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1.1 Meaning & Definition In general terms and from the perspective of commercial banking, treasury refers to the fund and revenue at the possession of the bank and day-to-day management of the same. Idle funds are usually source of loss, real or opportune, and, thereby need to be managed, invested, and deployed with intent to improve profitability. There is no profit or reward without attendant risk. Thus treasury operations seek to maximize profit and earning by investing available funds at an acceptable level of risks. Returns and risks both need to be managed. If we examine the balance sheets of Commercial Banks, we find investment/deposit ratio has by far overtaken credit/deposit ratio. Interest income from investments has overtaken interest income from loans/advances. The special feature of such bloated portfolio is that more than 85% of it is invested in government securities. The reasons for such developments appear to be as under: Poor credit off-take coupled with high increase in NPAs. Banks' reluctance to cut-down the size of their balance sheets. Government's aggressive role in lowering cost of debt, resulting in high inventory profit to commercial banks. Capital adequacy requirements. The income flow from investment assets is real compared to that of loan-assets, as the latter is size ably a book-entry. In this context, treasury operations are becoming more and more important to the banks and a need for integration, both horizontal and vertical, has come to the attention of the corporate. The basic purpose of integration is to improve portfolio profitability, riskinsulation and also to synergize banking assets with trading assets. In horizontal integration,


dealing/trading rooms engaged in the same trading activity are brought under same policy, technological and accounting platform, while in vertical integration, all existing and diverse trading and arbitrage activities are brought under one control with one common pool of funding and contributions. Meaning: Treasury is the glue binding together liquidity management, asset/liability management, capital requirements and risk management. It has an increasingly important job to do. At one end of the spectrum it manages balance sheets and liquidity, and does good things to enhance the yield on assets and minimize the cost of liabilities, mostly through the clever and intelligent use of derivatives. At the other end of the spectrum, treasury can help restructure the balance sheet and provide new products. All banks have departments devoted to treasury management, as do larger corporations. Treasury management modules are available for many larger enterprise software systems. Banks do not disclose the prices they charge for Treasury Management products. Definition: Treasury management is the management of an organizations liquidity to ensure that the right amount of cash resources are available in the right place in the right currency and at the right time in such a way as to maximize the return on surplus funds, minimize the financing cost of the business, and control interest rate risk and currency exposure to an acceptable level. In other words,Treasury management (or treasury operations) includes management of an enterprise' holdings in and trading in government and corporate bonds, currencies, financial futures, options and derivatives, payment systems and the associated financial risk management.


1.2 Objectives of Study To have in-depth knowledge about the meaning of Treasury Management.

To know about the functions, organizational structure and objective of Treasury Management in Banks.

To understand the elements of Treasury Management and the functions of treasurer.

To understand the risk associated with Treasury Management and their mitigation.

To know what are the RBI guidelines formulated for Treasury Management.

To know the future scope involved in Treasury Management.

To have an in-depth knowledge of how SBI Bank & CITI Bank manages its treasury.

1.3 Scope of Study Treasury management includes the management of cash flows, banking, money market and capital-market transactions; the effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks. This definition is intended to embrace an organizations use of capital and project financings, borrowing, investment, and hedging instruments and techniques.


1.4 Review of Literature Abstract 1: treasury_transactions_and_e.pdf/ Managing of Treasury transactions in banking SystemWithin a multi currency economy Author: Nidal Rashid Sabri (2012) Diama K. Abulabn (2012) Dima W. Hanyia (2012) The Palestinian economy has no national currency which led to having three currencies in use for deposits, saving, wealth measurement and trade transactions. Thus leads to make challenges to the management of banking treasury activities and balances of each single currency in the Palestinian economy. Therefore, this research aimed to target this issue, using three research instruments. Three research instruments were used including: Examining the related laws, imposed by the PMA on banks working in Palestinian economy as well as individual banking regulations, structures interviews with banks treasurers, and a relevant questionnaires was directed to a selected samples of treasury staff and employees regarding challenges to the management of banking treasury and closeting of foreign currency positions. The study found that management of the banks working in the Palestinian economy imposed more strict levels then that imposed by PMA and decreased it to 1% to 3%, of the total owner equity instead of 5%, while others (42%) reduced the maximum permitted surplus of a currency to a value ranged between 200,000 US$ and 500,000 US$. For closing the surplus of currencies, the majority of banks close it in the last hour of working day. The majority of treasuries' staff strongly agreed that there is a need for additional legislation to cover all related transactions to facilitate the work of the treasury. The study recommended to relaxing the maximum ratio of 5% imposed on each single


currency to be hold more than blatancies, keeping the 20% level from owner equity to the total of currencies, extending the time of work including Fridays, reducing the restrictions on investments outside Palestine, permitting trading in options and future transactions including duke deposits and margins Abstract 2: A STUDY ON THE ROLE OF TREASURY MANAGEMENTON CURRENCY RISK MANAGEMENT: THE CASE OF SELECTED COMMERCIAL BANKS Author: Moremi Marwa: (2005) The increased volatility of the international foreign exchange market generates increased financial risk especially to commercial banks. Exchange rate change is one of the financial risks where the increased volatility is reflected to the greatest extent. Therefore, if banks are to measure, price, and control currency risk, they must establish an appropriate unit responsible for currency risk management. This paper attempts to show that, commercial banks in Tanzania have the necessary resources to curb risks associated to currency risks. This paper briefly provide some highlights on the research findings as regards to the role of treasury management in currency risk management and then poses recommendations and challenges on the magnitude of sustainability of the registered best practice for currency risk management in commercial banks. The study employed both primary and secondary data with a comparative case study orientation. Published financial statements and other desk materials were collected principally from selected banks. Interviews were also conducted with responsible treasury managers. There are various ways (economic, translation and transaction), that the bank can utilize in analyzing and setting the exchange rate risk management. In this study, transaction and translation exposure were the chosen methods of analysis. 1.5 Research Methodology 5


1.5.1 Formation of problem: To study the various treasury management operations & risk management techniques. 1.5.2 Methods of Collection of data: Gathering primary data through meeting key officials from the related area of Treasury Management, collecting view points from them to arrive at meaningful conclusion. Gathering secondary data from books, periodicals, publications, newspaper, survey reports, journals, websites, and internal website. Conducting interview with appropriate officials relating to the field of Treasury Management by designing appropriate questionnaires. 1.5.3 Research Limitation: Time allotted for making the project is very limited.


2.1 Organizational structure of treasury There is no standard structure for treasury department of a bank. Depending on the responsibilities assigned and power delegated, it can be aptly structured. Typically, banks maintain three independent tiers at the functional/operational levelTier I Dealing Desk (Front Office): The dealers and traders in different markets- money, stock, debt, commodity, derivatives and forex- operate in their respective areas. They are the first point if interface with other participants in the market. The number of dealers depends on the size and frequency of the operations. In case of larger in each bank, operations would be carried out by separate and independent set of dealers in each market. But, for a relatively smaller treasury, operations would be done by one or more dealers jointly in all the markets. Tier II Settlement Desk (Back Office): Once the deals are concluded, it is for the back office to process and settle the deals. Indeed, the back office undertakes settlement and reconciliation operations. Tier III Accounting, Monitoring and Reporting Office (Audit group): This department looks after the activities relating to accounting, auditing and reporting. Accountants record all deals in the books of accounts, while auditors and inspectors closely monitor all deals and transactions done by the front and the back office, and send regular reports to authorities concerned. This department independently inspects daily operations in the treasury department to ensure internal/regulatory system and procedures.


Head of Treasury

Chief Dealer

Market Intelligence Research and analysis

Head of Settlements

Head of Accounting Monitoring and Reporting


ManagerSettlements Documentation

Manager Settlements Custodian

Accounts/ Monitoring


Dealer- Rupee Money Market. Department

Dealer- Forex. Currency/ Investment

Dealer- Corpo Merchant/ Service

The three departments should be compartmentalized and they act independently. The heads of each section reports directly to the Head of the Treasury. A treasury can have more functional desk depending on the size and structure of the bank, and activities undertaken by the bank. 2.2 Functions of treasury department 8


Since 1990s, the prime movers of financial intermediaries and services have been the policies of globalization and reforms. All players and regulators had been actively participating, only with variation of the degree of participation, to globalize the economy. With burgeoning forex reserves, Indian banks and Financial Institutions have no alternative but to be directly affected by global happenings and trades. This is where; integrated treasury operations have emerged as a basic tool for key financial performance. A treasury department of a bank is concerned with the following functions: a) Reserve Management & Investment: It involves (i) meeting CRR/SLR obligations, (ii) having an appropriate mix of investment portfolio to optimise y ield and duration. Duration is the weighted average life of a debt instrument over which investment in that instrument is recouped. Duration Analysis is used as a tool to monitor the price sensitivity of an investment instrument to interest rate charges. b) Liquidity & Funds Management: It involves (i) analysis of major cash flows arising out of asset-liability transactions (ii) providing a balanced and welldiversified liability base to fund the various assets in the balance sheet of the bank (iii) providing policy inputs to strategic planning group of the bank on funding mix (currency, tenor & cost) and yield expected in credit and investment. c) Asset Liability Management & Term Money: ALM calls for determining the optimal size and growth rate of the balance sheet and also prices the Assets and liabilities in accordance with prescribed guidelines. Successive reduction in CRR rates and ALM practices by banks increase the demand for funds for tenor of above 15 days (Term Money) to match duration of their assets.

d) Risk Management: integrated treasury manages all market risks associated with a banks liabilities and assets. The market risk of liabilities pertains to floating interest 9


rate risk for assets & liability mismatches. The market risk for assets can arise from (i) unfavorable change in interest rates (ii) increasing levels of disintermediation (iii) securitization of assets (iv) emergence of credit derivates etc. while the credit risk assessment continues to rest with Credit Department, the Treasury would monitor the cash inflow impact from changes in assets prices due to interest rate changes by adhering to prudential exposure limits. e) Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed optimally, without sacrificing yield or liquidity. An integrated Treasury unit has as idea of the banks overall funding needs as well as direct access to various market ( like money market, capital market, forex market, credit market). Hence, ideally treasury should provide benchmark rates, after assuming market risk, to various business groups and product categories about the correct business strategy to adopt. f) Derivative Products: Treasury can develop Interest Rate Swap (IRS) and other Rupee based/ cross- currency derivative products for hedging Banks own exposures and also sell such products to customers/other banks. g) Arbitrage: Treasury units of banks undertake this by simultaneous buying and selling of the same type of assets in two different markets to make risk-less profits. h) Capital Adequacy: This function focuses on quality of assets, with Return on Assets (ROA) being a key criterion for measuring the efficiency of deployed funds. An integrated treasury is a major profit centre. It has its own P&L measurement. It undertakes exposures through proprietary trading (deals done to make profits out of movements in market interest/ exchange rates) that may not be required for general banking. i) Coordination: Banks do operate at more than one money market centers. All the centers undertake similar transactions with differing volumes. There is a need to coordinate the activities of these centers so that aberrations are avoided (situations 10


where one center is lending and the other one is borrowing at the same time). The task of coordination of foreign exchanges positions is no different. j) Control and Development: Treasury operates as the focal point of dealing operations. Dealing operations could include cash/spot, forward, futures, options, interest and currency liability swaps, forward rate agreements and the like. Treasury is the sole owner and performer of these transactions. k) Fraud Protection: The decade of nineties has witnessed more frauds in trading than banking books. The amount and variety of such embezzlements have been directly relatable to the operational level. The ground level task of this kind is to be undertaken at the treasury.

2.3 Elements of treasury management



2.3.1 Cash Reserve Ratio (CRR) The core business of banks is mobilizing the deposits and utilizing the same for credit accommodation. However, it should be taken into consideration that the banks are not allowed to use the entire amount for extending credit. In order to promote certain prudential norms for healthy banking practices, most of the developed economies require all banks to maintain minimum liquid and cash reserves. As such, banks are required to ensure that these statutory reserve requirements are met before directing on their credit plans. Maintenance of CRR As per the RBI Act 1934, Scheduled Commercial Banks are required to maintain with RBI an average cash balance, the amount of which shall not be less than three per cent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934. At present, effective from October 2,2004, the rate of CRR would be 5 per cent of the NDTL. Thus, all Scheduled Commercial Banks are required to maintain the prescribed Cash Reserve Ratio based on their NDTL as on the last Friday of the second preceding fortnight. With a view to providing flexibility to banks in choosing an optimum strategy of holding reserves depending upon their intra period cash flows, all Scheduled Commercial Banks are required to maintain minimum CRR balances upto 70 per cent of the total CRR requirement on all days of the fortnight with effect from the fortnight beginning December 28, 2002. If any Scheduled Commercial Bank fails to observe the minimum level of CRR on any day/s during the relevant fortnight, the bank will not be paid interest to the extent of one fourteenth of the eligible amount of interest, even if there is no shortfall in the CRR on average basis. Computation of Demand & Time Liabilities



Liabilities of a bank may be in the form of demand or time deposits or borrowings or other miscellaneous items of liabilities. 'Demand Liabilities' include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. Time Liabilities are those which are payable otherwise than on demand and they include fixed deposits, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held against letters of credit if not payable on demand, deposits held as securities for advances which are not payable on demand and Gold Deposits. Money at Call and Short Notice from outside the Banking System should be shown against Liability To Others. Loans/borrowings from abroad by banks in India will be considered as 'liabilities to others' and will be subject to reserve requirements. When a bank accepts funds from a client under its remittance facilities scheme, it becomes a liability (liability to others) in its books. The liability of the bank accepting funds will extinguish only when the correspondent bank honors the drafts issued by the accepting bank to its customers. Other Demand and Time Liabilities (ODTL) include interest accrued on deposits, bills payable, unpaid dividends, suspense account balances representing amounts due to other banks or public, net credit balances in branch adjustment account, any amounts due to the "Banking System" which are not in the nature of deposits or borrowing. Liabilities not to be included for NDTL computation The under-noted liabilities will not form part of liabilities for the purpose of CRR: 13


a) Paid up capital, reserves, any credit balance in the Profit & Loss Account of the bank, amount availed of as refinance from the RBI, and apex financial institutions like Exim Bank, IDBI, NABARD, NHB, SIDBI etc. b) Amount of provision for income tax in excess of the actual estimated liabilities. Amount received from DICGC (Deposit Insurance and Credit Guarantee Corporation) towards claims and held by banks pending adjustments thereof. d) Amount received from ECGC (Export Credit Guarantee Corporation) by invoking the guarantee. e) Amount received from insurance company on ad-hoc settlement of claims pending Judgment of the Court. f) Amount received from the Court Receiver. g) The liabilities arising on account of utilization of limits under Bankers Acceptance Facility h) Inter bank term deposits/term borrowing liabilities of original maturity of 15 days and above and upto one year with effect from fortnight beginning August 11, 2001. Change in CRR as RBI's Strategy In case of any shortfall banks generally tend to borrow from the call money market to meet the cash reserve ratio (CRR) requirements, which they should maintain with the Reserve Bank of India (RBI) every fortnight. When the Reserve Bank of India (RBI) cuts the CRR rates, the general expectation is that bankers would greet the news warmly as it provides them an opportunity to retain more funds, which could be used productively. However, taking into consideration the recent banking scenario the bankers consider it as a not very fruitful exercise, as the investment avenues are very minimal and highly risky in nature. Moreover, a decrease in CRR results into lesser funds to be locked up in RBIs vaults and further infusing greater funds into a system. When there is a fall in CRR, it increases money with the banks, which could then be used for productive purposes. However, the question that one needs to ask is "Why infuse more 14


money into a system which is already flush with liquidity? The main reason for high liquidity is increasing number of customers approaching banks to open up deposit accounts. Moreover, credit risk has always been present in the banking industry because of its very nature of business. This has gathered momentum in the recent past due to mounting nonperforming assets (NPAs). Almost all the banks are facing the problem of bad loans, burgeoning non-performing assets, thinning margins, etc. as a result of which, banks are little reluctant in granting loans to corporates. This results into a good liquidity position of commercial banks as deposits are showing a continuous increase whereas, mobilization of funds for productive purposes is much more restrictive in nature. Also, the bankruptcy of major corporates in recent past has added to their fear of possible non-recovery of advances. As such, as and when Reserve Bank of India (RBI) reduces the CRR, it further enhances loanable funds with the banks and reduces their dependence on the call and term money market. This will in turn reduce the call rates and the borrowing cost of the government. Thus the Impact of CRR cut as RBIs strategy creates a terribly uncomfortable situation from the banks point of view and Reserve Bank of India (RBI) further enhances its liquidity position, with no productive avenues available for investment purposes.



2.3.2 Statutory Liquidity Ratio (SLR) As per the B.R. Act, 1949 all Scheduled Commercial Banks, in addition to the average daily balance which they are required to maintain u/s 42 of the RBI Act, 1934, maintain1 a) In cash, or b) In gold valued at a price not exceeding the current market price, or c) In approved securities valued at a price as specified by the RBI from time to time an amount of which shall not, at the close of the business on any day, be less than 25 per cent or such other percentage not exceeding 40 per cent as the RBI may from time to time, by notification in gazette of India, specify, of the total of its demand and time liabilities in India as on the last Friday of the second preceding fortnight. At present, all Scheduled Commercial Banks are required to maintain a uniform SLR of 23% of the total of their demand and time liabilities in India. Computation of demand and time liabilities for SLR The procedure to compute total NTDL for the purpose of SLR is similar to the procedure followed for CRR purpose. However, it is clarified that Scheduled Commercial Banks are required to include inter-bank term deposits/ term borrowing liabilities of original maturities of 15 days and above and up to one year in 'Liabilities to the Banking System'. Similarly banks should include their inter-bank assets of term deposits and term lending of original maturity of 15 days and above and up to one year in 'Assets with the Banking System' Penalties If a banking company fails to maintain the required amount of SLR, it shall be liable to pay to RBI in respect of that default, the penal interest for that day at the rate of 3 per cent per annum above the bank rate on the shortfall and if the default continues on the next succeeding working day, the penal interest may be increased to a rate of 5 percent per annum above the Bank Rate for the concerned days of default on the shortfall.



3.1 Classification of investments The entire investment portfolio of the banks (including SLR securities and non-SLR securities) should be classified under three categories viz. Held to Maturity, Available for Sale and Held for Trading. However, in the balance sheet, the investments will continue to be disclosed as per the existing six classifications viz. a) Government securities, b) Other approved securities, c) Shares, d) Debentures & Bonds, e) Subsidiaries/ joint ventures and f) Others (CP, Mutual Fund Units, etc.). Banks should decide the category of the investment at the time of acquisition and the decision should be recorded on the investment proposals.

3.1.1 Held to Maturity



The securities acquired by the banks with the intention to hold them up to maturity will be classified under Held to Maturity.

Investment classified under Held to Maturity category need not be marked to market and will be carried at acquisition cost unless it is more than the face value. In such a case, the premium should be amortized over a period remaining to maturity.

The investments included under 'Held to Maturity' should not exceed 25 per cent of the banks total investments. But Sept 2004 onwards, RBI has revised this norm allowing banks to park up to 25% of their NDTL in the HTM category.

The following investments will be classified under Held to Maturity but will not be counted for the purpose of ceiling of 25% specified for this category: Re-capitalization bonds received from the Government of India towards their re-capitalization requirement and held in their investment portfolio. This will not include re-capitalization bonds of other banks acquired for investment purposes. (The funds that banks received in lieu of equity issued by the government were invested in government bonds i.e. recapitalisation bonds. The government serviced these bonds paying interest and banks, in turn, paid dividends to the government. recapitalisation bonds) Investment in subsidiaries and joint ventures. [A joint venture would be one in which the bank, along with its subsidiaries, holds more than 25% of the equity.]



3.1.2 Available for Sale & Held for Trading The securities acquired by the banks with intention to trade by taking advantage of the short-term price/interest rate movement will be classified under Held for Trading. The investments classified under Held for Trading category would be those from which the bank expects to make a gain by the movement in the interest rates/ market rates. These securities are to be sold within 90 days. The individual scrips in the Held for Trading category will be revalued at monthly or at more frequent intervals and net appreciation/depreciation under each classification will be recognized in income account. The book value of the individual scrip will be changed with revaluation. The securities which do not fall within the above two categories will be classified under Available for Sale The investments classified under Available for Sale category should be held for minimum period of 90 days. Individual scrips in the Available for Sale category will be marked to market at the year-end. The net depreciation under each classification should be recognized and fully provided and any appreciation should be ignored. The book value of the individual securities would not undergo any change after the revaluation The banks will have the freedom to decide on the extent of holdings under Available for Sale and Held for Trading categories. This will be decided by them after considering various aspects such as basis of intent, trading strategies, risk management capabilities, tax planning, manpower skills, capital position.



3.1.3 Shifting among categories 1. Banks may shift investments to/from Held to Maturity category with the approval of the Board of Directors once a year (beginning of the year). 2. Banks may shift investments from Available for Sale category to Held for Trading category with the approval of their Board of Directors/ ALCO/ Investment Committee. 3. Shifting of investments from Held for Trading category to Available for Sale category is generally not allowed. However, it will be permitted only under exceptional circumstances like not being able to sell the security within 90 days due to tight liquidity conditions, or extreme volatility, or market becoming unidirectional. Such transfer is permitted only with the approval of the Board of Directors/ ALCO/ Investment Committee. 4. Transfer of scrips from one category to another, under all circumstances, should be done at the acquisition cost/ book value/ market value on the date of transfer, whichever is the least, and the depreciation, if any, on such transfer should be fully provided for.



3.1.4 Investment Fluctuation Reserve (IFR) With a view to building up of adequate reserves to guard against any possible reversal of interest rate environment in future due to unexpected developments, banks are advised to build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the investment portfolio within a period of 5 years. IFR should be computed with reference to investments in two categories, viz., Held for Trading and Available for Sale. RBI GUIDELINES FOR NON- SLR INVESTMENTS Banks should prescribe minimum disclosure standards as a policy with Board approval, with regards to the investments made by the treasury department. Banks should ensure that their investment policies duly approved by the Board of Directors are formulated after taking into account the following aspects: The Boards of banks should lay down policy and prudential limits on investments in bonds and debentures including cap on unrated issues and on private placement basis, sub limits for PSU bonds, corporate bonds, guaranteed bonds, issuer ceiling, etc. Banks should make their own internal credit analysis and rating even in respect of rated issues and should not entirely rely on the ratings of external agencies The investments should be well diversified and there should be no concentration of risk. The banks should put in place proper risk management systems for capturing and analysing the risk in respect of these investments and taking remedial measures in time.



Due caution should be taken by the bank while investing in bonds, debentures of companies and should not invest in companies whose name appear in the Defaulters list. In case a director of a company, in which the bank wants to invest in, is in the Defaulters list, prior approval from the Board is required.

Direct investment in shares, convertible bonds and debentures etc: Banks are free to acquire shares, convertible debentures of corporates and units of equity-oriented mutual funds, subject to a ceiling of 5 per cent of the total outstanding domestic credit (excluding inter-bank lendings and advances outside India) as on March 31 of the previous year. Within the overall ceiling of 5 per cent for total exposure to capital market, the total investment in shares, convertible bonds and debentures and units of equity-oriented mutual funds by a bank should not exceed 20 per cent of its net worth. While making investment in equity shares etc., whose prices are subject to volatility, the banks should keep in view the following guidelines:

Underwriting commitments taken up by the banks in respect of primary issues through book building route would also be within the above overall ceiling. Investment in equity shares and convertible bonds and debentures of corporate entities.



3.2 Investment Options A large portion of the banks investment is made in debt instruments i.e. to the extent of 9095 % while investment in Equity amounts to hardly 5 % of banks portfolio. 3.2.1 Equity Market The Banks are permitted to invest in Equity within a limit set up by the RBI, the limit as of now is 5%. Though the cap is 5% many or almost all banks hardly invest 2-3% in equity. Now a days banks are also exploring investment opportunities in capital market through Mutual Funds. Investing in equity markets include areas like:

Individual companies scrips Index Derivatives (Futures, Options, Interest rate swaps, currency rate swaps, commodity)

Mutual Funds offer various products with varied risk levels related to capital market, which includes options like:

Equity Funds Growth Funds Sectoral Funds Balanced Funds Value Funds



3.2.2 DEBT MARKET Role of Debt Market The key role of the debt markets in the Indian Economy stems from the following reasons:

Efficient mobilization and allocation of resources in the economy Financing the development activities of the Government Transmitting signals for implementation of the monetary policy Facilitating liquidity management in tune with overall short term and long-term objectives.

Since the Government Securities are issued to meet the short term and long term financial needs of the government, they are not only used as instruments for raising debt, but have emerged as key instruments for internal debt management, monetary management and short term liquidity management. The returns earned on the government securities are normally taken as the benchmark rates of returns and are referred to as the risk free return in financial theory. The Risk- Free rate obtained from the G-sec rates are often used to price the other non-govt. securities in the financial markets. Participants in the Debt Market



Debt markets are mainly wholesale markets dominated by institutional investors, namely, Banks FIs Mutual funds Provident funds Insurance companies & Corporates.

Many of these participants are issuers of debt instruments.



VARIOUS DEBT INSTRUMENTS Debt instruments represent contracts whereby one party lends money to another on predetermined terms with regard to rate of interest to be paid by the borrower to the lender. In India, we use the term bond for debt instruments issued by central & state governments and public sector organizations and the term debentures issued by private corporate sector.

Short Term Debt Instruments CALL MONEY The call money market is a part of money market, where day-to-day surplus funds, mostly of banks, are traded. The call money market comprises an interbank call market, and the market between banks on one hand and security brokers and dealers on the other hand. The call money market is most liquid of all the money market segments and it is also the most sensitive barometer measuring the liquidity conditions prevailing in the financial markets. The call money is the money repayable on demand. The maturity of call loans varies between 1 to 14 days. The money that is lent for one day in the call money market is also known as overnight money. The term notice money also refers to the money lent in the call market, but a notice is served by the lender for payment in a day or two before payment date. Duration of notice money is similar to that of call money i.e. upto 14 days. The money that is lent for more than 14 days is referred to as term money. In call money market any amount could be lent or borrowed at an interest rate, which is acceptable to both borrower and lender. These loans are considered as highly liquid; as they are repayable on due date. Initially, banks were only permitted to deal in this market; it was then referred as Inter bank market. RBI acts as a regulator of the call money market, but neither borrows from nor lends to it. Participants



Scheduled commercial Banks (private sector, public sector and cooperative banks) Discount and Finance House of India (DFHI) Securities Trading Corporation of India Limited (STCI) Primary Dealers Financial Institutions Mutual Funds

Purpose The short-term mismatches arise due to variation in maturities. The banks borrow from this market to meet the Cash Reserve Ratio requirements, which they should maintain with RBI every fortnight. Money is borrowed in the call/notice market for short periods to discount commercial bills. Call Rates The interest paid on call loans is known as the call rates. Though the rate quoted in the market is annualized one, the rate of interest on call money is calculated on a daily basis. These rates vary from day to day, often from hour to hour. High rates indicate a tightness of liquidity in the financial system while low rates indicate an easy liquidity position in the market. The rate is largely subjected to influence by the forces of demand and supply for funds.




Government issues Treasury bills (T-bills) and dated securities as a means to raise funds, in the short term and long term markets respectively. T-bills constitute a major portion of shortterm borrowings by the Government of India. T-bills are issued in the form of promissory notes or finance bills (a bill which does not arise from any genuine transaction in goods is called a finance bill) by the government to tide over short-term liquidity shortfalls. These short-term instruments are highly liquid and virtually risk free as they are issued by the government. They are the most liquid instruments after cash and call money, as repayment guarantee is given by the central government. Tbills do not require any grading or further endorsement like ordinary bills, as they are claim against the Government. These instruments have distinct features like zero default risk, assured yield, low transaction cost, negligible capital depreciation and eligible for inclusion in SLR and easy availability, etc. apart from high liquidity. Issuer The RBI acts as a banker to the Government of India. It issues T-bills and other government securities to raise funds on behalf of Government of India, by acting as an issuing agent. Investors Though various groups of investors including individuals are eligible to invest, the main investor found in T-bills are mostly banks to meet their SLR requirements. Other large investors include: Primary Dealers Financial Institutions (for primary cash management) Provident Funds (PFs) Insurance Companies Non-banking Finance Companies (NBFCs) 28


Foreign Institutional Investors (FII) State Governments. NRIs and OCBs are allowed to invest only on non-repatriable basis.

Purpose T-bills are raised to meet the short-term requirements of Government of India. As the Governments revenue collections are bunched and expenses are dispersed, these bills enable the Government to manage cash positions in a better way. T-bills also enable the RBI to perform Open Market Operations (OMO), which indirectly regulate money supply in the economy. Banks prefer T-bills because of high liquidity, assured returns, no default risk, no capital depreciation and eligibility for statutory requirements. Size The T-bills are issued for a minimum amount of Rs. 25000 and in multiples of 25000. Tbills are issued at discount and redeemed at par. Types T-bills are issued at various maturities, generally upto one year. Thus they are useful in managing short-term liquidity. They are: 91-day T-bills - 91-day T-bill- maturity is in 91 days. Its auction is on every Wednesday of every week. The notified amount for this auction is Rs. 250 cr.



364-day T-bills - 364-Day T-bill- maturity is in 364 days. Its auction is on every alternate Wednesday (which is a reporting week). The notified amount for this auction is Rs. 750 cr.

Categorization of T-Bills based on the nature of issue Ad hoc Treasury bills: These are issued in favor of the RBI when Government needs cash. They are neither issued nor available to the public. On Tap Treasury bills: RBI issues on-tap T-bills to investors on any working day. They have a maturity of 91 days. Auctioned Treasury bills: Various T-bills are auctioned on different days. The RBI issues a calendar of T-bill auctions. RBI also announces the exact date of auction, the auction amount and the dates of payment. The bids are tendered and accepted at the auction.



T-Bills Issuance Treasury bills are sold through an auction process, in which banks and primary dealers are major bidders. Non-competitive bids are allowed in the auction, in which provident funds and other investors can participate. Non- competitive bidders need not quote the rate of yield at which they desire to buy the T-bills. The Reserve Bank of India allots bids to the noncompetitive bidders at the weighted average yield arrived at, on the basis of the yield quoted by accepted competitive bid at the auction. Allocation to non-competitive bids is outside the amount notified for sale. Non-competitive bidders therefore do not face any uncertainty in purchasing the desired amount of T-bills from the auctions. The RBI issues a calendar of TBills auctions. The system of underwriting the T-bills by the PDs has been replaced by a system of minimum bidding commitment. Each PD is required to make a minimum commitment for auction of T-bills so that they together absorb 100% of the notified amount. Both discriminatory and uniform method is used for issuance. Auctions for 91-day T-bills are uniform price auctions where all successful bidders have to pay the cut-off price. Therefore, in 91-day T-bill auctions, the weighted average is same as the cut-off price. In case of all other bills, discriminatory auction is followed, where all the successful bidders have to pay the prices at which they had bid for. Subsidiary General Ledger (SGL) A/C: SGL A/C is a facility provided by RBI to large banks and financial institutions to hold their investments in Government securities and T- bills in electronic book entry form. Such entities can settle their trades in securities held in SGL a/c through delivery versus payment (DVP) mechanisms, which ensures moment of funds and securities simultaneously .As all investors do not have access to the SGL system, RBI has permitted such investors to hold their securities in physical certificate form. They may also open an SGL a/c with any such entity approved by RBI for this purpose, and thus avail of the DVP settlement system. Such client accounts are also referred as Constituent SGL A/C. 31


Both buyer and the seller have to maintain a Current a/c with the RBI and no overdraft facility will be provided.

RBI GUIDELINES All the transactions put through by a bank, either on outright basis or ready forward basis and whether through the mechanism of Subsidiary General Ledger (SGL) Account or Bank Receipt (BR), should be reflected on the same day in its investment account and, accordingly, for SLR purpose wherever applicable. Purchase/ sale of any securities will be done through SGL A/c under the Delivery Versus Payment (DVP) System. All transactions in Govt. securities for which SGL facility is available should be put through SGL A/cs only. Under no circumstances, a SGL transfer form issued by a bank in favour of another bank should bounce for want of sufficient balance of securities in the SGL A/c of seller or for want of sufficient balance of funds in the current a/c of the buyer. The SGL transfer form received by purchasing banks should be deposited in their SGL A/cs. immediately i.e. the date of lodgement of the SGL Form with RBI shall be within one working day after the date of signing of the Transfer Form. SGL transfer forms should be signed by two authorised officials of the bank whose signatures should be recorded with the respective PDOs (Public Debt Office) of the Reserve Bank and other banks. Any bouncing of SGL transfer forms issued by selling banks in favour of the buying bank, should immediately be brought to the notice of the Regional Office of Department of Banking Supervision of RBI by the buying bank. If a SGL transfer form bounces for want of sufficient balance in the SGL A/c, the following penal action against it is taken: 32


In case of any default arising in the current a/c, such amount will be penalised by the RBI @ of 3 % above the Discount and Finance House of Indias (DFHI) call money lending rate of that day. And if this rate is lower than the PLR than the penal rate would be 3 % above the current PLR.

If the bouncing of the SGL form occurs thrice, the bank will be debarred from trading with the use of the SGL facility for a period of 6 months from the occurrence of the third bouncing. If, after restoration of the facility, any SGL form of the concerned bank bounces again, the bank will be permanently debarred from the use of the SGL facility in all the PDOs of the Reserve Bank.



COMMERCIAL PAPERS (CPs) Commercial Papers (CPs) are short-term unsecured usance promissory notes issued at a discount to face value by reputed corporates with high credit rating and strong financial background. Companies issue CPs typically to finance accounts receivable and inventories at a discount reflecting the prevailing market interest rates. Issuers: private sector Co., public sector unit, non-banking Co., primary dealers. Commercial Papers are open to individuals, corporates, NRIs and banks, but NRIs can invest on non-repatriable / non-refundable basis. FIIs have also been allowed to invest their short-term funds in Commercial Papers. CPs have a minimum maturity of 15 days and a maximum maturity of 1 year. They are available in the denomination of Rs. 5 lakh and multiples of 5 lakh and a minimum investment is Rs. 5 lakh per investor. Secondary market trading takes place in the lot in lots of Rs.5 lakh each usually by banks. The transfer is done by endorsement and delivery. CPs are issued only if the total cost is lower than PLR of banks. The features of CPs are: 1. They do not originate from specific trade transactions like commercial bills. 2. They are unsecured. 3. Involve much less paper work. 4. Have high liquidity. CPs are issued at a discount to the face value. The issue price is calculated as below. P = Face value / (1 + D * (N / 365)) Where, F= Face/Maturity value D= Discount Rate P = Issue price of the CP N = Usance period (No. of days)



Types of Papers Commercial paper can be issued either directly or through a dealer. If the paper is issued by the company directly to the investors without dealing with an intermediary, it is referred as direct paper. If CPs is issued by an intermediary (i.e. dealer / merchant banker) on behalf of its corporate client, it is known as dealers paper. In India, the CPs are usually placed with the investors with the help of Issuing & Paying Agents (IPA). Only scheduled banks can act as IPAs.



CERTIFICATE OF DEPOSIT (CDs) Certificate of Deposit (CDs) are usance promissory notes, negotiable and in marketable form bearing a specified face value and number. Scheduled commercial banks and the major financial institutions can issue CDs within the umbrella limit fixed by RBI. Individuals, corporate, companies, funds, associations, trusts and NRIs are the main investors in the CDs (on non-repatriable basis). CDs are issued for a period of 14 days to one year (normally one to three years by the financial institutions) at a minimum amount of Rs. 5 lakh and in multiples of Rs.5 lakhs thereafter with no upper limit. There is no specific procedure to issue CDs. It is available, on tap, with the bankers. CDs are the largest money market instruments traded in dollars. They are issued by either banks or depository institutions, mostly in bearer form enabling trading in the secondary market. The features of CDs are:

It is title document to a time deposit, riskless, liquid and highly negotiable and marketable. It is issued at a discount to the face value. It is freely transferable by endorsement and delivery. CDs are maturity-dated obligations of banks forming a part of time liabilities, and are subjected to usual reserve requirements. It does attract stamp duty. CDs issued are within the limit as specified by Reserve Bank of India (in case of FIs only). CDs are also issued in demat forms. Thus various advantages of dematerialization can be availed.



The benefits of issuing CDs to the bank are:

Interest can be determined on a case-to-case basis. There is early maturity of a CD Rates are more sensitive to call rates.

Discount CDs are issued at a discount to the face value. Bank CDs are always discount bills, while CDs of DFIs (Development Financial Institutions) can be coupon bearing as well. The discount rate is calculated as follows: DR = F 1 + (I * N) 100*365 Where: DR =Discounted Rate F=Face Value N=Issuance period I=Effective Interest rate per annum



BILL FINANCING Monetary policy and Bill financing refers to the use of the official instruments under the control of the Central Bank of the country to regulate the availability, cost and use of money and credit. The bank standard rate is the rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchases. A bill of exchange has been defined as an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or to the bearer of the instrument. Bills of exchange can be classified as demand or usance bills, documentary or clean bills, D/A or D/P bills, inland or foreign bills, supply bills or government bills or accommodation bills. Bills can also be classified as traders bills, bills with co-acceptance, bills accompanied by letter of credit and drawee bills. Originally discounted bills can be rediscounted by banks for their corporate clients with financial institutions, as long as such bills arise out of genuine trade transactions. RBI has instructed the banks to restrain from rediscounting bills outside the consortium of banks and initially discounted by finance companies and merchant bankers. Further discounting should be only for the purpose of working capital / credit limits and for the purchase of raw materials / inventory. Accommodation bills are not to be discounted under any circumstances. The specific features of a negotiable instrument are:

There must be three parties to the exchange, namely drawer, drawee and payee. found in the bills of exchange It should be duly signed by the drawer and presented to the drawee for acceptance. 38




REPOS & REVERSE REPOS Repo is a money market instrument, which enables collateralized short term borrowing and lending through sale/ purchase of debt instruments. Under a repo transaction, the seller of the instrument enters into an agreement with the buyer to repurchase the instrument at a predetermined price and date. A repo is also called as a Ready Forward transaction as it is a means of funding by selling a security on spot and repurchasing the same on a forward basis. The main objective of trading in Repos is to meet temporary short-term liquidity requirements in the short-term money market. For the lender of cash, the securities offered by the borrower serve as a collateral; whereas for the lender of securities, the cash borrowed serves as a collateral. Repos, thus are called as collateralized short term borrowings. The lender of the securities (borrower of cash) is said to be doing a repo, whereas the lender of cash (borrower of securities) is said to be doing a reverse repo. A reverse repo is a mirror image transaction of a repo. In this transaction, the investor purchases with an agreement to resell the securities. Hence, whether a transaction is a repo or a reverse repo depends on who initiated the first leg of the transaction. One factor which encourages an organization to enter into a reverse repo is to earn some extra income on its idle cash. Though there is no restriction on the maximum duration for a repo, generally repo transactions do not exceed 14 days. It is essential for the participants of the repo market to hold SGL & current accounts with the RBI. Repo transactions are also reported on the WDM segment of the NSE.

Consider the following eg: 40


Trade date: 13th July 2004 Trade price: 108.5 Total Face value: Rs.100 *1000 = 100000 Security: 9.5 %, maturing on 22nd March 09 Repo rate: 4.5 % Repo term: 2 days First leg: On 13th July the seller of the repo (borrower of cash) receives the following amount: Value of the security: 108.5/100*100000 =108,500.00 Accrued interest: 9.5/100 * 100000* 112 / 360 = 2955.56 Settlement amount: 108500 + 2955.56 = 111455.56 Second leg: On 15th July (repo term is 2 days), the seller returns the following amount: Original borrowing: 108,500.00 Accrued interest: 9.5/100 * 100000 * 114 / 360 = 3008.33 Repo interest: 4.5 /100 * 100000 * 2/360 = 25 Settlement amount: 108500 + 3008.33 + 25 = 111533.33




Ready forward contracts may be undertaken only in (i) Dated Securities and Treasury Bills issued by Government of India and (ii) Dated Securities issued by State Governments.

Ready forward contracts in the securities specified above may be entered into by a banking company, a co-operative bank or any person maintaining a Subsidiary General Ledger Account with Reserve Bank of India, Mumbai.

Such ready forward contracts shall be settled through the Subsidiary General Ledger Accounts of the participants with Reserve Bank of India or through the Subsidiary General Ledger Account of the Clearing Corporation of India Ltd. with Reserve Bank of India, and

No sale transaction shall be put through without actually holding the securities in the portfolio.



LONG-TERM DEBT INSTRUMENTS By convention, these are instruments having a maturity exceeding one year. The main instruments are Government of India dated securities (GOISEC), State Government securities (state loans), public sector bonds (PSU bonds), corporate debentures etc. Most of these are coupon bearing instruments i.e. interest payments (called coupons) are payable at pre specified dates called "coupon dates". At any given point of time, any such instrument has a certain amount of accrued interest with it i.e. interest, which has accrued (but is not due) calculated at the "coupon rate" from the date of the last coupon payment. E.g. if 30 days have elapsed from the last coupon payment of a 14% coupon debenture with a face value of Rs 100, the accrued interest will be 100*0.14*30/365 = 1.15 Whenever coupon-bearing securities are traded, by convention, they are traded at a base price with the accrued interest separate; in other words, the total price would be equal to the summation of the base price and the accrued interest. A brief description of these instruments is as follows: Government of India dated securities (GOISECs): Like treasury bills, GOISECs are issued by the Reserve Bank of India on behalf of the Government of India. These form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget). They are issued in dematerialized form but can be issued in denominations as low as Rs 100 in physical certificate form. They have maturity ranging from 1 year to 30 years. Very long dated securities i.e. those having maturity exceeding 20 years were in vogue in the seventies and the eighties while in the early nineties, most of the securities issued have been in the 5-10 year maturity bucket. Very recently, securities of 15 and 20 years maturity have been issued.



Like T-Bills, GOISECs are most commonly issued in dematerialized form in the "SGL" account although it can be issued in physical certificate form on specific request. Tradability of physical securities is very limited. The SGL passbook contains a record of the holdings of the investor. The RBI acts as a clearing agent for GOISEC transactions by being the custodian and operator of the SGL account. GOISECs are transferable by endorsement and delivery for physical certificates. Transactions of securities held in SGL form are effected through SGL transfer notes. Transfer of GOISECs does not attract stamp duty or transfer fee. Also no tax is deductible at source on the coupon payments made on GOISECs. Like T-Bills, GOISECs are issued through the auction route. The RBI pre specifies an approximate amount of dated securities that it intends to issue through the year. However, it has broad flexibility in exceeding or being under that figure. Unlike T-Bills, it does not have a pre set timetable for the auction dates and exercises its judgement on the timing of each issuance, the duration of instruments being issued as well as the quantum of issuance. Sometimes the RBI specifies the coupon rate of the security proposed to be issued and the prospective investors bid for a particular issuance yield. The difference between the coupon rate and the yield is adjusted in the issue price of the security. On other occasions, the RBI just specifies the maturity of the proposed security and prospective investors bid for the coupon rate itself. In either case, just as in T-Bills, the auction is conducted on a French auction basis. Also, the RBI has wide latitude in deciding the cut off rate for each auction and can end up with unsold securities, which devolve on itself. Apart from the auction program, the RBI also sells securities in its open market operations (OMO), which it has acquired in devolvements or sometimes directly through private placements. Similarly, it also buys securities in open market operations if it feels fit.



New types of GOISECs Earlier, the RBI used to issue straight coupon bonds i.e. bonds with a stated coupon payable periodically. In the last few years, the RBI has been innovative and new types of instruments have also been issued. These include: Inflation linked bonds: These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate. Zero coupon bonds: These are bonds for which there is no coupon payment. They are issued at a discount to face value with the discount providing the implicit interest payment. State government securities (state loans): These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year, which is decided in consultation with the planning commission. Though there is no central government guarantee on these loans, they are deemed to be extremely safe since the RBI debits the overdraft accounts of the respective states held with it for payment of interest and principal. Generally, the coupon rates on state loans are marginally higher than those of GOISECs issued at the same time. The procedure for selling of state loans, the auction process, allotment procedure & transfer is similar to that for GOISEC. They also qualify for SLR status and interest payment and other modalities are similar to GOISECs. They are also issued in dematerialized form and no stamp duty is payable on transfer. In general, state loans are much less liquid than GOISECs. Primary Issuance Process of G-Secs RBI announces the auction of G-Secs through a press notification and invites bids. The sealed bids are opened at an appointed time, and the allotment is based on the cut-off price decided by the RBI. Successful bidders are those that bid at a higher price than the cut-off price. The two choices in treasury auctions widely used are: 45


1. Discriminatory Price Auctions (French Auction) 2. Uniform Price Auction (Dutch Auction) In both these type of auctions, the winning bids are those that exhaust the amount on the offer, beginning at the highest quoted price (or lowest quoted yield). However, in a uniform price auction, all successful bidders pay a uniform price, which is usually the cut-off price. In case of the discriminatory price auction, all successful bidders pay the actual price they had bid for. If successful bids are decided by filling up the notified amount from the lowest bid upwards, such an auction is called a yield-based auction. In such an auction, the name of the security is the cut-off yield. Such auction creates a new security with a distinct coupon rate every time an auction is completed. For example, a 10.3% G-Sec 2010 derives its name from the cut-off yield i.e. 10.3%, which becomes the coupon payable on the bond. The coupon payment and redemption dates are unique for each security depending on the deemed date of allotment of the securities auctioned. If successful bids are filled up in terms of the prices bid by the participants, from the highest bid downwards, such an auction is called a price-based auction. A price-based auction facilitates the re-issue of an existing security. The coupon rate and the dates of payment of coupons and redemption are already known. RBI moved from the yield-based auction to price-based auction in 1998, in order to enable consolidation of G-Secs through re-issue of existing securities. The RBI has the authority to shift to yield-based auctions and notify the same in the auction notification. GUIDELINES ON TRANSACTIONS IN GOVERNMENT SECURITIES In the light of fraudulent transactions in the guise of Government securities transactions in physical format by a few co-operative banks with the help of some broker entities, it has been decided to accelerate the measures for further reducing the scope of trading in physical forms. These measures are as under: For banks, which do not have SGL account with RBI, only one CSGL account can be opened.



In case the CSGL accounts are opened with a scheduled commercial bank, the account holder has to open a designated funds account (for all CSGL related transactions) with the same bank.

The entities maintaining the CSGL / designated funds accounts will be required to ensure availability of clear funds in the designated funds accounts for purchases and of sufficient securities in the CSGL account for sales before putting through the transactions.

No transactions by the bank should be undertaken in physical form with any broker.

Banks should ensure that brokers approved for transacting in Government securities are registered with the debt market segment of NSE/BSE/OTCEI.

Public Sector Undertaking Bonds (PSU Bonds): These are long-term debt instruments issued by Public Sector Undertakings (PSUs). They have maturities ranging between 5-10 years and they are issued in denominations (face value) of Rs1000 each. Most of these issues 47


are made on a private placement basis to a targeted investor base at market determined interest rates. These PSU bonds are transferable by endorsement and delivery and no tax is deductible at source on the interest coupons payable to the investor (TDS exempt). In addition, from time to time, the Ministry of Finance has granted certain PSUs, an approval to issue limited quantum of tax-free bonds i.e. bonds for which the payment of interest is tax exempt in the hands of the investor. This feature was introduced with the purpose of lowering the interest cost for PSUs which were engaged in businesses which could not afford to pay market determined rates of interest e.g. Konkan Railway Corporation was allowed to issue substantial quantum of tax free bonds. Bonds of Public Financial Institutions (PFIs): Apart from public sector undertakings, Financial Institutions are also allowed to issue bonds, that too in much higher quantum. They issue bonds in 2 ways through public issues targeted at retail investors and trusts and also through private placements to large institutional investors. Usually, transfers of the former type of bonds are exempt from stamp duty while only part of the bonds issued privately have this facility. On an incremental basis, bonds of PFIs are second only to GOISECs in value of issuance. Corporate debentures: These are long-term debt instruments issued by private sector companies. These are issued in denominations as low as Rs 1000 and have maturities ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities. Generally, debentures are less liquid as compared to PSU bonds and the liquidity is inversely proportional to the residual maturity.

Bond Issuance Board meeting and approval of issue as an ordinary resolution at the AGM 48


Credit rating of the issue (mandatory in case of a public issue) Creation of security for the bond /debenture through appointment of debenture trustees (period greater than 18 months) Appointment of advisors and investment bankers for issuance management Finalizations of the initial terms of the issue Preparation of the offer document (for public issue) and Information memorandum (for private placement.) SEBI approval for the offer document of the issue Listing agreement with Stock Exchanges Offer the issue to prospective investors and/or book-building Acceptance of the application money/advance deposit for the issue Allotment of the issue Issue of letters of allotment and certificate / Depository conformation Collect final amount from the investors Refund excess application money / interest on application money.

A key feature that distinguishes debentures from bonds is the stamp duty payment. Debenture stamp duty is a state subject and the quantum of incidence varies from state to state. There are two kinds of stamp duties levied on debentures viz issuance and transfer. Issuance stamp duty is paid in the state where the principal mortgage deed is registered. Over the years, issuance stamp duties have been coming down and are reasonably uniform. Stamp duty on transfer is paid to the state in which the registered office of the company is located. Transfer stamp duty remains high in many states and is probably the biggest deterrent for trading in debentures resulting in lack of liquidity. Pass Through Certificates (PTCs): Pass through certificate is an instrument with cash flows derived from the cash flow of another underlying instrument or loan. Most commonly, they have been issued by foreign banks like Citibank on the basis of their car loan or 49


mortgage/housing loan portfolio. The issuer is a special purpose vehicle, which just receives money from a multitude of (may be several hundreds or thousands) underlying loans and passes the money to the holders of the PTCs. This process is called securitization. Legally speaking PTCs are promissory notes and therefore tradable freely with no stamp duty payable on transfer. Most PTCs have 2-3 year maturity because the issuance stamp duty rate of 0.75% makes shorter duration PTCs unviable.

RBI GUIDELINES FOR INVESTMENT BY BANKS The Reserve Bank of India has issued guidelines on classification, valuation and operation of investment portfolio by banks from time to time as detailed below: Investment Policy i) While framing the investment policy, the following guidelines are to be kept in view by the banks; (a) No sale transactions should be put through without actually holding the security in its investment account. However, banks successful in the auction of primary issue of Government securities, may, enter into contracts for sale of the allotted securities. (b) The brokerage on the deal payable to the broker, if any, should be clearly indicated on the notes/ memoranda put up to the top management seeking approval for putting through the transaction and a separate account of brokerage paid, broker-wise, should be maintained. For engagement of brokers to deal in investment transactions, the banks should observe the following guidelines Transactions between one bank and another bank should not

be put through the brokers' accounts.



If a deal is put through with the help of a broker, the role of the broker

should be restricted to that of bringing the two parties to the deal together. While negotiating the deal, the broker is not obliged to disclose the

identity of the counterparty to the deal. On conclusion of the deal, he should disclose the counterparty and his contract note should clearly indicate the name of the counterparty. warranted A disproportionate part of the business should not be transacted through With the approval of their top managements, banks should prepare a

panel of approved brokers which should be reviewed annually, or more often if so

only one or a few brokers. Banks should fix aggregate contract limits for each of the approved brokers. A limit of 5% of total transactions (both purchase and sales) entered into by a bank during a year should be treated as the aggregate upper contract limit for each of the approved brokers. However, if for any reason it becomes necessary to exceed the aggregate limit for any broker, the specific reasons therefore should be recorded, in writing, by the authority empowered to put through the deals. Further, the board should be informed of this, post facto. However, the norm of 5% would not be applicable to banks dealings through Primary Dealers. The concurrent auditors who audit the treasury operations should

scrutinize the business done through brokers also and include it in their monthly report to the Chief Executive Officer of the bank

(c) Banks desirous of making investment in equity shares / debentures should observe the following guidelines: Formulate a transparent policy and procedure for investment in shares, etc., with the approval of the Board. 51


The decision in regard to direct investment in shares, convertible bonds and debentures should be taken by the Investment Committee set up by the banks Board. The Investment Committee should be held accountable for the investments made by the bank.

(d) A copy of the Internal Investment Policy Guidelines, duly framed by the bank with the approval of its Board, should be forwarded to the Reserve Bank certifying that the same is in accordance with the RBI guidelines and that, the same has been put in place. While laying down such investment policy guidelines, banks should strictly observe Reserve Bank's detailed instructions on the following aspects :



Yield is the return you actually earn on the bond-based on the price you paid and the interest payment you receive. Yield refers to the percentage rate of return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note. There are many different kinds of yields depending on the investment scenario and the characteristics of the investment. T-bills do not carry a coupon rate, but they are issued at a discount. Though the yields on Tbills are less when compared to other money market instruments, the risk averse banks prefer to invest in these securities. Yields on T-bills are considered as benchmark yields. It is considered as a representative of interest rates in the economy in general, while arriving at the interest rate or yield or any short-term instruments. Eg: The yield is calculated on the basis of 365 days a year. If the face value of a 364-day Tbills is Rs.100, and if the purchase price is 88.24 for a T-bills, then the yield is calculated as below:

Days * Yield 365

+ 1 =

Face value Price

Yield =

100 88.24

1 *

365 = 13.36 % 364



4.1 Types of yield There are basically three types of bond yields you should be aware of: current yield, yield to maturity & yield to call. Current yield (CY) Current yield is the yield on the debt instrument based on the current market price. It is actually the return you earn on the instrument, if you purchase the instrument at the current market price. It is calculated as follows: CY = Coupon payment ---------------------Current market price Current Yield is the coupon divided by the Market Price and gives a fair approximation of the present yield. Again the thumb rule is that if the CY is more than the required rate of return, invest in the instrument otherwise not. Therefore, Current Yield = Coupon of the Security (in %) x Face Value of the Security ----------------------------------Market Price of the Security Eg: Suppose the market price for a 10.18% G-Sec 2012 is Rs.120. The current yield on the security will be (0.1018 x 100)/120 = 8.48%



Yield to maturity (YTM) The current yield calculation shows us the return the annual coupon payment gives the investor, but this percentage does not take into the account the time value of money, or, more specifically, the present value of the coupon payments the investor will receive in the future. Yield to maturity tells you the total return you will receive by holding the bond until it matures. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its paR) or loss (if you purchased it above its par value). It is the discount rate, which equals all the cash flows (coupon payments and the debt repayment) arising from the instrument with the purchase price. The concept of YTM is based on following implicit assumptions:

The instrument is held till maturity The intermediate cash flows are reinvested at the rate of YTM There is no put and call facility available to investors or the issuers

Given a pre-specified set of cash-flows and a price, the YTM of a bond is that rate which equates the discounted value of cash flows to the present price of the bond. It is the internal rate of return of the valuation equation. For example, if a 11.99% 2009 bond is being issued at Rs.108 and the coupons are paid semi-annually, we can state that: 108 = 5.995 + 5.995 + + 105.995 ------- ----------------(1 + r) (1 + r)2 (1 + r)18 The value of r, which solves the equation, will be the YTM of the bond. The value of r in the above equation is found to be 5.29%, which is the semi-annual rate and hence YTM of the bond would be 10.58% 55


YTM of a Zero Coupon Bond In case of a zero coupon bond, since there are no intermittent cash flows in the form of coupon payments, YTM of the bond is the rate that equates the present value of the maturity or redemption value of the bond to the current market price. For example, if a zero coupon bond sells at Rs.93.76 issued on February, 5 2001 and matures on 1 st January 2002, its YTM is computed as 93.76 = 100 -----------(1 + YTM) 330/365

= 7.39% One can compare the YTM with one's required rate to take investment decisions. If the YTM is more than the required rate of return of an investor, he should invest in the instrument otherwise not. Yield-to-Call Yield to call tells you the total return you will receive by holding the bond until it is called. This yield is valid only if the security is called prior to maturity. Yield to call is calculated the same way as yield to maturity, but assumes that a bond purchased at a premium will be called and that the investor will receive face value back at the call date. Yield vs. Price Yields and Bond Prices are inversely related. So a rise in price will decrease the yield and a fall in the bond price will increase the yield.

Interest vs. Price 56


There will be an immediate and mostly predictable effect on the prices of bonds with every change in the level of interest rates. (The predictability here however refers to the direction of the price change rather than the quantum of the change) When the prevailing interest rates in the market rise, the prices of outstanding bonds will fall to equate the yield of older bonds into line with higher-interest new issues. This will happen, as there will be very few takers for the lower coupon bonds resulting in a fall in their prices. The prices would fall to an extent where the same yield is obtained on the older bonds as is available for the newer bonds. When the prevailing interest rates in the market fall, there is an opposite effect. The prices of outstanding bonds will rise, until the yield of older bonds is low enough to match the lower interest rate on the new bond issues. These fluctuations ensure that the value of a bond will never be the same throughout the life of the bond and is likely to be higher or lower than its original face value depending on the market interest rate, the time to maturity (or call) and the coupon rate on the bond. Term Structure of Interest Rates The term structure of interest rates refers to the relationship between long-term and shortterm interest rates. Investors are concerned with the term structure because it affects their investment preferences for long- or short-term bonds. Corporate treasurers also must decide whether to borrow by issuing long or short-term bonds.



4.2 Yield curve If we plot the YTM of various debt instruments against the time to maturity, the resultant curve is known as a Yield Curve. In other terms, a graphic representation of the term structure of interest rates is called a yield curve. Under normal circumstances, bonds with longer term maturity will offer a greater return as there is a far greater element of uncertainty and therefore, risk (High risk-high returns). The yield curves slope changes as various factors affect the pricing of debt market instruments. A negatively sloping yield curve indicates that the short-term instruments are priced lower than long-term. Therefore, the yield curve could give an indication about which instruments are attractive, and which, are not, in a particular market environment. If the yield curve is downward sloping, a strategy could be to buy short-term securities and sell long-term securities, whereas if the yield curve is upward sloping, a strategy would be to buy long term and sell short term securities. Factors affecting the yield curve Monetary Policy Suppose the RBI feels that there is too much liquidity in the system leading to high inflation, in such a scenario, RBI will adopt tight monetary policy. i.e. it will sell government bonds and thus reduce the money available in the system. Consider a situation where the interest rates on deposits are expected to decline, the shortterm instruments become expensive as they continue to offer higher interest rates. Consequently, the yield declines and the yield curve slopes downwards. On the contrary, when the expectations are that the interest rates on deposits would rise, the price of debt instruments would fall increasing the yield and thus the yield curve would rise upwards. 58


Economic Growth Monetary is largely influenced by the health of the economy. The growth prospects of the economy affect the allocation of capital. If there is no growth prospect, the demand for capital would be sluggish. Banks would be saddled with surplus funds, which they would be uncomfortable lending to corporates due to chances of default and hence they would prefer to invest in risk-free return instruments such as T-bills and G-Secs. This will drive the demand for debt instruments and thus the prices of the instruments would rise, implying a decline in the yield of the same and thus the yield curve slopes downwards. Fiscal Policy If the fiscal situation of a country looks precarious, the short-term interest rates tend to be much higher than the long term. The long-term interest rates will be relatively lower on hopes that the situation improves in the future. But if the fiscal deficit continues to rise, then the interest rate in the long term would be higher due to continuous borrowing by the government to meet its fiscal deficit, increasing the demand for money. The market as a result would demand higher interest rates causing the prices for the instruments to decline resulting in an upward sloping yield curve. Inflation Inflation affects both the short-term and the long-term yields. If the inflation is around 7% and the long-term yield is around 11%, then the real rate of return is 4%. Thus, if the inflation rises, the real rate of return would decline causing the price of the instruments to fall, thereby increasing the yield resulting in an upward sloping yield curve.



Tenor 30-Aug-04 3 months 4.7 6 months 4.88 1 year 5.14 2 years 5.57 3 years 5.86 4 years 5.93 5 years 6.04 7 years 6.21 10 years 6.3 15 years 6.5 20 years 7.18

30-Aug-04 8 7 6 5 4 3
m on th s 6 m on th s 1 ye ar 2 ye ar s 3 ye ar s 4 ye ar s 5 ye ar s 7 ye ar s 10 ye ar s 15 ye ar s 20 ye ar s 3

Yield (%)


1) Normal Yield Curve: An upward sloping yield curve is called a normal yield curve. The market expects long-term fixed income securities to offer higher yields than short-term fixed income securities. This is a normal expectation of the market because short-term instruments generally hold less risk than long-term instruments: the further into the future the bonds maturity, the more time and therefore uncertainty the bondholder faces before being paid 60


back the principal. To invest in one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk.

2) Flat Yield Curve: These curves indicate that the market environment is sending mixed signals to investors, who are interpreting interest rate movements in various ways. During such an environment, it is difficult for the market to determine whether interest rates will move significantly in either direction. This condition will create a curve that is flatter than its normal positive slope.



3) Inverted Yield Curve: A downward sloping yield curve is called an abnormal (inverted) yield curve. These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects interest rates to decline as time moves further into the future, which in turn means the market expects yields of long-term bonds to decline. You may be wondering why investors would choose to purchase long-term fixed income investments when there is an inverted yield curve, which indicates that investors expect to receive less compensation for taking on more risk. Some investors, however, interpret an inverted curve as an indication that the economy will soon experience a slowdown, which causes future interest rates to give even lower yields.



The Credit Spread The credit or quality spread is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument. As illustrated in the graph below, the spread is demonstrated as the yield curve of the corporate bond is plotted with the term structure of interest rates. Remember that the term structure of interest rates is a gauge of the direction of interest rates and the general state of the economy. Since corporate fixed-income securities have more risk of default than federal securities, the prices of corporate securities are usually lower, and as such corporate bonds usually have a higher yield. When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. This is because investors must be offered additional compensation (in the form of a higher coupon rate) for acquiring the higher risk associated with corporate bonds. When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed-income securities generally narrows. The lower interest rates give companies an opportunity to borrow money at lower rates, which allows them to expand their operations and also their cash flows. When interest rates are declining, the economy is expanding in the long run, so the risk associated with investing in a long-term corporate bond is also generally lower.



4.3 Normal Yield Curve Theories There are three prevailing theories that explain why the upward sloping yield curve is considered normal. These three theories are: 1. The expectations theory, 2. The market segmentation theory, and 3. The liquidity preference theory. Expectations Theory The basis of the expectations theory is that the yield curve reflects lenders' and borrowers' expectations of inflation. Changes in these expectations cause changes in the shape of the yield curve. Remember, the inflation premium is a major component of interest rates. To illustrate the expectations theory, suppose that inflation is expected to be 4 % this coming year, 6 % in the year following, and 8 % in the third year. The inflation premium (average expected yearly inflation) will be 4 % for the first year, 5 % for the second year, and 6% for the third year. If the real, risk-free rate is 3 %, then the resulting Treasury bill interest rates (risk- free rate plus inflation premium) will be 7 % for a one- year T-bill, 8% for a two-year T-Bill, and 9% for a three-year T -bill. A change in these expectations will cause a shift in the yield curve for the T -Bills.

Particulars Expected Inflation Average Inflation Premium (+) Risk-free interest rate T-bill Interest Rate

Ist Year 4% 4% 3% 7%

IInd Year 6% 5% 3% 8%

IIIrd Year 8% 6% 3% 9%

Market Segmentation Theory 64


Each lender and each borrower has a preferred maturity. Some lend / borrow for long-term needs and others lend / borrow for short-term needs. The market segmentation- theory states that the slope of the yield curve depends on supply / demand conditions in the short-term and long- term markers. An upward sloping curve results from a large supply of funds in the short-term market relative to demand and a shortage of long-term funds. A downward sloping curve indicates strong demand in the short-term market relative to the long-term market. A fairly horizontal yield curve indicates that supply and demand for funds is roughly balanced both in the short-term and long-term markets. Liquidity Preference Theory The liquidity preference theory is based on the observation that long-term securities often yield more than short-term securities. Two reasons are given to explain this: Investors generally prefer short-term securities, which are more liquid and less expensive to buy and sell. Investors require higher yield on long -term instruments to compensate for the higher cost. Investors generally prefer short-term securities, as they are less risky. They would demand higher yields in the long run as money gets block for a longer period and also the risk premium increases. Borrowers dislike short-term debt because it exposes them to the risk of having to roll over the debt or raise new principal under adverse conditions (such as a rise in rates). Borrowers will pay a higher rate for long-term debt than for short-term debt, all other factors being held constant. Under these "normal" conditions, there is a positive correlation between risk premium increases and maturity. Therefore, the "normal " yield curve slopes upward.




The emergence of ALM can be traced to the mid 1970s in the US when deregulation of the interest rates compelled the banks to undertake active planning for the structure of the balance sheet. The uncertainty of interest rate movements gave rise to interest rate risk thereby causing banks to look for processes to manage their risk. In the wake of interest rate risk came liquidity risk and credit risk as inherent components of risk for banks. The recognition of these risks brought Asset Liability Management to the center-stage of financial intermediation. 5.1 What is Asset/ liability management? Asset/ liability management (A/LM) is a tool that enables bank managements to take business decisions in a more informed framework. The A/LM function informs the manager what the current market risk profile of the bank is and the impact that various alternative business decisions would have on the future risk profile. The manager can then choose the best course of action depending on his board's risk appetite. Consider for example, a situation where the chief of a banks retail deposit mobilization function wants to know the kind of deposits that the branches should be told to encourage. To answer this question correctly he would need to know inter alia the existing cash flow profile of the bank. Let us assume that the structure of the existing assets and liabilities of the bank are such that at the aggregate the maturity of assets is longer than maturity of liabilities. This would expose the bank to interest rate risk (if interest rates were to increase it would adversely affect the banks net interest income). In order to reduce the risk the bank would have to either reduce the average maturity of its assets perhaps by decreasing its holding of Government securities or increase the average maturity of its liabilities, perhaps by reducing its dependence on call/money market funds. Thus, given the above information on the existing risk profile of the bank, the retail deposits chief knows that the bank can reduce its future risk by marketing its long-term deposit products more aggressively. If necessary he may offer increased rates on long-term deposits and/or decreasing rates on the shorter-term deposits.



The above example illustrates how correct business decision-making can be added by the interest rate risk related information. The important thing, however, is that A/LM is a tool that encourages business decision making in a more disciplined framework with an eye on the risks that the bank is exposed to. It has to be closely integrated with the banks business strategy as this affects the future risk profile of the bank. This framework needs to be built around a foundation of sound methodology and human and technological infrastructure. It has to be supported by the board's risk philosophy, which clearly specifies the risk policies and tolerance limits. 5.2 Purpose of ALM An efficient ALM technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities as a whole so as to earn a predetermined, acceptable risk/reward ratio. 5.3 RBI guidelines on ALM The Reserve Bank Of India in 1999 has issued comprehensive guidelines for banks for Asset Liability Management. Guidelines inter alia include directions for classification of various assets and liabilities, parameterization of various associated market risks, and frequency of evaluation of exposure. Following three Statements showing position of maturity of assets and liabilities (Inflow and Outflow of Funds) are required to be prepared by the banks. a) Banks should give adequate attention to putting in place an effective ALM System. Banks should set up an internal Asset-Liability Committee (ALCO), headed by the CEO/CMD or the ED. The Management Committee or any specific Committee of the Board should oversee the implementation of the system and review its functioning periodically. b) Statement of Structural Liquidity: All commercial banks have to distribute the outflows/inflows in different residual maturity period known as time buckets. On balance sheet as well as off balance sheet items are required to be included in the classification: 67


1 to 14 days 15 to 28 days 29 days to 3 months 3 months to 6 months 6 months to 1 year 1 year to 3 years 3 years to 5 years 5years and above This statement is required to be prepared, presently at quarterly frequency, as on last reporting Friday of the quarter. Based on behavioral pattern, Savings deposits and Current Deposits, which form a significant portion of the banks deposits are required to be classified into 1 to 14 days and 1 to 3 years time buckets. Term deposits are classified on actual residual maturity. Similarly based on behavioral pattern cash credit, overdrafts and other loans are required to be classified into various time buckets depending upon expected inflow of funds. c) Statement of interest rate sensitivity: All assets and liabilities, on balance sheet as well as off balance sheet, are required to be classified into various time buckets, given below, based on their maturity for repricing. Thus the cash credit facility, though perennial in nature which gets repriced with change in prime lending rate, matures for repricing generally twice in a year, at the time when reserve bank declares credit policy. For the purpose of classification in this statement this facility is classified into 3 to 6 months time buckets. Installments falling due in loans are repriced when reinvested. Thus all repayments are considered due for repricing and are classified accordingly.

d) Statement Of Short Term Dynamic Liquidity: This is required to be prepared fortnightly and include expected inflows and outflows in next 3 months classified into 3 time buckets. 68


This classification is capable of reflecting any short fall in liquidity during next 3 months, hence assumes great importance from ALM angle. The Board Of Directors through a Committee of Directors is required to monitor the process of ALM in banks.

Successful implementation of any risk management process has to emanate from the top management in the bank with the demonstration of its strong commitment to integrate basic operations and strategic decision making with risk management. Ideally, the organization set up for Market Risk Management should be as under: -The Board of Directors -The Risk Management Committee -The Asset-Liability Management Committee (ALCO) -The ALM support group/ Market Risk Group



Risks are inherent quality of both the commercial banking business and the investment banking implying that all the PIs, Banks and NBFCs are affected more by risks. The widened resource base, service range and the client base has further led to a remarkable transition in the risk profile of the financial intermediaries. The most prominent of the financial risks to which the institutions are exposed to are classified into the following: 6.1 Types of Risks

Interest-rate Risk -This risk arises when the income of the company is sensitive to the interest-rate fluctuations. Liquidity Risk -When there is a mismatch in the maturity patterns of the assets and liabilities, thereby leading to a situation where the firm is not in a position to impart enough liquidity into its system, liquidity risk arises. Credit Risk -This risk originates when there is a default in the repayment obligation by the borrowers of funds on the due date. Foreign Exchange Risk (Currency Risk) -This risk is the consequence of the presence of multi-currency assets and liabilities. Contingency Risk -The off-balance sheet items such as guarantees, letters of credit, underwriting commitments etc. will give rise to the contingency risk. There is a definite linkage between the various risks involved in the investment and lending business. The interest-rate risk might eventually lead to a credit risk, while the credit risk itself is closely associated to the forex risk in the foreign exchange business. The risks associated with any investment and financing activity cannot be eliminated for reasons more than one. The most important of these can be stated as the accuracy levels of forecasting the interest-rate movements since it leads to the interest-rate risk as well as other related risks. Then there are the fluctuations that occur in the forex market. Thus, the uncertainties existing in both the domestic and the foreign markets make forecasting and risk elimination a difficult task.



6.2 Risk management Though elimination of risk originating due to rate fluctuations is one of the prime concerns for most businesses, it may not be the same with the banking business. The income for these investment banks comes mostly by way of the spreads maintained between the interest income and interest expense since greater the spread more will be the income. However, the direct correlation that exists between risks and returns further imply that greater spreads result in an enhanced risk exposure. It would be more prudent for banks to concentrate more on managing the assets and liabilities and maintain profitability at a particular risk exposure limit. Thus it is risk management that holds the key to success/ profitability and not risk elimination.

The objective function of the risk management policy in a banking firm is two fold. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate more than the costs. Similarly, liquidity is ensured by grouping the assets, liabilities based on their maturing profiles. The gap is then assessed to identify the future financing requirements. This ensures liquidity. However, maintaining profitability by matching prices and ensuring liquidity by matching the maturity levels is not a very easy task. The following tables explain the process involved in price matching and maturity matching:



PRICE MATCHING Table I Liabilities Assets Amt Rate Amt 15 25 30 30 (%) 0 5 12 13 10 20 50 20 Table I (Rearranged) Liabilities Assets Amt Rate Amt Rate (%) 0 0 5 5 12 13 13 8.75* 10 5 15 10 30 10 20 100 (%) 0 12 12 15 15 15 18 13.5*

Rate (%) 0 12 15 18

Spread (%) 0 12 7 10 3 2 5 4.75*

10 5 15 10 30 10 20 100 8.75* 100 13.5* 100 * Average cost/return on liabilities/assets.

MATURITY MATCHING Liabilities Table II Maturing Assets within 10 5 8 4 45 20 8 100 (months) 1 3 6 12 24 36 >36 15 10 5 10 30 10 20 100 Maturing within (months) <1 3 6 12 24 36 >36 10 5 8 4 45 20 8 100 15 10 5 10 30 10 20 100 -5 -5 +3 -6 +15 +10 -12 Table II (Rearranged) Assets Gap Liabilities Cumulative Gap -5 -10 -7 -13 +2 +12 0

Table I shows how a proper deployment of liabilities ensure positive spreads. These spreads can however be attained if the interest rate movements are known with accuracy, and the forecasts made fall close to actual movements. This approach further ignores maturity mismatches, which may to a certain extent affect the expected results.



Similarly, Table-II helps in forecasting the cash flows both inflow and outflow and the gap that exists. It further forecasts the surplus/ deficit fund position and thereby enables better financing plan. Maturity matching however is possible if the financial requirements are forecasted accurately. This approach further undermines the price-matching concept. Though these two approaches i.e. price matching and maturity matching, effectively reduce risks, the methodology adopted may not be feasible in reality. Risk management approaches cannot be unidimensional since the risks need to be managed collectively. The purpose of ALM is thus, to enhance the asset quality, quantify the risks associated with the assets and liabilities and further control them. The process will involve the following steps: Though this process of price matching can be done well within the risk/exposure levels set for rate fluctuations it may, however, place the bank in a potentially illiquid position.

Efficient matching of prices to manage the interest rate risk does not suffice to meet the ALM objective. Price matching should be coupled with proper maturity matching. The inter-linkage between the interest rate risk and the liquidity of the firm highlights the need for maturity matching. The underlying implication of this inter-linkage is that rate fluctuations may lead to defaults severely affecting the asset-liability position. Further in a highly volatile situation it may lead to liquidity crisis forcing the closure of the bank. Firstly, reviewing of the interest-rate structure and comparison of the same to the interest product pricing of both assets & liabilities. This to a certain extent will highlight the impending risks and the need for managing the same.

Secondly, the loan and the investment portfolios should be examined in the light of the foreign exchange risk and liquidity risk that might arise. At the same time the affect of these risks on the value and cost of liabilities should also be given due consideration.



Thirdly, examine the probability of the credit risk that may originate either due to rate fluctuations or otherwise and assess the quality of assets.

Finally, review the actual performance against the projections made and analyze the reasons for any affect on the spreads.

These steps envelope the tasks of asset-liability management i.e. identification of the various risks present in the system and design an appropriate ALM technique that suits the organizational requirements.



6.3 Asset liability committee (ALCO) The ALCO is a decision making unit consisting of the banks Senior management including CEO, responsible for integrated balance sheet management from risk return perspective including the strategic management of interest rate and liquidity risks.while each bank will have to decide the role of its ALCO, it s powers and responsibilities as also the decisions to be taken by it, its responsibilities would normally include: Monitoring the market risk levels of the bank by ensuring adherence to thr various risks limits set by the Board. Articulating the current interest rate view and a view on future direction of interest rate movements and base its decisions for future business strategy. Deciding the business strategy, both on the assets and liabilities side consistent with the banks interest rate view, budget and predetermined risk managements objectives. This would in turn include: o Determining the desired maturity profile and mix of the assets and liabilities o Product pricing for assets and liabilities o Deciding the funding strategy i.e the source and mix of liabilities or sale of assets; the proportion of fixed v/s floating rate funds, wholesale v/s retail funds, money market v/s capital market funds, domestic v/s foreign currency funding etc. Reviewing the results of and progress in implementation of the decisions made in the previous meetings. Composition of ALCO The size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity. To ensure commitment of the Top Management and timely response to market dynamics, the CEO/CMD or the ED should head the Committee. The Chiefs of Investment, Credit, Resources Management or Planning, Funds Management / Treasury (forex and domestic), International Banking and Economic 75


Research can be members of the Committee. In addition, the Head of the Technology Division should also be an invitee for building up of MIS and related computerisation. Some banks may even have Sub-committees and Support Groups. ALCO Meetings The individual bank will have to decide the frequency for holding their ALCO meetings. This committee meets regularly, at least once a month, though ideally it should be once a fortnight, to review the liquidity position, vis--vis market conditions and determines the strategies to maintain adequate liquidity, decisions on raising resources having regard to the cost in tune with the market conditions, and deployment of resources in profitable avenues. ALM Support Group The ALM Support Group consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effect of various possible changes in the market conditions related to the balance sheet and recommend the action needed to adhere to banks internal limits. The Middle Office is responsible for the critical functions of independent market risk monitoring, measurement, analysis and reporting for the bank's ALCO. Ideally this is a full time function reporting to, or encompassing the responsibility for, acting as ALCO's secretariat. An effective Middle Office provides the independent risk assessment, which is critical to ALCO's key-function of controlling and managing market risks in accordance with the mandate established by the Board/Risk Management Committee. It is a highly specialised function and must include trained and competent staff, expert in market risk concepts.



6.4 Interest rate risk management To have a proper insight of the interest-rate risk and thereby design a methodology to tackle the same, it is but imperative to have an in-depth knowledge of the various components that constitute such a risk. The interest-rate risk is a mixed affect of a host of other risks which when segregated, fall under the following categories: Rate Level Risk: During a given period there is high possibility for restructuring the interest rate levels either due to the market conditions or due to regulatory Maturity Gap Method: This asset-liability management technique aimed to tackle the interest rate risk, highlights on the gap that is present between the RSAs and the RSIs, the maturity periods of the same and the gap period. The objective of this method is to stabilize/improve the net interest income in the short run over discreet, periods of time called the gap periods- The first step is Thus-to select the gap period which can be anywhere between a month to a year. Having chosen the same, all the RSAs and RSLs are grouped into 'maturity bucket' based on the maturity and the time until the first possible re pricing due to change in the interest rate. The gap is then calculated by considering the difference between the absolute values of the RSAs and the RSLs, which is mathematically expressed as: RSG Gap Ratio where, RSG = Rate Sensitive Gap based on maturity = = RSAs RSLs RSAs / RSLs



The gap so analyzed can be used to cut down the interest rate exposure in two ways, As mentioned earlier, The bank can use it to maintain/improve its net interest income for changing interest rates, otherwise adopt a speculative strategy wherein by altering the gap effectively depending on the interest rate forecasts net interest income can be improved. In either way, the basic assumption of this model is that there will he an equal change in interest rates for all assets and liabilities. During a selected gap period, The RSG will be positive when the RSAs are more than the RSLs, negative when the RSLs are in excess of the RSAs and zero when the RSAs and RSLs are equal. Based on these outcomes, the maturity gap method suggests various positions that the treasurer can take in order to tackle with the rising/falling interest rate structures. Consider the following illustration to understand the approach.

Illustration In the illustration given below, for the three different gap portion i.e. positive, negative and zero, the impact of rate fluctuations i.e. a rise or a fail, on the NII are explainedOption I: Positive Gap (Rs. Cr) Liability 200 1800* 2000 4000 Interest 400 418 382 4000 Interest Income 176 186 166 576 604 548 10 11 11 11 9 11 200 800* 1000* 1000* 1000 12 14 16 18 13 15 17 18 11 13 15 18 Rate (%) Increased Rate (%) Decreased Rate (%) Asset Rate (%) Increased Rate (%) Decreased Rate (%)

Expense Net Interest Income** RSAs: Rs 2800



RSLs: Rs1800 GAP: Rs1000

Option II Negative Gap (Rs. Cr.) Liability 200 1800* 2000 4000 Interest Rate (%) 10 11 Increased Rate (%) 11 11 Decreased Rate (%) 9 11 200 800* 1000 1000 1000 4000 Interest Income 176 166 186 Asset Rate (%) 12 14 16 18 576 Increased Rate (%) 13 14 16 18 584 Decreased Rate (%) 11 14 16 18 568




Expense Net Interest Income RSAs: Rs 800 RSLs: Rs1800 GAP: Rs 1000 Option III- Zero Gap

(Rs. Cr.) Liability 200 1800* 2000 4000 Interest Expense 10 11 11 11 9 11 200 800* 1000* 1000 1000 4000 Interest Income 79 12 14 16 18 576 13 15 16 18 594 11 13 16 18 558 Rate (%) Increased Rate (%) Decreased Rate (%) Asset Rate (%) Increased Rate (%) Decreased Rate (%)





Net Interest Income RSAs: Rs 1800 RSLs: Rs 1800 GAP: Rs 0




(* Represents RSAs and RSLs, ** Net Interest Income (NII) = Interest Income Interest Expense.) The following are the implications of an increase/decrease in interest rates for a given RSG level

RSG is Positive When RSG is positive it is understood that the yield earned in such a situation will be more than the rate at which the liabilities are serviced. In the illustration given above, option I has a positive gap of Rs.1000 cr. Initially, the cost of funds is Rs.400 cr., while the total returns are Rs-576 cr. resulting in a NII of Rs 176cr. This will, however, be affected by changes in the interest rates. When the interest rates rise/fall by equal amounts, then the increase/decrease in the interest income will be more than the servicing cost of liabilities, merely due to the fact that there are more re priceable assets than the re priceable liabilities.

RSG is Negative In the second situation where the RSG is negative, an increase/decrease in the interest

rates by an equal amount will lead to a greater rise/fall in the interest expenses than the interest income earned. The presence of more RSLs as compared to the RSAs explains this phenomenon. Consider option II where the RSAs and RSLs are Rs.800 cr. and Rs.1800 cr. respectively resulting in a negative gap of Rs. 1000. When there is a negative gap, the 80


consequence of a rate fluctuation is a decrease in the net interest income when the interest rates rise and decrease in the same when the rates fail. RSG is Nil As a third option, the bank can maintain a zero gap and thus remain neutral to the interest rate fluctuations. It can be observed in Option III of the illustration that when the RSAs and the RSLs are equal to Rs 1800 cr. The NII remains at Rs.176 cr. in a rising/falling interest rate scenario. The utility of the Maturity Gap approach is that for a given level of RSG and with a forecast of a rise/fall in interest rates, the banker can take the following positions to improve the net income, Maintain a positive gap when the interest rates are rising;

Maintain a negative gap when the interest rates are on a decline,

Alternatively, maintain a zero gap position for the firm to ensure a complete hedge against any movements in the future interest rates. Though this policy will reduce the interest rate risk to a large extent, it will not lead to any speculative gains. While such a situation may not occur in reality, it will also be unwarranted since there a are no major benefits arising from it. Rate Adjusted Gap The Maturity Gap approach assumes a uniform change in the interest rates for all assets and liabilities. In reality, however, it may not be the case basically due to two main reasons. Firstly, the market perception towards the change in the interest rate may be different from the actual rise/fall in the interest rates, For instance, If the bank rate is cut by 1 percent, according to the gap method, there will be a 1 percent fall in the rate of in the rate of interest



for both assets and liabilities. However this may not be the case if the market perception for the decline in the interest rate is short-term in nature. This might eventually lead to a fall in the interest rate by less than 1 percent, Alternatively, the market may also perceive the rate fluctuations differently for the long-term interest rates and the short-term interest rates. For instance rate fluctuation may lead to a 0,75 percent fall in the short term interest rates while the long-term rates may witness a mere decrease by 0.25 percent. The second reason for differential rise/fall in interest rates of assets/liabilities can be the presence of a certain regulation. To explain this further, consider the differential interest rate loan extended by banks, which has an interest rate of 4 percent. This rate remains constant irrespective of any amount of fluctuation in the interest rate of the bank. Similarly, it is quite common to find that the interest rates on term deposits rise fall with changes in interest rates though the same does not effect the interest paid on savings bank. Having done away with the assumption of a uniform change in interest rates of

assets/liabilities, the Rate Adjusted Gap methodology seems to be superior than the Maturity Gap methodology. In this approach all the rate sensitive asset's and liabilities will he adjusted by assigning weights based on the estimated change in the rate for the different assets/liabilities for a given change in interest rates.

Rate Adjusted Gap = [RSA1 x WA1 + RSA2 x WA2 +.] - [RSL1 x WL1 + RSL2 x WL2 + ] .....Eq. 3.6 where, W A1, WA2 = Weights of the corresponding RSAs WL1, WL2 = Weights of the corresponding RSLs



Consider the following illustration which measures the rate adjusted gap for option 1 of illustration 3.1.

Illustration 3.3 Positive Gap (Rs Cr.) Liability (Rs) 200 1800* 2000 Rate (%) 10.00 11.00 Increased Rate % 10.75 11.00 0.75 Weight Asset (Rs) 200 800* 1000* 1000* 1000 Rate (%) 12.00 14.00 16.00 18.00 Increased Rate % 12.50 14.25 16.50 18.00 0.50 0.25 0.50 Weight

Rate Adjusted Liabilities = 1800 x 0.75 = 1350 Rate Adjusted Assets Rate Adjusted Gap = (800 x 0.50) + (10000.25) + (1000x0.50) = 1150 = 1,150 - 1,350 = (200) In this case, the interest rate change for the liability of Rs-1800 cr. is given as 0.75 percent (10.75 - 10.00). This implies that on account of rate fluctuation, the interest rate for that particular liability has increased by 0.75 percent. Thus the weight attached to this is 0,75. Similarly, for the asset valuing Rs.800 cr. the weight assigned is 0.50 percent since the rate fluctuation led to an increase in the yield from 12 to .12.50 percent. The Gap will then be assessed from these rate adjusted assets and liabilities which is termed as the rate adjusted gap. Thus, it can be observed from the illustration that by assigning weights, the positive gap has actually become negative. If policies were formulated to control the interest exposure based on the Maturity Gap methodology, it might actually lead to a different and a very serious situation by changing the nature and size of the risk, 83


6.5 Liquidity risk management While introducing the concept of asset-liability management it has been mentioned that the object of any ALM policy is twofold ensuring profitability and liquidity. Working towards this end, the bank generally maintains profitability/spreads by borrowing short (lower costs) and lending long (higher yields). Thus, while management of the prices of assets and liabilities is an essential part of ALM, so is liquidity. Liquidity, which is represented by the quality and marketability of the assets and liabilities, exposes the firm to liquidity risk. Though the management of liquidity risk and interest rate risks go hand in hand, there is, however, a phenomenal difference in the approach to tackle both these risks. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable, while elimination of liquidity risk does result in long-term sustenance. Before attempting to analyze the elimination of liquidity risk, it is essential to understand the concept of liquidity management. The core activity of any bank is to attain profitability through fund management i.e. acquisition and deployment of financial resources. An intricate part of fund management is liquidity management. Liquidity management relates primarily to the dependability of cash flows, both Inflows and outflows and the ability of the bank to meet maturing liabilities and customer demands for cash within the basic pricing policy framework. Liquidity risk hence, originates from the potential inability of the bank to generate cash to cope with the decline in liabilities or increase in assets. Thus, the cause and effect of liquidity risk are primarily linked to the nature of the assets and liabilities of the bank. All investment and financing decisions of the bank, irrespective of whether they have long term or short term implications do effect the asset-liability position of the bank which may further affect its liquidity position. In such a scenario, the bank



should continuously monitor its liquidity position in the long run and also on a day-to-day basis.

Given below are two approaches that relate to these two situational decisions: I. Fundamental Approach. II. Technical Approach. These two methods distinguish from each other in their strategically approach to eliminate liquidity risk. While the fundamental approach aims to ensure the liquidity for long run sustenance of the bank, the technical approach targets the liquidity in the short run. Due to these features, the two approaches supplement each other in eliminating the liquidity risk and ensuring profitability.

I. Fundamental Approach: Since long run sustenance is a driving factor in this approach, the bank tries to tackle /eliminate the liquidity risk in the long run by basically controlling its assets-liability position. A prudent way of tackling this situation can be by adjusting the maturity of assets and liabilities or by diversifying and broadening the sources of funds. The two alternatives available to control the liquidity exposure under this approach are Asset Management and Liability Management. This implies that liquidity can be imparted into the system either by liability creation or by asset liquidation, which ever suit the situation.

Asset Management: 85


Asset management is to eliminate liquidity risk by holding near cash assets i.e. those assets, which can be turned into cash whenever required. For instance, sale of securities from the investment portfolio can enhance liquidity. When asset management is resorted to, the liquidity requirements are generally met from primary and secondary reserves. Primary reserves refer to cash assets held to meet the statutory cash reserve requirements (CRR) and other operating purposes. Though primary reserves do not serve the purpose of liquidity management for long period, they can be held as second line of defense against daily demand for cash. This is possible mainly due to the flexibility in the cash reserve balances (statutory cash reserves are required to be maintained only on a daily average basis for a reserve maintenance period). However, most of the liquidity is generally attained from the secondary reserves, which include those assets held primarily for liquidity purposes. These secondary reserves are highly liquid assets, which when converted into cash carry little risk of loss in their value. Further, they can also be converted into cash prior to their maturity at the discretion of the management. When asset management is resorted to for liquidity, it will be through liquidation of secondary reserves. Assets that fall under this category generally take the form of unsecured marketable securities. The bank can dispose these secondary reserves to honor demands for deposit withdrawals, adverse clearing balances or any other reasons. Liability Management: Converse to the asset management strategy is liability management, which focuses on the sources of funds. Here the bank is not maintaining any surplus funds, but tries to achieve the required liquidity by borrowing funds when the need arises. The underlying implications of this process will be that the bank mostly will be investing in long-term securities /loans (since the short-term surplus balance will mostly be in a deficit position) and further, it will not depend on its liquidity position/surplus balance for credit accommodation/business proposals. Thus in liability management a proposal may be passed even when there is no 86


surplus balance since the bank intends to raise the required funds from external sources. Though it involves a greater risk for the bank, it will also fetch higher yields due to the longterm investments. However, sustenance of such high spreads will depend on the cost of borrowing. Thus, the cost and the maturity of the instrument used for borrowing funds play a vital role in liability management. The bank should on the one hand be able to raise funds at low cost and on the other hand ensure that the maturity profile of the instrument does not lead to or enhance the liquidity risk and the interest rate risk. Of the two strategies available in fundamental approach, it is understood that while asset management tries to answer the basic question of how to deploy the surplus to eliminate liquidity risk, liability management tries to achieve the same by mobilizing additional funds.

Asset Management or Liability Management? Selection of an appropriate alternative from these two strategies depends to a considerable extent on the size and the nature of operations of the bank. For instance, consider a bank that basically concentrates on retail banking and which deploys funds based on its deposit level. This suits the retail bank since it has a customer profile comprising mostly of the household and the small/medium-scale sectors, whose requirements for funds will be reasonably low. Due to this client network, the bank will generally be deposit-rich and proper deployment of these funds into assets can be done to manage the liquidity. Hence, asset management seems to be the appropriate strategy for managing the liquidity position of such a bank. Differentiating from this retail entity is the large bank, which is mostly into wholesale business activities and fund requirement for which is generally in large quantums. Its customer profile, which comprises of large corporates, other banks and high net worth individuals, explains the need for such large amounts. Since its exposure is limited only to a selected few customers, its deposit base is poor when compared to the retail bank. However, it has the ability to raise large volumes of funds at short notice. In such a situation, the strategy adopted by this bank can be that of liability management so that it can mobilize funds to meet its asset requirements.



If the banks strategic policy is liability management, in an increasing interest rate scenario, such a policy will not be advisable. In such a case, the bank will have to go for asset management and the time the interest rates stabilize and revert back to the liability management. Thus, while the bank can take its investment decisions based on its strategic policy the same will have to be reviewed to adopt tactical policy to suit the changes in the operating environment. The important criteria in taking such decisions will also be the yields on investments and the cost of borrowing. After making clear the basic distinction between the deposit-rich and the deposit-poor bank, a suitable liquidity management strategy can now be identified for each of them.



Consider the statement of assets and liabilities of a Bank for a particular period ended: (Rs. Cr) Liabilities Capital Reserves And Surplus Deposits Borrowings Other Liabilities and Provisions 3116.85 34070.25 Amount 577.00 800.03 28369.53 1206.84 Assets Cash and Balances with RBI Call Money Advances Investments Fixed Assets Other Assets 2656.14 16012.56 9594.71 223.00 1713.32 34070.25 Amount 3870.52

It can be observed from the balance sheet that the Bank is a deposit-rich bank since it has a basic objective of accepting deposits and financing investments to the industry. Setting aside the cash and bank balances, advances, fixed and other assets, the bank has Rs.12,250.85 cr. at its disposal. The bank is a net lender in the call/money as seen from the deployment of Rs.2,656.14 cr. as against borrowing of Rs.1,206.84 crore. To stabilize its liquidity position and thereby eliminate liquidity risk, the Bank will now have to invest these surplus funds effectively through a proper asset management policy. Thus, asset management involves acquisition of liabilities first and then determining the composition of assets. Investments can be made in the call market, in government securities or instruments of other corporates. When funds are put into the call market, they are invested only for a very short period of time and are rolled over. There is a high level of liquidity in such investments, which is, however, attached with a lower yield. Technically, the deployment in call market is unsecured. However, the risk perceived is lower since all the participants in the call market are institutions such as banks, DFIs, Discount Houses, etc. When compared to call market instruments, government securities offer higher yields and are at the same time highly secured with moderate liquidity when compared to call market. The main disadvantage in this investment will be the transaction costs involved while buying/selling the instruments. Compared to the call market instruments and the government securities, the corporate 89


instruments provide lesser liquidity but at the same time higher returns for greater risk involved in such investments. Due to these short-term investments, the bank opting for asset management may have to forego higher yields. To overcome this shortfall, in certain cases of asset management, the bank would like to take the benefit of higher yields by investing long. It can disinvest these long-term securities in the secondary market as when it needs funds. However, the major considerations in opting for long-term investments are the transaction costs and the secondary market characteristics. Whichever may be the investment policy, it should, however, be made within the interest rate exposure limits. This implies that an effective asset management policy requires meeting the dual purpose of profitability and liquidity. After having studied the management of liquidity position from the assets side, consider liability management for tackling the liquidity position. The following is the balance sheet of another Bank for the period ended March 31,1996: (Rs. Cr) Liabilities Current Liabilities and Provisions Indebtness Rupee loans Foreign Currency Loans Equity Reserves and Surplus 272534.88 101950.63 11132.67 41921.76 Investments Advances Fixed Assets Miscellaneous Expenses 31119.30 73300.01 Current Assets, Loans and 64509.10 Amount 31661.57 Assets Loans Concerns to Amount Industrial 287217.59

3055.51 4592011.51 459201.51 The balance sheet of this bank reveals that its sources of funds are basically borrowings from the government and the domestic and international markets. From the assets side, it can be observed that nearly 79 percent of the deployment has been made into long-term assets (investments and loans). Further, the most liquid current assets that are cash and bank 90


balances and securities as stock-in-trade are only to the extent of 45 percent of the total current assets (RS. 29131 million). Thus being a large player, catering mostly to the high net worth clients, the banks liquidity position can be managed by prudent liability management. The strategy adopted in liability management makes it an aggressive policy. Nevertheless, it enhances the banks income. This increase will be the outcome of a decrease in the shortterm investments and an increase in the long-term credit deployment, which offer higher yields. There are, however, a few inherent risks present in liability management. Firstly since funds are raised by borrowing from various sources and different markets, rate fluctuations in any of the markets can enhance the cost of borrowing and thereby increase the interest rate exposure. Secondly, the bank will have to maintain its credibility throughout. Since the borrowings are from well-qualified institutions and investors who are well aware of the happenings in the market, a default or decrease in its credibility might affect the interest rates and other borrowing terms, costing dearly to the bank. Other critical aspects in liability management relate to the sources and the time period for the borrowings. Over indulgence in short-term/overnight borrowings at low costs should be avoided so as to maintain stability in the sources of funds and also to control the interest rate exposure. At the same time medium and long-term loans should be selected in a manner so as to reduce asset-liability mismatch. One major consideration for adopting this strategy is that the bank should be in a strong borrowing position lest it may lead to liquidity risk.

II. Technical Approach: As mentioned earlier, technical approach focuses on the liquidity position of the bank in the short run. Liquidity in the short run is primarily linked to the cash flows arising due to the operational transactions. Thus, when technical approach is adopted to eliminate liquidity 91


risk, it is the cash flows position that needs to be tackled. The bank should know its cash requirements and the cash inflows and adjust these two to ensure a safe level for its liquidity position. Working Funds Approach and the Cash Flows Approach are the two methods to assess the liquidity position in the short run. Of these two approaches, the former concentrates on the actual cash position and depending on the factual data, it forecasts the liquidity requirements. The latter approach goes a step forward and forecasts the cash flows i.e. estimates any change in the deposits withdrawals credit accommodation etc. Thus apart from assessing the liquidity requirements, it also advises the bank on its investments and borrowing requirements well in advance. Discussed below are these two models of technical approach used for liquidity risk management. Working Funds Approach: Under this approach, liquidity position is assessed based on the quantum of working funds available to the bank. Since working funds reflect the total resources available with the bank to execute its business operations, the amount of liquidity is given as a percentage to the total working funds. The bank can arrive at this percentage based on its historical performance. This approach of forecasting liquidity requirement takes a broad overview of the liquidity position since the working funds are taken as a consolidated figure. The working funds comprise of owned funds, deposits and float funds. Instead of a consolidated approach, the bank can have a segment-wise break up of the working funds to arrive at the percentage for maintaining liquidity. Based on the position of the limit arrived as above and the available liquidity, the bank will have to invest/borrow the surplus/deficit balances to adjust the liquidity position. In this approach, the bank will have to assess the liquidity requirements for each of the components of working funds. The liquidity requirement for the owned funds component, due to its very nature of being owners capital will be nil. 92


The second component of working funds is deposits, the liquidity requirements of which depend on the maturity profile. Thus, prior to assessing the liquidity requirements of these deposits, the bank should categorize them into different segments based on the withdrawal pattern. All deposits based on their maturity fall under the following three categories: Volatile Funds Vulnerable Funds Stable Funds

Volatile funds include those deposits, which are sure to be withdrawn during the period for which the liquidity estimate is to be made. These include, short-term deposits like the 30 days deposits, etc. raised from the corporate high net worth clients of the bank. The probability of these funds being withdrawn before or on their maturity is high. Included in this category of volatile funds are current deposits of corporates that also have a high degree of variability. Due to the nature of the volatile funds, they demand almost 100 percent liquidity maintenance since the demand for funds can arise at any time. Deposits, which are likely to be withdrawn during the planning tenure, are categorized as vulnerable deposits. A very good example of this type of deposits is the savings deposits. However, the entire quantum of savings deposits cannot be considered as vulnerable. On an average, it can be observed from the operations of the bank, that there will be a certain level up to which the funds are stable i.e. the level below which the funds will not be withdrawn. Hence, the liquidity requirements to meet the maturity of the vulnerable funds will be less than 100 percent and varies depending upon the risk-return policy of the bank. Finally, the residual of the deposit base after segregating them into the above two categories will fall under the stable funds category. These deposits have the least probability of being withdrawn during the planning period and hence the liquidity to be maintained to meet the maturing stable deposits will also be lower when compared to the other two types of 93


deposits. As explained above, the stable portion of the savings deposits fall under this category. Most of the term deposits, by their nature fall under this category. Float funds, which are the third component of the working funds, are much similar to the volatile funds. These funds are generally in transit and comprise of DDs, Bankers cheques, etc. which may be presented for payment at any time. However, this segment also has a minimum level over and above which the variability occurs. Hence, 100 percent liquidity will have to be provided for the variable component. Based on the working funds, consolidated or component-wise, the bank will have to assess the cash balances/ liquidity position in the following manner: Lay down the average cash and bank balances to be maintained as a percentage of total working funds. Lay down the range of variance that can be taken as the acceptance level.

Having obtained the consolidated/component-wise working funds, the bank will now have to estimate the average cash and bank balances that are to be maintained. This average balance can be maintained as a percentage to the total working funds. This percentage level is based on forecasts, the accuracy levels of which vary depending on the factors affecting the cash flows. Hence, it is advisable for the bank to set up a variance range for acceptance depending on its profitability requirements. Thus, as long as the average balances vary within this tolerance range, profitability and liquidity are ensured. Any balance beyond this range will necessitate corrective action either by deploying the surplus funds or by borrowing funds to meet the deficit. This acceptance level is, however, a dynamic figure since it depends on the working funds that may keep changing from time to time. Illustration



ABC Financial Institution Ltd. (ABCFI) which has been offering banking and investment services for the past 2 decades has a branch network of 250. The working funds of ABCFI at the end of 1996-97 were Rs. 1500 crore. The average cash balances are maintained at 1 percent of the total working funds. Further, the management has decided that to ensure proper liquidity, the acceptance range for variance can be up to 5 percent. With this data compute the following: The average cash balance to be maintained and the acceptance range; The average cash balance and the acceptance range, if the working funds have increased to Rs. 2300 crore. Solution: Average cash balance = 1,500 * .01 = Rs 15 crore. Acceptance range = 15 +- (15*0.05) = Rs. 14.25 15.75 crore. Thus, the cash balances of MMFI can lie between Rs. 14.25 15.75 crore. Average cash balance with increased working funds = 2300 * .01 = Rs. 23 crore. Acceptance range = 23 +- (23 * .05 ) = Rs. 21.85 24.15 crore

Thus, if the working funds of the bank are increased to Rs. 2300 crore the range for maintaining cash balances will be Rs. 21.85 24.15.



In case the variance in the cash balances is beyond this range, the bank should take the corrective measures. However, before taking any such measures it is advisable for the bank to first identify the reasons for such variances. If there has been any fundamental change in the operating environment of the bank, then the variance in the cash balance will generally be long-term in nature. Thus, there will be a need for adjusting the cash balances as per the situation. However, in cases where the deviation in the cash balances has been due to certain short-term changes in the market, the variance will not last for long and hence it may not necessitate any corrective action. Of the two different methods of forecasting within the working funds approach, the consolidated method suits the bank, which is mainly playing the role of a development bank. This is basically due to its small deposit base and less volatile working funds. Distinguishing from this bank is the deposit-rich commercial bank, which has a greater component of working funds falling into the deposits category. Due to this, the volatility level is also higher and hence the consolidated approach of working funds may not indicate the real liquidity requirements. In such a case, a component-wise assessment of liquidity would be a better alternative. The working funds approach of estimating the liquidity position, however, has a few limitations: Firstly, it is a subjective decision to some extent to classify deposits based on their withdrawal pattern. Secondly, the focus is laid only on the existing deposits and it ignores potential deposits. Thus, the forecasts may go haywire when there is an unanticipated change in incremental deposits and loan demands. To avoid subjectivity, the variation in different types of deposits may be considered based on the historical data. The percentages can be worked out as weighted average of individual segments. However, the methodology involved in the computation of the percentages will be different for different banks since it depends on the deposit mobilization, branch networking and the liquidity policy of the banks.

Cash Flows Approach: 96


This method of forecasting liquidity tries to eliminate the drawback faced in the Working Funds approach by forecasting the potential increase/decrease in deposits/credits accommodation. To tackle such a situation, trend can be established based on historical data about the change in the deposits and loans. Before proceeding to discuss about the cash flows approach it is essential to understand two important parameters that relate to the approach. Firstly, it is the decision regarding the planning horizon for the forecasts and secondly, the costs involved in forecasting. The planning horizon of a bank may be a financial year or a part of it i.e. a few months to a quarter/half-year period. The bank should ensure that the planning horizon for estimating the liquidity position should neither be too long or too short if the benefits of forecasting are to be reaped. There are various factors both external and internal to the bank which have an impact on the forecasted cash flows. Thus, when the forecasts are made for a long period they might actually not remain the same thereby affecting all the decisions that have been taken based on such forecasts. Similarly when the planning horizon is too short, decisions relating to borrowings and investments may not be effective enough to increase profitability. Considering these factors, the bank should decide on a period, which will not affect the forecasted cash flows to a large extent and at the same time will enable it to make optimal investment-borrowing decisions. Forecasting cash flows to assess and manage the liquidity position of the bank, however, involves expenditure. These forecasting costs can further be classified into recurring costs and non-recurring costs. Non-recurring costs are those, which occur when the bank initiates the cash forecasting process. These include cash outflows for installation of the necessary information system that collates and maintains the data necessary for forecasting. On the other hand, there are certain recurring costs occurring on a regular basis, which include the man-hours spent, data transmission costs and the maintenance of the systems used for this process.



These costs incurred in forecasting further depend on three important factors viz. branch networking, forecasting periods within the planning horizon and the details of information required for forecasting. By nature, these three factors have a direct influence on the forecasting costs. This can be explained by the fact that if the bank has a wide branch network, it will definitely have to incur more expenditure since data has to be collated from such a wide network accurately and at regular intervals. Similarly, when the bank plans to forecast its cash position for every month during the planning horizon of, say a year, the cost of forecasting will be more as compared to the expenditure incurred for forecasting for every quarter/half-yearly period. The bank should first decide on the planning horizon that suits its operational style and then based on the cost constant decide on the number of forecasting periods and other such details. Following such decisions will be the assessment of the liquidity position based on the forecasts made for the cash inflows and outflows. The basic steps involved in this process are as follows: Estimate anticipated changes in deposits Estimate the cash inflows by way of loan recovery Estimate the cash outflows by way of deposit withdrawals and credit accommodations Forecast these for the end of each period Estimate the liquidity needs over the planning horizon

The most critical task of liquidity management is predicting the expected cash inflows coming by way of incremental deposits and recovery of credit and the outflows relating to deposit withdrawals and loan disbursals. In this process, accuracy levels when a bank forecasts cash outflows by way of deposit withdrawals and credit disbursals are fairly high, when compared to the cash inflow forecasts relating to loan repayments and deposit accretion. This difficulty in the forecasting of cash flows coupled with the mismatches arising due to the maturity pattern of assets and liabilities result in the liquidity risk. Thus the 98


process of forecasting cash flows with a high degree of accuracy holds the key to risk management. All estimates are generally given as at the beginning of the month or at the end of the month and are silent upon the fluctuations that may occur during the month, when the forecasting period is chosen as a month. In order to manage the intra-month liquidity problems, there should always be a surplus balance. In such a scenario, it is always better for the bank to consider that the deficit occurs at the beginning of the period while the surplus occurs at the end of the period. Thus, funds should be provided to meet the deficit balance at the beginning of the forecasting period.

Investment-Borrowing Decisions: Assessment of the liquidity gap based on the forecasts is essentially one aspect of the liquidity management. The other major task of liquidity management is to manage this liquidity gap by adjusting the residual surplus/deficit balances. Considering the high costs associated with cash forecasting, it is essential that the benefits drawn by the bank from such forecasting should be substantially large to give some residual gains after meeting the forecasting costs. This objective can, however, be attained only if the bank makes prudent investment/borrowing decisions to manage the surplus/deficit. There are, however, a few factors which must be considered before deciding on the deployment of excess funds/borrowings for meeting the deficit which are given below: Deposit Withdrawals Credit Accommodation Profit fluctuation



The liquidity level to be maintained by a bank should firstly, provide for deposits withdrawals and secondly to accommodate the increase in credit demands. While deposit withdrawals must be honored immediately, it is also of priority to ensure that legitimate loan requests of customers are met regardless of the funds position. Satisfactory credit accommodation ultimately results in more business for the bank. Liquidity is further influenced by the fluctuation in the business profits of the bank. Any fluctuation in the interest rates may result in an increase or decrease in the net interest earnings of the bank. Considering these factors, the bank should adjust its surplus/ deficit to meet the liquidity gap. While surplus funds can be invested in short/long-term securities depending on the banks investment policy, the shortfalls can be met either by disinvesting the securities or by borrowing funds from the market. This again will depend on the strategical issue of whether the bank prefers to manage its liquidity risk using asset management or liability management. Surplus Balance: In case of a surplus balance, the bank has the option of either maintaining cash balances or investing these excess funds in securities/loans. Though holding adequate cash reserves can eliminate the liquidity risk completely, the cost involved in doing so could be prohibitive, especially for a bank. Hence the bank should make optimum use of its idle funds by investing in such a way that the yields earned are greater. There are generally 2 options available to the bank while it makes its investment decisions. It can invest either for a short term and roll over until the funds are required for some other purpose of, invest for a longer period after properly assessing the cash requirements through the forecasting process.



In this decision making process one has to, however, consider/understand the behavior of the yield curves on the long/short-term investments. The long-term investments do give higher yields than short-term investments. The firm will also have to consider the transaction cost involved while converting its marketable securities. Deficit Balance: The second important question that the bank will have to face is, how to meet the deficit cash balances. The only alternative available to meet its deficit is by borrowing funds from the market. While doing this, the aim of the bank should be to keep its cost of raising such short-term funds as low as possible. The bank also has an option of meeting its deficit by internal sources by adjusting against surplus balances obtained earlier. In this option, the number of forecasting periods plays a vital role. There are various models that discuss the suitable ratio that can be maintained between the cash balances and the investments. Thus, the criteria while taking such decisions will be to increase yields on investments and lower the costs of borrowings. Thus there should be optimization in the investment deposit ratio to ensure that the level of idle funds at any point of time is not as high so as to cut into profitability of the bank. This trade off decision of the bank depends upon its attitude towards the liquidity policy i.e. aggressive/conservative. Depending on the liquidity position to be maintained, the risk preferences and risk factors, management can have a policy which has a relatively large/small amount of liquidity. Securitisation: Yet another method of imparting liquidity into the system by way of securitisation. There is, however, a remarkable difference in this strategy used in this approach when compared to the earlier models. Distinguishing itself from the earlier methods, which resort to a sale of securities/borrowings as and when the need for funds arises, securitisation can impart liquidity on a continuous basis and has little or no relation to be surplus deficit balances. The 101


loan profile of the bank will generally be long term in nature. Large volumes of funds get blocked in project financing and asset financing activities of the institution. Securitisation is an effective way to release these funds for further investments. In securitisation the future cash flows from the advances made by the bank are repackaged into negotiable securities and issued to the investors. This arrangement induces liquidity into the system by imparting liquidity to the highly illiquid asset. In the process of enhancing liquidity, securitisation also reduces the interest rate exposure for the bank since risk associated to the risk fluctuations will also be eliminated. Securitisation can in fact be taken up on a continuous basis to supplement the other approaches.

The paradigm shift of the risk exposure levels of the financial institutions, has definitely led to ALM assuming a center stage. Undoubtedly all financial institutions need to perform ALM. But to have a proper ALM process in place, a thorough understanding of the various operations on its assets liabilities becomes essential. Such an understanding will enable the financial institution to identify and unbundled the risks and further aid in adopting and developing appropriate risk management models to manage risks




Citibank in India is not a separate entity; it is a subsidiary of Citibank New York. Citibank has 30 branches in India. The main objective of our study was to have an overview of how a multinational bank manages its treasury effectively. For this purpose, we had a discussion with the Vice President of the Teasury Department, Citibank, Mr. G Ravi Shankar. Structure of Treasury Department

Treasury Department

Front Office

Middle Office

Back Office

Market Risk Mgmt

Risk Treasury

Treasurer Bond/Fixed Income Head Interest Rate Head Mktg & Sales Head Sales & Structuring Head Dealers Sales Structuring Executives

Product Control Executives

Operations Settlement



The structure of Citibank Treasury Department is divided into 5 units namely, Front Office, Middle Office, Back Office, Market Risk Management & Risk Treasury. The Front Office, which is headed by the Treasurer, is exposed to the market. The Bond/Fixed Income Head is responsible for investments in T-Bills, G-Secs & corporate bonds. The interest rate head looks after spot-forex deals and forwards. The marketing & sales head works in tandem with the sales & structuring head to deal with the corporates. Corporates approach banks to hedge their positions through derivatives in case they are engaged in export/import, ECB loans, etc. as they are restricted from dealing in derivatives. Structuring head also does Pricing. The Middle Office contains of Product Control Executives whose main function is to explain the movement in Profit/Loss Account and also to track the various market risk factors. The Back Office handles operations and settlement. They also provide the other units with the requisite information. The Market Risk Management unit is a separate committee who forecasts the banks risk in accordance with the market fluctuations in the future. The Risk Treasury Unit analysis the effect on the Balance Sheet due to the market fluctuations. Products offered The bank offers the following products:

Simple Forward Contracts Interest Rate Swaps Currency Rate Swaps



Income from Treasury On a general basis, private banks have a more aggressive approach in treasury operations than public sector banks. Treasury accounts for approximately 50-60% of the total revenues made by the bank.

Treasury across countries The bank has a Asia Pacific Region Head Office in Singapore, which conducts a review once in a year to compare the performance of various treasuries across 14 countries.

Investment Portfolio Citibank invests 100% in debt instruments. They do not believe in investing in Equity and Mutual Funds. There is no laid down structure for investment. The dealers are given full freedom to manage investments in instruments where they see optimum returns. Citibank India do not invest in instruments of foreign countries. The bank does not hold any securities in the Held to Maturity category and prefer holding securities in Available for Sale and Held for Trading category. B //The bank has set issuer limits for their investments. For example, the bank has set an exposure limit of about Rs.6500 crores in G-Secs.

Dealing through Brokers Around 80% of their dealings are done through Brokers who are registered with SEBI.

Securitization The bank actively engages in securitization with respect to its lendings, receivables, credit cards, lease receivables, etc. The bank targets Transportation companies to conduct leasing of vehicles. 105


Constituent SGL Account The bank offers constituent SGL account facilities as a value added service to their existing corporate clients. Though reporting with regards to the same needs to be done to RBI fortnightly, the bank reports weekly to RBI. Reconciliation of the CSGL account needs to be done on a daily basis.

Implications of the budget The service tax and educational cess implications of the Budget has affected the revenue from fee based services.

ALCO The bank has a separate ALCO for each city, which holds meetings twice a month. There are separate ALCOs for the Consumer banking Division and the Corporate Banking division of the bank. There is an ALCO for each country, which conducts meeting once in a year. The ALCO comprises of the Treasurer, Market Risk Manager, Middle Office Head, Risk Treasury Head, Cash Management Head, Other Product Heads and the country business manager.

Asset or Liability Management The bank follows Liability Management strategy to manage liquidity in the sense that it prefers borrowing from the market to meet their short-term requirements.




Treasury Profile Profile India's largest bank is also home to the country's biggest and most powerful Treasury, contributing to a major chunk of the total turnover in the money and forex markets. Through a network of state-of-the-art dealing rooms in India and abroad, backed by the assured expertise of informed professionals, the SBI extends round-the-clock support to clients in managing their forex and interest rate exposures. SBI's relationships with over 700 correspondent banks are also leveraged in extracting maximum value from treasury operations. SBI's treasury operations are channeled through the Rupee Treasury, the Forex Treasury and the Treasury Management Group. The Rupee Treasury deals in the domestic money and debt markets while the Forex Treasury deals mainly in the local foreign exchange market. The TMG monitors the investment, risk and asset-liability management aspects of the Bank's overseas offices. Rupee treasury The Rupee Treasury carries out the banks rupee-based treasury functions in the domestic market. Broadly, these include asset liability management, investments and trading. The Rupee Treasury also manages the banks position regarding statutory requirements like the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR), as per the norms of the Reserve Bank of India.



Products and Services Asset Liability Management (ALM): The ALM function comprises management of liquidity, maturity profiles of assets and liabilities and interest rate risks. Investments: SBI offers financial support through a wide spectrum of investment products that can substitute the traditional credit avenues of a corporate like commercial papers, preference shares, non-convertible debentures, securitized paper, fixed and floating rate products. SBI invests in primary and secondary market equity as per its own discretion. These products allow you to leverage the flexibility of financial markets, enable efficient interest risk management and optimize the cost of funds. They can also be customized in terms of tenors and liquidity options. SBI invests in these instruments issued by your company, thus providing you a dynamic substitute for traditional credit options. The Rupee Treasury handles the banks domestic investments. Trading The banks trading operations are unmatched in size and value in the domestic market and cover government securities, corporate bonds, call money and other instruments. SBI is the biggest lender in call.

FOREX TREASURY (FX) The SBI is the countrys biggest and most important Forex Treasury, both in the Interbank and Corporate Foreign Exchange markets, and deals with all the major corporate and institutions in all the financial centers in India and abroad. The banks team of seasoned, skilled and professional dealers can tailor customized solutions that meet your specific requirements and extract maximum value out of each market situation.



The banks dealing rooms provide 24-hour trading facilities and employs state-ofthe-art technology and information systems. SBIs relationships with over 700 correspondent banks and institutions across the globe enhance the strength of the Forex treasury. The FX Treasury can also structure and facilitate execution of derivatives including long term rupeeforeign currency swaps, rupee-foreign currency interest rate swaps and cross currency swaps.

OVERSEAS TREASURY OPERATION Treasury Management Group The Treasury Management Group (TMG) is a part of the International Banking Group (IBG) and functions under the Chief General Manager (Foreign Offices). As the name implies the department monitors the management of treasury functions at SBIs foreign offices including asset liability management, investments and forex operations. Products and Services offices. Investments: Monitoring of investment operations of the foreign offices of the bank Asset Liability Management (ALM): The ALM function comprises management of

liquidity, maturity profiles of assets and liabilities and interest rate risks at the foreign

is one of the principal activities of TMG. The main objectives of investment operations at our foreign offices, apart from compliance with the regulatory requirements of the host country, are (a) safety of the funds invested, (b) optimization of profits from investment operations and (c) maintenance of liquidity. Investment operations are conducted in accordance with the investment policy for foreign offices formulated by TMG. The activities include appraisal of the performance of the foreign offices broad parameters such as income earned from investment operations, composition and size of the portfolio, performance vis--vis the budgeted targets and the market value of the portfolio.



Forex monitoring: Monitoring of forex operations of our foreign offices is done with

the objective of optimizing of returns while managing the attendant risks. Forex and Interest rate (Foreign Currency) derivatives: TMG also plays an important

role in structuring, marketing, facilitating execution of foreign currency derivatives including currency options, long term rupee - foreign currency swaps, foreign currency interest rate swaps, cross currency swaps and forward rate agreements. Commodity hedging is one of the recent activities taken up by TMG. Reciprocal Lines: The department is also responsible for maintenance of reciprocal lines with international banks. PORTFOLIO MANAGEMENT & CUSTODIAL SERVICES The Portfolio Management Services Section (PMS) of SBI has been set up to handle investment and regulatory related concerns of Institutional investors functioning in the area of Social Security. The PMS forms part of the Treasury Dept. of SBI, and is based at Mumbai. PMS was set up exclusively for management of investments of Social Security funds and custody of the securities related thereto. In the increasingly complex regulatory and investment environment of today, even the most sophisticated investors are finding it difficult to address day to day investment concerns, such as Adherence to stated investment objectives Security selection quality considerations Conformity to policy constraints Investment returns The team manning the PMS Section consists of highly experienced officers of SBI, who have the required depth of knowledge to handle large investment portfolios and address the concern of large investors. The capabilities of the team range from Investment Management and Custody to Information Reporting.



The project has given an insight into the various aspects of treasury management namely Meaning and definition of treasury management. Different functions of treasury departments in banks like reserve management& investment, liquidity & fund management, assets liability management, etc. Organisational structure & objective of treasury management Element of treasury management and functions of treasurer in these elements. Nature of treasury assets and liabilities, treasury products and services, risk associated in treasury, their mitigation and RBI guidelines for risk management. Future scope and role of information technology in treasury management. SBIs treasury. SBI is the first treasury operator. SBI bank has an integrated treasury management; they dont have any competitors as such because it is well maintained and functioned. SBI has their own procedure for treasury management which is followed very well by them. Percentage of income is not disclosed by them to anyone. SBI does follow RBI guidelines for treasury management properly which they think that it is well formulated.



Risk involved in treasury management for SBI is the same like operational risk and financial risk and they aim for a well integrated and innovative management of treasury with low risk and proper function of treasury assets and liabilities. It also has good career opportunities.

Conclusion To conclude it can be said that Treasury Management forms one of the most essential part of any Bank. Banks being the major investors in debt market, treasury helps in exploiting this market to a great extent. Revenues from treasury management mainly depends on the economy, i.e. if the economy is at a boom, it results in higher returns to the banks as evident from the past years and viceversa. Treasury management being a complicated mechanism has been effectively implemented the banks to maximize their investment rationale. Treasury management helps the banks to sustain and survive in the market despite of various fluctuations and regulations in the market. Also it forms the major portion of the banks revenue as no bank can function effectively without a proper structure and strategies of treasury management and proper implementation of the same. Treasury management in it self is vast topic and is still in its niche stage as there is a wide scope that needs to be explored.