Audit Treasury Bank of India

www.icai.orgMay / 2010 (Reprint)

ISBN : 978-81-8441-296-3

The Institute of Chartered Accountants of India(Set up by an Act of Parliament)

New Delhi

Price : Rs. 150/-

Technical Guide on Internal Audit of

Treasury Function in Banks

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Technical Guide on Internal Audit of

Treasury Function in Banks

DISCLAIMER:

The views expressed in the Technical Guide are those of author(s). The Institute of Chartered Accountants of India may not necessary subscribe to the views of the author(s).

The Institute of Chartered Accountants of India

(Set up by an Act of Parliament) New Delhi

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The Institute of Chartered Accountants of India

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior permission, in writing, from the publisher.

Edition : January, 2010

Committee / : Internal Audit Standards Board Department

Email : [email protected]

Website : www.icai.org

Price : Rs. 150/- (Including CD)

ISBN No. : 978-81-8441-296-3

Published by : The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi-110 002.

Printed by : Sahitya Bhawan Publications, Hospital Road, Agra-3. May/2010/1,000 Copies (Reprint)

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FOREWORD

With the significant developments that have taken place in the capital, money and foreign exchange markets in the recent years affecting volatility in exchange rates and accentuating liquidity constraints, organisations have started paying closer attention to the treasury management function. The globalization of the economy with mobilization and deployment of funds from/in other countries is also necessitating increased attention in the area of treasury management. Banking industry has been all long focusing on successful treasury management, which is extremely necessary for their strong, viable and profitable existence.

In view of the complexity, volume and growth of treasury function in banks, internal auditors have a dynamic role to play to support the banks in helping to achieve the strategic goals. Internal auditors can strengthen the banks treasury functions by reviewing critical control systems and risk management processes and providing valuable suggestions.

I am happy to note that the Internal Audit Standards Board of the Institute is issuing this publication Technical Guide on Internal Audit of Treasury Function in Banks containing extensive knowledge on this complex subject.

I congratulate CA. Shanti Lal Daga, Chairman, Internal Audit Standards Board and the members of the Board on issuance of this publication. I am confident that this comprehensive publication would help the members as well as other readers in acquiring good knowledge of products, practices and regulations of treasury function in banks.

January 12, 2010 CA. Uttam Prakash Agarwal New Delhi President

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PREFACE

In this financially globalized volatile world, banks treasury groups which are ultimately responsible for keeping their banks in business are witnessing tremendous changes. The change is being forced with rapid economic developments, globalizing industries and competition, new technologies and revolutionary changes in the regulatory environment. Apart from responding to these changes, treasury functions of banks are under pressure to add value to the banks through their operations and contribute to achieve strategic goals.

Internal audit helps the organisations to achieve their stated objectives. Carrying out an internal audit of treasury functions in banks requires an in-depth understanding of the applicable statutes, systems and processes since it operates under a very regulated and governed atmosphere. Specialist knowledge in certain areas of banking is also of equal importance.

In the wake of these developments in the field of treasury management in banks, the Internal Audit Standards Board of the Institute is issuing this publication Technical Guide on Internal Audit of Treasury Function in Banks for the members of the Institute as well as bankers. This publication is aimed to help the readers in understanding the roles and responsibilities of the treasury function in banks as well as in determining the nature of internal audit procedures to be undertaken. The Technical Guide has been divided into various chapters covering aspects such as treasury products and services, treasury dealing room, organisational structure of a banks treasury, investment portfolio, asset liability management, treasury risks. The guide also deals with the fundamental controls and the internal audit procedures with special reference to treasury/ market risk segments. It also contains detail checklist on internal audit of treasury operations, foreign exchange operations and domestic operations of treasury. It also includes a compilation of relevant circulars issued by the Reserve Bank of India applicable to treasury operations of a bank. For better understanding of the readers, the guide also contains an introduction section and also a glossary of some technical terms used in the Guide.

At this juncture, I am grateful to CA. Rajkumar S. Adukia, Central Council Member and convenor of the Group ably assisted by other members of the Group, viz., CA. Pankaj Adukia, CA. Abhay Arolkar and CA. Vijay Joshi for

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squeezing out time out of their professional and personal commitments and preparing the basic draft of this Technical Guide. I would also take the opportunity of placing on record my gratitude to CA. Akeel Master for reviewing the draft and giving his valuable comments and suggestions.

I also wish to thank CA. Uttam Prakash Agarwal, President and CA. Amarjit Chopra, Vice President for their continuous support and encouragement to the initiatives of the Board. I must also thank my colleagues from the Council at the Internal Audit Standards Board, viz., CA. Ved Jain, CA. Abhijit Bandyopadhyay, CA. Bhavna G. Doshi, CA. Pankaj I. Jain, CA. Sanjeev K. Maheshwari, CA. Mahesh P. Sarda, CA. S. Santhanakrishnan, CA. Vijay K. Garg, Shri Krishna Kant, Shri Manoj K. Sarkar and Shri K. P. Sasidharan for their vision and support. I also wish to place on record my gratitude for the coopted members on the Board, viz., CA. N. K. Aneja, CA. Verendra Kalra, CA. M. Guruprasad, CA. Dilip Kumar Vadilal Shah and CA. K. S. Sundara Raman as also special invitees on the Board, viz., CA. K. P. Khandelwal, CA. S. Sundarraman, CA. Ravi H. Iyer, CA. Rajiv Dave, CA. Pawan Chagti, CA. Ram Mohan Johri and CA. Arindam Guha for their devotion in terms of time as well as views and opinions to the cause of the professional development. I also wish to place on record the efforts put in by CA. Jyoti Singh, Secretary, Internal Audit Standards Board and CA. Arti Aggarwal, Senior Executive Officer, for their inputs in giving final shape to the publication.

I am sure that the members of the Institute would find the Technical Guide immensely useful in understanding the intricacies of the subject matter and in carrying out their professional duties diligently.

January 29, 2010 CA. Shantilal Daga Hyderabad Chairman Internal Audit Standards Board

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CONTENTS

Foreword................................................................................................... iii Preface.......................................................................................................v Glossary.................................................................................................... ix Introduction ............................................................................................ xvii CHAPTER : 1. Treasury- An Introduction .............................................................. 1 - 4 2. Treasury Products and Services ............................................. 1 - 7 3. The Treasury Dealing Room................................................... 1 - 3 4. Organisational Structure of A Banks Treasury ........................ 1 - 6 5. Investment Portfolio..................................................................... 1 - 13 6. Asset Liability Management...........................................................1 6 7. Treasury Risks....................................................................... 1 - 6 8. Treasury Unit Fundamental Controls........................................ 1 - 13 9. Internal Audit of Treasury Operations............................................ 1 - 6 ANNEXURES : Annexure A- Specimen Checklist for Internal Audit of Treasury Operations...... Annexure B - Specimen Checklist for Internal Audit of Foreign Exchange Operations of Treasury......................................... Annexure C- Specimen Checklist for Internal Audit of Domestic Operations of Treasury........................................................ Annexure D- Guidance Note on Market Risk Management ................... Annexure E - Assets Liability Management (ALM) System.................... Annexure F- RBI Mc Guide primary dealers 2009................................. Annexure G RBI Mc Capadeqrm 2009 .................................................

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Annexure H- RBI Mc Callmoney 2009.................................................. Annexure I - RBI Mc Cd 2009 .............................................................. Annexure J - RBI Mc Comlpaper 2009 ................................................. Annexure K- RBI Mc Prunormsinvestt 2009 ........................................

GLOSSARY

Arbitrage The purchase or sale of an instrument and simultaneous taking of an equal and opposite position in a related market, in order to take advantage of small price differentials between markets.

Asset Class Securities with identical risk/reward composition, attributes and features.

At-the-money An option contract with identical risk/ reward composition and features.

Asset Allocation Investment practice that divides funds among different markets to achieve diversification for risk management purposes and/or expected returns consistent with an investors objectives.

Asset Liability Management (ALM)

A risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities.

Business Risk Risk associated with the unique circumstances of a particular entity, as they might affect the price of that entitys securities.

Back-office The departments and processes related to the settlement of financial transactions.

Cash Money in the form of authorized currency (including coins) and bank balances.

Cash Management: The strategy by which a company administers and invests its cash.

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Cash Flow at Risk The Cash Flow at Risk approach answers the question of how large the deviation between actual cash flow and the planned value (or that used in the budget) is due to changes in the underlying risk factors.

Cash Position Cash Position in foreign exchange deals with all the transactions effecting Nostro account, funding of Nostro (in case of overdraft), utilization of surplus cash balance in Nostro and deployment of funds so as to ensure optimum utilization. Examples are delivery under forward contracts, inward /outward telex transfer, etc. It is also called fund position.

Centralised Funds Management System (CFMS)

The Centralised Funds Management System (CFMS) provides for a centralised viewing of balance positions of the account holders across different accounts maintained at various locations of the RBI.

Collar Option A protective options strategy that is implemented after a long position in a stock has experienced substantial gains. It is created by purchasing a put option while simultaneously writing a call option. (also known as hedge wrapper)

Cost of Carry Expenses incurred while a position is being held, for example, interest on securities bought on margin, dividends paid on short positions, and other expenses.

Cross Hedge Hedging a cash market position in a futures or option contract for a different but price-related commodity.

Credit Information Bureau of India Ltd. (CIBIL)

Indias first credit information bureau- is a repository of information, which contains the credit history of commercial and consumer

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borrowers. CIBIL provides this information to its members in the form of credit information reports.

Currency Position It deals with daily sale/purchase of foreign currency/transaction. It could be excess, less or equal. In that case we call it overbought (more purchase) oversold (more sales) or square (purchase matches sales) respectively.

Currency Risk The probability of an adverse change in exchange rates.

Day Trading Refers to positions which are opened and closed on the same trading day.

Derivative A contract that changes in value in relation to the price movements of a related or underlying security, future or other physical instrument. An option is the most common derivative instrument.

Duration The weighted average term to maturity of a security's cash flows, where the weights are the present value of each cash flow as a percentage to the security's price.

Earnings at Risk Outcome of notional interest rate shock on interest income.

Electronic Clearing Services (ECS) ECS (Credit)

Credit clearing ensures multiple repetitive credits to the accounts of constituents of banks situated at various branches of banks on the basis of a single debit to the account of a corporate customer called the user.

ECS (Debit) Debit clearing ensures multiple repetitive debits to the accounts of constituents of banks situated at various branches of banks and a corresponding single debit to the account of a corporate customer called the user.


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Expected Loss High frequency but low severity from any activity or risk.

Financial Risk Uncertainty of results to the investor due to financial modality.

Forward The pre-specified exchange rate for a foreign exchange contract settling at some agreed future date, based upon the interest rate differential between the two currencies involved.

Fundamental Analysis Analysis of economic and political information with the objective of determining future movements in a financial market.

Futures Contract An obligation to exchange a good or instrument at a set price on a future date. (The primary difference between a future and a forward is that futures are typically traded over an exchange (Exchange Traded Contracts ETC), versus forwards, which are considered Over the Counter (OTC) contracts. An OTC is any contract not traded on an exchange.)

Growth Stock Stock of a company which is growing earnings and/or revenue faster than its industry or the overall market, and as compared to stock with similar risk features.

Herstatt Risk or Systemic Risk This risk was in focus in 1974 when Herstattt Bank (a German bank) had to shutter down, as settlement of second leg of currency could not be completed due to time zonefactors.

Hedge A position or combination of positions that reduces the risk of your primary position.

Indian Financial Network (INFINET)

The Indian Financial Network (INFINET) is the communication backbone for the Indian

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Banking and Financial Sector. All banks, public sector undertakings, private sector organisations, co-operative, etc., and the premier financial institutions in the country are eligible to become members of the INFINET.

Inflation An economic condition whereby prices for consumer goods rise, eroding purchasing power.

Initial Margin The initial deposit of collateral required to enter into a position as a guarantee on future performance.

In the Money Situation in which an option's strike price is below the current market price of the underlier (for a call option) or above the current market price of the underlier (for a put option). Such an option has intrinsic value.

Leading Indicators Statistics that are considered to predict future economic activity.

Limit Order An order with restrictions on the maximum price to be paid or the minimum price to be received.

Liquidity The ability of a market to accept large transaction with minimal to no impact on price stability.

Liquidity Risk The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset.

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Liquidation The closing of an existing position through the execution of an off-setting transaction.

Long Position A position that appreciates in value if market prices increase.

Market Risk Exposure to changes in market prices.

Mark-to-Market Process of re-evaluating all open positions with the current market prices. These new values then determine margin requirements.

Maturity The date for settlement or expiration of a financial instrument.

National Settlement System (NSS)

All clearings conducted in all clearing houses in all parts of the country will be settled in a single centralized location in central bank money.

Negotiated Dealing System (NDS)

Negotiated Dealing System (NDS) is an electronic platform for facilitating dealing in Government Securities and Money Market Instruments.

Offer The rate at which a dealer is willing to sell a currency.

Open Position A deal not yet reversed or settled with a physical payment.

Operational Risk The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

Over the Counter (OTC) It is used to describe any transaction that is not conducted over an exchange.

Overnight A trade that remains open until the next business day.

Political Risk Exposure to changes in governmental policy which will have an adverse effect on an investors position.

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Position The netted total holdings of a given currency.

Premium In the currency markets, it describes the amount by which the forward or futures price exceed the spot price.

Primary Dealers Primary dealers can be referred to as Merchant Bankers to the Government of India, comprising the first tier of the government securities market. Satellite dealers work in tandem with the Primary dealers forming the second tier of the market to cater to the retail requirements of the market.

Quote An indicative market price, normally used for information purposes only.

Rate The price of one currency in terms of another, typically used for dealing purposes.

Risk Exposure to uncertain change, most often used with a negative connotation of adverse change.

Risk Management The employment of financial analysis and trading techniques to reduce and/or control exposure to various types of risk.

Roll Over Process whereby the settlement of a deal is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies.

Settlement The process by which a trade is entered into the books and records of the counterparts to a transaction .The settlement of currency trades may or may not involve the actual physical exchange of one currency for another.

Settlement Risk The risk that one party will fail to deliver the terms of a contract with another party at the time of settlement.

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Short Position Investments position that benefit from a decline in market price.

Spot Price The current market price. Settlement of spot transactions usually occurs within two business days.

Spread The difference between the bid and offer prices.

Structured Financial Messaging Solution (SFMS)

SFMS allows intra/inter bank message transfer. This also provides for transfer of file attached in a secured mode.

Swap A currency swap is the simultaneous sale and purchase of the same amount of a given currency at a forward exchange rate.

Tail Risk Probability of loss due to most unsecured market movements.

Technical Analysis An effort to forecast prices by analyzing market data, i.e., historical price trends and averages, volumes, open interest, etc.

Tick Size The smallest increment in which the price for a futures contract can move.

Transaction Cost The cost of buying or selling a financial instrument.

Transaction Date The date on which a trade occurs. Turnover The total money value of all executed

transactions in a given time period. Value at Risk (VAR) It is a measure of how the market value of

an asset or of a portfolio of assets is likely to decrease over a certain time period under usual conditions.

Yield to Maturity (YTM) The percentage rate of return paid on a bond, note, or other fixed income security if the investor buys and holds it to its maturity date.

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INTRODUCTION

1. Preface to the Standards on Internal Audit issued by the Institute of Chartered Accountants of India defines Internal Audit as follows:

Internal audit is an independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entitys strategic risk management and internal control system. Internal audit, therefore, provides assurance that there is transparency in reporting, as a part of good governance.

2. Internal audit objectives, with specific reference to treasury function in a bank, includes following important aspects:

(a) To ensure that policies and procedures relating to all treasury activities have been framed and are periodically reviewed for adequacy and coverage.

(b) To determine whether management has planned for liquidity needs for both normal operating conditions and emergency situations.

(c) To ensure adequate physical and access control procedures are in place in the department.

(d) To verify existence of satisfactory controls in the processing of deals.

(e) To ascertain that the bank receives favorable rates for all its deals.

(f) To check authenticity and appropriateness of the sources of inputs used for valuation of unquoted treasury instruments.

(g) To check that there is accurate recording and accounting of positions.

(h) To ensure that proper documentation procedures and filing systems are in place.

(i) To ensure that limits are set for different procedures and they are adhered to in a consistent manner.

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(j) To verify that any violations are promptly reported and properly dealt with.

(k) To ensure that reconciliation is being made timely and accurately, including daily reconciliation of the dealers profit and loss to the general ledger.

(l) To evaluate the adequacy and effectiveness of the internal control system and to suggest measures for improvement, if any.

(m) To indicate probable risk-prone areas within treasury, based on the prevailing external economic environment, and to offer views for safeguarding the interest of the bank.

(n) To aid and facilitate risk based supervision function of the RBI (Pillar 2 of the Basel Accord) in regard to a banks treasury/market risk business areas.

(o) To ensure compliance with the guidelines issued by the RBI, SEBI, FEMA, FEDAI, etc., and other guidelines issued from time to time.

(p) To verify that interest and dividend income is accounted for fully and correctly.

(q) To verify that all counterparty confirmations are received.

3. The precise scope of risk-based internal audit of treasury transactions must be determined by each bank for low, medium, high, very high and extremely high risk areas. This Technical Guide contains matter relevant for domestic compliance only. In case of overseas treasury operations, the RBI guidelines on the subject and the domicile country requirements will also be required to be considered.

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Raj aalianSticky Notecounter party confirmations are not required by the treasury department.

CHAPTER 1

TREASURY- AN INTRODUCTION

Meaning 1.1 A treasury is any place where currency or items of high monetary value are kept. The term treasury was first used in classical times to describe the votive buildings erected to house gifts to the gods, such as the Siphnian Treasury in Delphi or other similar buildings erected in Olympia, Greece by competing city-states, to impress others during the ancient Olympic Games.

1.2 A treasury can either be:

The part of a government which manages all money and revenue;

The funds of a government or institution or individual;

The government department responsible for collecting, managing and spending public revenues;

A depository ( room or building) where wealth and precious objects can be kept; or

The center of financial operations within an organisation.

Treasury in Banks 1.3 Traditionally, the treasury function in banks was limited to Funds management, i.e., maintaining adequate cash balances to meet day-to-day requirements and deploying surplus funds from operations. The treasury in a bank is also responsible for maintenance of reserve requirements (Cash Reserve Ratio and Statutory Liquidity Ratio). Treasury was considered a service centre and liquidity management was its main function.

The scope of treasury has now expanded beyond liquidity management and treasury has now evolved as a profit centre with its own trading and investment activity.

1.4 Presently, as per RBI circular on Guidelines Accounting Standard 17 (Segment Reporting) Enhancement of Disclosures dated April 18, 2007, banks

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are required to report under the following business segments as primary reporting format and for the purpose of segment reporting under Accounting Standard (AS) 17, Segment Reporting:

(a) Treasury

(b) Corporate / Wholesale banking

(c) Retail banking and

(d) Other banking operations

Domestic and International segments will be the geographic segments for disclosure. Treasury activity in a bank depends on its size, complexity of operations, area of operations and risk profile.

Integrated Treasury 1.5 Traditionally, the domestic treasury operations were independent of forex dealings of a bank. The need for an integrated treasury rose in the backdrop of interest rate deregulations, liberalization of exchange control, development of forex market and advancement in the settlement systems and dealing environment. The integrated treasury besides performing the functions of the traditional roles also performs the following functions:

(a) Reserve management and Investment- This involves meeting Cash Reserve Ratio (CRR)/Statutory Liquidity Ratio (SLR) obligations and having an optimum mix of investment portfolio.

(b) Liquidity and Funds management- This involves analysis of major cash flows; providing inputs to planning group on funding mix( currency, tenor and cost) and yield expected in credit and investment.

(c) Asset liability management and term money- This involves determining the optimum size and growth rate of the balance sheet; and also price the assets and liabilities in accordance with the prescribed guidelines.

(d) Risk Management- This involves managing all market risks associated with the banks assets and liabilities. Risk management also includes management of credit risks on treasury products and operations risks on payments and settlements.

(e) Transfer pricing- Ideally , the integrated unit should provide benchmark rates after assuming market risks to various business groups and product

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categories about adopting the correct business strategy to ensure that the funds are deployed optimally.

(f) Derivative products- Treasury can develop Interest rate swaps, and other derivative products to hedge the banks exposure and also sell such products to customers or other banks.

(g) Arbitrage- This involves simultaneous buying and selling of the same type of assets in two different markets in order to make risk-less profits.

(h) Capital adequacy- This focuses on quality of assets and Return on investments is key criteria for evaluating the efficiency of deployed funds.

(i) Canalizing and managing other asset instruments into investment instruments e.g., instruments resulting out of Corporate Debt Restructuring, Asset Reconstruction, Pass Thru certificates, Asset Backed Securitization (ABS), Mortgage Backed Securitization(MBS), etc.

(j) To monitor the Rating Migrations on an on going basis and take timely corrective action.

(k) To minimize the level of provisional requirements due to non-performing investments.

1.6 Treasury operations play a pivotal role in not only improving the bottom line of banks but also in Balance Sheet management by reducing risks by hedging sensitive exposures. Treasury management would, normally, consist of management of its cash flows, banking, money market and capital market transactions; effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks keeping in mind the business objectives and in consonance with the regulatory framework.

Objectives of Treasury management 1.7 The objectives of treasury management can be stated as under:

(a) To plan, organize and manage funds profitably and to ensure compliance with respect to regulatory requirements (SLR/CRR).

(b) Treasury services are also being utilized for Balance Sheet management (CRAR-Capital Risk weighted Adequacy Ratio, Asset and Liability product hedging, etc).

(c) To optimize return on surplus funds invested and to keep cost of funds to the minimum.

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(d) To keep investment portfolio healthy and liquid.

(e) To minimize non-performing investments.

(f) To take advantage of market volatility and trade/arbitrage in permitted products (including overseas) and avail arbitrage opportunities between rupee and forex treasury operations.

(g) To invest in tax free instruments as per the tax planning of the bank.

(h) To conduct derivative transactions to hedge banks own balance sheet gaps and exposure of the clients.

(i) To optimize returns from forex operations.

Areas in treasury management 1.8 From the viewpoint of a bank or a financial institution, treasury management

covers the following major areas:

(a) Liquidity risk management

(b) Interest risk management

(c) Currency risk management

(d) Equity risk management

(e) Commodity risk management

(f) Investment management.

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CHAPTER 2

TREASURY PRODUCTS AND SERVICES

Money Market 2.1 Money market desk is involved in management of assets and liabilities of the bank. The main function involves the following:

(a) Management of statutory reserves viz., Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) of the bank.

(b) Daily Funds Management for the bank. (c) Balance Sheet Management. (d) Debt Securities Trading.

Range of Products 2.2 The Money Market Desk trades in the following Instruments:

(i) Treasury-Bills

Treasury Bills (T-bills) are short-term debt instruments issued by the Central Government for maturities of 91, 182 and 364 days.

Commercial banks, primary dealers, mutual funds, corporates, institutions, provident or pension funds and insurance companies can participate.

RBI issues a calendar of T-bill auctions. Periodic auctions are held for their issue and these are tradable in the secondary market, which is quite active.

T-bills are issued at a discount to face value and are redeemable at par on maturity.

(ii) Commercial Paper (CP)

A Commercial Paper (CP) is an unsecured money market instrument through which corporate entities raise short-term money.

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It is issued as per RBI guidelines. (Refer Master Circular on Guidelines for Issue of Commercial Paper dated July 1, 2009.)

It is issued at a discount to face value

It can be issued either in the form of a promissory note or in a dematerialised form.

It attracts issuance stamp duty in primary issue.

It has to be mandatorily rated for issuance by one of the four credit rating agencies.

It can be issued for maturities between a minimum of seven days and a maximum upto one year from the date of issue.

(iii) Call Linked Products

Corporates can participate both as lenders and borrowers.

It can be issued for a maximum period of 89 days.

Pricing is linked to a benchmark like, MIBOR.

Flexible call or put option could be exercised.

(iv) Certificates of Deposit (CD)

Certificate of Deposits (CDs) are unsecured, negotiable money market instrument usually issued at a discount on face value. (Refer to RBI Master Circular on Guidelines for Issue of Certificates of Deposit dated July 1, 2009.)

The maturity period is from 7 days to 12 months.

It attracts issuance stamp duty and is issued in dematerialised form or as a Usance Promissory note. .

They are negotiable, and transferred by endorsement and delivery, after 15 days of issue.

(v) Collateralised Borrowing and Lending Obligations (CBLO)

CBLO is a money market instrument designed to meet the borrowing and lending needs of banks, financial institutions, mutual funds, NBFCs and corporates.

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Borrowing and lending is collateralised i.e., secured using G-Sec or T-Bills.

Trades are screen based and with Clearing Corporation of India Limited (CCIL) being central counter party.

(vi) Repo/ Reverse Repo

The Reserve Bank of India (Amendment) Act, 2006 provides a legal definition of repo and reverse repo as an instrument for borrowing (lending) funds by selling (purchasing) securities with an agreement to repurchase (resell) the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed (lent). Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the transaction. Market participants may undertake repos from any of the three categories of investments, viz., Held for Trading, Available for Sale and Held to Maturity.

(vii) Liquidity Adjustment Facility (LAF) with RBI

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. All commercial banks (except RRBs) and Primary Dealers having current account and SGL account with RBI can use eligible securities as collateral through a repo agreement and will use funds to alleviate their short-term requirements, thus remaining stable.

RBI has issued Circular Liquidity Adjustment Facility Revised Scheme on March 25, 2004 which lays down the revised scheme effective from March 29, 2009.

Operation of LAF through repo by means of daily auctions has provided the benchmark for collateralised lending and borrowing in the money market. This mechanism has helped in providing liquidity to the government securities market.

Raj aalianSticky NoteREPO:-seller, i-e sell and buy backsale 90 purchase 100 interest expense 10Reverse REPO:- i-e buy now and sell back laterpurchase 90 sale 100 interest income 10

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(viii) Inter-Bank Participation Certificate (IBPC)

The objective behind introduction of this instrument is to even out the short term liquidity within the banking system. This instrument was introduced in 1988 and Scheduled commercial banks were permitted to share a portion of their eligible loan assets with other banks through issue of IBPC. RBI has vide Circular Inter-Bank Participations Scheduled Commercial Banks dated August 4, 2009 has allowed Regional Rural Banks (RRBs) to also issue IBPCs. The bank sharing its loan portfolio is known as issuing bank, and the bank which is buying the portion of loan portfolio through IBPC is known as participating bank. Both issuing and participating bank will have to execute participation contract. The loan asset which is to be shared with participating bank must be a standard loan asset and it cannot be more than 40 per cent of the outstanding advance at the time of issue of IBPC. As per the existing guidelines of the RBI, commercial banks have been permitted to issue two types of IBPCs which are as under:

(a) With Risk Sharing Basis

Under risk sharing participation certificate scheme, risk of default of the borrower is shared by the issuing bank and the participating bank. The participating bank has no recourse to the issuing bank if there is default by the borrower for that loan amount which is shared. The IBPC can be issued for a minimum period of 91 days and a maximum period of 180 days.

(b) Without Risk Sharing Basis

Under without risk sharing participation certificate scheme, the participating bank does not share any risk with the issuing bank and, therefore, participating bank has a right to receive the payment from the issuing bank even though the borrower has defaulted in its payment. Tenor of IBPC under this scheme cannot be more than 90 days.

Forex Market 2.3 Customers (exporters and importers) buy and sell their foreign exchange needs from the treasury in various currencies depending on their business exposure. Rates are quoted by the dealers depending on the amounts and delivery period. Dealers trade on these flows from the customers and try to maximize profits. Besides, customer flows, dealers take proprietary position in various currencies in Spot and Forward contracts for trading.

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Range of Products 2.4 The following are products traded in Foreign Exchange Market:

(i) Spot Contract

It is the simplest and most common foreign exchange transaction widely used by corporates to cover their receivables and payables. The commitment by the client is to buy and sell one currency against another at a fixed rate for delivery two business days after the transaction. This eliminates the possible risk due to exchange rate fluctuation for the client. Corporate can buy or sell foreign currency for genuine transactional purposes only.

(ii) Forward Contract

It is a contract between the bank and its customers in which the exchange/conversion of currencies would take place at future date at a rate of exchange in advance under the contract. The essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. Forward Rates = spot rate +/- premium/discount

(iii) Currency Swaps

It is an agreement between two parties to exchange obligations in different currencies at the beginning, during the tenure and at the end of the transaction. At the start, initial principal is exchanged, though it is not obligatory. Periodic interest payments (either fixed or floating) are exchanged throughout the life of the contract. The principal is exchanged invariably on termination at the exchange rate decided at the start of the transaction. By means of currency swap, the associated currency and interest rate risks on the underlying asset can be hedged.

(iv) Interest Rates Swaps(IRS)

It is a financial transaction in which two counterparties agree to exchange streams of cash flows throughout the life of contract in which one party pays a fixed interest rate on a notional principal and the other pays a floating rate on the same sum. The basic purpose of IRS is to hedge the interest rate risk of constituents and enable them to structure the asset/liability profile best suited to their respective cash flows.


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(v) Options

It is a contract between the bank and its customers in which the customer has the right to buy/sell a specified amount of underlying asset at fixed price within a specific period of time, but has no obligation to do so. In this contract, the customer has to pay specified amount upfront to the counterparty which is known as premium. This is in contrast to the forward contract in which both parties have a binding contract. This is a facility offered to customers to enable them to book forward contracts in cross currencies at a target rate or price. This facility helps the customers to encash the currency movements in late European market, New York market and early Asian market

(vi) Forward Rate Agreement (FRA)

A Forward Rate Agreement (FRA) is an agreement between the bank and a customer to pay or receive the difference (called settlement money) between an agreed fixed rate (FRA rate) and the interest rate prevailing on stipulated future date (the fixing date) based on a notional amount for an agreed period (the contract period). In short, this is a contract whereby interest rate is fixed now for a future period. The basic purpose of the FRA is to hedge the interest rate risk. For example, if a borrower is going to borrow FC loan for 6 months at LIBOR rate after 3 months, he can buy an FRA whereby he can fix interest rate for the loan.

Capital Market 2.4 Funds are also invested through:

a) Investment in units of Mutual fund- Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Each scheme of a mutual fund can have different character and objectives. Mutual funds issue units to the investors, which represent an equitable right in the assets of the mutual fund.

b) Investment in Equity IPO These are securities which were not previously available and are offered to the investing public for the first time.

Regulatory Framework for Capital Markets in India 2.5 In India, the capital market is regulated by the Capital Markets Division of the Department of Economic Affairs, Ministry of Finance. The division is responsible for formulating the policies related to the orderly growth and development of the securities markets (i.e., share, debt and

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derivatives) as well as for protecting the interest of the investors. In particular, it is responsible for following:

(i) institutional reforms in the securities markets;

(ii) building regulatory and market institutions;

(iii) strengthening investor protection mechanism; and

(iv) providing efficient legislative framework for securities markets, such as Securities and Exchange Board of India Act, 1992 (SEBI Act 1992), Securities Contracts (Regulation) Act, 1956, and the Depositories Act, 1996.

The Division administers these legislations and the rules framed thereunder.

2.6 The Securities and Exchange Board of India (SEBI) is the regulatory authority established under the SEBI Act 1992. The Preamble of the SEBI describes the basic functions of the SEBI, as to protect the interests of the investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto. It involves regulating the business in stock exchanges; supervising the working of stock brokers, share transfer agents, merchant bankers, underwriters, etc; as well as prohibiting unfair trade practices in the securities market. The following departments of SEBI take care of the activities in the secondary market:-

Market Intermediaries Registration and Supervision Department (MIRSD) It is concerned with the registration, supervision, compliance monitoring and inspections of all market intermediaries in respect of all segments of the markets, such as equity, equity derivatives, debt and debt related derivatives.

Market Regulation Department (MRD) It is concerned with formulation of new policies as well as supervising the functioning and operations (except relating to derivatives) of securities exchanges, their subsidiaries, and market institutions such as clearing and settlement organizations and depositories.

Derivatives and New Products Departments (DNPD) It is concerned with supervising trading at derivatives segments of stock exchanges, introducing new products to be traded and consequent policy changes.

CHAPTER 3

THE TREASURY DEALING ROOM

3.1 The Treasury Dealing Room within a bank is, generally, the clearinghouse for matching, managing and controlling market risks. It may provide funding, liquidity and investment support for the assets and liabilities generated by regular business of the bank. The Dealing Room is responsible for the proper management and control of market risks in accordance with the authorities granted to it by the bank's Risk Management Committee. The Dealing Room is also responsible for meeting the needs of business units in pricing market risks for application to its products and services. The Dealing Room acts as the bank's interface to international and domestic financial markets and, generally, bears responsibility for managing market risks in accordance with the instructions received from the bank's Risk Management Committee.

3.2 The Dealing Room may also have allocated to it by the Risk Management Committee, a discretionary limit within which it may take market risk on a proprietary basis. For these reasons, effective control and supervision of bank's Dealing Room activities is critical to its effectiveness in managing and controlling market risks.

3.3 It is critical to effective functioning of the Dealing Room that the dealer has access to a comprehensive Dealing Room manual covering all aspects of their day-to-day activities. All dealers active in day-to-day trading activities must acknowledge familiarity with and provide an undertaking in writing to adhere to the bank's dealing guidelines and procedures. The Dealing Room procedures manual should be comprehensive in nature covering operating procedures for all the banks trading activities in which the Dealing Room is involved and, in particular, must cover the bank's requirements in respect of:

a) Code of Conduct - All dealers active in day-to-day trading activities in the lndian market must acknowledge familiarity with and provide an undertaking to adhere to Foreign Exchange Dealers Association of India (FEDAI) code of conduct (and Fixed Income Money Market and

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Derivatives Association of India (FIMMDA) Code of Conduct where applicable).

b) Adherence to Internal Limits - All dealers must be aware of, acknowledge and provide an undertaking to adhere to the limits governing their authority to commit the bank to risk exposures, as they apply to their own particular risk responsibilities and level of seniority.

c) Adherence to RBI limits and guidelines - All dealers must acknowledge and provide an undertaking to adhere to their responsibility to remain within RBI limits and guidelines in their area of activity.

d) Dealing with Brokers - All dealers should be aware of, acknowledge and provide an undertaking to remain within the guidelines governing the bank's activities with brokers, including conducting business only with brokers authorised by bank's Risk Management Committee on the bank's Brokers Panel. The following are important aspects in this regard:

(i) Ensuring that their activities with brokers do not allow for the brokers to act as principals in transactions but remain strictly in their authorised role as market intermediaries.

(ii) Requiring brokers to provide all brokers notes and confirmations of transactions before close of business each day (or exceptionally by the beginning of the next business day, in which case the note must be prominently marked by the broker as having been transacted the previous day, and the back office must recast the previous night's position against limits reports) to the bank's back office for reconciliation with transaction data.

(iii) Ensuring all brokerage payments and statements are received. reconciled and paid by the bank's back office department and under no circumstances authorised or any payment released by dealers.

(iv) Prohibiting acceptance by the dealers of gifts, gratifications or other favours from brokers, instances of which should be reported in detail to RBIs Department of Banking Supervision indicating the nature of the case.

(v) Prohibiting dealers from nominating a broker in transactions not done through that broker.

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(vi) Rules should be framed for prompt investigation of complaints against dealers and malpractices by brokers and reporting to FEDAI and RBIs Department of Banking Supervision.

e) Dealing Hours - All dealers should be aware of the bank's normal trading hours, cut-off time for overnight positions and rules governing after hours and off-site trading (if allowed by the bank).

f) Security and Confidentiality - All dealers should be aware of the bank's requirements in respect of maintaining confidentiality over its own and its customers' trading activities as well as the responsibility for secure maintenance of access media, keys, passwords and PINS.

g) Staff Rotation and leave requirements - All dealers should be aware of the requirement to take at least one period of leave of not less than 14 days continuously per annum, and the bank's internal policy in regards to staff rotation.

h) Customer/User Appropriateness and Suitability Policy - Banks usually have a Customer/User Appropriateness and Suitability Policy in place for transacting in complex treasury instruments such as, derivatives. The objective of such policy is to protect the bank against the credit, reputation and litigation risks which may arise on account of misselling products to users who may not understand the nature of the risks inherent in these transactions or products. All front office sales team or dealers, must be aware of and be educated about such policy. Sales dealers should conduct proper due diligence regarding user appropriateness and suitability of products before offering derivative products or other complex treasury instruments to users.

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ORGANISATIONAL STRUCTURE OF A BANKS TREASURY

4.1 The various functions handled by a bank treasury can be divided as under:

(a) Front-office: Dealing Risk taking

(b) Mid-office: Risk Management and Management Information

(c) Back-office: Confirmations, Settlements, Accounting and Reconciliation.

1. Front-office 4.2 The scope of functions of front-office, as the name itself states, is to buy, sell and trade in money market instruments, securities, forex, equity, derivatives and precious metal. The decisions in regard to any restructuring, reorganizing, pre payment, etc. are taken at front-office. The front-office dealers keep track of and develop their views on different asset class, securities, currencies, derivative products which are put up to Department Head/Investment Committee for arriving at trading/strategic investment entry/exit decisions.

4.3 Front-office functions can be summarized as under:

Significant interaction with various trading and delivery teams; Liquidity Management; ALM implementation; Striking of Deals (trading) and earning profits from trading; Maintenance of CRR and SLR; Follow When Issued Securities place order and square up the order well in

time against future holding; Manage short selling and square off the securities well in advance; and Reporting to respective authorities.

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Mid-office 4.4 The mid-office can be considered to be the conscience keeper of the treasury. It is responsible for the critical functions of independent market risk monitoring, measurement, analysis and reporting for the bank's Asset-Liability Management Committee (ALCO). Ideally, this is a full time function of reporting to, or encompassing the responsibility for, acting as Asset-Liability Management Committee (ALCO)'s secretariat. An effective mid-office provides independent risk assessment which is critical to Asset-Liability Management Committee (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, and expert in market risk concepts.

4.5 The methodology of analysis and reporting will vary from bank to bank depending on their degree of sophistication and exposure to market risks. These same criteria will govern the reporting requirements demanded of the mid-office, which may vary from simple gap analysis to computerized VaR modeling. Mid-office staff may prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to risk exposures. Banks using VaR or modeling methodologies should ensure that its Asset-Liability Management Committee (ALCO) are aware of and understand the nature of the output, how it is derived, assumptions and variables used in generating the outcome and any shortcomings of the methodology employed. Segregation of duties principles must be evident in this function which must report to Asset-Liability Management Committee (ALCO) independently of the treasury function.

4.6 The main functions of mid-office can be summarized as under:

(i) Management of risks:

(a) Market risk which arises on account of:

- Interest rate movement - Foreign exchange rate movement - Commodity prices - Equity prices

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(b) Liquidity risk

(c) Country risk

(i) Independent market risk monitoring, measurement, analysis and reporting for banks ALCO (Asset Liability Management Committee)

(ii) Formation of Investment policy for banks treasury

(iii) Formation of ALM policy for the bank.

Back-Office 4.7 The back-office is responsible for delivery and settlement of all transactions concluded by the front-office officials. It is also responsible for reconciliation of securities portfolio with respective holding entity. Payment of brokerage to brokers, empanelment of brokers, reviewing performance of brokers and monitoring the volume of business passed on to each broker is also under the purview of back-office.

4.8 The main functions of back-office can be summed up as under:

Co-ordination with front-office to ensure optimum usage of all treasury dealing systems;

Internal control and check over treasury dealings, confirmation and settlement activities, and accounting thereof;

Ensuring compliance with stated treasury procedures and stipulations;

Monitoring of SLR/CRR maintenance and submission of compliances, MIS to Board of Directors and RBI;

Audit facilitation (concurrent, statutory and AFI / RBI).

4.9 The key controls over market risk activities, and particularly over dealing room activities, exist in the back-office. It is critical that clear segregation of duties and reporting lines is maintained between dealing room staff and back-office staff, as well as clearly defined physical and systems access is also maintained between the two areas. It is essential that critical back-office controls are executed diligently and completely at all times including:

a) The control over confirmations both inward and outward: All confirmations for transactions concluded by the dealing room must be

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issued and received by the back-office only. Discrepancies in transaction details, non-receipts and receipts of confirmations without application must be resolved promptly to avoid instances of unrecorded risk exposure.

b) The control over dealing accounts (vostros and nostros) - Prompt reconciliation of all dealing accounts is an essential control to ensure accurate identification of risk exposures. Discrepancies, non-receipts and receipts of funds without application must be resolved promptly to avoid instances of unrecorded risk exposure. Unreconciled items and discrepancies in these accounts must be kept under heightened management supervision, and as such discrepancies may at times have significant liquidity impacts, represent unrecognised risk exposures, or at worst represent collusion or fraud.

c) Revaluations and marking-to-market of market risk exposures: All market rates used by the bank for marking risk exposures to market or used to revalue assets or for risk analysis models such as, Value at Risk analysis must be sourced independently of the dealing room in order to provide an independent risk and performance assessment.

One of the audit objectives with specific reference to treasury also includes verifying the authenticity and appropriateness of the sources of inputs used for valuation of unquoted treasury instruments and derivative products (such as swaps, options) which the bank has entered into. When quotations or rates are not directly available for treasury instruments, then usually such instruments are valued as at any reporting date using appropriate valuation techniques or models. Such valuation techniques involve an amount of subjectivity and also certain objective parameters such as, reference to any recent past market transaction in the underlying instrument or a like instrument. Such model based valuations require data feed or inputs (such as volatility in case of valuing options using Black-Scholes Model).

The inherent risk here is the appropriateness of the input parameters fed into the valuation model/technique, stale quotes. For example, where the bank has positions in interest rate swaps then for the purpose of projecting the future floating interest rates (for projecting future cashflows) the appropriate interest rate curve should be used (this is usually the par curve). As per extant RBI guidelines, investments in unquoted equity shares should be valued at their break-up value, however, the latest financials of the respective

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companies may not be available to the banks for determining the break-up value.

The risk of using inappropriate or stale quotes for valuation has a direct bearing not only on financial reporting but also on computing exposure limits. Thus, the scope of the auditor should include an evaluation of the control environment surrounding the valuation and marking-to-market of treasury instruments. If the bank has an established and independent mid-office function, the responsibility or soliciting quotes, rates, curves resides with the mid-office. Another related risk to valuation and marking-to-market of treasury investments is the timely monitoring of non-performing investments (NPIs). RBI has defined NPIs as investments where the interest/return or principal has been in arrears for a period exceeding 90 days. The important consideration for NPIs is that, banks should not reckon income on such investments and should provide for depreciation on them appropriately, such depreciation is further not allowed to be set-off against appreciation on other performing investments. The back-office of a bank should have appropriate procedures/controls instated for timely capturing of NPIs.

d) Monitoring and reporting of risk limits and usage: Reporting of usage of risk against limits established by the Risk Management Committee (as well as Credit Department for Counterparty risk limits) should be maintained by the back-office independently of the dealing room. Maintenance of all limit systems must also be undertaken by the back-office and access to limit systems (such as counterparty limits, overnight limits, etc.) must be secure from access and tampering by unauthorised personnel. If the bank has an established and independent mid-office function, this responsibility may properly pass on to the mid-office.

e) Control over payments systems: The procedures and systems for making payments must be under, at least, dual control in the back-office independent from the dealing function. Payment systems should be at all times secure from access or tampering by unauthorised personnel.

f) Reconciliation of dealers profit or loss account: All dealers at the end of day prepare their profit or loss account for the day and compute their net open position. The back-office personnel who are independent of the front-office dealer are responsible for recording and processing of the deals/transactions into the general ledger system or the core banking system. Banks should have in place a process of daily reconciliation of


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the dealers profit or loss vis--vis the profit or loss as per the general ledger system to avoid instances of unrecorded transactions.

g) Controls in respect of financial reporting and MIS: A banks financial statements include many exhaustive disclosures with treasury related disclosures forming a significant portion thereof (such as, concentration risk for swaps, PV01 disclosures for derivatives, maturity pattern for investments, forex). The collation of information to be presented in these disclosures is tedious and requires liaisoning with several treasury sub-functions. Further, banks also have an exhaustive base of MIS (such as ALM, concentration exposures, VAR or other measures capturing market risk, net open positions) presented at the various senior management committees (such as ALCO, Risk, Board, Investment, Credit).

Contents of an MIS pack or in a banks financials have a direct bearing on the management decision making and users of financial statements. The internal auditor should include within his scope the controls around information flow and data integrity for collation and preparation of the disclosures and MIS reports.

CHAPTER 5

INVESTMENT PORTFOLIO

5.1 The primary function of banks is to accept deposits and to lend money. Earlier, the investments were made only to meet out the SLR requirements. By the span of time the face of banking has changed. Due to the recessionary conditions in the economy the credit demand decreased substantially. It forced the banks to invest the surplus medium to long term funds in SLR/NSLR securities and debts. The investments portfolio of a bank may have a number of varieties of instruments. Keeping in view the return from lending and surplus investments, dynamic decision making is required whereby return on deployment is optimized.

5.2 The banks investment book may comprise the following:

(a) Central Government dated securities

(b) State Government developmental loans

(c) Treasury Bills

(d) Trust Securities

(e) Equity / Preference Shares

(f) Units of Mutual Funds

(g) Pass through Certificate/CDR/ARCIL

(h) Commercial Papers

(i) Corporate Bonds and Debentures

(j) Bonds and debentures of PSUs, Government / Semi-Government autonomous bodies, etc.

(k) Venture capital investments

(l) Investment in subsidiaries and joint ventures(Indian/overseas)

(m) Other Asset backed/Mortgage backed securities.

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Merchant and Trading in Precious Metal 5.3 The RBI launched the gold import scheme in September, 2000 and subsequently, included import of silver business in the same. Precious metal dealing desk functions is a part of inter-bank forex desk in the front office of the treasury. Presently, banks only deal in gold and silver in terms of approval obtained from the RBI. Gold and silver are imported on a consignment basis from the designated supplier on the terms and conditions agreed to with them by the bank. Precious metal consignment is kept in the vaults of designated branches or security agencies. As and when the parts of consignment are sold to the importers in India the remittances are being made to the suppliers for the gold quantity on spot payment basis. Similarly, trading in gold and silver is done with the agreement tied foreign banks.

Investment Policy 5.4 RBI has issued Master Circular on Prudential Norms for classification,valuation and operation of investment portfolio by banks (DBOD No. BP. BC.3 / 21.04.141 / 2009-10) on July 1, 2009.

The following is a gist of RBI guidelines issued to banks with respect to investment policy.

(a) Banks should frame Internal Investment Policy Guidelines and obtain the Boards approval.

(b) The investment policy guidelines should be implemented to ensure that operations in securities are conducted in accordance with sound and acceptable business practices

(c) The size of the banks operations, composition of assets and liabilities, risk policy and risk appetite are to be considered while framing the policy.

(d) The broad structure of the Investment policy should be based on: (i) No sale transaction is to be completed without the bank actually holding

the relative security (ii) Banks may sell a government security already contracted for purchase

subject to certain conditions. (iii) Banks successful in the auction of primary issue of government

securities, may enter into contracts for sale of the allotted securities in accordance with the terms and conditions given in the Master Circular.

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(iv) 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.

(v) All brokerage deals have to be specifically approved by the delegated authorities in the bank and a

(vi) separate account of brokerage paid, broker-wise, should be maintained.For issue of Bank Receipts ( BRs), the banks should adopt the format prescribed by the Indian Banks' Association (IBA) and strictly follow the guidelines prescribed by them in this regard. The banks, subject to the above, could issue BRs covering their own sale transactions only and should not issue BRs on behalf of their constituents, including brokers.

(vii) The banks should be circumspect while acting as agents of their broker clients for carrying out transactions in securities on behalf of brokers.

(viii) Investment in equity shares and debentures must be undertaken after considering the following: Build up adequate expertise in equity research by establishing a

dedicated equity research department, as warranted by their scale of operations;

Formulate a transparent policy and procedure for investment in shares, etc., with the approval of the Board; and

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

(ix) The banks Board of Directors should specify: the level of authority to put through deals, procedure to be followed for obtaining the sanction of the

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Internal control System 5.5 The abovementioned Master Circular issued by the RBI requires the banks to adopt the following guidelines for internal control system while undertaking investment transactions:

(a) There should be a clear functional separation of trading, settlement, monitoring and control, and accounting.

(b) There should be a functional separation of trading and back office functions relating to banks' own Investment Accounts, Portfolio Management Scheme (PMS) Clients' Accounts and other Constituents (including brokers') accounts.

(c) PMS Clients Accounts should be subjected to a separate audit by external auditors.

(d) For every transaction entered into, the trading desk should prepare a deal slip containing data relating to following:

nature of the deal, name of the counter-party, whether it is a direct deal or through a broker, and if through a broker,

name of the broker,

details of security, amount, price, and contract date and time.

The deal slips should be serially numbered and controlled separately to ensure that each deal slip has been properly accounted for. Once the deal is concluded, the dealer should immediately pass on the deal slip to the back office for recording and processing. For each deal there must be a system of issue of confirmation to the counterparty.

(e) Once a deal has been concluded, there should not be any substitution of the counter party bank by another bank by the broker, through whom the deal has been entered into; likewise, the security sold/purchased in the deal should not be substituted by another security.

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Raj aalianSticky NoteThe deal slip is called as the deal ticket in the BOK treasury department however these all details are included in the deal ticket.

Raj aalianSticky NoteThe deal tickets were pre numbered.

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(f) The Accounts Section should independently write the books of account on the basis of vouchers passed by the back office.

(g) Records of SGL and BR transactions should be maintained.

(h) Balances as per bank's books should be reconciled at quarterly intervals with the balances in the books of the Public Debt office (PDOs).

(i) The investment transactions should be reported to the top management, on a weekly basis covering the following:

details of transactions in securities,

details of bouncing of SGL transfer forms issued by other banks,

BRs outstanding for more than one month, and

a review of investment transactions undertaken during the period.

(j) Bankers' cheques/ pay orders should be issued for third party transactions, including inter-bank transactions.

(k) In case of investment in shares, the surveillance and monitoring of investment should be done by the Audit Committee of the Board. In each of its meetings it shall review:

the total exposure of the bank to capital market both fund based and non-fund based, in different forms,

ensure that the guidelines issued by RBI are complied with, and

adequate risk management and internal control systems are in place.

(l) In order to avoid any possible conflict of interest, it should be ensured that the stockbrokers as directors on the Boards of banks or in any other capacity, do not involve themselves in any manner with the Investment Committee or in the decisions in regard to making investments in shares, etc., or advances against shares.

(m) An on-going internal audit system should be in place to report the deficiencies directly to the management of the bank.

(n) The banks should get compliance in key areas certified by their statutory auditors and furnish such audit certificate to the Regional Office of Department of Banking Supervision of RBI under whose jurisdiction the HO of the bank falls.

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Classification 5.6 The RBIs Master Circular on Prudential norms for clarification, valuation and operation of investment portfolio by banks lays down that the entire investment portfolio of the banks (including SLR securities and non-SLR securities) should be classified under three categories

(a) Held to Maturity

(b) Available for Sale and

(c) Held for Trading.

However, in the balance sheet, the investments will continue to be disclosed as per the following existing six classifications:

(a) Government securities,

(b) Other approved securities,

(c) Shares,

(d) Debentures and Bonds,

(e) Subsidiaries/ joint ventures, and

(f) Others (CP, Mutual Fund Units, etc.).

Held to Maturity 5.7 The securities acquired by the banks with the intention to hold them up to maturity will be classified under Held to Maturity (HTM).The investments included under Held to Maturity should not exceed 25 per cent of the banks total investments. The banks may include, at their discretion, under Held to Maturity category securities less than 25 per cent of total investment. The following investments will be classified under Held to Maturity but will not be accounted for the purpose of ceiling of 25% specified for this category: a) Re-capitalisation bonds received from the Government of India towards

their re-capitalisation requirement and held in their investment portfolio. This will not include re-capitalisation bonds of other banks acquired for investment purposes.

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b) 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.]

c) The investments in debentures/ bonds, which are deemed to be in the nature of an advance.

5.8 Banks are, however, allowed since September 2, 2004, to exceed the limit of 25 per cent of total investment under HTM category provided the excess comprises only of SLR securities; and the total SLR securities held in HTM is not more than 25 per cent of their DTL as on last Friday of the second preceding fortnight.

Profit on sale of investments in this category should be first taken to the Profit & Loss Account and thereafter be appropriated to the Capital Reserve Account. Loss on sale will be recognised in the Profit & Loss Account.

Available for Sale and Held for Trading 5.9 The securities acquired by the banks with the intention to trade by taking advantage of the short-term price/interest rate movements will be classified under Held for Trading (HFT). The securities which do not fall within the above two categories will be classified under Available for Sale. The banks will have the freedom to decide on the extent of holdings under Available for Sale and Held for Trading categories taking into account various aspects such as basis of intent, , trading strategies, risk management capabilities, tax planning, manpower skills, capital position. HFT securities are to be sold within 90 days from the date of acquisition. Profit or loss on sale of investments in both the categories will be taken to the Profit & Loss Account.

Shifting among Categories 5.10 As per the RBI Guidelines, banks may shift investments to/from Held to Maturity category with the approval of the Board of Directors once a year. Such shifting will normally be allowed at the beginning of the accounting year. No further shifting to/from this category will be allowed during the remaining part of that accounting year. 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. In case of exigencies, such shifting may be done with the approval of the Chief Executive of the bank/ Head of the ALCO, but should be ratified by the Board of Directors/ ALCO.

Raj aalianSticky NoteAccounting treatment as per IAS 39:-

Raj aalianHighlight


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5.11 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 with the approval of the Board of Directors/ ALCO/ Investment Committee. 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.

Valuation 5.12 RBI Guidelines for valuation for the three categories is as follows:

(a) Held to maturity

(i) Investments 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 which case the premium should be amortised over the period remaining to maturity.

(ii) Banks should recognise any diminution, other than temporary, in the value of their investments in subsidiaries/ joint ventures which are included under Held to Maturity category and provide therefore. Such diminution should be determined and provided for each investment individually.

(b) Available for sale

(i) The individual scrips in the Available for Sale category will be marked to market at quarterly or at more frequent intervals.

(ii) While the net depreciation under each classification should be recognised and fully provided for, the net appreciation under each classification should be ignored.

(iii) The book value of the individual securities would not undergo any change after the marking of market.

(iv) The provisions required to be created on account of depreciation in the Available for Sale category in any year should be debited to the Profit & Loss Account and an equivalent amount (net of tax benefit, if any, and net of consequent reduction in the transfer to Statutory Reserve) or the balance available in the Investment Fluctuation Reserve Account, whichever is less, shall be transferred from the Investment Fluctuation Reserve Account to the Profit & Loss


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Account. In the event provisions created on account of depreciation in the Available for Sale category are found to be in excess of the required amount in any year, the excess should be credited to the Profit & Loss Account and an equivalent amount (net of taxes, if any, and net of transfer to Statutory Reserves as applicable to such excess provision) should be appropriated to the Investment Fluctuation Reserve Account to be utilised to meet future depreciation requirement for investments in this category. The amount debited to the Profit & Loss Account for provision and the amount credited to the Profit & Loss Account for reversal of excess provision should be debited and credited respectively under the head Expenditure Provisions & Contingencies. The amounts appropriated from the Profit & Loss Account and the amount transferred from the Investment Fluctuation Reserve to the Profit & Loss Account should be shown as below the line items after determining the profit for the year.

(c) Held for Trading category

The individual scrips in the Held for Trading category will be revalued at monthly or at more frequent intervals and provided for as in the case of those in the Available for Sale category. The book value of the individual scrip will change with the revaluation.

General 5.13 In respect of securities included in any of the three categories where interest/ principal is in arrears, the banks should not reckon income on the securities and should also make appropriate provisions for the depreciation in the value of the investment. The banks should not set-off the depreciation requirement in respect of these non-performing securities against the appreciation in respect of other performing securities.

Market value 5.14 The market value for the purpose of periodical valuation of investments included in the Available for Sale and the Held for Trading categories would be the market price of the scrip as available from the trades/ quotes on the stock exchanges, SGL account transactions, price list of RBI, prices declared by Primary Dealers Association of India (PDAI) jointly with the Fixed Income Money Market and Derivatives Association of India (FIMMDA) periodically.


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In respect of unquoted securities, the procedure as detailed below should be adopted.

Unquoted Non-SLR Securities-Debentures/ Bonds 5.15 All debentures/ bonds other than debentures/ bonds which are in the nature of advance, should be valued on the YTM basis. Such debentures/ bonds may be of different companies having different ratings. These will be valued with appropriate mark-up over the YTM rates for Central Government securities as put out by PDAI/ FIMMDA periodically. The mark-up will be graded according to the ratings assigned to the debentures/ bonds by the rating agencies subject to the following: -

(a) The rate used for the YTM for rated debentures/ bonds should be at least 50 basis points above the rate applicable to a Government of India loan of equivalent maturity. The special securities, which are directly issued by Government of India to the beneficiary entities, which do not carry SLR status, may be valued at a spread of 25 basis points above the corresponding yield on Government of India securities, with effect from the financial year 2008 - 09. At present, such special securities comprise: Oil Bonds, Fertiliser Bonds, bonds issued to the State Bank of India (during the recent rights issue), Unit Trust of India, Industrial Finance Corporation of India Ltd., Food Corporation of India, Industrial Investment Bank of India Ltd., the erstwhile Industrial Development Bank of India and the erstwhile Shipping Development Finance Corporation.

(b) The rate used for the YTM for unrated debentures/ bonds should not be less than the rate applicable to rated debentures/ bonds of equivalent maturity. The mark-up for the unrated debentures/ bonds should appropriately reflect the credit risk borne by the bank.

(c) Where the debenture/ bonds is quoted and there have been transactions within 15 days prior to the valuation date, the value adopted should not be higher than the rate at which the transaction is recorded on the stock exchange.

Investment Fluctuation Reserve 5.16 A reserve is to be maintained to guard against any possible reversal of interest rate environment on unexpected developments. It is prudent to transfer maximum amount of gains realised on sale of securities to the Investment Fluctuation Reserve (IFR). Banks are free to build IFR up to 10 per cent of the


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investment portfolio under HFT and AFS with the approval of the Board of Directors. The amount held under IFR arising out of gains on sale of investments will be reckoned for the purpose of TIER II capital.

Transactions through SGL Account 5.17 SGL or CSGL are a demat form of holding government securities with the RBI. SGL stands for 'Subsidiary General Ledger' account. It is a facility provided by RBI to large banks and financial institutions to hold their investments in Government securities and Treasury bills in the electronic book-entry form. Such institutions can settle their trades for securities held in SGL through a Delivery-ver

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