Treasury Management and Foreign Exchange Markets

SAT ISH KR I S HNAN

Introduction
25 years in Financial Markets
◦ Both a Market Risk Manager and Risk Advisor

◦ Risk Manager in a Large Corporate responsible for FX/Interest Rate risk management

◦ Then, 2 decades in Financial Markets function in Standard Chartered Bank on risk advisory

◦ Managing Director, Financial Markets : Heading risk advisory function for Commercial Banking Segment,
South Asia Region

◦ Visiting Faculty & Trainer of Bank/Corporate Treasury Executives

◦ Technical Analyst and active Market Participant & Consultant, Investor & Mentor

◦ Specialised in Elliott Wave Analysis

Sessions
Session Topic Details
1 Introduction to Financial Markets and Treasury Function
2 Bank Treasury Operation
3 Corporate Treasury Management
4 -7 Foreign Exchange Management – FX market, FX rate
forecasting with fundamentals and Technical analysis
8 Banks FX Trading Desk
9 FX Advisory in Banks
10 Risk Management, Regulations and Controls
Coverage & Evaluation
➢Treasury Activities with focus on Foreign Exchange markets
➢Presumes students are well versed with
➢ Fixed income markets
➢ Banking
➢ Derivatives

➢Evaluation
➢ Quiz 1 (post session 4)
➢ Quiz 2 (post session 7)
➢ Group Project (sessions 6-10) – teams made, Group/Individual participation considered
➢ End term exam
Treasury Function in
Banks
SESSION 2
What is liquidity Risk?
Liquidity :
◦ Bank’s ability to fund increase in asset and meet all cash & collateral obligation, at a reasonable funding
cost
Liquidity Risk :
◦ Risk of not able to meet such obligations without affecting banks financial condition
Solvency vs Liquidity
Types
◦ Funding Liquidity : ability to obtain funding at reasonable price
◦ Market Liquidity : ability to convert asset into cash
Mismatch – Negative/positive – Benefits and risks
◦ Negative Gap : Outflows > Inflows in the time bucket
◦ Positive Gap : Inflows > Outflows in the time bucket
Northern Rock – meltdown story
1997 : British Bank, listed in London stock exchange in 1997
2007 : Among top 5 mortgage lenders in UK, grew rapidly - (always relied on negative gap in ALM)
Aug’07 : subprime crisis led nervousness made borrowing difficult
Sep’07 : FSA commented:
‘The FSA judges that it is solvent, exceeds its regulatory capital requirement, has a good quality loan
book’
12-sep : NR approached for emergency funding of £ 3b
13-sep : BBC broke news on NR seeking emergency funding
14-sep : Run on the bank started and estimated £2b was withdrawn till 17sep
17-sep : Exchequer announced full guarantee of deposits & imposed penal interest for banks with risky funding
Feb’08 : Emergency borrowings reached £25b. Bank was nationalised, split into (AMC) with bad debts & Banking
Nov’11 : Virgin group acquired Northern Rock Plc for £747 m.
A solvent, healthy bank was quickly brought down due to poorly managed Liquidity risk.
Liquidity Risk Management (LRM)
Balancing between liquidity vs profitability
◦ Excessive liquidity : Loss of profitability
◦ Inadequate liquidity: Loss of trust and risk of collapse

Sound LRM process critical

◦ Commensurate with the size and complexity of the bank

Maturity mis-matches an inherent risk in banking

◦ How well managed differentiates the good vs others
◦ Funding gap monitored on bucket-wise and on cumulative basis also

External Shocks and unforeseen mis-matches

◦ Contagion impact and systemic risk
LRM some considerations
Liquid assets proportion
Extent of volatility in deposits
Degree of reliance on volatile source of funding
Level of funding source diversification
Historical trend on stable deposit
Quality of maturing assets
Market reputation
Availability of undrawn standby
Impact of off-balance sheet exposure
Contingency plans
Liquidity: Source and Deployment
➢Cash in excess of CRR requirement
➢Investment in excess of SLR requirement - Repo
➢Prime Assets – T Bills, Top rated ST papers, Loans to top rated companies
➢Swapping Forex funds to INR
➢Undrawn lines from RBI – Marginal Standing Facility
➢Undrawn lines from FIs & other Banks
➢Deposits (public and other banks)
Sound LRM principles
Basel Committee of Banking Supervision (BCBS) published ‘Principles for Sound Liquidity Risk
Management and Supervision’ in Sep 2008. It envisages the fol:
Fundamental Principle of Management & Supervision
◦ Bank to establish robust framework, Supervisors should assess it adequacy, liquidity position and take prompt
corrective action to limit damage to financial system
Governance
◦ Articulate Risk tolerance and Strategy
◦ Senior mgmt. to develop, review and report strategies & policies and report to Board
◦ Incorporate liquidity cost in internal pricing, performance evaluation & new product approval process
Measurement and Management of Liquidity risk
◦ Sound process of identifying, measuring, monitoring and controlling liquidity risk
◦ Monitor and control across entities, business line, currencies
Sound LRM principles
Basel Committee of Banking Supervision (BCBS) published ‘Principles for Sound Liquidity Risk
Management and Supervision’ in Sep 2008. It envisages the fol:
Measurement and Management of Liquidity risk (contd.)
◦ Establish funding strategy. Regularly gauge its funding capacity
◦ Manage intraday funding positions : stress test to ensure no damage to payment
◦ Manage collateral position and settlement systems differentiating between encumbered and
unencumbered assets
◦ Stress test – short-term and protracted, Institution-specific & market wide scenarios
◦ To have Contingency Funding Plan
◦ Maintain High Quality Liquid Assets as cushion as insurance against stress scenario
Public disclosure
◦ LRM framework soundness to be transparent to avoid surprises
Regulatory requirements
Basel Framework for Liquidity Risk Management in Banks
Regulatory reserve requirement
◦ Cash Reserve Ratio (CRR)
◦ Statutory Liquidity Ratio (SLR)
◦ Liquidity Coverage Ratio (LCR)
◦ Net Stable Funding Ratio (NSFR)
Other Risk Monitoring Tools
◦ Contractual Maturity mismatch
◦ Funding Concentration
◦ Available unencumbered assets
◦ LCR by significant currency
◦ Market-related monitoring tools
◦ Early warning indicators like equity price movement, Bond/CD rates, etc.,
Statutory Reserves
➢CRR
➢ (3%) of NDTL (Net Demand & Term Liabilities)
➢ Should maintain atleast 95% of Reserve requirement on a daily average
➢ Every Rs 100 borrowed, will allowing lending of Rs 97 only

➢SLR
➢ (18%) of NDTL (Net Demand & Term Liabilities)
➢ Specified Assets
➢ Cash, Gold, Unencumbered approved securities
➢ SLR securities include G sec., SDL, T Bills, etc.,
Stat Cost Computation
➢Assume cost of NDTL funds is 7%
➢Weighted Return on Specific securities held in SLR is 4%.
➢What is the effective cost of funds, taking CRR/SLR into account?
Stat Cost Computation
➢Assume cost of NDTL funds is 7%
➢Weighted Return on Specific securities held in SLR is 4%.
➢What is the effective cost of funds, taking CRR/SLR into account?

• {Borrowing cost – Return on Reserve) * {1/(1-Reserve %)}

• {(100 * 7%) – (3 * 0%) – (18 * 4%)} * { 1/ 0.79)
• 6.28 / 0.79
• 7.95%
➢ Thus, the stat cost is 95 bps
Liquidity Coverage Ratio (LCR)
Basel Framework post 2007 crisis
Aimed to promote short term resilience to survive acute stress over 30days
LCR = ≥ 100%
◦ [High Quality Liquid Asset] / [Total net cash outflows 30 day horizon, under stress scenario ]
HQLA - characteristics
◦ Unencumbered
◦ Low credit and market risk
◦ Ease and certainty of valuation
◦ Low correlation with risky assets
◦ Listing on recognised exchange
◦ Active and sizeable market
◦ Presence of committed market makers
◦ Low market concentration and flight to quality
HQLA assets
Categories of HQLA and Value assumed
Level 1 – full value
◦ Cash & G secs (in excess of CRR/SLR), Marketable securities of foreign sovereigns
◦ 0% haircut on the market value
Level 2 - with haircut, and cannot be more than 40% of HQLA stock
◦ Level 2-A - 15% haircut
◦ CP, Corp Bonds, etc with minimum rating of AA-, PSE marketable securities, multi development banks
with risk weight of upto 20% under Basel, etc.,
◦ Level 2-B – 50% haircut
◦ This category should not be more than 15% of total HQLA stock
◦ Equity shares of non-bank/FI/NBFC or affiliated entities and included in Sensex/nifty. marketable
securities on sovereigns with risk weights of 20-50% under basel, credit rating not below BBB-, etc.,
Total Net Cash Outflow
Total Expected cash outflow Less expected cash-inflow
For the subsequent 30 calendar days, in stressed scenario
Cash outflow
◦ Outstanding bal. of various liabilities and off balance sheet commitment
◦ Multiplied by Run off rate
Cash inflow
◦ Expected to flow
◦ Subject to cap of 75% of cash outflow
Run off rate/inflow rates prescribed
Liquidity Monitoring Tools
➢Basel framework prescribes for better monitoring of liquidity position
➢Metrics
1. Contractual Maturity Mismatch - funding needs
2. Funding Concentration
3. Available Encumbered Assets
4. LCR by Significant currency
5. Market Related Monitoring Tools - equity, bond/credit market price
discovery clues
Net Stable Funding Requirement (NSFR)
Definition:
NSFR: ‘amount of available stable funding relative to the amount of required stable
funding’
Available Stable funding (ASF) : “ a proportion of capital and liabilities expected to be
reliable over the time horizon considered by NSFR, which extends to one year’
Required Stable Funding (RSF) : ‘is a function of liquidity characteristics and residual
maturities of various assets held, as well as those of its off-balance sheet exposure’
Ensures maintenance of stable funding profile in relation to the composition of assets
and off balance sheet activities
Net Stable Funding Requirement (NSFR)
Ensures maintenance of stable funding profile in relation to the composition of
assets and off balance sheet activities
Limits over-reliance on short term wholesale funding and promotes funding
stability
NSFR : [ ASF / RSF ] ≥ 100%
◦ ASF = Available Stable Funding = Liability category x Associated ASF factor
◦ RSF = Required Stable Funding = Asset Category, Off BS exposure x Associate RSF factor
Comparing LCR & NSFR
LCR
Risk Addressed Liquidity
Objective Promotes ST resilience to
potential Liquidity disruption
to survive an acute stress
scenario for 30days
Time horizon in focus 30 days
Means of regulation Quality of Asset held
Adjustment factor Run off Factor for cashflow
Scenario presumed Stressed
NSFR
Liquidity
Promotes resilience over
longer term by requiring
funding of activities with more
stable source on ongoing basis
1 year
Stable funding source
Associated Available Stability
Factor
Associated Required liability
Factor
Normal
Bond Portfolio Management
➢Investment Policy of the bank to govern
➢Active and Passive Approach
➢Banking Book and Trading Book
➢Categorisation
➢ Held Till Maturity (HTM)
➢ Available for Sale (AFS)
➢ Held For Trading (HFT)

➢Buying corporate bonds by private placement counted as part of this

Held till Maturity
➢Intention to hold and receive interest, not capital gains
➢Not to marked to market
➢Profit/(loss) on sale of these investments to be
➢ To P&L and
➢ Gains taken to Capital Reserve Account
➢Once a year, shifting from/to HTM is permitted with Board approval, usually at the
beginning of the year
➢If shift >5% of investment book value, disclosure of market value and provision not
done
➢Exception: SLR holding reduction, direct OMO, Govt buying back securities
➢Conversion into HTM, at cost or market which ever is lower
Held for Trading/Available for Sale
➢Securities held for short term price movement is HFT
➢Securities not falling into HTM & HFT, is classified as AFS
➢Banks treasury investment/trading policy to guide on quantum, limit, exposure
type, stop loss, etc., for HFT category
➢HFT securities need to be sold within 90 days.
➢Gain/loss is taken to P&L account
➢Shift from AFS to HFT is done with approvals, as delegated in Board approved
policy
Bond Book
➢Buy and Hold strategy
➢Investment maturity strategies
➢ Varying maturities
➢ Re-investment risk
➢Ladder or spaced Maturity strategy
➢ With limited portfolio expertise
➢ Efficient way to build is to participate in auction
➢Front End loaded Maturity Strategy – emphasise on liquidity over income
➢Back End loaded Maturity Strategy – emphasise on income
➢The Barbell Strategy – combination of the above
➢Immunisation, Dedication, Riding the Yield curve, etc.,
Assessing Market conditions / views
➢Central Bank Liquidity framework
➢Policy Rates and monetary Policy transmission
➢Market pricing and Banking System Liquidity
➢Understanding Banking System Liquidity & Tools
➢Drivers
➢ Statutory Reserve requirement
➢ Govt. spending / tax remittances
➢ OMO
➢ Cash in circulation- change
➢ FX intervention / swaps
System Liquidity
➢Deficit/Surplus
➢ On a given day, banking system is net borrow under LAF deficit, surplus if lender

➢Measuring system Liquidity

➢ Net Borrowing under LAF +
➢ Excess of reserves maintained by banks

➢Transient Vs Durable deficit/surplus

➢ GoI balance contribute to transient/temporary diff
➢ Unsterlised FX, Change in Cash in Ciruclation, etc., contribute to durable
➢ Durable = Net borrowing by banking system over GOI balance