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AN INTRODUCTION TO TREASURY MANAGEMENT Treasury Management in a financial entity is a principal determinant in the entity¶s financial strategy and financial policy enabling the entity to determine what businesses to invest in, organising the appropriate funding for the varying business segments, and controlling the risk in the organisation. Dependent on the inherent risks prevailing in the current environment in which the entity is operating in, treasury management seeks to create an appropriate capital structure of debt and equity in order to fund the entity, getting the optimum balance between expenses and risk. This translates into the need to ensure that at all times the entity has the liquidity and cash to meet its financial obligations as they become due, taking in funding from equity or debt capital markets activities, bank borrowings, through to dayto-day cash management and investment. The Treasury Management process is responsible for risk identification associated with the entity¶s varying activities and for controlling risks that could erode financial strength, using mitigation and hedging techniques and encouraging a culture of sound financial practice. In essence treasury management is all about handling the banking requirements, the funding for the entity and managing financial risk. It therefore incorporates raising and managing money, currency, commodity and interest rate risk management and dealing, and, in some entities the related areas of insurance, pensions, property and taxation.

Objective 1: y Discuss the reasons for the development of treasury operations; describe the scope of treasury functions in a bank; and contrast a bank treasury and a corporate treasury.

Role of the Treasurer
The treasury department is concerned with managing the financial risks of a business. Hence, the treasurer's job is to understand the nature of these risks, the way they interact with the business, and to minimize or to offset them. He must assist and advise the board in its decision-making activity, based on his understanding of the risks. In order to do this efficiently many treasurers prefer to organise their department around treasury processes. This method is very efficient as it allows for a focus as well as links to similar functions in other geographic areas of the organisation. The treasury processes mentioned generally consist of


cash flow management. shortterm borrowing. money transmission. Exposure management ± currency exposure. Setting corporate financial objectives ± strategies. In the past two decades. international monetary planning and reporting. 3. As such the treasurer has significant leeway in both the design and implementation of the process. but his actual role. internal capital allocation. treasury is also responsible for investing surplus funds. Everything. pricing. these two tend to be the most 'treasury independent' processes. types of funds and self-funding mechanisms. Treasury plays a pivotal role in managing risks and rewards both inside and outside the organisation. procedures. Both these processes require a significant amount of attention to detail but also differ in one other aspect. The most operational of these processes are risk management and cash management. Treasury is becoming involved in handling operational risks through insurance mechanisms and. Liquidity management ± The treasury function has to ensure that the company has sufficient liquid funds available to ensure a smooth running of its operations and to meet short-term financial obligations as and when due. Not doing so results in the Treasurer getting caught up in the execution of a particular transaction. viable risk/reward management systems. Funding management ± policies. banking relationships and streamlining the operational flow of funds. managing staff. As the function concerned with the provision and use of finance. Increasingly. Treasury Activities comprise the following: 1. 4. exchange dealing. 2. and cash management. banking. international netting/pooling. working capital. Moreover. policies. and obtaining resources to support the function. foreign currency management. Treasury has become more involved in identifying unmanageable organisational risk and hedging it in open markets. reporting and systems. commodities markets and hedging. in some leading companies. provision of capital and money market investment. measurement. working capital. control of funds. THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 2 . risk management (FX and money market). Treasury typically handles collections. Given this flexibility and the operational nature of the processes it is in the best interests of the Treasurer to pay a high level of attention to the design and implementation of the processes. credit management. funding. Of all the processes mentioned.

Corporate finance ± equity capital management. pension funding. dealing and settlement. the bank has to demonstrate to the regulatory authorities and to its own senior management that the bank is operating ethically. 9. foreign exchange. Globalization of world markets and the complexities involved in a bank's trading operations have led to the setting up of a department specializing in the areas of funding. Within the control office. fraud prevention. Dealing. compliance.the settlement office and the control office. a treasury function is best placed to establish and run the back-office operations .5. 3. Treasury Function in an International Bank A treasury function in an international bank is concerned with three main activities:± 1. Further. cost-centre/profit-centre management. 7. 2. credit and counterparty risks. Settlement Control. staffing. Banks felt that they could operate more profitably by engaging in a function whose purpose is to minimize funding costs and to maximize returns. Corporate treasury structure ± information systems support. taxation issues. 6. lending. central/local procedures. interest rate and commodity price risks. business acquisitions and disposals. Objective 2: y Summarise the treasury management roles of portfolio management. Bank. project finance and joint ventures. THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 3 . legally and profitably. asset management. controls. as well as liquidity. Debt portfolio management: The treasury function has to manage the debt portfolio which emerges from the accumulation of individual financing transactions so as to achieve an acceptable cost and risk profile for the portfolio over time. investment and foreign exchange. 8. risk attitudes. Risk management: The treasury function has to advise on and implement effective hedging of treasury type risks. Funding management: The treasury function has to source and secure funds for the needs of the business. given the need to manage the flow of transactions. 10. financial counterparty and rating agency relationship management. prudently. business unit evaluation and Treasury performance evaluation. especially. and proprietary trading.

The principle that the deal. clients have to pay or be paid. Prudent control maintains the good name of the bank while it pursues its main function as the provider of the funding for both the bank's foreign currency investments and for their international business. liquidity. systems. It maintains and develops the investment portfolios and seeks to utilize the bank's surplus funds to best advantage for:    Day-to-day funding requirements Funding investments in associated companies and subsidiaries Raising debt to meet capital requirements Valeur Compensee (VC) ± Valeur Compensee (VC) relates to the aggregate of purchase and sales that mature on any one value date in the future. in turn. Control The treasury function takes on the responsibility for producing a set of policies and procedures governing the way in which the bank trades in the various instruments and the levels at which it trades. loans or trading in currency instruments. interest rates and exchange rates will also be controlled by the function using a THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 4 . cash flows. Dealing The treasury maintains and develops its dealing operations. Recent advances in electronic settlement have made the process quicker and more effective. This is an important part of the bank's operation and requires skilled managers to ensure that there is a smooth flow of paper to support the transactions taking place. affect the efficiency and even the reputation of the institution. should be completed on the same day. Sales have to be reconciled in the bank's back office.Treasury operations A dedicated treasury operation would normally be involved in the activities centering around dealing. evolving its business and controlling its operations across the broad range of instruments . Heavy dealing in any day or over a period of time can cause serious bottlenecks which. reconciliation of accounts. Risks relating to credit limits. cash. options. certificates have to be exchanged and purchases and sales have to be reconciled. and control. and accounting and statutory returns. swaps and forward-rate agreements.for example in futures. settlement. This area clears the paperwork following the purchase or sale of financial products investments. Settlement The settlement office is responsible for processing payments. custody of securities. issuing confirmations.

The board is responsible for setting the bank¶s tolerance for risk or ³risk appetite´. could have catastrophic consequences for the very survival of the institution as demonstrated by the events that unfolded at the Bank of International Credit and Commerce and at Barings Bank. The board should seek active responses to limit breaches. limits and business strategy. which has ultimate responsibility for the sound and prudent management of a bank. Objective 3: y Differentiate between front-office. The Boards Responsibility Prudential management of any bank is based on the primacy of the board. The board is expected to review policies and strategy on at least an annual basis.system of checks and reviews through audits and the examination of returns required to be made by each of the dealing and settlement operations. Proprietary Trading This occurs when a bank trades for direct gain instead of commission dollars. Even fraudulent activity on a much smaller scale can impact on the confidence the financial markets have in an institution. the board is responsible for the institution¶s operations and risk management and for ensuring that senior management is monitoring the effectiveness of risk controls. THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 5 . internally or by third parties. policies and procedures. revaluations and new products. All existing stock also has to be managed and this will be done through a set of guidelines. For the purpose of maintaining the bank's capital adequacy requirements. a crucial function for the very survival of the bank. and back-office activities from a control perspective. In the management of the treasury area. Particular attention should be paid to the possibility of fraudulent activity. Essentially. reporting. the bank has decided to profit from the market rather than from commissions from processing trades. Market risk policies should cover matters such as delegations. Banks that engage in proprietary trading believe that they have a competitive advantage that will enable them to earn excess returns. in the context of a bank trading in enormous amounts of money each day. The board should ensure that the institution¶s risk controls are effective. It undermines the perceived level of control exercised by the bank. the agreed business strategy is being followed and that the board is being regularly informed on whether risk policies are being adhered to. which. middle-office. through its approval of market risk policies. the treasury control office will be involved in capital and loan stock issues relating to the bank's own balance sheet management. Treasury functions often need to lead their organisations in understanding and managing risk and reward. escalation.

The board should also regularly review stress tests and back testing results and should ensure. Senior management should keep the board fully THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 6 . senior management should have delegated trading authority from the board and should be accountable for the actions of dealers under their control. limits and strategy. For example.The board should have a good general understanding of the types of treasury products and trading strategies used by their institution and to review new products. Senior Management Responsibility Senior management is responsible for ensuring that risk-taking is done within a controlled environment which is in keeping with board-approved policies. competitive and at times frenzied environment in dealing rooms. Senior management should ensure that trading desks are following the board approved business strategy. a senior management committee (market risk committee or Asset Liability Committee) should review trading activities on a regular basis. systems and processes are up to the task. stress tests. that the internal models and the market risk management framework is regularly reviewed by the internal audit function. It is their responsibility to ensure that people. For example. and thus the crucial need to maintain clear and strong separation of front. Leave policies should also include minimum consecutive days of leave each year. This culture results in budget targets stretched beyond dealers¶ competence and underinvestment in treasury risk management. In the dealing area. it is expected that boards should understand the aggressive. This understanding should be reinforced by board information sessions which explain the inherent risks in. middle and back offices. In addition to day-to-day oversight by senior management. New products and changes to limits and policies should also be agreed by the committee before being proposed to the board. usage of market risk capital. The committee¶s charter should include reviews of performance and operational issues. back testing performance. limits and strategy on a continuous basis. Treasury dealer compensation policies should be consistent with the trading strategy and bonuses structured to encourage appropriate dealing behaviour. Senior management should have an open and constructive working relationship with the market risk function of the institution and ensure proper segregation of responsibilities between the front-office and middle/back office staff. trading with interbank counterparties should predominantly be for the purpose of reducing risk rather than for taking large directional positions. The board is expected to be able to assess from the reports they receive whether trading is within the risk appetite it has approved and conforms to the agreed business strategy. Senior management is expected to guard against a dealing culture that is biased towards shortterm profitability. trading strategy and the appropriateness of the risk management framework. if a derivatives desk is meant to be mainly client-driven. to ensure that a second set of eyes reviews dealers¶ activities. Boards are required to be vigilant and effective in their oversight of risk. through the Board Audit Committee. for example. derivative instruments. Senior management of trading activities should ensure that dealers comply with policies.

Systems should be in place to ensure that dealers report their position and profit and loss on a daily basis to line managers and to finance personnel. does so at its peril. Market risk management The Middle Office Market risk management ² the middle office ² is responsible for ensuring treasury dealers are complying with board-approved policies and trading within risk limits. In turn. Dealing rooms that adopt a ³catch-me-if-you-can´ approach to risk management are asking for trouble. desk and trading room limit usage. banks strive for the highest level of professionalism in this area. Line management should also have access and the capability to view dealer positions and monitor dealer. and this must be reinforced by senior management through its remuneration policies. The bank should ensure that breaches of limits are reported immediately by the dealer to line management. An institution which calculates Value at Risk (VaR) using a THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 7 . at all times. stop loss and position limits both within the day and at the end of day. Front office systems should provide a secure and efficient platform for entering and pricing deals. A dealing mandate specifies the products. starting with recruitment and remuneration practices. as well as any other conditions such as practices when trading after hours. blinded by the lure of short-term profitability. The culture of the dealing room must be one in which dealers see risk management as a core competency. a management that allows such a culture to emerge. The escalation process for reporting and managing limit excesses should be clear and effective. Limits should encompass all risks and should be set at levels where a breach clearly signals that trading has taken place outside the agreed trading strategy. providing risk analytics and monitoring risk limit usage. And in the same way. The market risk management system must be robust and include regular reconciliations to ensure its completeness and accuracy. treasury dealers have responsibility for trading within their delegated mandate and for conducting their affairs. It should not be a crime to report ³bad news´ to the board! Such a culture is a recipe for turning small problems into big ones. For this reason. checking credit availability pre-dealing. Being independent of the dealers. with integrity and honesty.informed on emerging risk issues in the treasury portfolio. whose task it is to reconcile dealer profit and loss estimates with independent financial accounts. Integrated front office systems provide the ability to monitor limit usage on a real-time basis. Treasury dealers should have appropriate systems on the desk for pricing and processing deals and for monitoring positions against limits. Treasury dealers should have written dealing mandates that provide them with a clear understanding of their dealing authorities. Front-office Treasury dealers The front office is the first line of defence against risk in treasury operations. currencies. the middle office provides an objective view of front office activities and ensures that limits can be monitored and risk exposures removed from the business.

Any unusual activity should be escalated to senior management. The group provides an assurance that model outputs can be relied upon. There should also be a periodic review of pricing models. The middle office should have staff with sufficient skills and standing in the institution to be an effective counterbalance to the front office and to ensure the integrity of reporting and oversight of trading activities. dealers should not be able to change standard settlement instructions (SSI) nor advise the back office of changes to SSI. the finance area should calculate profit and loss for trading activities and compare the figures with dealers¶ estimates. It is important that the conditions imposed on products be monitored on a regular basis by the middle office or the quantitative support group. The back office should be alert to large and unusual trades as well as unusual amendments to trades and/or frequent cancellation of trades. The middle office should not be lagging behind the front office in terms of investment in systems. The back office ensures that the deal information reported by the middle office is complete and accurate. weakening the effectiveness of the risk management framework.model approved by the board. should regularly review the model assumptions and parameters. particularly in escalating limit breaches. it is essential that the middle office not be the ³poor cousin´ at budget time. There should be strict controls around deal amendment and cancellation. settlement and payment functions and may also handle financial accounting and regulatory reporting. to ensure accuracy. Quantitative support should be actively involved in the development of new products and provide a sign-off before the products are recommended to the board for approval. The area must have clear reporting lines. In addition. Senior dealing management should not have any disproportionate influence over the budget of market risk and support areas. Ideally. Trading positions should be marked-to-market daily and revaluation rates must be provided independently of the front office. the area should also have the authority to require risk positions to be reduced when dealers are in breach of limits. including stress testing scenarios. we would expect to see a revaluation committee which continually reassesses the appropriateness of the source of revaluation rates and of assumptions and practices used. For example. Back office support Back office support is responsible for ensuring the integrity of deal confirmation. To be fully effective. On a daily basis. Back testing of the model should be performed regularly to ensure that the model remains valid. there should be a daily validation of rates in the form of stale price checks and checks for large and unusual movements. Quantitative support A number of institutions maintain a quantitative support group to develop and/or independently validate complex models used by the front office for pricing and by the middle office for risk management. particularly around the end of day and other key financial reporting periods. people and processes to measure and manage the risks in existing and new trading activities. For complex trading environments. they might also suggest conditions to be imposed on the pricing models involved. Differences should be reconciled and unexplained THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 8 .

and resolved quickly. Where there are trading activities across multiple branches. Risk management works most effectively when an enterprise risk management approach is used. All risks across a financial institution have to be managed together. risk management. support a process for managing risk across the financial institution. It must be emphasized that quantifying risk alone is not sufficient. Operational controls to ensure that the treasury function did not inadvertently threaten the rest of the organisation were a part of this control function. Though it should go without saying. Internal audit Internal audit is responsible for reviewing the effectiveness of people. Objective 4: y Summarise the principles of risk management. there should also be a reconciliation of internal and inter-company balance sheets and profit and loss accounts. For internal model users. and explain the importance of prudential control. In financial institutions. the primary risk management function is to develop. Only then will the risk management model be sufficient. RISK MANAGEMENT Management of risks has always been foremost in Treasury Management and the scope has been foremost in recent years due to the number of banks which has failed locally and internationally. source systems should be reconciled with the general ledger and internal balance sheet and profit and loss accounts should be reconciled. The financial Institution business units should have primary responsibility for and knowledge in managing risk in their own markets and products. the objective is to help identify and take advantage of varying opportunities to optimise risk-adjusted return on capital. and risk-management processes. An effective risk framework must be inclusive of stress-testing capabilities. internal audit provides assurance to the board that the front office. On a regular basis. a review of the overall risk management process should take place at regular intervals. both the back office and the finance function should be independent of the front office and be appropriately resourced. or have access to external qualified resources. implement and communicate a consistent framework. Treasuries require the ability to monitor and exercise control in order to ensure that the information on which dealing decisions were based are accurate. to be able to undertake regular reviews of treasury operations. However. The internal audit function should be adequately resourced. market risk and back office support areas are functioning effectively and that senior management is active in its risk oversight. Treasury Risk THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 9 .differences highlighted to risk management and senior management. They should manage both risk before an event and profit and loss after an event. systems and processes which comprise the treasury risk management framework. By virtue of its independence from executive management and its direct reporting line to the Board Audit Committee.

Forced Sale risk) Curve Risk. Settlement Risk . Market Risk. Maturity mis-match risk. A credit risk arises where there is a commercial contract between two parties in which one party has a future obligation to repay moneys to the other with the risk that those moneys will not be repaid or a settlement is deferred or rescheduled. Correlation risk. operational and reputational risk as well as credit risk. The results of those forecasts influence potential resources available to enable the vision of attainable goals for the enterprise. Basis risk. Option Specific risk. In each case it will result in a loss to the lender or a significant reduction in the margin on which the transaction was made. Financial Risk ± Credit Risk/Counterparty .the risk that the completion or settlement of a financial transaction will fail to take place as expected. Credit risk otherwise known as bank counterparty risk. THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 10 . Factors in such arrangements that have a bearing on credit risk include: the timing of the exchange of value. The main types of risk associated with treasury operations are. Price Risk (Interest rate risk. price indices. market.Treasury Risk is a subset of the overall risk profile of the institution. Most institutions forecast future interest rates. and related economic factors. payment/settlement finality. The level of risk is determined by the particular arrangements for settlement. equity. Settlement risk includes elements of liquidity. Treasury Risk first appears within the array of Expectation Risk elements. currency differentials. financial institutions around the world are exposed to a multiplicity of risks. Treasury Management is also the Management of Risks. and the role of intermediaries and clearing houses. currency risk.Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Movements in the rates of interests and volatility of exchange rates in an increasingly complex environment have made the process of managing risks a critical aspect of treasury management. is concerned with counterparty limits between banks and focusing on acceptable exposure levels. With the globalization of financial markets. earnings and investment returns.

It also includes other categories such as fraud risks. lending officers or other staff exceeding their authority or conducting business in an unethical or risky manner. by its dealers. Manufacturing process. Operational Risk includes legal risks ± but excludes reputational and strategic risks. It is a very broad concept which focuses on the risks arising from the people. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. Real estate. fraud.The ever present forces of globalization. systems and processes through which a company operates. Elasticity risk . Other aspects of operational risk include major failure of information technology systems or events such as major fires or other disasters. Such breakdowns can lead to financial losses through error.Liquidity Risk .the ratio of the percentage change in the price of a bank¶s product (such loans and deposits) and the percentage change in demand for that product. supply chain. Sales Risk ± Competition Risk . Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. Basel II regulations define Operational risk: as the risk of loss resulting from the inadequate or failed internal processes. legal risks. physical or environmental risks. and systems or from external events´. people. for example. or failure to perform in a timely manner or cause the interests of the bank to be compromised in some other way. technology. The relationship between THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 11 . and economic liberalization are combining to make life harder than ever for established entities. Physical Risk ± Physical Assets. Banks who are able to effectively lower their costs and possess a comparative advantage over their competitors will capture a greater market share.Liquidity risk is the current and prospective risk to earnings or capital arising from a bank¶s inability to meet its obligations when they come due without incurring unacceptable losses. The most important types of operational risk involve breakdowns in internal controls and corporate governance. Operational Risk ± is the risk arising from execution of a bank¶s business functions.

Political Risk ± Country Risk ± Relates to that associated with the credit afforded to the borrowers of a sovereign country. This may be realized by disruptions in a strategic operation or process. A financial institution¶s treasury function has grown in importance. Economic Risk . It includes the risk that a bank will not generate sufficient revenues to cover operating costs and to repay contractual obligations. the loss of key personnel. It is their duty to ensure that all types of risk are minimized and controlled. The aim of prudential control is to ensure the safety of depositors' funds and to ensure the stability of the financial system. Currency Policy. Control is the responsibility of senior management. Tax Risk. Predictive Risk ± Exists when banks use statistical analysis to predict future trends and behavior patterns. the change of a political regime. largely because of the complex nature of financial instruments traded across borders. not the regulatory authorities. and although a slice of the work carried out by the bank's internal control functions will include the implementation of the rules laid down under statute. notwithstanding the need to meet its legal requirements. THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 12 . and exploiting it to predict future outcomes. The risk arises out of the possibility that the borrowers in that sovereign country may be unwilling or unable to pay their debts. or natural disasters.movements in interest rates and service cost and the resultant impact on consumer demand.Includes Regulatory Risk. The core of predictive analytics relies on capturing relationships between explanatory variables and the predicted variables from past occurrences. the issue of internal prudential control should be high on the agenda. Prudential Controls The prudential control refers to the regulation of deposit-taking institutions and supervision of the conduct of these institutions and set down requirements that limit their risk-taking. Legal Risk Legal Risk arises from exposure that exists from being unable to enforce agreements that have been drawn up incorrectly. Strategic Risk . Catastrophe risk.Investment risk associated with the overall health of the economy of the country or locality in which the investment is made. emergence of a serious competitor on the market. When a predicted variable behaves contrary to ones expectation it generates risk to the banks operation.

They are mandated to achieve the entities financial goals and controlling financial risks. the Asset and Liabilities Committee (µALCO¶). but all focus closely on the activities of the dealing operations because this is where most of the risk lies in the form of the trading exposures. mix. plus the credit risks associated with the ability of counterparties to meet their commitments. The two ends of the extreme have so far been discussed .The internal control function varies from one bank to another in its form and its brief. Objective 6: y Discuss the reasons for and processes of internal controls. Risks that exist from volatile interest rates and exchange rates. In between these two areas of control are the limits within which traders are allowed to operate. Board of Directors The principal role of the board of directors is to determine strategy. cost and yield of the consolidated funds of the financial institution. in line with the principles determined by the board of directors. Asset and Liability Committee Often boards delegate the setting of the financial institution risk appetite relating to balance sheet exposure to a special formed Asset liability Management Committee (ALCO). can be difficult to predict. They set the terms and reference of the varying sub-committees in the institution and these committees remain responsible to the board. The areas that typically form part of such a function's responsibility are: THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 13 . and other risk committees. The risks that can be even more difficult to detect are those related to internal or third-party fraud. Within the internal control role specification there should therefore be a framework for the monitoring of transactions in order to detect fraud at an early stage. but they are part and parcel of trading. ALCO set the framework for treasury activities. The Internal Control Function Given that it is senior management's responsibility to prudently control the dealing operations of an international bank. directs and controls the flow. at the other end of the scale. and the integrity they must demonstrate in order not to place the bank in an exposed position. whether these be at the dealing stage or at the settlement stage. level. Objective 5: y Describe the functions of the board of directors. the risks associated with fraudulent activity. ALCO plans.the standard risks involved in running the business and. including the internal audit function. one would expect to see an internal control department specifically tasked with putting controls in to place.

but the need for it has been no better demonstrated than in the late 1980s. as far as the bank is concerned. If the Financial Services Commission (FSC) were to review the measures being undertaken by a bank to keep its own house in order it would expect to see: (a) (b) (c) Random audits. the FSC will observe the ability of the Jamaican banks to operate within their own guidelines or within the guidelines of the central bank. For example. do in reality exist.      To ensure compliance with directives and policies issued by senior management To devise and put into place controls To monitor performance against these controls To ensure the security of the company's assets To ensure the dealing and settlement functions operate efficiently To satisfy management and regulators that records are accurately kept Internal Audit Internal audit functions have important control functions. Random checks with counterparties to confirm that deals. At whatever stage the level of control has settled the internal control function will take responsibility for enforcement. What the banks are unable to control voluntarily the regulators will seize upon to put their control requirements into statute. The aim. is a common approach that convinces the central banks that self-regulation is exercised at such a level as to be satisfactory for their purpose. Sensible targets imposed on dealers in order to ensure that they are not tempted to compromise the bank in search of their optimistic profit targets. Objective 7: y Evaluate the functions of the compliance office. This in itself will keep the regulators at arm's length. The need to exercise caution and prudence in dealing operations has been around for as long as trading has existed. If they are not fully understood by the management then it is unlikely that awareness of the control requirements will exist either. Internal Audit will demonstrate to their senior managers and to the banking authorities that they are able to exercise the appropriate level of prudence. such as forward contracts. THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 14 . Its role is generally to monitor the appropriateness and effectiveness of a firm¶s systems and controls. If it is not then satisfied with the results of this level of intervention then statute can become a reality. The internal auditor would be expected to investigate unusual patterns of activity such as unusually high levels of business transacted with one particular third party. outside any regular audit cycle. or at least into a code of practice. 1990s and early 2000s when complex derivative instruments were embraced by the markets but not always fully understood across the dealing rooms and among managers.

or loss to reputation a bank may suffer as a result of its failure to comply with laws. Objective 8: y Evaluate the functions of financial markets. These functions are briefly listed below: THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 15 . a bank will be able to manage its compliance risk more effectively if it has a compliance function in place that is consistent with the ³compliance function principles´ in the paper. brokers. Failure to consider the impact of its actions on its shareholders. It concerns everyone within the bank and should be viewed as an integral part of the bank¶s business activities. The expression ³compliance function´ is used in the paper to describe staff carrying out compliance responsibilities. o Compliance function staff should have access to the information and personnel necessary to carry out their responsibilities. related selfregulatory organisation standards. investment banks. It will be most effective in a corporate culture that emphasises standards of honesty and integrity and in which the board of directors and senior management lead by example. and discuss the roles of participants in these markets.´ The expression ³compliance risk´ is defined in this paper as the risk of legal or regulatory sanctions. material financial loss. should not be placed in a position where there is a possible conflict of interest between their compliance responsibilities and any other responsibilities they may have. and investors. and at all times strive to observe the spirit as well as the letter of the law. and codes of conduct applicable to its banking activities (together. customers. employees and the markets may result in significant adverse publicity and reputational damage. y The bank¶s compliance function should be independent. financial markets facilitate borrowing and lending by facilitating the sale by newly issued financial assets. the head of compliance. o There should be a group compliance officer or head of compliance with overall responsibility for co-ordinating the management of the bank¶s compliance risk. market makers/dealers. In addition to enabling exchange of previously issued financial assets. ³compliance laws. credit institutions. it is not intended to prescribe a particular organisational structure. Nevertheless. it is not just the responsibility of specialist compliance staff. o Compliance function staff. rules. o The compliance function should have a formal status within the bank. namely exchanges and clearing houses. regulations. even if no law has been broken. A bank should hold itself to high standards when carrying on business. Financial markets serve six basic functions. A financial market is a market in which financial assets are traded.Basel Committee on Banking Supervision paper on Compliance and the compliance function in banks ³Compliance starts at the top. and in particular. rules and standards´). Compliance should be part of the culture of the organisation.

and back offices. 2. Transformation of maturities and provision of Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.1. Financial markets reduce risk through risk spreading or risk pooling. the segregation of duties between trading and settlement functions. Dealing activities are undertaken by both market makers and dealers. 6. and practicalities of. middle offices. Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers. In attempting to characterize the way financial markets operate. Major Players in Financial Markets Exchanges Credit Institutions Investment Banks Brokers Market makers/dealers Investors and issuers Objective 9: y Describe the processes involved in dealing rooms or front offices. one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured. Risk pooling is undertaken by spreading any risky investment across a sufficiently large number of lenders. 5. The difference is that market makers will quote prices on an almost continuous basis. Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes. Transformation of Risk: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments. Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets. while dealers will only be active in the market when it THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 16 . Front-office The term front-office is used for dealing activities. Financial intermediaries have the ability to hold assets that are less liquid than their liabilities. 4. and discuss the rationale for. 3. Transformation of transaction costs: Financial markets reduce transaction costs and information costs.

Market makers are needed to ensure a market exists while dealers add additional liquidity to a market. Developments in other markets may also affect prices and participants need to track of what market prices do to ensure that their own prices do not diverge without good reason from the market trend. 5. dealers and market makers will take into account existing demand and supply and how they are likely to change. THE FUNCTIONS OF A BANK¶S TREASURY AND PRUDENTIAL CONTROL 17 . Middle office functions: 1. maturity and settlement details. 5. Agree to the deal as it relates to price. Middle office functions: 1. amounts. Nostro accounts may also have to be reconciled. Confirmation received Payments are authorized Accounting records for funds or securities are reconciled with actual payments/deliveries. 3. 5. 4. Liaise with back-office Filter queries from the back-offices on deals. Margin payments may have to be made. 4. Back-office Sometimes the activities undertaken by back-offices are collectively known as settlement activities. 2. Making sure that accounting entries are correct. 2. Deal included into bank¶s accounting records Middle-office Middle offices arose from the need for improved risk management. if the dealer quotes prices. Prices will be either on a bid or offer basis. 3. 3. Check that the proposed deal does not breach the internal limits. A bid price is the price at which dealers are prepared to borrow or purchase. 6. The dealer then: 1. When determining prices. may be contacted by other market participants. A dealer may either initiate a deal or. 2. Once all the relevant details are agreed the deal has been done.suits them. Deal incorporated in the risk management systems of the bank. 4. Contact with dealers and market makers may be established via telephone or computer screen. Produce risk management reports Check for compliance with internal limits. The offer price is the price at which they are prepared to lend or sell. Details of deal input into the systems. Check valuations for inputting into integrated risk reporting. 6.