CHAPTER SIX

TREASURY MANAGEMENT

Without question, a bank's Treasury Management is not only a major revenue source but at the same
time, the part of the bank that manages the most vital responsibility--the liquidity of the bank and all the
attendant risks and income opportunities. The other equally important set of Treasury's responsibilities
is the management of the bank's foreign exchange operations--its assets and liabilities as well as all
transactions that have a foreign exchange component with institutional and individual clients of the
bank and in some cases, counter-parties.

LIQUIDITY MANAGEMENT: RISKS AND STRATEGIES

Definition of Liquidity Risk

Liquidity risk refers to when an institution is unable to meet demands for funds (e.g., deposit
withdrawals, lending opportunities) in a timely and cost-effective manner. A bank is said to be liquid if it
can service deposit withdrawals and credit line availments and make payments when due without
having to dispose liquid or non-liquid assets at fire-sale prices or borrowing at inordinately high interest
rates. Liquidity management is therefore key to avoid a bank run that takes place when a large number
of withdrawals happen simultaneously out of fear that the bank could become insolvent.

If a bank's loan portfolio is made up of all very short-term loans, say three months being the longest
maturity, and all its fund sources have a maturity of more than one year, then liquidity management
may not be that much of a challenge. The reality, however, is very different. Banks grant loans that have
tenors longer than three months, in fact, some well in excess of one year like five to ten-year term loans.
Likewise, even three-month loans have a tendency to be renewed or rolled over. The fund sources, on
the other hand, are mostly short-term like traditional deposits that are either on demand (savings and
current accounts) or mostly time deposits with maturities of three months or less.

ACQUISITION OF LIQUID ASSETS WITH ZERO OR MINIMAL CREDIT RISKS

The foregoing discussion on the prescribed Liquidity Coverage Ration (LCR) and the Net Stable Funding
Ratio (NSFR) has given us a good insight into the composition of the bank's fund uses and sources that
will result in a minimum acceptable level of liquidity. These ratios are practical guides for the treasurer
but he/she needs to build into the acquisition and deployment of funds the element of yield and risk,
interest or pricing risk in particular. First, let us go through a list of options that he/she has in use of the
funds without taking any significant credit risk, if there is any at all.

1. Treasury Bills or T-Bills. These are government issued securities that mature in less than one
year. They are direct and unconditional obligations of the National Government and these are
 non-interest bearing but instead are sold at a discount from face value of the instrument. The
maturities issued by the Bureau of Treasury are 91, 182, and 364 days. Bids for these securities
may either be competitive or non-competitive. Non-competitive bids are generally awarded in
full provided that the bid does not exceed 40% of the total auction volume; otherwise, it is
awarded on a pro-rated basis. A non-competitive bid, as the name implies, is awarded at the
average of accepted competitive bids while competitive bids are accepted from the lowest yield
and awarded progressively higher until the required amount is met. Auctions for T-bills are
typically conducted on a weekly basis and may be traded in the secondary market before
maturity.

2. Treasury Bonds or T-Bonds are also called Fixed Rate Treasury Notes (FXTNS). They are direct
and unconditional obligation of the National Government that pays a fixed amount of interest in
the form of coupon payments and principal payment on final maturity. The common tenors
used by the Bureau of Treasury (BTr) are 2, 3,5,7, 10, 15, 20, and 25-year bonds. They are
considered free of credit risks but they do carry, particularly for the longer maturities, interest
or pricing rate risks as the market values are sensitive to changes in interest rates in the market.
FXTNS are awarded on a Uniform Price or Dutch Auction which means that the coupon rate is
set equivalent to the yield of the highest of the highest accepted bid and the bonds are awarded
at par.

The auction committee may choose to fully award, partially award, or even reject bids in an
auction proceeding should the BTr deem those bids too high. Like T-Bills, the T-Bonds or FXTNS
may be traded in the secondary market before the maturity of the instrument. Retail Treasury
Bonds (RTBs) as the name suggests primarily caters to the retail market or the end-users. Unlike
FXTNs whose coupons are paid semi-annually, the RTB coupons are paid quarterly.

3. Repurchase (often called Repo) transactions. These happen when a bank borrows money from
the BSP by selling government securities as collateral with a commitment to repurchase them at
a predetermined rate and date.

4. Reverse Repurchase (Reverse Repo) transactions. This time it is the BSP that takes money from a
lending bank in exchange for securities which it commits to repurchase at a specified future date
and at a predetermined rate.

At present, the Reverse Repo has been modified to be a purely overnight facility while the Repo
facility has been replaced by the overnight lending facility of the BSP. The OLF does not require
the more onerous transfer of the securities while still earmarking to indicate the encumbrance.

5. BSP Term Deposit Facility or TDE. This is another key liquidity management tool used by the BSP
to absorb liquidity from the financial system to calibrate the market rates to bring them closer
to the policy rates with the BSP interest rate corridor. Similar to the Reverse Repurchase
(Reverse Repo), auctions are conducted periodically depending on the liquidity forecasts of the
BSP. Unlike the Reverse Repo, however, eligible participants leave variable bids for various
maturities which the BSP awards based on an English-type auction or at multiple prices
 beginning with the lowest asking price and ascending until it fills the volume on auction. It may
opt to reject bids deemed too high or away for the desired corridor.

EFFECTIVE COST OF DEPOSITS

When a bank accepts a savings or time deposit and pays an interest rate of say, 1% per annum, many
are surprised to learn that the effective cost to the bank of that deposit is significantly more than 1% per
annum. The reason for this is that the bank has to add up all the direct costs related to taking in that
deposit in the books of the bank. Often referred to by bankers as “friction costs" or intermediation
costs" added to the nominal interest paid on the deposit, these are broken down as follows:

1. Philippine Deposit Insurance Corporation premium = 1/5 of 1% of deposits

2. Documentary Stamp Tax (DST) = P2.00 for every P200 (current formula but subject to change
depending on tax legislation)

3. BSP Supervision Cost = 1/28 of 1% of total assets

4. Agri/Agra Penalty =.044% (there is legislation and BSP regulations ring banks to grant loans to
agriculture and agrarian reform beneficiaries equivalent to 15% and 10% of their loan portfolio,
respectively. Banks are penalized for failure to comply.

5. Required Reserves = percentage subject to BSP policy. For the example below. assume 18% (the
requirement in the past).

FOREIGN EXCHANGE

Like the first part of this chapter, Local Currency Interest Rates and Liquidity Management, the second
part, Foreign Exchange Management is no less challenging, The US dollar/peso rate has been the object
of discussion and speculation particularly when there is some volatility in its movements. Every importer
and exporter watches it and of course, overseas Filipino workers and their families are always interested
in this rate because it determines the pes0 value of their remittances. Two other sectors that depend on
the Foreign Exchange (FX) rate as this could greatly affect their revenues and profitability are the
Business Process Outsourcing (BPO) and Tourism. Too strong a peso would impact their operations.

It was not always this intriguing or challenging. History will show us that prior to that fateful day in
February 22, 1970 to be exact, businessmen and the general public hardly ever followed the FX
dollar/peso rate. For many years before, it hardly ever moved from the "pegged" rate of P3.90 to $1.

Since then, everybody is used to the floating rate in monitoring the US dollar value of the peso. In fact,
except for our neighbor Hongkong, which has a fixed exchange rate policy, i.e., the US dollar is
exchanged at HK $7.80 (tourists are more familiar with exchange rates of HK7.50 to 7.70 when they sell
their US dollars), most, if not all other countries in Asia and Australia/New Zealand are on a floating rate
system.

The BSP has a very informative write-up done by its Department of Economic Research entitled The
Foreign Exchange Rate: Key Definition and Concepts." A major part of the question-and-answer material
is quoted here as it gives the reader very helpful insights into what the foreign exchange rate is all about.

KEY DEFINITIONS AND CONCEPTS

1. How is the exchange rate defined? The exchange rate is the price of a unit of foreign currency in
terms of the domestic currency. In the Philippines, the exchange rate is conventionally
expressed as the value of one US dollar in peso equivalent. For example, US$1 = P50.00.

In every exchange rate quotation, therefore, there are always two currencies involved.

2. Why is the exchange rate important? The exchange rate is important for several reasons:

It serves as the basic link between the local and the overseas market for various goods, services,
and financial assets. Using the exchange rate, we are able to compare prices of goods, services,
and assets quoted in different currencies.

Exchange rate movements can affect actual inflation as well as expectations about future price
movements. Changes in the exchange rate tend to directly affect domestic prices of imported
goods and services. A stronger peso lowers the peso prices of imported goods as well as import-
intensive services such as transport, thereby lowering the rate of inflation. For instance, an
increase in the value of the peso from US$1: P50 to US$1:P40 will lower the price of a $1 per
liter gasoline from P50.00 (P50 x $1) to P40.00 (P40X $1).

Exchange rate movements can affect the country's external sector through its impact on foreign
trade. An appreciation of the peso, for instance, could lower the price competitiveness of our
exports versus the products of those competitor countries whose currencies have not changed
in value.

• The exchange rate affects the cost of servicing (principal and interest payments) on the
country's foreign debt. A peso appreciation reduces the amount of pesos needed to buy
foreign exchange to pay interest and maturing obligations.

3. How is the exchange rate determined? Under the system of freely floating exchange rates, the
value of the dollar in terms of the peso is determined in the interbank foreign exchange market
(by the forces of supply and demand just like any commodity or service being sold in the
market). Under a fixed exchange rate system, a par value rate is set between the peso and the
dollar by the central bank. The par value may be adjusted from time to time.
4. How does the exchange rate change? Under a floating exchange rate system, if more dollars are
demanded than are offered, the price of the dollar in terms of the peso will tend to increase;
that is, it will cost more pesos to acquire one dollar. If, on the other hand, more dollars are
Offered than are demanded, the value of the dollar in terms of the peso will tend decrease; that
is, it will cost less pesos to acquire one dollar. In contrast, under ed rate system, a change in the
exchange rate is effective through an official announcement by the central bank.

5. What is the country's foreign exchange policy? At present, the country's exchange rate policy
supports a freely floating exchange rate system whereby the Bangko Sentral ng Pilipinas (BSP)
leaves the determination of the exchange rate to market forces. Under a market-determined
exchange rate framework, the BSP does not set the foreign exchange rate but instead allows the
value of the peso to be determined by the supply and demand for foreign exchange.

Thus, the BSP's participation in the foreign exchange market is limited to tempering sharp
fluctuations in the exchange rate. On such occasions of excessive movements, the BSP enters
the market mainly to maintain order and stability. When warranted, the BSP also stands ready
to provide some liquidity and ensure that legitimate demands for foreign currency are satisfied.

6. How is foreign exchange traded in the market? In the Philippines, banks trade foreign exchange
using an electronic trading platform called the Philippine Dealing and Exchange Corporation
(PDEx) through any of the following ways: Reuters or Bloomberg dealing, over-the-Counter, or
via voice/ box brokers. The PDEx captures all spot transactions (which involve the purchase or
sale of a foreign currency for immediate delivery, i.e., within one day for US dollars and within
two days for other convertible currencies), done through any of these transaction vehicles.

When banks trade, either for their clients or for their own accounts, they follow a set of
guidelines laid by the BSP (Manual of Regulations on Foreign Exchange Transactions, as
amended; Circular471 dated January 24, 2005; and other applicable BSP regulations) to ensure
orderly trades in the foreign exchange markets.