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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
TREASURY MANAGEMENT IN BANKS
MET’s Institute of Management
December 2006
2
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
?Treasury Management
Bank’s Balance SheetBank’s Balance Sheet
NDTLNDTL
What is Treasury What is Treasury Management?Management?
Treasury ProductsTreasury Products
Forex Market,Forex Market,Money Market Money Market
Securities marketSecurities marketElements of TreasuryElements of Treasury
ManagementManagementVaR, Price Gap &VaR, Price Gap &
Time GapTime Gap
Risk Exposure in MoneyRisk Exposure in MoneyMarket InstrumentsMarket Instruments
Dynamics of AssetDynamics of AssetLiability ManagementLiability Management
RBI Guidelines onRBI Guidelines onALMALM
Liquidity RiskLiquidity RiskManagementManagement
Interest Rate RiskInterest Rate RiskManagementManagement
Basel AccordBasel Accord
BANK ??BANK ??
3
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
What is a Bank???“A financial Institution that is
owned by stockholders, operates
for a profit, and engages in
lending activities”
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Bank Goals and Constraints
5
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
A Bank’s Balance Sheet
LIABILITIESLIABILITIES ASSETSASSETS
Capital Cash in hand
Reserves & Surplus Balances with RBI
Deposits Balances with other banks, money at call and notice
Borrowings Investments
Other liabilities & provisions Advances
Contingent Liabilities Fixed Assets
Others
6
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Net Demand Time Liabilities???Banks have to maintain statutory reserves on their NDTL. For calculating its
NDTL, a bank has to first sum• up its total gross liabilities, which include all demand and term deposits.
Once the gross demand and time• liabilities (DTL) is determined, the bank can deduct its Interbank assets (IBA)
from this DTL only to the extent• of its Interbank liabilities (IBL). Usually NDTL is calculated with reference to
alternate Fridays called• "Reporting Fridays". The banks are required to maintain their CRR and SLR
with reference to the NDTL as of the• reporting Friday.
• Liabilities of a bank may be in the form of demand or time deposits or borrowings or other miscellaneous items of liabilities.
• Liabilities of the banks may be towards the banking system (as defined under Section 42 of RBI Act, 1934) or towards others
• in the form of Demand and Time deposits or borrowings or other miscellaneous items of liabilities. Reserve Bank of India has
• been authorized in terms of Section 42 (1C) of the RBI Act, 1934 to classify any particular liability and hence for any doubt
• regarding classification of a particular liability, the banks are advised to approach RBI for necessary clarification.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Demand LiabilitiesDemand Liabilities
They include current deposits, demand liabilities portion of savings
bank deposits, margins held against letters of credit/guarantees,
balances in overdue fixed deposits, cash certificates 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. Money
at Call and Short Notice from outside the Banking System should be
shown against liability to others.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Time Liabilities
They include fixed deposits, cash certificates, 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,
India Millennium Deposits and Gold Deposits.
Time Liabilities
9
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Net Demand and Time Liabilities
Formula:
NDTL = liabilities to others + liabilities to
banking system – assets with
banking system
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Net Demand and Time Liabilities
• Liabilities to others = Deposits (total) –
deposits of banks
• Liabilities to banking system =
borrowings from other banks (do not
include borrowings from RBI)
• Assets with banking system = balances
with other banks, money at call/notice
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Net Demand and Time Liabilities
Statutory Requirements:
• Fortnightly Reporting
• Form – A
• Section 42(2) of the RBI Act
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Fortnightly return in Form ‘A’
• Under Section 42 (2) of RBI Act, 1934 submit
a provisional return in Form 'A' within 7 days
• Final Form 'A' is required to be sent to RBI
within 20 days
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Form A
• Memorandum to form 'A'- paid-up capital,
reserves, time deposits i.e. of short term and
Long term, CoD, NDTL, total CRR requirement etc.
– Annexure A- foreign currency liabilities and assets – Annexure B- investment in approved securities,
investment in non-approved securities, memo items such as subscription to shares /debentures / bonds in primary market and subscriptions through private placement.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Computation of DTL in Form AConverting all the foreign current assets and bank credit of
the following 4 major currencies viz. US dollar, GBP, Japanese Yen and Euro into Rupees
Format of fortnightly returns in Form ‘A’ and the method of computing DTL in Form ‘A’ i.e. if (I-III) is positive, then [(I-III) plus II], otherwise only II.
The explanations to item No's. I, II and III of the return in form 'A' are given below
• Item I - Liabilities to the Banking System in India .• Item II - Liabilities to Others in India.• Item III - Assets with the Banking System in India.
15
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
RBI act Section 42(2) SCB’s Banks Two responsible officers Return
(a) the amount of its demand and time liabilities and the amount of its borrowings from banks in India, classifying them into demand and time liabilities,
(b) the total amount of legal tender notes and coins held by it in India,
(c) the balance held by it at the Bank in India,(d) the balances held by it at other banks in current account
and the money at call and short notice in India,(e) the investments (at book value) in Central and State
Government securities including treasury bills and treasury deposit receipts,
(f) the amount of advances in India,(g) the inland bills purchased and discounted in India and
foreign bills purchased and discounted,
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
What is Treasury Management?
“Treasury management is the management of an organization’s 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 costs of the business, and control interest rate risk and currency exposure to an acceptable level.”
17
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Objectives of Treasury• Funding of investment
• Working Capital Management
• Short-term Investments
• Risk (hedging) and Forex Management
• Responsibility for the judicious use of bank’s
name
• Asset & liability management
• Maintenance of statutory reserve requirements
18
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Integrated Treasury- A Typical set up
Top Management
Treasurer
Balance sheetmanagement
Money Market activities
Forex activities
DerivativesTreasury marketing
Equities &
Commodities
ALMManagement of:ReservesGaps,liquidity
Swap TradingBond Trading (gilts & corporate paper
Spot trading,merchant cover operations
Interest rate derivatives &Forexderivatives
Marketing all the interest rate ,Foreign exchange & derivatives products
Trading in equities & commodities like gold, oil etc.
Middle officeBack-office
Financial control
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
TREASURY PRODUCTS
20
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
FOREIGN EXCHANGE MARKET
• Most liquid market. Free currencies can be readily bought and sold.
• Not fully convertible currencies which have limited demand also have sufficient liquidity.
• Virtual market. Information dissemination through electronic media like Reuters, Bloomberg.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
PRODUCTS OF FOREX MARKET
SPOT TRADES• Mostly bought and sold in spot trades• Settlement happens on a T+2 basis• Settlement can happen on the same day or the next day.• Exchange rates displayed are for spot trades unless
specified other wise.• Same day or next day trading rates are at a discount to
the SPOT rates.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
FORWARDS• Refers to purchase or sale of currency on a future
date.• Treasury gets into forward contracts with customers
(importers,exporters who do not want the currency risk) and simultaneously gets into reverse positions in the inter-bank market.
• Treasury may get into forward market to make speculative gains.
• Forward rates are arrived by adding the interest rate differential to the spot rate of low interest yielding and deducted from the spot rate of high interest yielding .
• However this is applicable in perfect markets where the currency is fully convertible. In India the demand for the currency influences the rate more than the interest differentials.
23
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
SWAPS
• Combination of spot and forward transaction.• Generally used for funding requirements, but also
arbitrage opportunity.
INVESTMENT OF FOREX SURPLUSES
• Surpluses arise due to variety of reasons• Can invest in
Inter-bank loans
Short term investments
Nostro accounts
24
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
REDISCOUNTING OF FOREIGN BILLS
• Inter bank advance where treasury refinances bills purchased by another bank.
• Though it is an inter bank deal, RBI has asked the banks to include it in their credit portfolio.
25
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
MONEY MARKET
• Refers to raising and deployment of short term resources with maturity not exceeding 1 year
• It is sub-divided into CALL (over night placements), NOTICE ( < 14 days), TERM ( < 1 year typically 1 –6 months)
• RBI has imposed restrictions on non- banks with a view to phase out their participation and make money market as a pure inter-bank market.
26
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Money Market Players & their Role
PlayerPlayerCentral BankCentral BankGovernmentGovernment
BanksBanksDiscount HousesDiscount Houses
Acceptance HousesAcceptance HousesFIsFIs
MFsMFsFIIsFIIs
DealersDealersCorporatesCorporates
RoleRoleIntermediaryIntermediaryBorrower / IssuerBorrower / IssuerBorrowers / IssuersBorrowers / IssuersMarket MakersMarket MakersMarket MakersMarket MakersBorrowers / IssuersBorrowers / IssuersLenders / InvestorsLenders / InvestorsInvestorsInvestorsIntermediariesIntermediariesIssuersIssuers
27
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Money Market Instruments
• Call Money
• Treasury Bills
• Commercial
Paper (CP)
• Certificate of
Deposits (CDs)
• Bill Financing
• Repurchase
Agreements (REPOs)
• Interest Rate Swaps
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Call Money
• Participants
• Purpose
• Call Rates
• Operation Mechanism
• Location
Mon
ey M
ark
et
Instr
um
en
ts
29
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Treasury Bills
• Issuer
• Investor
• Purpose
• Form and Size
• Types
• Yields
Mon
ey M
ark
et
Instr
um
en
ts
30
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Commercial Papers
• Definition
• Issuers
• Investors
• Features
• Maturity
• Denomination and size
Mon
ey M
ark
et
Instr
um
en
ts
31
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Certificate of Deposits
• Definition
• Issuers
• Subscribers
• Features
• Purpose
• Min size and denomination
• Term/maturity
Mon
ey M
ark
et
Instr
um
en
ts
32
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Repurchase Agreements (REPOs)
• Purpose
• Participants
• Liquidity
• Term / Maturity
Mon
ey M
ark
et
Instr
um
en
ts
34
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Interest Rate Swaps
Basic Interest Rate Swap
The difference in rates –
Fixed Market 12.00% - 10.00% = 2.00%
Floating Market MIBOR+0.50% - (MIBOR + 0.25%) = 0.25%Mon
ey M
ark
et
Instr
um
en
ts
FirmFirm ObjectiveObjective Fixed InterestFixed Interest Floating InterestFloating Interest
X Fixed Rate 12% MIBOR + 0.50%
Y Floating Rate 10.00% MIBOR + 0.25 %
35
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
SECURITIES MARKET
• Investment business is an important aspect of treasury.
• Involves buying and selling in securities market.
GOVERNMENT SECURITIES• Treasury invests primarily in Gsecs to comply
with the SLR (25%).• SLR gradually reduced over the years.• Gsecs issued by public debt office of RBI on
behalf of government.• Interest is fixed known as coupon rate but price
keeps on changing hence yield keeps on changing.
36
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
• Government uses securities to fund its deficit.• RBI uses Gsecs to control liquidity through open
market operations.• As the interest rates were falling, Gsecs were very
attractive and banks invested to the tune of 41% as against the requirement of 25%.
• However now with increasing interest rates, apprehension is the norm.
• Gsec yields are used as benchmark for other bonds.
CORPORATE DEBT PAPER• Medium and long term bonds issued by corporate
and financial inst.• Yields higher than Gsec and they differ based on
credit rating• Fairly active secondary market, hence liquid.
37
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
DEBENTURES AND BONDS• Debt instruments secured or unsecured.• Conventionally in India debentures issued by private
sectors and bonds by public sector.• Debentures are transferable only by registration
whereas bonds are negotiable.• Debentures governed by company law, bonds by
contract act.• Internationally no difference between the two.• Debenture and bond holders have the prior legal
claim ahead of preference share holders and equity shareholders.
EQUITY• Banks are allowed to invest in equities subject to a
ceiling.(currently at 5 % of total assets)
38
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
TreasuryTreasuryManagementManagement
TreasuryTreasuryManagementManagement
MoneyMoneyMarketsMarketsMoneyMoney
MarketsMarketsForeignForeign
ExchangeExchangeForeignForeign
ExchangeExchange
39
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Money Markets
Measures affecting Money Markets:
• Changes in CRR
• Changes in SLR
• Open Market Operations
• Bank Rate
• ReposTre
asu
ry M
an
ag
em
en
t
40
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Foreign Exchange
Funding avenues in Forex Market:
• Bonds
• Syndicate Credits
• Medium Term Loans
• Committed underwritten facilities
Tre
asu
ry M
an
ag
em
en
t
41
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Value at Risk (VaR)
• VaR summarizes the worst loss over a target horizon with a given level of confidence.
• Risk measured in currency unit.
• It is an estimate
• Three factors– Time horizon– Probability– Actual rupee amount itself
42
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Computation of VaR…Illustration
Change in ValueChange in Value ProbabilityProbability<=Rs 10,00,000 0.01
- Rs 5,00,000 to – Rs 9,99,999
0.04
- Rs 2,50,000 to – Rs 4,99,999
0.15
Rs 0 to – Rs 2,49,999 0.30
Rs 1 to Rs 2,49,999 0.3
Rs 2,50,000 to Rs 4,99,999
0.15
Rs 5,00,000 to Rs 9,99,999
0.4
>= Rs 10,00,000 0.1
Expected change E(∆ V)
Standard deviation (∆ V)
VaR (1%) = E(∆ V) –
2.33 (∆ V)
VaR (5%) = E(∆ V) –
1.65 (∆ V)
43
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Computation of VaR…Illustration
E(∆ V) - Rs 10,00,000
(∆ V) - Rs 15,00,000
Thus ,
VaR (1%) = 10,00,000 – 2.33 (15,00,000)
= - Rs 24,95,000
VaR (5%) = 10,00,000 – 1.64 (15,00,000)
= - Rs 14,60,000
44
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Methods used to calculate VaR
Inputs to VaR computation are obtained
through
•Historical Simulation Method
– Value at mark to market
– Requires at least 250 weeks of data.
•Monte Carlo Simulation
– Requires at least 1000 simulations
45
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Price Gap
• Price Gap can be defined as the difference in the value (Price) of the assets and liabilities, which occurs due to changes in Interest rates.
Let us consider an example:– XYZ bank issues a 5 year, 6% coupon rate bond at
face value of Rs 1000 and invests in 5 year, 6% coupon rate bond at face value of Rs 500.
– Interest rate drops to 5%– Market Price of Bond issued = 60/0.05 = Rs 1200.– Market Price of the Bond Invested = 30/0.05 = Rs 600
46
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Time Gap
• Time gap can be defined as the Gap occurring due to the difference in the maturity periods of assets and liabilities.
Let us consider an example:– Mr. X deposits Rs. 1000 with a Bank at 6% rate of
interest for a period of 1 year. – Let us consider that the bank lends this money to Mr.
Y at 11% rate of interest for 3 years. – Thus at the time of payment to Mr. X after 1 year the
bank has no money left with it since it has provided this to Mr. Y.
47
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Risk Exposure in Money Market Instruments
RisksRisksRisksRisks
CreditCreditRiskRisk
CreditCreditRiskRisk
MarketMarketRiskRisk
MarketMarketRiskRisk
48
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Market Risks…
RisksRisksRisksRisks
CreditCreditRiskRisk
CreditCreditRiskRisk
MarketMarketRiskRisk
MarketMarketRiskRisk
Exchange RisksExchange RisksExchange RisksExchange Risks
Interest Rate RisksInterest Rate RisksInterest Rate RisksInterest Rate Risks
Liquidity RisksLiquidity RisksLiquidity RisksLiquidity Risks
Equity Price RiskEquity Price RiskEquity Price RiskEquity Price Risk
Commodity RiskCommodity RiskCommodity RiskCommodity Risk
49
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Credit Risk
• Counterparties may be unwilling or
unable to fulfill obligations
• Losses due to credit risk can occur
before actual default
• Credit risk is controlled by imposing
credit limits
Market RiskMarket RiskCredit RiskCredit Risk
Tre
asu
ry M
an
ag
em
en
t R
isk
50
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Market Risk
Definition:
Market Risk is the risk to the Bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities as well as the volatilities of those changes.
Market RiskMarket RiskCredit RiskCredit Risk
Tre
asu
ry M
an
ag
em
en
t R
isk
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Asset Liability Management in Banks
52
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Components of a Bank Balance sheet
Liabilities Assets1. Capital
2. Reserve & Surplus
3. Deposits
4. Borrowings
5. Other Liabilities
1. Cash & Balances with RBI
2. Bal. With Banks & Money at Call and Short Notices
3. Investments
4. Advances
5. Fixed Assets
6. Other AssetsContingent Liabilities
53
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Banks Profit & Loss Account
A bank’s profit & Loss Account has the following components:
I. Income: This includes Interest Income and Other Income.
II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.
54
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Assets Liability Management
• It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII.
• ALM is a system of matching cash inflows and outflows, and thus of liquidity management
• ALM is the act of Planning, Acquiring and Directing the ALM is the act of Planning, Acquiring and Directing the flow of funds through the bankflow of funds through the bank
55
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Evolution of the concept of ALM
• Managing liquidity on the bank's asset side • Later shift to the liability side, termed liability management • Using both the assets as well as liabilities sides of the balance sheet to
achieve optimum resources management • In the 1980s, volatility of interest rates in USA and Europe caused the
focus to broaden to include the issue of interest rate risk • Prior to the 1990s, there was no interest rate risk as the interest rates
were regulated and prescribed by the RBI . Now the banks have been given a large amount of freedom to manage their balance sheets
• Reserve Bank of India to announce in its monetary and credit policy of October 1997 that it would issue ALM guidelines to banks
• Current decade focuses on earning a proper return of bank equity and hence maximization of its market value has meant that ALM covers the management of the entire balance sheet of a bank
56
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
RBI DIRECTIVES
• Issued draft guidelines on 10th Sept’98.• Final guidelines issued on 10th Feb’99 for implementation
of ALM w.e.f. 01.04.99.• To begin with 60% of asset &liabilities will be covered;
100% from 01.04.2000.• Initially Gap Analysis to be applied in the first stage of
implementation.• Disclosure to Balance Sheet on maturity pattern on
Deposits, Borrowings, Investment & Advances w.e.f. 31.03.01
• RBI has propose to switch over to Risk Based Supervision
57
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Objectives of ALM
• Aimed at identification, measurement, monitoring and control of the market risk segment…
• Its key objectives are:
1)stabilization of net interest income, 2)maximization of shareholders wealth, 3)managing liquidity
• The primary objective of an Asset Liability management system is liquidity risk management and interest rate risk management.
58
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Objectives of ALM in Banks
Banks Banks response to response to
Interest Rate Interest Rate ChangesChanges
Banks Banks response to response to
Interest Rate Interest Rate ChangesChanges
Interest Interest IncomeIncome
Interest Interest ExpenseExpense
Market Value of Market Value of Banks AssetsBanks Assets
Market Value of Market Value of Banks LiabilitiesBanks Liabilities
Banks NIMBanks NIM
Banks Net Banks Net WorthWorth
Invest. Value,
Profit & Risk
59
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Prerequisites of ALM
• Developing a better understanding of ALM concepts,
• Introducing an ALM information system, • Setting up ALM decision-making processes (ALM
Committee/ALCO). • Awareness for ALM in the Bank staff at all levels–
supportive Management & dedicated Teams.• Insight into the banking operations, economic
forecasting, computerization, investment, credit.• Linking up ALM to future Risk Management
Strategies.
60
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
ALCO
• Administers on a daily basis the componenets tht affect financial performance
• Develops, implements and manages banks’s annual budget or profit plan and its risk management programme
• Its compositions depends on: - size of the organisation - magnitude of operations - business mix - need for response to market dynamics
61
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Composition of ALCO
Head of Committee Head of Committee CEO/CMD/EDCEO/CMD/ED
Head of Committee Head of Committee CEO/CMD/EDCEO/CMD/ED
Chief of Chief of InvestmentsInvestments
Chief of Chief of InvestmentsInvestments
Chief of Chief of CreditCredit
Chief of Chief of CreditCredit
Chief of Chief of PlanningPlanning
Chief of Chief of PlanningPlanning
Chief of Chief of Treasury Treasury
Chief of Chief of Treasury Treasury
ChiefChiefInt. BankingInt. Banking
ChiefChiefInt. BankingInt. Banking
Economic Economic ResearchResearch
Economic Economic ResearchResearch
Head of Technical Head of Technical DivisionDivision
Head of Technical Head of Technical DivisionDivisionInvitee
62
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Responsibilities of ALCO Committee
• Balance sheet planning from risk-return perspective
- pricing bank’s liabilities (deposits) in accordance with its various assets
- to arrrive at the appropriate maturity profile for the assets and lab and to have a proper product mix
• Articulate the current interest rate view and make future strategies
• Determine source and mix of assets and liabilities
63
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Responsibilities of ALCO Committee
• Review of decisions and progress made
• Frequency of holding meetings
• Strategic management of Structural
liquidity and interest rate risk.
64
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
ALM Process
• Efficiency of ALM process depends on ALM MIS and ALM structure
• Its primary goal is to identify risk parameters• It takes care of foll. Risks
Liquidity
Interest risk
Currency
Equity
Commodity
65
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
ALM Process
• Risk Identification
• Risk Measurement
• Risk Management
• Risk Tolerance And Limit Levels
66
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Significance of ALM
• Volatility
Deregulation of financial system changed the dynamics of financial markets. Such free economic environment are reflected in Interest Rate Structure, Money Supply, Exchange Rate and Price Level
• Product Innovations & Complexities
Rapid innovation take place in financial products of the bank. They have an impact on the risk profile of the bank
• Regulatory Environment• Management Recognition
67
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Purpose & Aims of ALM
An effective Asset Liability Management
Technique aims to manage the volume, mix,
maturity, rate sensitivity, quality and liquidity of
assets and liabilities as a whole so as to attain a
predetermined acceptable risk/reward ration.
It is aimed to stabilize short-term profits, long-term
earnings and long-term substance of the bank.
The parameters for stabilizing ALM system are:
• Net Interest Income (NII)
• Net Interest Margin (NIM)
• Economic Equity Ratio
68
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Scope of ALMScope of ALMScope of ALMScope of ALM
LiquidityLiquidityRiskRisk
ManagementManagement
LiquidityLiquidityRiskRisk
ManagementManagement
InterestInterestRate RiskRate Risk
ManagementManagement
InterestInterestRate RiskRate Risk
ManagementManagement
69
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Liquidity risk
• Liquidity risk is often related to bank’s inability to pay to its depositors
• It leads to distress pricing of assets and liabilities• A bank with high degree of liquidity risk has 2
options
- to borrow funds from money market at high rates
- to increase its deposit rates• Liquidity risk has strong co-relation to interest risk
and credit risk.
70
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Adequacy of liquidity position for a bank
Analysis of following factors throw light on a bank’s adequacy of liquidity position:a. Historical Funding requirementb. Current liquidity positionc. Anticipated future funding needsd. Sources of fundse. Options for reducing funding needsf. Present and anticipated asset qualityg. Present and future earning capacity andh. Present and planned capital position
71
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Funding Avenues
To satisfy funding needs, a bank must perform one or a combination of the following:
a. Dispose off liquid assetsb. Increase short term borrowingsc. Decrease holding of less liquid assetsd. Increase liability of a term naturee. Increase Capital funds
72
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Types of Liquidity Risk
• Liquidity Exposure can stem from both internally and externally.
• External liquidity risks can be geographic, systemic or instrument specific.
• Internal liquidity risk relates largely to perceptions of an institution in its various markets: local, regional, national or international
73
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Other categories of liquidity risk
• Funding Risk
- arises due to maturing of liabilities
• Time Risk
- arises if funds lent lent with structured repayment schedule do not come back as planned
• Call Risk
- arises on crystallization of contingent liabilities
74
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Liquidity Risk Management
• Initially there was surplus liquidity but after 2004-05 the scenario changed so the need for LRM was felt evn more
75
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Liquidity Risk Management
• Liquidity management is viewed from 2 angles
- Short term Implications
- Long term Implications• Short term Implications may be viewed as per
convenience. The 2 set of tools for this purpose are: Working Funds approach and Cash flow Approach.
• Long term Implications takes into account 2 crucial aspects: Asset management and Liquidity management
76
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Dynamic v/s Static Liquidity management
• Static Liquidity Management:
- based on Balance sheet items
- behavioral pattern of deposits and liabilities
- sensitivity in response to pricing• Dynamic Liquidity Management
- analysis of cash flows
- meeting fresh investments (regulatory priorities)
- monitoring
77
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Structural liquidity statement
• It is a framework for measuring liquidity risk
• RBI’s prescription to have a fortnightly statement
• It is prepared on the basis of assets and liabilities
• It is to be reported every Friday
• Time Bucketing has to be made on residual maturity of each item
78
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Structural liquidity statement TIME BUCKETS
All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:
i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years
79
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Structural liquidity statement
• Places all cash inflows and outflows in the maturity ladder as per residual maturity
• Maturing Liability: cash outflow• Maturing Assets : Cash Inflow• Classified in to 8 time buckets• Mismatches in the first two buckets not to
exceed 20% of outflows (RBI limits)• Shows the structure as of a particular date• Banks can fix higher tolerance level for other
maturity buckets.
80
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
For Outflows of Bucketing
1. Capital & R/S
2. Current deposits
- volatile portion(15%)
- core portion (85%)
3. Time deposits, CD’s, Repos, bills discounted, interest payable
4. Bills payable
- non core portion
- core portion
5. All overdue liabilities
1.Over 5 yrs bucket
2.
- 1 to 14 days
- 1 to 3 yrs
3. Placed in respective time buckets depending on residual maturity
4.
- 1 to 14 days
- 1 to 3 yrs
5. 1 to 14 days
81
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
For Inflows of Bucketing
1.Cash, balances with RBI
2. Investments
3. Term loans , Leased Assets
4. NPA
- Substandard
- Doubtful
5. Fixed Assets
6. Reverse Repos, swaps, bills rediscntd, Int Rec
1. 1 to 14 days
2. Depends
3. Interim Cash flows under respectve maturity buckts
4.
- 3 to 5 yrs
- over 5 yrs
5. Over 5 yrs
6. Respective maturity Buckets
82
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
An Example of Structural Liquidity
Statement 1-14Days
15-28 Days
30 Days-3 Month
3 Mths - 6 Mths
6 Mths - 1Year
1Year - 3 Years
3 Years - 5 Years
Over 5 Years Total
Capital 200 200Liab-fixed Int 300 200 200 600 600 300 200 200 2600Liab-floating Int 350 400 350 450 500 450 450 450 3400Others 50 50 0 200 300Total outflow 700 650 550 1050 1100 750 650 1050 6500Investments 200 150 250 250 300 100 350 900 2500Loans-fixed Int 50 50 0 100 150 50 100 100 600Loans - floating 200 150 200 150 150 150 50 50 1100Loans BPLR Linked 100 150 200 500 350 500 100 100 2000Others 50 50 0 0 0 0 0 200 300Total Inflow 600 550 650 1000 950 800 600 1350 6500Gap -100 -100 100 -50 -150 50 -50 300 0Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0Gap % to Total Outflow-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57
83
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Its Utility and Drawbacks
Utilities
• Mismatch control
• Dominance or weakness of a bucket
• Initiate policies
• Compute interest rate sensitivity
Drawbacks
• Static and not dynamic
• Depends on residual maturity without considering the duration
84
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Dynamic Liquidity Statement
• It shows inflows and outflows limited to a period of 90 days
• To capture negative mismatch in a short term period
• Total of 3 buckets in this statement :
- 1 to 14 days
- 15 to 28 days
- 29 to 90 days
85
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Short term liquidity statement format
Particulars 1 to 14 days 15 to 28 days
29 to 30 days
Outflows
Inflows
Mismatch
Cumulative mismatch
Mismatch as a % to outflow
86
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Strategies to Address the Mismatches
• Mismatches can be positive or negative
• Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.
• In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc.
• For –ve mismatch,it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.
87
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
STRATEGIES…contd
• To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.
• The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.
88
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Maturity Pattern of Select Assets & Liabilities of A Bank
Liability/Assets Rupees(In Cr)
In Percentage
I. Depositsa. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years
1520080006700230270
10052.6344.08 1.51 1.78
II. Borrowingsa. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years
450180 00150120
10040.00 0.0033.3326.67
III. Loans & Advancesa. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years
880034003000 4002000
10038.6434.09 4.5522.72
Iv. Investmenta. Up to 1 yearb. Over 1 yr to 3 yrsc. Over 3 yrs to 5 yrsd. Over 5 years
58001300 300 9003300
10022.41 5.1715.5256.90
89
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Accounting Ratios in Liquidity Risk Management
• LRM is management of Balance sheet and ratios provide a direction to this.
• Some of the ratios are and what is desirable from liquidity point of view:
- Loans and advances to Total Assets(60% to 65%)
- Loans and advances to Core deposits(70% to 75%)
- Large liabilities to Earning assets(50%)
- Purchased funds to Total Assets(10% to 15%)
- Cash Ratio(30%)
- Loan losses to Net loans(1%)
90
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Interest Rate Risk
Interest rate risk maybe defined as the probability of loss on account of movement in interest rates, having an effect on the value of assets, liabilities, Net Interest Income (NII) and Net Interest Margin (NIM) over a period of time.
91
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Interest Rate Risk
Net Interest Income
- Difference between the interest income and interest expenses
Net Interest Margin
- Net Interest Income as a percentage of average assets.
92
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Impact of Interest rate fluctuations
Change in interest rate causes
• Change in the value of Assets & Liabilities.
• Change in the Net Interest Income (NII)
93
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Earnings at Risk
Outcome of application of a notional interest rate shock in the interest segment of a bank or a financial institution to give a stress tested earning position.
Basel Norms suggest:- Standardized interest rate shock of 2%- Danger incase of economic value below
20% of tier I and tier 2 capital.
94
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Earnings at Risk
Calculations
- Classification
- Multiply by the remaining months of maturity
- Sum up the totals
- Find the net product
- Compute the risk or fall based on 1% shock.
95
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Components
• Price Risk
• Basis Risk
• Embedded Option Risk
• Mismatch Risk
• Reinvestment Risk
Mark
et
Ris
ks
Interest Rate RiskInterest Rate RiskExchange RiskExchange Risk Liquidity RiskLiquidity Risk
96
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Maturity or Static Gap Analysis
• Measures how much Interest Rate Risk a Bank evidences at a fixed point time.
• Interest Rate risk is measured by calculating GAPs over different time periods on aggregate Balance sheet data at a Fixed point in time – hence termed as Static GAP.
Inte
rest
Rate
Ris
k M
an
ag
em
en
t
Duration Gap AnalysisDuration Gap AnalysisStatic Gap AnalysisStatic Gap Analysis
97
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
GAP STATEMENT
1. Gap for 1-14 & 15-28 Days is within limits. It does not exceed 20% of Outflows.
2. Not liquid up to 3 years horizon. Severe liquidity problems 3 months on Wards.
3. Short term deposits are funding investments 1-3 yrs and 3-5 yrs. This is Creating liquidity crunch.
98
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Interest Rate Risk Management
There are 2 Methods for managing Interest
Rate Risk.
• GAP Analysis
• Duration Analysis
99
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Rate Sensitivity
An Asset / Liability is classified as rate sensitive if
• Within the Time Interval in consideration there is a cash flow
• The interest rate resets / re-prices during the interval
• RBI changes the interest rate
• It is prepayable or withdrawable before the stated maturity
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Classification of Liabilities as Risk Sensitive
Liabilities Rate Sensitivity
1 Capital, Reserves & Surplus Non-Sensitive
2 Current Deposits Non-Sensitive
3 Saving Bank Deposits Sensitive - To the Extent of Interest paying (Core) portion.
4 Term Deposits and Certificate of Deposit
Sensitive
5 Borrowings - Fixed Sensitive
6 Borrowings - Floating Sensitive
7 Borrowings - Zero Coupon Sensitive
8 Other Liabilities and Provisions
i) Bills Payable Non-Sensitive
ii) Inter-Office Adjustment Non-Sensitive
iii) Provisions Non-Sensitive
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Classification of Assets as Risk Sensitive
Assets Rate Sensitivity
1 Cash Non-Sensitive
2 Balances with RBI Sensitive - (only the Interest earning portion)
3 Balances with other Banks
i) Current Account Non-Sensitive
ii) Money at call and Short Notice, Term Deposits and other placements
Sensitive
4 Investments
I) Fixed Rate / Zero Coupon Sensitive
ii) Floating Sensitive
5 Shares / Units of Mutual Funds Non-Sensitive
6 Advances & Investments
I) Bills Purchased and Discounted Sensitive
ii) Fixed Assets Non-Sensitive
iii) Leased Assets Sensitive
102
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Income GAP - Net Interest Income (NII)
GAP = RSA – RSL
NII = RSA*I –RSL*I
NII = GAP I
103
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Example – GAP Statement of Bank A
RSA = Rs. 100 Cr (Within 1 yr Maturity and earning 15% p.a.)RSL = Rs. 60 Cr. (Within 1 yr Maturity and raised at 9% p.a.)
Current Level Amount Rate of Interest Interest earnings / Cost
RSA Rs. 100 Cr 15% Rs. 15 Cr
RSL Rs. 60 Cr. 9% Rs. 5.4 Cr
RSA > RSL – GAP is +veCumulative GAP = RSA – RSL = Rs. 40 CrNII = 15 Cr – 5.4 Cr = 9.6 Cr
RSL maturing during 1 yr bucket RSA maturing during 1 yr bucket
Call Money 5 Investment in G-Secs 30
Borrowings from LAF 20 Loans and Advances 55
Fixed Deposit 35 Commercial papers 15
104
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Example contd.
If interest rate increase by 1%
Position at Repricing
Amount Rate of Interest
Interest earnings / Cost
RSA Rs. 100 Cr
16% Rs. 16 Cr
RSL Rs. 60 Cr.
10% Rs. 6 Cr
NII = 16 Cr – 6 Cr = Rs. 10 CrNII increased by 0.4 Cr with 1% rise in Interest rateIncome = GAP I = Rs. 40 Cr * 0.01 = Rs. 0.4 Cr
105
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Example contd.
If interest rate decrease by 1%
Position at Repricing
Amount Rate of Interest
Interest earnings / Cost
RSA Rs. 100 Cr
14% Rs. 14 Cr
RSL Rs. 60 Cr.
8% Rs. 4.8 Cr
NII = 14 Cr – 4.8 Cr = Rs. 9.2 CrNII decreased by 0.4 Cr with 1% rise in Interest rateIncome = GAP I = Rs. 40 Cr * 0.01 = Rs. 0.4 Cr
106
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Summary of Impact of interest rate movement
GAP Position
in Interest rate
in Interest income
in Interest expense
in Net Interest Income(NII)
+VE Increases
Increases
> Increases Increases
+VE Decreases
Decreases
> Decreases Decreases
-VE Increases
Increases
< Increases Decreases
-VE Decreases
Decreases
< Decreases Increases
Zero Increases
Increases
= Increases Neutral
Zero Decreases
Decreases
= Decreases Neutral
107
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
GAP Analysis - Pitfalls
• Equal Size gaps in different buckets are treated equally.
• Equity classified as Non-sensitive.
• Fixed assets as Non-sensitive.
• Effective maturity of Demand & Savings Deposit is Uncertain.
• Difficult to assess Overall Risk on the basis of gaps in various time buckets.
108
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Duration Analysis
• It is used to measure Interest Rate Sensitivity of an Asset / Liability
• It is the Weighted Avg. Maturity of all the cash flows.
• Formula:
109
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
ExampleFive Year Bond
Par Value = Rs. 10,000 , Coupon rate = 8%, YTM = 10%, Maturity = 5 Years
Time Cash Flow PV Multiplier PV Weighted PV
1 800 0.909091 727.27 727.27
2 800 0.826446 661.16 1,322.31
3 800 0.751315 601.05 1,803.16
4 800 0.683013 546.41 2,185.64
5 10800 0.620921 6,705.95 33,529.75
9,241.84 39,568.14
Duration = 39,568.14 / 9,241.84 = 4.2814 Yrs
110
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Duration GAP SummaryDGA
PInterest Rates
Change in
Assets
Market
ValueLiabiliti
esNII
+ve Increase
Decrease
> Decrease
Decrease
+ve Decrease
Increase > Increase
Increase
-ve Increase
Decrease
< Decrease
Increase
-ve Decrease
Increase < Increase
Decrease
Zero Increase
Decrease
= Decrease
None
Zero Decrease
Increase = Increase
NoneInte
rest
Rate
Ris
k M
an
ag
em
en
t
Duration Gap AnalysisDuration Gap AnalysisStatic Gap AnalysisStatic Gap Analysis
111
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Limits and Triggers
• Cap on inter-bank borrowings
• Purchased funds vis-à-vis liquid
assets
• Core deposits vis-à-vis Core Assets
• Duration of liabilities and investment
portfolio
Mark
et
Ris
ks
112
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
“All of life is the management of Risk, not its
elimination.”- Walter Wriston
Former Chairman of Citicorp
113
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Assets Liabilities
100 Crores, 5 years, Fixed rate loan@10%
90 Crores, 30 days deposit @6%
Equity 10 Crores
Total 100 Crores Total 100 Crores
Consider an Example…
NII = 10 Crores – 5.4 Crores = 4.6 CroresNIM = (10 crores-5.4 crores)/100 Crores = 4.6%
114
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Assets Liabilities
100 Crores, 5 years, Fixed rate loans@10%
90 Crores, 30 days deposits @8%
Equity 10 Crores
Total 100 Crores Total 100 Crores
Interest Rates Increase by 2%
NII = 10 Cr – 7.2 Cr = 2.8 CrNIM = (10 Cr-7.2 Cr)/100 Cr = 2.8%Change In NII &NIM = 1.6Cr, -1.6%
115
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Some
Sample
Strategies
by Banks
116
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Money Market Instrument
Exporter expecting a payment of $1000 (in 30 days) Current rate Rs. 44/ $1 Payment after conversion is Rs. 44000
Borrow $1000 from US Market – Interest rate 3%(30 days)Convert into Rupees i.e. Rs. 44000
Invest the Rs. 44000 in Indian Money market instrument – interest rate 2% (30 days)
117
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Example contd…
After 30 days Receive the payment of $1000, and use it to pay off the Principal.
Interest to be paid - $1000 * 0.03 = $30 = Rs 30 *42 = Rs 1260 Interest earned – Rs 44000 * 0.02 = Rs. 880
After 30 days Exchange rate – Rs 42/$1
Cost of the Hedge = 1260 – 880 = Rs 380
Loss if not hedged = (44-42) * 1000 = Rs. 2000
118
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Interest Rate Swaps (IRS)
Bank A has Investment of Rs 1000 in a Bond with a coupon rate of 10% and maturity 5 years.
It wants to hedge the entire Rs.1000 against Interest Rate Risk.
It gets into an IRS with Bank B.
119
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
IRS Example Contd.
Bank A Bank B
Fixed Rate 10%
Floating Rate
120
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
IRS Example Contd.Notional amount = 1000 Duration 5 Yrs
Years A Pay-in
(Fixed 10%)
B Pay-in
(Floating)
Current Interest
rate
Difference
A Pay-Out
B Pay-Out
1 10 10 10 0 0 0
2 10 11 11 1 10 -10
3 10 10.5 10.5 0.5 5 -5
4 10 10 10 0 0 0
5 10 9.5 9.5 0.5 -5 5
Pay-out from Bond
Total pay-out
Rate of return
100 100 10
100 110 11
100 105 10.5
100 0 0
100 95 9.5
121
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Without Hedging
With Hedging
Risk management through derivatives
122
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Main types of strategy
Buying an option Defensive strategy
Selling an option Offensive strategy
Dealing a firm product Neutral strategy
123
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Hedging techniques for an Fx.risk
View of Currency View of Risk ActionVery Bullish Risk Averse Buy Currency ForwardVery Bullish Risk Tolerant Buy Currency ForwardBullish Risk Averse Buy Currency ForwardBullish Risk Tolerant Buy ATM call
Flat Market Risk AverseDo Nothing or Buy OTM Call
Flat Market Risk Tolerant Do nothiingNo View Risk Averse Buy ATM call
No View Risk TolerantDo nothing or Buy ATM call
Bearish Risk Averse Buy OTM CallBearish Risk Tolerant Do Nothing
Very Bearish Risk AverseDo nothing or Buy FAR OTM Call
Very Bearish Risk Tolerant Do Nothing
124
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Can you beat that !!In India,
• we have 88 commercial banks,
• which account for about 82%
(total assets of the financial sector)
• over 2000 cooperative banks, which account for about 5%;
• and 133 Regional Rural Banks, which account for about 3%.
125
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Taking into account the ---• size, • complexity of operations,• relevance to the financial sector,• need to ensure less risk • and the need for having an efficient delivery
mechanism
We need constant changes to make it more competitive !!
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
APPROACH OF RBI
With the commencement of the banking sector reforms in the early 1990s,
RBI has been consistently upgrading the Indian banking sector by adopting international best practices.
The approach to reforms is by having clarity about the destination, deciding on the sequence and modulating the pace of reforms to suit Indian conditions
127
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
BASEL I
The current risk-based capital adequacy rules, adopted in 1989, are based on the International Basel Capital Accord of 1988 (Basel I).
• Basel I requires all banks to maintain a minimum total risk-based capital ratio of 8 percent.
• India implemented the Basel I framework with effect from 1992-93 which was, however, spread over 3 years
128
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Limitations of Basel I
• Insufficiently sensitive to risk (broad categories)
• Very limited account of risk mitigation
• To lend to poorer quality credits
• No incentive structure to improve risk measurement and risk management practice
129
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
WHY TO SHIFT TO BASEL II ?
• it is more risk sensitive;
• it recognizes developments in risk measurement and risk management techniques
• Basel II takes the regulatory framework closer to the business models employed in banks
• Further, the Basel I framework can be seen as a “one size fits all” model
130
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
PILLAR 1 PILLAR 3PILLAR 2
IncreasedSupervisory
Power
IncreasedDisclosure
Requirements
Minimum Capital
Requirement
MarketDiscipline
Requirements
SupervisoryReviewProcess
RulesTo Calculate
Required Capital
Capital Adequacy
Basel II – the Three Pillars
Keeping in mind following risk -- Credit risk , Market risk & Operational risk
implementing Basel II with effect from March 31, 2007
131
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
The Risk Categories in Basel II
• Credit risk – the risk that a borrower or counterparty might not honour its contractual obligations
• Market risk – the risk of adverse price movements such as exchange rates, the value of securities, and interest rates
• Operational risk – the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events
132
Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Credit Risk
• Basel II places emphasis on improving the management and measurement of credit risk
• The measurement of credit risk implies assessing the borrower’s creditworthiness.
• A loan should, therefore, be priced to reflect how much risk it involves.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
1.What is the probability of a counterparty going into
default?
1.What is the probability of a counterparty going into
default?
2. How much will customerowe the bank in the case ofdefault? (Expected Exposure)
2. How much will customerowe the bank in the case ofdefault? (Expected Exposure)
3.How much of that exposure is the bank going to lose?3.How much of that exposure is the bank going to lose?
“Probability of Default”“Probability of Default”
“Loan Equivalency”(Exposure at Default)“Loan Equivalency”(Exposure at Default)
“Severity”(Loss Given Default)
“Severity”(Loss Given Default)
PDPD
LGDLGD
EaDEaD
=
=
=
X
X
Size of Expected Loss Size of Expected Loss “Expected Loss““Expected Loss“ ELEL=
=
Components of Credit Risk
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Credit Risk Approaches
For each portfolio, the banks must choose One approach from a set of Three:
– Standardised Approach – Ratings Based Approach
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Standardised Approach
• New risk weights (0%; 20%; 50%; 100%, 150%) used for assessing capital required.
• Uses External Ratings (where available)
• Unrated weighted at 100%
• 35% weight for claims secured by Residential Mortgage
• 100% weight for claims secured by Commercial Mortgage
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Internal Rating (IR) Approach
This method has been further classified to• Foundation IR approach• Advanced IR approach
In both methods, capital is allocated based on the following 3 factors:
• Exposure at default (EAD) –amount that is likely to be drawn in default.
• Loss given at default (LGD) – Measures the proportion of lost exposure in default
• Probability of default (PD) - chances of default in terms of percentage (Default – fails to repay borrowings)
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Advanced Internal Ratings Based Approach
- Same principles as for Foundation Approach, but all items are provided by the bank, based on internally developed models
- Capital charge - subject to a floor at 90 % in 2008 and 80 % in 2009
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Expected Loss(EL) =
Probability of Default
(PD)
Severity of Loss(LGD)
Exposure atDefaultxx
Standardised = External x Regulatory x Regulatory Rating Imposed Imposed
IRB = Proprietary x Regulatory x Regulatory
Foundation Rating Imposed Imposed
IRB = Proprietary x Proprietary x Proprietary
Advanced Rating Severity Exposure
Credit Risk Approaches
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Some simple Calculations … Some simple Calculations …
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
The 3 Approaches
Standardised
Approach
AdvancedIRB
Approach
- One size fits all- No capital incentives
for better Credit Risk
- Risk based- Incentive to
manage risks
Simple
Low level of detail
Sophisticated
High level of detail
High sensitivity to risk Little sensitivity to risk
FoundationIRB
Approach
Management
(Internal RatingsBased)
(Internal RatingsBased)
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Operational Risk
It is defined as the risk of losses resulting from inadequate -
• or failed internal processes, • people, and systems, or• external events• and Banks use their own methodology for
assessing exposure to operational risks.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
• Operational Risk (OR) will add to banks’ regulatory capital requirements
• Operational risk is not restricted to banks, it’s present in all organisations including yours
Operational Risk
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
PILLAR 1 – Minimum Capital Requirement
• A banks own assessment of key risk factors for a particular exposure serve as the primary inputs in the calculation of the banks risk-based capital requirements.
• These risk factors are then inserted into formulas specified by the Agencies to derive a specific rupee amount capital requirement for each exposure or group of exposures.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
PILLAR 2 Supervisory Review Process
• It focuses on the regulatory review that would be necessary to ensure that a bank holds sufficient capital given its overall risk profile.
• Since banks are already required to hold capital sufficient to meet their risk profiles under Basel I, the new accord does not propose anything new under the second pillar.
• Existing rules such as the prompt corrective action rules would continue to be enforced and supplemented as necessary to ensure that an institution holds sufficient capital given its overall risk profile.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
PILLAR 3 Market Discipline Requirements
• Specific disclosure requirements would be applicable to all banks
• Banks would have to disclose in their public financial
reports or in regulatory reports on a quarterly basis, their risk management policies for each separate risk area and their exposures to credit and other types of risks.
• This would allow shareholders and debt holders to assess a banks capital structure, risk exposures, risk assessment processes, and capital adequacy.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Comparison of Basel Accords
Greater Risk Sensitivity
Broad Brush
Menu of ApproachesOne Size Fits All
Three Pillars Focus on Single Measure (Capital)
2004: Basel II1988: Basel I
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Minimum RegulatoryCapital
Capital=
Minimum RegulatoryCapital
Capital
Creditrisk
Operationalrisk
Marketrisk
= + +
Basel II
Basel I
(Credit & Market) Risk adjusted assets
Comparison ..
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
Consolidations in the Indian Banking Industry
• Lower capital levels that large banks obtain under Basel II will likely result in more acquisitions by the larger banks.
• Since most community banks will remain under Basel I, they will have difficulty competing against bigger Basel II banks that benefit from reduced capital requirements and higher ROEs. Basel I banks will become likely takeover targets for Basel II banks that believe they can deploy Basel I bank capital more efficiently.
• Even without the compulsions of Basel, Indian banking industry is on a look out for expanding their operations to the overseas countries. The domestic markets are saturated and some of the banks have already tested the foreign waters for profitable markets.Hence there is a need for consolidation in the banking industry today in order to compete for a piece of the pie in the international markets.
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
CONCLUSION• Future presents both challenges and opportunities
• Enhance the financial performance and raise the visibility of treasury
• Increased use of automation and outsourcing and relying on a more versatile staff
• As all policies with respect to Basel need to be considered within the broader context of the banks own business strategy.
• Banks need risk management packages not only to adhere Basel II ,also for effective risk management and mitigation, gain competitive advantage, develop the robust system, transparency, and cost reduction through detailed data analysis
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
?Treasury Management
Bank’s Balance SheetBank’s Balance Sheet
NDTLNDTL
What is Treasury What is Treasury Management?Management?
Treasury ProductsTreasury Products
Forex Market,Forex Market,Money Market Money Market
Securities marketSecurities marketElements of TreasuryElements of Treasury
ManagementManagementVaR, Price Gap &VaR, Price Gap &
Time GapTime Gap
Risk Exposure in MoneyRisk Exposure in MoneyMarket InstrumentsMarket Instruments
Dynamics of AssetDynamics of AssetLiability ManagementLiability Management
RBI Guidelines onRBI Guidelines onALMALM
Liquidity RiskLiquidity RiskManagementManagement
Interest Rate RiskInterest Rate RiskManagementManagement
Basel AccordBasel Accord
BANK ??BANK ??
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Treasury Management in Banks – Presented by Namrata Padhye, Ritu Madan & Anand Iyer
THANK YOU