
■ significant backlog of change requests;
■ systems which have been tailored to account for products for which they were not originally
intended. For example, accounting for swaps using a modified basic treasury system;
■ core systems supplemented by manually produced spreadsheets to provide further
functionality in accounting for new products;
■ bypassing of normal quality assurance procedures to meet deadlines to implement new
products;
■ high staff turnover; and
■ complex systems and interfaces involving a mixture of controls.
Fraud
■ large number of reconciling items;
■ large dollar values;
■ multiple payment systems; and
■ limited number of people.
Fraudulent misrepresentation
■ performance linked remuneration. Remuneration within a lot of institutions is directly
linked to performance. Performance is measured in terms of profit often at the expense of
risk management. Systems which effectively monitor exposures at the product, office and
group level are therefore important. As auditors, we need to be constantly aware of the
profit incentive and ascertain from bank management how they deal with this issue;
■ sharemarket pressure to perform;
■ pressure on profitability, and aggressive revenue budgets; and
■ limited number of people.
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Disruption to processing
■ lack of formalised and tested disaster recovery plan;
■ frequent and sometimes unexplained system downtime;
■ heavy dependence on processing; and
■ rapid growth in customer base and transaction volume without a similar increase in IT
processing capacity.
Risk of poor return on IT investment

■ IT developments continually over budget and late;
■ overtaxed IT staff and disgruntled users; and
■ IT spending as a percentage of revenue is above or below the industry average.
How clients manage (control) these risks in the banking industry

19.50 The methods banks use to manage risk are not unlike these of any other organisation that
uses IT. Controls are a combination of specific controls (within the application, manual
controls around the system such as reconciliations) and general IT controls. Given that most
banks have a number of different environments, depending upon the type of business being
supported, the types of controls implemented will vary depending upon the nature of the
system. Our evaluation of these controls will vary depending upon the type of system and its
environment. For example, the control environment that would need to be evaluated in
reviewing a treasury system would most likely be totally different from that appropriate to a
retail system.
Management controls
19.51 Banks rely on their IT systems to support their operational, financial and compliance
objectives. Management normally have monitoring (detective) controls which operate at a
higher level to enable them to identify after the fact potential problems or trends which may be
of concern. Where differences from expectations are noted, there must be sufficient
information available in the system to be able to identify or confirm the reasons for the
discrepancies, ie the reviewer or others should be able to “drill down” to the underlying
information. These controls often use information generated by the information systems or
compare information from other sources with information from these systems. Modern banking
systems provide much more of this information than in the past and also facilitate the follow up
of potential problems using Executive Information Systems (EIS).
Examples of controls used by management in this way include:
■ daily comparison of the rate applied to the total deal book to the daily market rate;
■ reporting on exposures by country, currency and major customer (corporate);
■ high level reports produced daily on internal rate of return on investments; and
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■ automated reconciliations.
These controls tend to be very effective in addressing major issues related to financial
objectives. However as discussed earlier, information and funds can be recorded and
transferred very quickly in today’s banking systems. The controls described above are not
particularly effective in protecting against losses in this environment although they would
generally be able to identify the loss after the event.
System and IT general controls

19.52 Most banking systems have detailed controls built into them to ensure the completeness,
accuracy and authorisation of information recorded. There are also controls around the systems
to ensure the security and confidentiality of information and integrity (completeness, accuracy
and authorisation) of processing.
Bank management need to satisfy themselves that these control activities are operating because:
■ a failure in such a control activity may result in losses or operational disruption;
■ whilst the 'higher level' controls may alert management to operational problems, this may
not be sufficiently timely to prevent problems and reduce their impact;
■ management often want to be satisfied their system prevents them against fraud, error and
embarrassment even where the monetary value of such errors may not be material to the
audit;
■ where management find potential discrepancies or exceptions at the higher level they want
to be able to 'drill down' and establish what caused the problem so they can resolve it; and
■ management want operational problems or issues to be identified as they occur so they can
be dealt with at the right (lower level) of management as far as possible without requiring
action by senior management.
These control activities must be well designed and operate effectively. There must also be a
framework in place to enable investigation and follow up should such control activities
highlight real or potential exceptions.
19.53 The following are examples of the types of control activities which might be
implemented for different types of systems:
■ a treasury system with on line dealer entry (front office dealing system)
Deals are entered directly. Deal information is re-input by another party and checked by the
system to the original entry. Any discrepancies are highlighted and must be corrected for
the deal to be finalised.
On line dealer limits will be used to control trading for dealers, currencies and
counterparties.
The interest rate is checked by the system against the market rate for the day. If the rates
vary by more than a specified percentage the rate must be re-input or may be subject to
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higher level approval. The market rate is entered daily by the operations manager and
checked before trading starts.
The date is compared by the system to today’s date. If it is subsequent to today’s date it
will be rejected. If it is more than 5 days earlier it will be rejected. Any dates between
today’s date and 5 days earlier are reported on an exception report which is followed up
daily by the operations manager.
The deal amount will be checked when the funds are paid or received. There is also an
automated bank reconciliation daily, probably reconciling individual payments and receipts
to deals.
Confirmations are sent electronically to the counterparty and received from them. These are
matched electronically and any discrepancies reported for immediate follow up.
■ a clearing and settlement system
Money market, fixed interest or foreign exchange deals are entered from deal slips, matched
after the other party to the deal has confirmed the accuracy of the deal terms and then all
deals are aggregated to obtain a net position at the end of the day. The net “end of day”
position can be either a payment or receipt. Regardless, the net payment or receipt normally
made to or by the clearing house and then reallocated as part of the end of day payments to
other participants in the settlement and clearing system, is usually significant.
Given the size and almost irrevocable nature of these payments, controls within a clearing
environment are almost always preventative in nature. For example:
- clearing system access is normally restricted to a few users; and
- access security over the data entry of the initial deals is controlled by a number of
passwords for which password changes are enforced every thirty days and old passwords
cannot be reused.
The deal would not progress to settlement until both parties had completed their on-line
authorisation procedures. Typically, these procedures can only be completed by users who
have access to a specific authorisation function.
Controls over the establishment of bank accounts for receipt of net end of day payments and
the signatories to those accounts are very strong. Normally minuted board approval is
obtained for the creation of these bank accounts and the modification of authorised
signatory lists. Further, the function within the system that allows the details of a clearing
bank account to be altered is typically restricted to a few key users.
In sum, the combination of system and manual controls is such that three way collusion
(staff of the clearing and settling organisation, the clearing house participant and the
clearing bank) would be required to effect a fraud.
19.54 The above controls depend on general IT controls to work effectively. For example,
access to specific functions are normally restricted by user and direct access to data is restricted.
The main control over whether calculations are correct is the design and adequate testing of
these.
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Implications for our audit approach
Overall approach
19.55 We would expect to conduct a systems-based audit for most banking clients. Because of
the high reliance of our banking clients on IT, from both an operational and financial
perspective, we need to gain an understanding of their computer systems and the general IT
controls which support these computer systems.
As noted earlier, many of the systems will be on different hardware and software platforms.
Note that although we would generally conduct a systems-based for most audit objectives, we
need to assess the extent to which we can conduct a systems-based audit for objectives related
to different banking products.
Strategy
19.56 At the strategy stage the audit team, often including relevant specialists, the audit partner
and manager should consider the contribution of IT/IS to audit risk. We look for “red flags”
which may indicate higher or lower risk. Factors that should be considered are as follows:
Dependence on IT/IS
19.57 Banks are highly dependent on IT and IS, particularly for their mainstream systems and
often they utilise complex and sophisticated systems. Note also that they often cannot survive
for extended periods of time without their computer systems. This needs to be taken into
account and may indicate the requirement for specialist involvement throughout.
19.58 In a number of countries we may be required by regulatory authorities to report on the
business resumption/disaster recovery planning capabilities of our banking and finance clients.
External IT/IS
19.59 The audit team need to look at the extent to which the IT function is outsourced and the
resultant increase or decrease in risk. It is also important to look at the extent of end-user
computing and the quality of the users involved as well as the nature and history of the
developments.
Where clients utilise packages, particularly where these have not been altered (often the case for
banking clients) this may indicate lower risk, especially where these packages are widely used.
There are several packages that are widely used by the banking community internationally - for
example MIDAS and HOGAN. Our knowledge of the use and reliability of these packages at
other clients or the same client in other countries will help us assess the risk associated with the
package and the way it is implemented.
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IT/IS reliability
19.60 Banking systems tend to be relatively complex and there are often old legacy systems
particularly in retail. Furthermore, many of the systems are not fully integrated, rather,
information is transferred manually between systems via journals or by purpose-built interfaces.
As a result, there may be reliability and integrity issues. The audit team should look at past
history and other information to assist the extent to which this may be a concern to the audit.
Note that new systems may also be less reliable, especially where they have been implemented
under pressure and are developed specifically by or for the client.
Changes in IT/IS
19.61 Wherever there are changes in IT or IS, there is potential for increased risk. Systems
may be delayed or cost more than expected (which may impact the client’s operational
performance). Where the software or hardware has been capitalised and there is no assurance
that it will meet its objectives, it may be that software or hardware are overvalued in the
accounts.
Often in the first year of operation, new systems are subject to errors, disruptions, and other
problems, particularly where the systems are complex.
19.62 Where major IT projects are associated with changes in business processes, risk may also
be introduced in terms of controls being eliminated. For example, direct input of deals at the
desk means they are not reviewed before input. However effective automated controls can be
built into the system which may ultimately be more effective than the manual controls.
19.63 Modern systems can also provide access to more information and enable management to
more easily evaluate information. This facilitates management review and this higher level of
control may be able to be used more effectively by us to perform our audit.
IT/IS skills and resources

19.64 The skills and capabilities and experience of staff need to be considered. Often this will
need to be considered across the board, over different systems, as different teams may be
involved in different areas of the business and therefore the risk may be greater for some
systems than for others.
We need to consider both IT and user staff. As banks have a broad range of products over a
range of platforms, the quality of both user and IT people responsible in this area can vary
significantly.
Business focus
19.65 The audit team needs to consider the extent to which the IT Strategy is aligned with
business requirements. With increasing management and user involvement in IT developments
and operations, it is also important to consider the extent to which management are aware of the
issues associated with the use of IT. In particular we need to consider the early involvement of
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IT management in new product decisions as IT systems are normally a key aspect of new
product delivery.
Risk is often increased in financial institutions where the business is under pressure to
implement IT systems or changes to where new products are being implemented in the
marketplace. Changes made to existing systems to meet product requirements, often driven by
the marketing or sales departments, may also introduce risk.
19.66 At the strategy stage, the audit team also assesses their requirements for reviewing
general IT controls. The team will need to consider:
■ which platforms they require general IT controls to be reviewed for;
■ what audit objectives are of concern in relation to this. This will help establish the focus
and emphasis of the review - for example for internally developed systems, testing and
change control is often the most important area; and
■ whether there are any additional client service or legislative requirements - for example, it
may be necessary to review business resumption planning due to requirements by
regulators. Or if the client is planning a new systems development project, we may identify
opportunities to provide consulting assistance.
19.67 In order to understand the client’s use of IT and how it relates to other aspects of the
client’s business processes, it may be beneficial to produce a summary document about this use
of IT, providing details of the following:
■ people (for example, number, location, responsibilities and reporting lines);
■ technology (for example, hardware platform, communications etc);
■ systems (for example, packages, nature of banking business, system age etc); and
■ processes (for example, high level systems map showing major business systems, the links
between them and the information flowing into the main financial systems).
19.68 The results of our review of general IT controls are especially important where the
reliability of processing is critical. For example, if system testing does not appear sufficiently
comprehensive, we would consider adopting a substantive approach for related audit objectives,
possibly using CAATs.
This IT summary provides essential background information to investigate further the
contribution of IT to audit work and to identify where general IT controls are to be evaluated. It
also enables the reviewer to evaluate the extent to which issues in the general IT controls are
relevant to the audit and relevant to the business.
Planning
19.69 In conducting the review of general IT controls, the reviewer, often the specialist, should
conduct the review within the context of the systems the client is running, and also consider the
impact on audit objectives.
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The review of general IT controls is conducted within the context of the client’s systems and
audit objectives.
For example:
The design of systems and the controls within them are obviously critical to their
effectiveness. Key controls over this are the initial definition of user requirements and the
quality of the testing performed during the system development stage. Ideally, for in-house
developed systems we would like to be involved in a review capacity during the testing
phase. Alternately, internal audit may be involved in a quality assurance role if no separate
function exists; and
If a package such as MIDAS is being used our key concern would be over the integrity of
the system implementation process. For widely used packages such as MIDAS, we can be
relatively comfortable with the adequacy of testing as the package has been well proven.
However, our major concern would be with the integrity of the implementation process.
19.70 We carefully consider the results of our review of general IT controls where the
reliability of processing is very important. If testing does not appear sufficiently
comprehensive, we would consider adopting a substantive approach for related audit objectives,
possibly using CAATs.
Systems documentation
19.71 The client may have their own systems documentation and overviews of systems.
However, if this is not in place, it is often useful to arrange for the specialist to assist in
developing such documentation. Often the documentation developed by the specialist is then
used later by the client. Typically, this style of information is more business process focused
than technical IT documentation such as network layouts and therefore is of greater value to line
management.
Substantive testing using CAATs

19.72 In a highly computerised environment, auditors need the capability to access and analyse
data to conduct effective reviews. The use of technology can remove much of the mechanical
routine of audit work so that audit coverage is wider, more efficient and of better quality.
Consideration should be given to balancing audit software development costs against
anticipated benefits. This is more difficult in the banking environment as needs change
continuously and complex technologies become quickly obsolete. Audit objectives and the
rationale for using computer assisted audit techniques (CAATs) should be re-evaluated each
year as the nature of the business and therefore audit risks change. Noted below are some
possible uses for CAATs:
■ financial instrument revaluation. The typical audit approach to revaluations is to select a
sample and revalue these using manual procedures. A more effective approach may be to
consider using a CAAT or a suite of CAATs if there are a number of different types of
instruments (for example, bonds, forward rate agreements, foreign exchange deals, swaps,
options) to perform the revaluations. This increases the extent of audit coverage but there is
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a cost in the development time for these CAATs. Nonetheless it may be possible to use
such CAATs on more than one client or internationally on one client;
■ analytical procedures can be aided with the use of CAATs to compare the actual figures for
the year to the expected figures. The expected figures could be based on prior year data
adjusted for the environment that the bank has been operating in and/or the bank’s internal
budget;
■ CAATs can be used to select transactions that are out of the ordinary. There is no point in
testing a large number of transactions that are more than likely to be correct, rather audit
effort should be directed towards transactions that are outside the normal processing
parameters;
■ transactions that have occurred in more than one system can be matched to ensure that the
information that has been recorded is the same in each system. This can be done using a
common key such as the transaction number or the account number to ensure that the
information has not been recorded twice or recorded incorrectly; and
■ significant movements in accounts or balances between periods could be highlighted by a
CAAT. These could then be reviewed to determine if they are correct.
The future - emerging technologies in banking

19.73 In order to maintain their competitiveness and look for the edge on competitors, banks
will continue to research into, and expand their use of new technology. Examples include:
■ use of ‘voice’ communications to facilitate interactive (home) banking by telephone;
■ use of imaging to store and retrieve source documents, such as securities information,
customer approvals and signatures, etc;
■ use of workflow management to transfer images and data between different parties with the
bank to facilitate approval of transactions and accumulation of information on customers or
transactions as it becomes available;
■ use of the ‘information superhighway’ (Internet) to communicate with customers in their
homes - providing personalised marketing and service;
■ increased use of data warehousing to make available information on customers and their
preferences;
■ greater concentration of information systems in a reduced number of operational centres,
linked to global sites;
■ increased use of ‘user friendly’ (GUI) front ends personalised to customer needs with on
line update to mainframe systems;
■ use of more flexible accounting systems (like SAP) personalised to the bank’s needs;
■ gradual replacement of legacy transaction processing systems with open systems (tailored or
parameterised packages) processed on massively parallel processors;
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■ continuing re-engineering of business processes based on the improved systems available,

leading to further reductions in back office staff;
■ greater ability to drill down and analyse information to support queries;
■ more effective measurement of profitability by line of business based upon easier access to
data;
■ use of neural networks to interact with the customer and to analyse information. Possible
applications include fraud detection, credit assessment and target marketing; and
■ paperless registries and automated settlement.
19.74 The above features provide both for improved control, which enables the audit team to
utilise more effectively, high level controls that management may implement. It also presents a
number of challenges, in that increasingly, information will be purely stored electronically with
printed copy simply being a reproduction of an electronic original. The audit team will need to
understand how their clients are using this technology and have an understanding of how this
technology works, or alternatively, may need to use specialists to a greater extent to identify the
risks associated with these new technologies, and also the potential for improved control.
For example, with the advent of “virtual” retail banking we will need to assess the audit impact
of the myriad of legal relationships required to control the changing responsibilities and
liabilities of the bank, the communication service provider and the customer.
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20 Regulation
20.1 Banking is one of the most heavily regulated industries throughout the world.
Governments, through supervisory agencies or central banks, limit the structures banks
operating within their jurisdiction can adopt, the kinds of services they can offer, and the risks
they can take. In addition, governments, through a variety of regulatory mechanisms, use their
domestic banking communities to implement monetary policy -- to control the growth in the
money supply, monitor the availability of credit, and limit the inflow and outflow of capital. In
most instances, the principal objective of such regulation, supervision, and control is to
maintain public confidence in the banking system as a whole and in individual banking
institutions.
20.2 Regulatory authorities also control banking activities to ensure that banks retain sufficient
capacity to withstand the flow-on effects of dislocations elsewhere in the economy, impacting
their exposure to the various banking risks including -- credit, liquidity, interest rate, foreign
exchange rate, and market. These authorities claim the right to so limit free-market activity
because they see themselves responsible for "picking up the pieces," should any particular bank
fail, to protect the viability of its banking system. Doing so can take a variety of forms
including deposit insurance and "lender of last resort" emergency liquidity assistance.
Ultimately, governments assume the responsibility for maintaining the integrity of their banking
systems on the basis that such systems are vital to preserving the stability of their economies
and ultimately, the value of their currencies.
20.3 Countries imposing strict regulatory controls can, to some extent, impose those controls
on a world-wide basis by requiring all banks operating within their jurisdictions (whether
domestic or foreign) to subject themselves to their regulation on a consolidated basis. Three
principles impede such efforts:
■ The principle of national autonomy in regulatory matters, which permits wide variation in
local regulatory practice;
■ The principle of neutrality, which requires that all banks operating within any one country
be subject to regulatory parity;
■ The principle of parental responsibility, which assumes that parent institutions will provide
required financial support to their foreign operations.
The effect of these three principles has been the emergence of so- called "soft" financial
centres, or banking havens, in which regulatory restraints are comparatively lax. These banking
havens can attract business without paying risk premiums on deposits taken because it is
assumed that the parent banks for the organisations taking those deposits will absorb the risks
involved. Thus, they enjoy a price advantage over financial centres subject to greater
regulatory restraint. However, though the parent may bear the risk of the deposits taken by its
foreign operations, the regulatory support mechanisms limiting the risks of its domestic
deposits (e.g., deposit insurance and lender of last resort arrangements) usually do not extend to
these offshore obligations. Such a structure, where the same market contains entities of widely
different risk characteristics that extend beyond those of the entities themselves, greatly
increases the instability of that market and opens the possibility that fears of a market collapse
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may prompt demands for the movement of funds that exceed the market's ability to absorb
them.
20.4 Because of wide discrepancies among the kind and severity of regulations different
jurisdictions impose and the development of Eurocurrency markets, through which banks trade
in financial instruments denominated in currencies other than that of the host country, a large
volume of international banking business remains effectively outside any jurisdictional control.
In 1975, the Bank for International Settlements established a committee on banking regulations
and supervisory practices ("the Basle Committee") to ensure that all banks are under some form
of regulatory supervision conforming to certain broad principles.
20.5 At present, the guiding document on international supervisory co-operation is the 1975
Basle Concordat, as amended. This is a guide for allocation of supervisory responsibility and
greater co-operation among domestic bank regulatory agencies, rather than a format for
supranational supervision. It relies on the principle of monitoring the totality of banks’
business, wherever conducted, and discusses supervisory responsibility in respect of liquidity,
solvency as well as foreign exchange operations and positions. In simple terms, the Concordat
assigns supervisory authority of subsidiaries to central banks of host countries and supervisory
authority of branches to parent country central banks.
20.6 In December 1987, the Basle Committee published proposals for international
convergence of capital measurement and capital standards to enable central banks in the Group
of Ten countries to achieve a common approach to measuring banks' capital adequacy. The
standard has also since been adopted, modified where necessary for local conditions, by a
number of non-G10 countries. Since first issued, the guidelines have been revised. For
example, in August 1994, the Basle Committee amended the Capital Accord to reduce the
capital to be held against off-balance sheet items capable of being netted with a single
counterparty.
20.7 The capital adequacy guidelines focus primarily on credit risk but with continued
exchange rate and interest rate volatility, there has been an increasing focus in financial markets
on interest rate and currency risk management. In July, 1994 the Basle Committee, together
with the International Organisation of Securities Commission, released documents providing
guidance on the sound risk management of derivatives activities. These guidelines are a
precursor to more detailed guidelines expected to be released in 1995/96, in which the Basle
Committee will address the conceptual and technical methodology for both assessing market
risk, as well as the scope of the supervisory role in determining the capital requirements for
such risk.
20.8 The following list identifies the principal regulatory authorities in a majority of the
banking centres of the world. These regulators, responsible for administering banking
operations within their respective jurisdictions, typically receive their mandates through formal
legislation and their requirements have the status of law. Approval of the appropriate
regulatory authority is required before a bank can begin operations in any of the countries
listed.
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Country Regulatory authority

Argentina Banco Central de la Republica Argentina
Austria Minister of Finance, Austrian National Bank
Australia Federal Treasurer, Reserve Bank of Australia
Bahamas Central Bank of the Bahamas
Bahrain Bahrain Monetary Agency
Belgium The Banking & Finance Commission
Brazil National Monetary Council, Central Bank of Brazil
Canada Minister of Finance, Superintendent of Financial Institutions
Cayman Islands Superintendent of Financial Services, Cayman Islands Financial
Services Supervision Department
Channel Islands Guernsey Financial Services Commission; Finance and
Economics Committee of the States of Jersey
China Peoples Bank of China
Czech Republic Czech National Bank
Egypt Central Bank of Egypt
France "Conseil National du Credit" and "Commission de Controle des
Banques"
Germany Federal Banking Supervisory Board, German Federal Bank
(Bundesbank)
Greece Bank of Greece
Hong Kong The Banking Supervision Department of the Hong Kong
Monetary Authority
Hungary State Banking Supervision, National Bank of Hungary
Indonesia Directorate of Financial Institutions, Department of Finance and
Bank Indonesia
Ireland Governor, Central Bank of Ireland and Minister of Finance
Italy Banca d'Italia, Ministry of the Treasury, and Inter- ministerial
Committee for Credit and Savings
Japan Minister of Finance, Bank of Japan
Luxembourg Luxembourg Monetary Institute
Malaysia Bank Negara Malaysia and Minister of Finance
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Country Regulatory authority

Netherlands "De Nederlandsche Bank N.V." (Dutch Central Bank)
New Zealand Reserve Bank of New Zealand
Panama National Banking Commission
Philippines Governor of the Central Bank and the Monetary Board
Singapore Monetary Authority of Singapore
South Africa South African Reserve Bank
Spain Ministry of Economy and Commerce and Bank of Spain
Switzerland Federal Banking Commission
Taiwan Ministry of Finance, The Central Bank of China
Thailand Bank of Thailand
United Arab Emirates Central Bank of the United Arab Emirates
United Kingdom Bank of England
United States Comptroller of the Currency, Federal Reserve Bank, Federal
Deposit Insurance Corporation and various State banking
departments
Vietnam State Bank of Vietnam
20.9 Regulatory authorities, in exercising their role to protect the integrity of their banking
systems to promote public confidence in those systems, impose two types of requirements on
the banks within their jurisdiction: requirements relating to what banks can do and requirements
relating to how these banks are to report what they do. Reporting requirements specify the
frequency with which banks are to report various kinds of information to the regulators
themselves and to the public and may specify the accounting principles and format for
compiling and presenting that information. Further, regulators themselves may audit such
information or require that it be subject to audit by independent and/or non-independent
(internal audit) accountants. It should be noted that regulation in developing nations is typically
less sophisticated than that of developed nations, as regulators try to balance the management of
their economies with the influence of overseas capital and trade.
The most common requirements relating to what banks can do are as follows:
■ Capital adequacy requirements - which specify capital (as defined) ratios to total assets (as
defined), the maximum allowable ratio of liabilities to equity, and limitations on off-balance
sheet exposures;
■ Minimum capitalisation requirements - which specify the minimum capital resources the
entity must maintain;
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■ Minimum reserve requirements - which specify the minimum percentage of total eligible
deposits that a banking entity must place with the central bank in the form of currency or
highest grade marketable securities. The existence of such reserves limits the extent to
which a banking system can generate money (through the form of reciprocal deposits) and
thus the reserve percentage is used, in some countries, to regulate the growth of the money
supply;
■ Minimum liquidity requirements - which specify the minimum amount of short-term funds
banking entities must pledge or maintain in relation to deposit liabilities outstanding in
addition to reserves maintained with the central bank;
■ Exchange control requirements - which specify the foreign possessions residents may hold,
and local currency possessions non-residents may hold, and which limit transactions
residents may engage in with non-residents;
■ Foreign currency position requirements - which specify the maximum open positions of
foreign currency denominated assets, liabilities, and forward contracts a banking entity may
maintain;
■ Lending limit requirements - which specify the maximum amount a banking entity may
lend or advance overall and/or to a single borrower. These requirements are usually based
upon a percentage of the particular entity's equity and other qualifying accounts (such as
reserves for loan losses);
■ Interest rate requirements - which specify the maximum interest rates banking entities may
pay for deposits or charge for loans;
■ Repatriation of earnings limitations - which specify the maximum amount of earnings a
banking entity may repatriate to its head office.
20.10 While banks are typically supervised on an institutional basis rather than a functional
basis, the dynamic nature and interaction of the financial markets and the expanding activities
of banks and other financial institutions and intermediaries, has seen the introduction of some
elements of functional supervision (ie, their securities and foreign exchange dealing
operations). This functional supervision may be undertaken by other than the primary banking
regulatory authority. However, in most cases, the primary banking regulatory authority will be
kept apprised by the other regulator of any matters or issues which may affect bank (either in
aggregate or individually) solvency, liquidity or reputation.
20.11 For specific information regarding regulatory requirements and constraints in individual
countries, please consult the appropriate National co-ordinator.
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Glossary
Glossary
Acceptance A time draft (bill of exchange) on the face of which the drawee
has written the work "Accepted" over his signature. The draft
also specifies date and place payable. The person accepting the
draft is known as the "acceptor." A "bank acceptance" is a
draft drawn on and accepted by a bank. A "trade acceptance" is
a draft drawn by the seller of goods on the buyer, and accepted
by the buyer. A statement that the acceptor's obligation arises
out of the purchase of goods often appears on the face of the
draft.
Acceptance credit A credit that gives an importer time to pay for goods.
Acceptance liability The total liability which the bank assumes when accepting
negotiable instruments drawn upon it by its customers. A
record of the instruments accepted is usually maintained in
account form for each customer in a separate ledger, termed the
"Acceptance Liability Ledger."
Acceptor A drawee on a time draft who has signed across the bill thereby
signifying assent to the transaction and willingness to pay the
bill on maturity.
Accommodation paper A note or draft signed or endorsed by another party solely for
the purpose of inducing a bank to lend money to a borrower
whose credit is not substantial enough to warrant a loan, on its
own right. The endorser, while liable to repay the amount in
full, ordinarily does not expect to do so. The endorser
ordinarily derives no benefit from the transaction, but acts as a
guarantor or surety for the borrower. Another form of
accommodation endorsement is the practice among banks of
endorsing the acceptances of other banks for a fee, in order to
make them acceptable for purchase in the acceptances market.
Advising bank A bank that advises a beneficiary that a letter of credit has been
issued.
Agent bank A bank through which syndicated loan payments are made.
Agreement among/by A legal document forming underwriting banks into a syndicate
underwriters for a new issue and giving the lead manager the authority to act
on behalf of the group.
American option An option that can be exercised anytime during the exercise
period.
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Glossary
Arbitrage The purchase of foreign exchange, stocks, bonds, silver, gold,

or other commodities in one market for sale in another market
to exploit price differentials between the two markets for a risk-
free profit. Arbitrage requires highly skilled traders and quick
action to complete the transactions before the intermarket
differentials are corrected.
Assignment, assignee, The transfer of title to certain property, usually securities, to
assignor another legal entity. A common example of assignment is
found in the hypothecation of securities, wherein the
assignment form usually contains the wording "sell, assign, and
transfer unto." This is distinguished from the term
"endorsement" wherein title to negotiable instruments is
transferred with the delivery of the instrument. Another
common term in banking is "Assigned Accounts Receivable."
The legal entity which assigns the property is known as the
"assignor," and the legal entity which takes title through
assignment is known as the "assignee."
Authorised credit A loan officer's authorisation for making advances to a
particular customer for an amount in excess of the loan officer's
discretionary limit.
Automated settlement Eliminates intervention between the back-office and the
settlement of the deal. The deal details are entered into the
settlement system and when the counterparty enters the same
details the deal is automatically settled.
Automatic teller machines A specialised form of point of sale terminal designed for
(ATMs) customer remote access. Typically ATMs allow a range of
banking and debit operations, especially deposits and cash
withdrawals. ATMs are usually located in uncontrolled areas,
and utilise unprotected telecommunications lines for data
transmissions. Therefore, the system must provide high levels
of logical and physical security for both the customer and the
computer equipment.
Back-to-back credit A letter of credit that is issued on the strength of an assignment
of another, irrevocable, letter of credit by its beneficiary. The
second letter of credit usually conforms strictly to the term of
the first, except that its amount may be less and expiration date
shorter.
Back-to-back loan A loan supported by an equivalent deposit. More usually, it
refers to a loan in one currency backed by a deposit in another
currency, possibly in a different country.
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Glossary
Balloon paper A note payable in instalments of which the final payment due is
for a much larger amount than any one of the others.
Bank draft A cheque drawn by one bank against funds deposited to its
account in another bank. Bank drafts are commonly purchased
for making remittances to distant places, where a bank cheque
is more acceptable than an individual's cheque, or where the
payee of the cheque has requested that exchange be provided in
the town or city where his place of business is located. Bank
drafts offer a convenient means by which a person who has no
current account may pay his bills in other towns or cities at
nominal cost.
Banker's acceptance A draft originally drawn by an individual or firm on a bank,
ordering that bank to pay a specified sum of money to a third
party, either on demand or at some specified date. When the
bank accepts the draft, the instrument becomes an acceptance,
and the act of acceptance binds the bank to pay the draft when
it falls due.
Basis price The price agreed in an option contract is the 'basis' or 'striking'
price. The buyer of the option pays a premium over and above
the basis price in return for receiving the option and this is the
amount of his risk.
Bill discounted A promissory note or bill of exchange for which a bank makes
payment prior to maturity, deducting from the funds disbursed,
its fee, or interest, for lending the money (usually paid to the
holder or endorser of one note).
Bill of exchange An unconditional order in writing addressed by one person to
another signed by the person giving it, requiring the person to
whom it is addressed to pay on demand, or at a fixed or
determinable future time, a certain sum of money to or to the
order of a specified person, or to the bearer.
Bond A certificate evidencing indebtedness - a legal contract sold by

an issuer promising to pay the holder its face value plus
amounts of interest at future dates.
Collateral Trust A bond for which collateral has been
pledged to guarantee repayment of the principal. This type of
bond usually arises out of intercompany transactions where the
parent company will issue bonds with securities of a subsidiary
as the underlying collateral. Railroads often do this type of
financing.
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Glossary
Convertible A bond which gives to its owner the privilege of

exchanging it for other securities of the issuing corporation on a
preferred basis at some future date or under certain conditions.
Debenture A bond for which there is no specific security set
aside or allocated for its repayment.
Guaranteed A bond on which the principal or income or both
are guaranteed by another corporation (including the issuer's
parent company), in case of default by the issuing corporation.
Income A bond on which interest is paid only if the issuing
corporation has made a profit before taking into account the
interest or dividend obligation incurred under the bond. This
interest is deemed to be paid and received as a dividend and
therefore is not tax deductible as interest expense to the payer
and is treated as a dividend in the hands of the recipient for tax
purposes.
Mortgage Bonds which have as an underlying security a
mortgage on properties of the issuing corporation. This
mortgage may be subject to prior liens.
Serial A bond in which the issuer undertakes to retire a certain
proportion thereof at regular intervals. Serial bonds are issued
where the security depreciates through use or obsolescence, and
they usually provide that the bonds outstanding shall not exceed
the value of the security.
Sinking Fund Bonds secured by deposits at regular intervals
of specified amounts with the bond's trustee. The issuing
corporation makes these deposits to secure the principal of the
bonds. It is sometimes required that the funds be invested in
other securities.
Call (option) The exercise of the right of an issuer of bonds or other
obligation to repay the obligation before its stated maturity, at a
given price on a given date.
Cashier's cheque A bank's own cheque drawn upon itself, and signed by the
cashier or other authorised official. It represents a direct
obligation of the bank that is used to pay obligations of the
bank; to disburse the proceeds of a loan to the borrower in lieu
of credit to his deposit account; and to provide customers an
alternative for domestic remittance purposes where a personal
cheque is not acceptable.
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Glossary
Certificate of deposit A receipt issued for funds deposited with a bank, payable on
(demand) demand to the holder. These receipts do not bear interest, and
are used principally by contractors and others to guarantee
performance on a contract or as evidence of good faith when
submitting a bid for a sale of merchandise to a governmental
agency. They may also be used as collateral for a loan.
Certificate of deposit (time) A receipt for funds deposited with a bank, payable to the holder
at some specified date and bearing simple interest.
Chattel mortgage A mortgage on moveable goods or equipment.
CHIPS(clearing house An automated system for clearing interbank settlements among
interbank payments major New York City banks and their correspondents.
systems)
Clearing house An association of banks in a city or country created to facilitate
the clearing of cheques, drafts, notes, and other items among its
members. It also formulates policies and rules for the mutual
welfare of all members, and in times of financial stress, may aid
those members who might require help in the process of
clearing cheques, etc. The settlement of debtor or creditor
balances usually must be made daily.
Closing day The day when securities in a new bond issue are delivered
against payment from syndicate members participating in the
offering.
Collateral Stock, bonds, evidences of deposit, and other marketable
properties which a borrower pledges as security for a loan.
Commercial bank A bank specialising in demand deposits and commercial loans.
Commercial banking activities concentrated in large-scale loans
to commercial and governmental concerns, funded by interbank
and corporate deposits are referred to as wholesale banking, as
compared with retail banking, in which transactions are
predominantly with consumers.
Commercial loan Loans made to business enterprises for financing inventory
purchases, the movement of goods, or other business purposes
as distinguished from personal loans or consumer credit loans.
Commercial paper Unsecured corporate debt with a short-term maturity used
chiefly in the U.S. capital market.
Compensating balances Balances required to be maintained on account with a lending
bank as security for a loan or in lieu of paying a fee for a
commitment to lend. Such requirements usually specify that a
minimum average balance equal to a fixed percentage of the
loan or commitment be kept on deposit.
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Glossary
Confirmed letter of credit A letter of credit issued by a foreign bank to a local concern
that has been confirmed by a local bank in the city where the
beneficiary is located. The confirming bank assumes
responsibility for the payment of all drafts under the credit and
usually charges a fee for doing so. The purpose of this
confirmation is to lend the prestige and responsibility of the
local bank to the transaction because the status of the foreign
bank may be unknown to the beneficiary.
Confirming bank A bank that undertakes to pay a beneficiary on a letter of credit
issued by one of its correspondent banks.
Contingent accounts Memorandum accounts, carried in the general ledger but not
reflected on the balance sheet, showing the future effect of
transactions entered into (e.g., commitments to lend, forward
exchange contracts, future cash in- and outflows).
Correspondent bank A bank in which another bank (its correspondent) maintains
deposits. The correspondent bank accepts all deposits in the
form of cash letters, and collects items for its bank depositor.
The depository bank will render all banking services to its
correspondent in the region in which it (the depository bank) is
located.
Coupon The attachments to a bond (usually non-registered) that
constitute evidence of interest payable on the bonded
indebtedness. These attachments usually consist of a series of
small sections, each dated serially for future payment dates.
These small sections when cut or "clipped" from the bond on
the date specified, are called coupons, and are negotiable
"bearer" instruments. The coupon recites the terms of the
payment and the legal entity which issues the bond, the date
and place of payment, and the number of the bond from which
the coupon was clipped.
Covenant Agreement by a borrower incorporated in the documents of a
new issue and legally binding upon the issuer over the life of
the issue, unless otherwise stated, to perform certain acts or to
refrain from certain acts.
Credit file A portfolio in which all credit information on a borrowing
customer is assembled. Such files typically include financial
statements, records of indebtedness, law suits, court actions,
credit references, various credit reports, and credit department
analyses. The credit file is a highly confidential folder, and is
available only to personnel of the credit department, bank
officers and directors, and bank examiners.
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Glossary
Credit equivalent amount A measure of the credit risk associated with off balance sheet
items calculated as the Gross amount of the off-balance sheet
instrument x BIS Weighting. The Bank of International
Settlements Weighting (BIS) is a widely accepted measure of
the risk of loss arising from default on a portfolio of off balance
sheet instruments.
Credit rating ■ The amount, type, and terms of credit, if any, which a
bank's credit department estimates can be extended to an
applicant for credit.
■ A measure of the credit and responsibility assigned to
business enterprises, other organisations, or individuals by
credit investigating and credit servicing agencies.
Credit risk ■ The degree of risk calculated by the credit department that
is connected with a particular application for credit.
■ The degree of risk assumed for possible non-payment of
credit extended.
Cross rate The exchange rate between two currencies both of which are
other than the reporting currency. (For example $/DM traded
in Amsterdam, DFLs/DM traded in New York).
Data base systems A data base system manages the access and storage of data,
provides the functions that an application uses and ensures the
integrity of the data. Data may be on internal storage, external
media or on another system. Customer transaction data can be
shared by different applications. It is critical that data integrity
be maintained. A data base system used commonly in banks is
IBM’s DB2, a relational data base. Auditors can use SQL to
select data and perform queries across the system.
Data warehousing A new term to describe a central information depository which
would sit above a bank’s existing systems. The “warehouse” is
fed by the underlying systems. Data is held in a standard,
consolidated format and all management reporting and analysis
is then driven from this repository. Aligned to the push by
banks to increased customer service, the data warehouse would
allow better analysis of product profitability and market trends.
In a wholesale banking environment it is also being used by
some European banks in areas such as trading analysis to
highlight market trends or for global risk management.
Dealing limit The maximum amount of all unmatured spot and forward
foreign exchange or other trading contracts that can be
outstanding for a given counterparty.
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Glossary
Delta The ratio by which the price of an option moves relative to the
underlying instrument.
Demand deposit Deposits that are payable on demand at any time the depositor
elects. They are drawn against by cheques, and require no
notice of withdrawal. Because these deposits are payable on
demand, regulatory authorities often require banks to maintain
much higher reserve balances on them than on other types of
deposits.
Deposit limit The maximum amount and the maximum term of all deposits
that can be outstanding with a given counterparty.
Derivative A financial instrument that derives its cash flows, and therefore
its value, by reference to an underlying instrument, index or
reference rate.
Documentary collection An operation whereby a bank collects a payment on behalf of
its customer by delivering documents to the buyer.
Documentary credit An undertaking given by a bank at the request of a customer to
pay a particular amount in an agreed currency to a beneficiary
on condition that the beneficiary presents stipulated documents
within a prescribed time limit.
Draft An order in writing signed by one party (the drawer) requesting
a second party (the drawee) to make payment in lawful money
at a determinable future time to a third party (the payee).
Drafts generally arise out of commercial transactions, wherein
the seller makes an agreement with a buyer in advance for the
transfer of goods.
The draft may be accompanied by a bill of lading for the goods,
evidencing that the goods have been shipped. The bank in turn
will surrender the bill of lading to the buyer upon payment of
the draft. The buyer can then claim the goods at the office of
the carrier who then transports the goods to the buyer's place of
business. Drafts may be classified with respect to date payable,
such as sight or presentation drafts, demand drafts, arrival
drafts, or time drafts.
Drawdown Payment to the borrower of all or part of a bank's loan
commitment.
Drawee The person to whom a bill is addressed (usually the buyer).
Drawer The person who fills out (draws) the bill (usually the seller).
Duration A measure of the sensitivity of a security’s market value that is
defined by the average time until receipt of the cash flows
weighted by the present value of those cash flows.
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Glossary
Effective yield The actual return earned by an investor consisting of all cash
received from the investment, including coupon return, interest
earned on re-invested interest or principal payments and any
capital gain or loss from disposing of the investment in
comparison to the initial acquisition price.
Electronic funds transfer The exchange of money via telecommunications, without
(EFT) physical currency actually changing hands. EFT refers to any
financial transaction that transfers a sum of money from one
account to another electronically. Usually, transactions
originate at one institution, and are transmitted to a computer at
another institution with the monetary amount recorded in the
respective organisations’ accounts. EFT transaction could be
high volume and low value or high value and therefore may be
in a high risk category. As such, access security and
authorisation of processing are key controls.
Endorser A payee who signs his name on the back of a bill and who
thereby assigns his rights to the endorsee.
Eurobond A debt instrument denominated in one of the several
Eurocurrencies and sold in the international bond market.
Euroclear An organisation which clears, or processes, the physical
exchange of Eurosecurities and stores such securities.
Eurocurrency Currency held by persons resident outside the country from
which the currency originates, and thus not subject to domestic
controls, e.g., US $ held by the London branch of a French
bank.
European option An option that can only be exercised on the expiration date.
Exchange rate contract An off-balance sheet transaction which involves a commitment
to deliver a certain amount of one currency in return for a right
to receive another currency. Examples include, foreign
exchange deals, currency swaps and currency options.
Exotic derivatives Derivative securities that have unusual features, especially
unusual requirements for payoff.
Federal funds U.S. dollar funds immediately available, that arise first as
deposits in U.S. Federal Reserve banks. Every bank which is a
member of the Federal Reserve System is required by law to
maintain a certain amount of reserves against its deposits in the
form of non-interest bearing balances with the Federal Reserve
Bank in its district. Federal funds trading is the trading of these
immediately available reserve balances to sell off excesses or to
buy needed reserves.
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Glossary
Float Funds in the process of collection, representing cheques or

other demands for payment in the possession of one bank but
drawn on and not yet paid by another.
Floating rate ■ In foreign currency exchange, the absence of any fixed
intervention rate at which a government or central bank will
act to maintain the exchange value of its currency. As a
result, each currency rate is determined largely by supply
and demand.
■ In lending, indebtedness for which the interest payable is
periodically adjusted.
Floating rate notes Bonds without a fixed rate of interest, the coupon rate
periodically determined according to a predetermined formula
typically tied to a short-term interest rate in an appropriate
market.
Foreign exchange Transactions involving different currencies. Rates of exchange
are established and quoted for various foreign currencies based
on the demand, supply and stability of the currency. Foreign
exchange markets enable importers to obtain their exporters'
currencies to pay them for their purchases. (See "Future
Exchange Contract" and "Spot Exchange Contract.")
Future (forward) exchange A contract entered into to exchange a specified amount
contract denominated in one currency for a specified amount
denominated in another at a determined future date. In order to
protect themselves from fluctuations in exchange rates, many
enterprises having forward commitments will arrange to hedge
their exposure under such commitments. (see "Hedging") (See
also "Spot Exchange Contract.")
Forward position An enterprise's future net holding as constituted by all
transactions already entered into, excluding the spot position; in
foreign exchange, the extent to which forward purchases and
inflows of a currency exceed forward sales and outflows of that
currency.
Futures contract A forward contract that is standardised and exchange traded.
Gamma The change in the delta for a unit change in the spot price of the
underlying instrument.
Guarantee A contract, agreement, or undertaking involving three parties.
The first party (the guarantor) agrees to ensure that the
performance of a second party (the guarantee) is fulfilled
according to the terms of the contract, agreement, or
undertaking. The third party is the creditor, or the party to
benefit by the performance.
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Glossary
Hedging Engaging in transactions to reduce or eliminate exposure to

changes in market conditions. (e.g., exchange rate, or interest
rate changes) under forward commitments. In foreign
exchange, a hedge contract is a forward commitment to deliver
the currency received under another contract (the hedged
contract) and to receive the currency delivered at the same time
as on the hedged contract. In such cases, the net differential on
the two contracts is fixed at the time the hedge contract is
negotiated, regardless of the movement in exchange rates to the
contracts' maturity.
Imaging Integrates information from a number of sources together in the
one system. The technology that permits this is the digital
optical disk which can store as much data as 1,000 magnetic
floppy disks.
Initial margin The amount of cash that must be deposited with a broker when
a futures position is initiated.
Interest margin/spread A measure of investment profitability often calculated as the
difference between interest income on loans or investments and
the applicable cost of funds (e.g., LIBOR) expressed as a
percent of the principal.
Interest rate contract An off-balance sheet transaction which involves a future
commitment to pay or right to receive certain cash flows
calculated on the basis of interest rates on an underlying
notional principal amount. Examples include, interest rate
swaps, forward rate agreements and interest rate options
(including caps, floors, collars and swaptions or other
derivatives).
Investment banking The activity of broking an enterprise's demand for capital (thus,
longer-term) funds, as opposed to its demand for working
capital (shorter-term) funds.
Irrevocable letter of credit A letter of credit that cannot be revoked by the issuing bank
without the prior consent of all parties to the transaction.
Issuing bank The bank that issues a letter of credit at the request of a
customer (the applicant).
Lease A contract, usually in the form of a written agreement, giving
the right, subject to the payment of rent or other consideration,
to the use of property for a specified or unspecified length of
time.
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Glossary
Letter of credit An instrument or document issued by a bank on another bank

or banks, foreign or domestic, or upon itself. The letter of
credit gives the buyer (possibly unknown to the seller) the
prestige and the financial backing of the bank who issues the
letter of credit in his behalf. A bank's acceptance of drafts
drawn under the letter of credit satisfies the seller and his bank
in the handling of the transaction. The buyer and the accepting
bank also have an agreement as to payment for the drafts as
they are presented.
LIBOR London Inter Bank Offer Rate. The interest rate which banks in
London charge on interbank deposits for set periods of time
(e.g., 3-month LIBOR).
Lien The right of the legally constituted governing body, or a legal
right granted to an individual by the authority of a court, to
control or to enforce a charge against another's property until
some legal claim is paid or otherwise satisfied.
Line or line of credit An arrangement whereby a bank will lend or trade for funds up
to an internally approved maximum amount. Such lines are an
essential feature of interbank deposit dealing and foreign
exchange trading.
Loan A business transaction between two legal entities whereby one
party, known as the lender, agrees to give the use of funds to
the second party, known as the borrower, with or without a fee.
Such a fee, if charged, is called interest or discount. Banks are
the principal lenders of funds for commercial purposes.
Margin For secured loans the difference between the market value of
collateral pledged to secure a loan and the face value of the loan
itself. Margin requirements, set by each bank, specify the ratio
of collateral to loan value that must be maintained by the
borrower to keep adequate security pledged to the bank for the
life of the loan.
Margin call When a borrower has securities pledged as collateral for a loan,
and the market value of the securities has decreased so that the
required margin is not met, the bank will request more margin
from the borrower, who will either have to pledge more
collateral or partially repay the loan so that the collateral
pledged will be sufficient to meet the established margin
requirements.
Mark-to-market The adjustment of a position to reflect accrued profits and
losses. (The adjustment of a position to its market value).
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Glossary
Matching Entering into an equal and opposite transaction which may

differ from the original transaction only as to price (for
example, the exchange rate or the interest rate). The effect of
matching, which is also referred to as covering, is to determine
the profit or loss attributable to the two deals.
Maturity The date on which a note, time draft, bill of exchange, or other
negotiable instrument becomes due and payable.
Memo (memorandum) The record of an account maintained by a bank but which is not
account included among its assets or liabilities. An example is the
record of a bad debt written off, on which subsequent
recoveries may be anticipated.
Mismatching Partial matching wherein a transaction differs from its pair in
more respects than simply price (for example, entering into an
opposite transaction but for only half the amount).
Nostro account A demand account, usually denominated in a foreign currency
that a bank maintains with another bank.
Note An instrument, such as a promissory note, recognised as legal
evidence of a debt.
Official cheque The Bank's own cheque drawn upon itself.
Option A contract giving the holder the right to either buy from or sell
to the issuer of the contract a fixed quantity (of, e.g., securities)
at a fixed price within a specified time period.
Option premium The total price paid by the buyer or received by the seller for
the option.
Overdraft The debit balance in a demand deposit or current/checking
account resulting when a cheque drawn against the account
exceeds the amount available and is paid.
Paperless registries Can record details of the shares on computer files instead of on
paper.
Participation loan Loans in which a group of lenders each own a portion of a
borrower's single obligation.
Payment systems The most well known of the international payment systems is
SWIFT.
Pledge The placement of personal property by its owner with a lender
as security for a debt. The hypothecation of stocks, bonds, or
collateral paper and the assignment of the cash surrender value
of life insurance are common forms of pledges.
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Glossary
Point of sale (POS) POS systems enable capture of data at the time and place that
sales transactions occur. POS terminals may have attached
peripheral equipment, such as optical scanners to read bar
codes, magnetic card readers for credit cards or electronic
scales, to improve the efficiency and accuracy of the transaction
recording process. POS systems may be on-line to a central
computer, or use local processors or microcomputers to hold
the transactions for a specified period after which they are sent
to the main computer for batch processing.
Presenting bank A collecting bank that presents documents to their drawee (used
in bills for collection situations).
Primary market The market for new issues.
Prime bill of exchange A draft or trade acceptance which states on the face of the
instrument that it was created through a business transaction
involving the movement of goods. Bankers' acceptances are
considered prime bills of exchange, although the acceptances of
smaller banks must generally have an endorsement without
recourse of a large bank enjoying high financial recognition in
order to give the instrument "prime status."
Prime rate A United States bank's minimum lending rate (interest rate
charged on loans to its best borrowers).
Principal The face value or par value of an instrument which becomes the
obligation of the maker or drawee to pay to a holder in due
course. Interest may be charged on this principal. In some
instances, however, the obligation is for the principal only.
This is termed "non-interest bearing" principal.
Promissory notes An obligation to pay a set amount of funds on a specified date
that a buyer writes in favour of the exporter (or bearer). It is
usually a negotiable instrument.
Rate of exchange The price relationship between the currencies of two countries
quoted in terms of either currency.
Recourse The right of a holder in due course of a bill of exchange to
recover from other parties to the bill, if the bill is dishonoured.
Redemption fund A fund created for the purpose of retiring an obligation
maturing serially or purchasing it as it becomes available on
secondary markets. (e.g., a fund created to redeem or retire
bonds on or before maturity.)
Reference bank A bank whose interest rate is used to establish for the purpose
of calculating interest due under a loan agreement.
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Glossary
Remitting bank The first bank that is involved in a bills for collection chain.
The remitting bank receives documents from the exporter and
remits them to a collecting bank.
Repurchase agreements Agreements to buy back treasury bills (or other instruments)
which have been sold for delivery on a set date and at an agreed
upon rate.
Revocable letter of credit A letter of credit that can be revoked by the issuing bank at any
time prior to the presentation of documents to the
correspondent bank.
Revolving credit A form of loan agreement that establishes a maximum line of
credit available to a borrower for a fixed period of time.
Revolving letter of credit A credit that enables a number of letters of credit to be issued
under one facility.
Rollover The period, usually 3 or 6 months, for which the interest rate on
an adjustable-rate loan is set. At rollover date the funds are
notionally repaid and relent (or rolled over) and the new interest
rate established.
Secondary market The market for buying and selling bond issues following their
initial issuance (i.e., their initial distribution has ended).
Securities A variety of financial instruments evidencing and promising the
fulfilment of certain obligations.
Security agreement An agreement between a seller and buyer that the seller shall
have a security interest in the goods sold. The security
agreement must be signed by the buyer and must describe the
collateral.
Settlement The actual delivery and receipt of the media of exchange under
a contract; in the case of a foreign exchange contract the
delivery of and payment for foreign exchange on the same day;
in the case of a Euro-deposit either delivery of or receipt of
foreign exchange.
Settlement risk The risk in foreign exchange contracts that the counterparty
will fail to settle on its contract obligation. (The counterparty
may be paid the sold currency before it is known whether the
counterparty has paid the purchased currency).
Short (oversold) Excess of sales over purchases or of foreign currency liabilities
over assets.
Sight bills Bills of exchange that are payable on presentation, i.e., on sight.
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Glossary
Sinking fund A voluntary or contractually required fund created by actually

setting aside from earnings a certain sum of money, for a
certain number of stated periods of time, in order to accumulate
a sufficient sum to liquidate or discharge a certain known
obligation on the date of its maturity.
Spot Cash settlement within two working or business days from the
trade date (exceptions to the general rule may occur by mutual
agreement among the counterparties). Spot trades apply to
foreign exchange and any type of Euro-deposit transaction. A
spot exchange rate is the rate applicable to a deal transacted for
value today, tomorrow or the next day.
Spot exchange contract A contract entered into for the purchase or sale of Foreign
Exchange (see definition) at a determined date within a few
days. The time period used to distinguish a Spot Exchange
Contract from a Future (Forward) Exchange Contract (see
definition) varies from bank to bank but is usually two or three
days.
Spot position The position at the present time encompassing present assets,
liabilities, and commitments due within two working days; for
foreign exchange purposes the extent to which a bank's assets in
any one currency exceed its liabilities (a long position) or vice
versa (a short position).
Standby letter of credit Any letter of credit (or similar arrangement, however named or
designed) that represents an obligation to the beneficiary on the
part of the issuer:
■ To repay money borrowed by, or advanced to, or for the
account of, the party at interest
■ To make payment on account of any evidence or
indebtedness undertaken by the party at interest
■ To make payment on account of any default by the party at
interest in the performance of an obligation.
Subordinated Debt obligations not in the first (senior) tier of obligations. In
the event of default, subordinated debt holders are paid after all
senior obligations have been discharged.
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Glossary
Surety ■ An individual who agrees, usually in writing, to be

responsible for the performance of another on a contract or
for certain debts of another individual.
■ An insurance, bond, guarantee, or other security which
protects a person, corporation, or other legal entity in case
of another's default in the payment of a given obligation,
proper performance of a given contract, malfeasance of
office, etc.
Swap The borrowing of currency 1 for a period to sell it spot for
currency 2, which is then loaned for a period and sold forward
at maturity for currency 1. A perfect swap will include the
forward sale of the interest, in currency 2, earned on the loan to
obtain the interest, in currency 1, to be paid on the borrowing,
such that the only difference between the value of currency 2
plus interest, converted at the appropriate forward rate, and
currency 1 plus interest, will be the amount of profit on the loan
which the bank would have made had currency 2 been
borrowed in the first place (also known as "deposit swap,"
"switch," "interest arbitrage," and other names).
Swaption An option giving the holder the right, but not the obligation, to
enter into or cancel a swap agreement at a future date.
SWIFT An acronym for the Society for World-wide Interbank Financial
Telecommunications, a system which provides electronic
payment of funds between banks in different countries
(principally in Europe, Canada, the U.S. and Australia).
Syndicate A group of bankers and/or bond houses which act together in
underwriting and distributing a new securities issue.
Syndicate loan A loan granted to a borrower by an organised group (syndicate)
of banks. (See Participation Loan.)
Synthetic instrument One or more transactions or positions that viewed as a unit, are
economically similar to a particular financial instrument.
Term bills Bills of exchange that are not sight bills, i.e., bills that have a
maturity at some specified time following presentation of the
documents.
Tombstone Advertisement in the financial press, announcing the fact that a
syndicated loan or bond issue has been made, and detailing the
parties involved.
Trust deed A contract defining the obligations of an issuer in a new bond
issue and appointing a trustee to represent the interests of bond-
holders.
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Glossary
Underwriting An arrangement under which bond houses agree each to buy a

certain agreed amount of securities of a new issue on a given
date and at a given price, thereby assuring the issuer the full
proceeds of the financing.
Underwriting agreement An agreement for the underwriting of a new issue between the
issuer and the collective underwriters or managers, describing
the terms and conditions of the issue and the obligations of both
sides.
Uniform commercial code In U.S. law, the code regulating a broad segment of business
activity, including the sales of goods, commercial paper (see
"Commercial Paper"), cheques, bank collections, and secured
transactions in personal property.
Vega The rate at which the price of an option changes because of a
change in the volatility of the underlying instrument.
Volatility The degree of price fluctuation for a given asset, rate or index.
Usually expressed as variance or standard deviation.
Vostro account A demand account, usually denominated in a foreign currency
that another bank maintains with a bank.
Warrant An instrument giving the holder the right to purchase a given
security at a given price; for either a set period of time or in
perpetuity.
Withholding tax A tax imposed in the locality of a borrower on the interest due
the lender. In many cases, the borrower will deduct the tax
from its remittance to the lender and pay the taxing authorities
directly.
Write-off An amount by which the value of an asset is reduced to state its
book value at its estimated realisable value; an appropriation.
Yield The return received from one's investment in a specific security
or a specific piece of property over and above the repayment of
the funds invested. Yield is most commonly expressed in terms
which designate an annual rate of return on the investment.
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Glossary
Zero coupon ■ A debt instrument where no coupon payments are made

over the term of the instrument and the purchaser's yield is
obtained by paying an amount less than the face value of
the instrument.
■ Interest or discount rates that are applicable to single cash
flows to be received at a discrete point in time. These rates
would be used to value zero coupon instruments and are to
be contrasted with discount rates on coupon based securities
where the yield is a weighted average based on the internal
rate of return of a coupon and principal cash flows over the
term of the transaction.
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Index
Index
Allowance for credit losses

Analytical procedures and tests of details Vol 1 3.84-86
Assessment Vol 2 4.58-69
Country risk Vol 2 4.54
Credit file reviews Vol 2 4.30-57
Credit review working paper Vol 2 4.70-71
General provision Vol 2 4.4
Internal controls Vol 1 3.82-83
Non-accrual loans Vol 2 4.7-10
Objectives Vol 1 3.80
Restructurings Vol 2 4.11
Risk alerts Vol 1 3.81
Specific provision Vol 2 4.4
Analytical procedures
Effective audit evidence Vol 2 16.5-10
Information sources Vol 2 16.11
Planning Vol 2 16.3-4
Audit strategy
Critical audit objectives Vol 1 2.23-25
Control risk assessment Vol 1 2.34-37
Gauge Vol 1 2.48-51
Inherent risk assessment Vol 1 2.32-33
Internal control overview Vol 1 2.26-30
Planned audit precision Vol 1 2.47
Role of internal audit Vol 1 2.43-46
Banking
Domestic and international Vol 2 1.8-9
International financial centres Vol 2 1.14-19
Nature Vol 2 1.1-7
Retail Vol 2 1.10
Wholesale Vol 2 1.11
Bullion trading
Accounting Vol 2 15.36-43
Auditing Vol 2 15.44-46
Allocated Vol 2 15.25
Policies and controls Vol 2 15.32-35
Types of transactions Vol 2 15.28
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Index
Capital markets
Borrowing and lending securities Vol 2 6.10
International clearing systems Vol 2 6.25
Investment securities - definition Vol 2 6.7
Repurchase and reverse repurchase agreements Vol 2 6.13-15, Vol 2 6.31
Risks Vol 2 6.27-31
Short sales Vol 2 6.60-6.62
Trading securities - definition Vol 2 6.8
Wash sales Vol 2 6.63
Classes of transactions
Accounting estimates Vol 1 2.42
Non-routine Vol 1 2.41
Routine Vol 1 2.40
Confirmations
Sample letters Vol 2 18.8
Types Vol 2 18.3-7
Deposits
Auditing guidance Vol 2 12.9-17
Controls Vol 2 12.4, Vol 2 12.14
Demand Vol 2 12.2
Dormant accounts Vol 2 12.8
Electronic funds transfer Vol 2 12.7
Time Vol 2 12.2
Derivatives
Introduction to Vol 2 7.1
Risks and regulation Vol 1 2.8
Documentary credits
Acceptances Vol 2 13.12-16
Auditing guidance Vol 2 13.45-53
Definition Vol 2 13.5
Risk participations Vol 2 13.17-19
Stand by letter of credit Vol 2 13.11
Types Vol 2 13.8
Foreign exchange
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Index

Exchange rates Vol 2 5.14-18
Position management Vol 2 5.19-27
Types of transactions Vol 2 5.11-13
Foreign exchange accounting

Accrual of swap profit Vol 2 5A.13-14
Deposit swap Vol 2 5A10, Vol 2 5A.23-27
Double currency Vol 2 5A.3-9
Forward revaluation Vol 2 5A.10, Vol 2 5A.13-14
Future income and expense Vol 2 5A.19
Hedges Vol 2 5A.2
Identification of swaps Vol 2 5A.23
Internal deal systems Vol 2 5A.17-22
Multi-currency Vol 2 5A.3-9
Spot revaluation Vol 2 5A.10, Vol 2 5A.13-14
Forward rate agreements

Elements Vol 2 11.4
Settlement Vol 2 11.7
Futures
Closing out Vol 2 7.20-21
Definition Vol 2 7.5
Margin Vol 2 7.14, Vol 2 7.22
Pricing Vol 2 7.17
Types of contracts Vol 2 7.12
Use of futures Vol 2 7.13
Information technology
Audit implications Vol 2 19.55-72
CAATs Vol 2 19.72
Controls Vol 2 19.50-54
Implications for clients Vol 2 19.5-11
3
Bank Practice Guide
kpmg
Index
Payment and clearing systems Vol 2 19.40-42

Retail banking environment Vol 2 19.16-25
Risks Vol 2 19.43-49
Wholesale banking environment Vol 2 19.26-39
Interest rate caps, floors and collars

Accounting Vol 2 10.11
Definition Vol 2 10.1, Vol 2 10.6
Risks Vol 2 10.12
Leasing
Direct lease Vol 2 14.3
Leveraged Vol 2 14.4
Lending
Accounting matters Vol 2 3.45-59
Collateral Vol 2 3.31-33
Credit review Vol 2 3.36-44
Security Vol 2 3.31-33
Types Vol 2 3.7-30
Limits
Credit Vol 2 2.19-21
Interest rate position Vol 2 2.26-29
Foreign exchange position Vol 2 2.32-34
Liquidity Vol 2 2.22-25
Money market assets and liabilities

Types of transactions Vol 2 5.9-10
Money transfer systems

Cable Vol 2 15.20
CHIPS Vol 2 15.20
SWIFT Vol 2 15.20
Nostro accounts and payments systems

4
Bank Practice Guide
kpmg
Index

Options
Black-Scholes Vol 2 9.16
Definition Vol 2 9.2-4
Delta Vol 2 9.13
Intrinsic value Vol 2 9.11
Gamma Vol 2 9.14
Pricing Vol 2 9.7-18
Time value Vol 2 9.11
Organisational structure
Capital markets Vol 2 6.16-33
Documentary credits Vol 2 13.20-29
Futures Vol 2 7.36-38
Leasing Vol 2 14.5
Lending Vol 2 3.34-35
Money market and foreign exchange Vol 2 5.28-37
Options Vol 2 9.34-36
Profit and loss account

Regulation
Basle Vol 2 20.4-7
Requirements Vol 2 20.9
Risks
By banking activity Vol 2 2.17
Credit Vol 1 2.10, Vol 2 4.23-24
Foreign exchange Vol 1 2.17-18
Identification Vol 1 2.6-22
Information technology Vol 2 19.37-43
Interest rate Vol 1 2.14-16
Legal Vol 1 2.21
Liquidity Vol 1 2.11-13
5
Bank Practice Guide
kpmg
Index
Market Vol 1 2.19

Operational Vol 1 2.22
Volatility Vol 1 2.20
Risk management
Asset-liability management Vol 2 2.2-15
Duration Vol 2 2.30-31
FX position management Vol 2 5.19-27
Limits Vol 2 2.18
Stress tests Vol 2 2.16
Value at risk Vol 2 2.16
Substantive sampling
Choice of technique Vol 2 17.16-18
Off balance sheet
instruments Vol 2 17.3-15
Swaps
Administration costs Vol 2 8.54-55
Analytical procedures and
tests of details Vol 1 3.36-38
Credit risk Vol 2 8.49-52, Vol 2 8.60
Cross currency swap Vol 2 8.12-14
Market liquidity Vol 2 8.53
Risks Vol 2 8.60
Single currency Vol 2 8.7-11
Swaptions Vol 2 8.15-18
Valuation Vol 2 8.26-57
Syndication
Auditing Vol 2 15.18
Bonds and loans Vol 2 15.4-7
Income Vol 2 15.13
Trusts
Auditing Vol 2 15.3
Fiduciary activities Vol 2 15.2

Banking Audit Practice Guide II

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kpmg

Bank Practice Guide

International Audit &

Foreign exchange........................... 3.23

Types of lending ............................. 3.7

Other matters............................... 11.19

1 The business of banking

Domestic and international banking

Retail and wholesale banking

International financial centres

sophistication, especially in international communications has made such expansion

2 Risk management and limits

Asset - liability management

Risk Factor Inflow of Cash - Outflow of Cash = Position and

■ Diversify exposures: through diversification a bank or financial institution can accomplish

Other risk management techniques

Banking risks by activity

Line of Volume 2 Primary banking Business Primary risks Secondary

Trading 5 Money market Short term Liquidity; Credit

Exposure Risk type Primary limits Secondary limits Key reports

Exposure Risk type Primary limits Secondary limits Key reports

Interest rate position limits

Cumulative gap limits: X = 6 month limit

Foreign exchange position limits

- improved land loans (land that generally has infrastructure in place);

Credit card financing

- obtaining prior authorisation on charges over a specified amount. National sponsors

Types of security (collateral)

■ Guarantee/Indemnity. These are usually forms of indirect securities commonly used by

Organisation, operations, and records

Responsibilities Credit Committee Credit and Loan

Responsibilities Credit Committee Credit and Loan

Accounting Controls: Authorisation Authorisation Completeness, Existence Completeness, Existence

■ industry diversification summaries;

■ if principal repayment is overdue and/or considered doubtful of collection, such payments

4 Allowance for credit losses

■ Concentration risk - Inadequate diversification of investment assets in terms of different

Substantive credit file reviews

■ financial data of the guarantor for guaranteed credits;

Category Ratio How calculated Significance

■ classification of loans according to risk;

Classification Description Provision

Assessing the adequacy of the allowance for loan loss

■ Consideration of the bank or financial institution’s particular environment - for example:

■ a description of the characteristics of the bank or financial institution’s credit portfolio;

Example commercial credit review working paper

Credit review sheet

Interest payments current? - yes/no

5 Reasons for assessment

Assessment discussed with:

Preparer Manager Partner

Report qualified - Yes/No

9 Most recent circularisation

Other credit evaluation considerations

■ inadequate qualifications of the appraiser;

5 Money market and foreign exchange

Money market transactions

Bank issued obligations

currency or as a Eurocurrency. The largest market exists in U.S. dollars, including

Repurchase and reverse repurchase agreements

Foreign exchange transactions

5.15 To illustrate, suppose a bank contracts to deliver Deutsche Marks to a customer in

Organisation, operations and records

Accounting Controls: Authorisation Authorisation Completeness, Existence