Treasury and Asset-Liability Management
Banks accept deposits from customer the maturity of which ranges from 7 days to 10 years. The banks return these deposits on maturity for which the depositors have the comfort that banks will not default in repayment on time. These funds are partly invested in cash to meet CRR requirement, in Govt_ securities to meet the SLR requirements, and in loans and advances of various maturities. Banks however, do not have similar type of comfort for receiving these funds back, particularly from the borrowers.
For example, a bank raised a term deposit of 3-years at 7% and lends the amount repeatedly for a 3-months bills discounting at 9%. After every 3 months the bank will face the liquidity problem besides other risk. Similarly, if by that time there is decline in the interest rate (say it comes down from 9% to 8%), the bank will also face interest rate risk. Hence, the risk arises out of mismatch of assets and liabilities of the bank and the ALM manages such balance sheet risk.
Liquidity Risk vs Interest Rate Sensitivity Risk
Liquidity and interest rate risks: Banks are sensitive to liquidity risk because they cannot afford to default on their payment obligation towards the depositors as that may lead to a run on the bank. Banks have to roll over the deposits and advances on market determined terms. Any mismatch in the maturity profile will not only lead to liquidity risk but to interest rate risk. Liquidity : Liquidity refers to a positive cash flow in the form of cash or cash like assets. The available cash resources are compared with the immediately due liabilities or liabilities in a given time range (called bucket). The difference between these sources and uses of funds in specific time buckets is the liquidity gap which may be negative or positive_ Hence the liquidity gap arises out of mismatch of assets and liabilities. RBI has prescribed 11 maturity time bands (called buckets) beginning from next day to more than 5 years for measuring and monitoring the liquidity gap.
Interest rate: Interest rate risk is measured by the gap between the interest rate sensitive assets and liabilities in a given time band. Rate sensitive assets and liabilities: Assets and liabilities are called to be rate sensitive when their value changes in the reverse direction corresponding to a change in the market rate of interest. For example, if a bank has invested in a bond having 8% coupon and later on the market interest rate increases to 9%, the value of the bond would decline. The difference between rate sensitive assets-and liabilities in each time band, either in absolute amount or as sensitivity ratio, is indicative of the risk arising out of interest rate mismatch.
Role of Treasury in ALM
Treasury maintains the pool of funds of the bank and its core function is funds management. Hence its activities expose the bank to liquidity and interest rate risk. Treasury Head in a bank is normally an important member of ALCO. Risk management has become integral part of Treasury, due to the following reasons:
Treasury operates in financial market directly by establishing a link between the core banking functions (of
collecting deposits 4: lending) and the market operations. Hence, the market risk is identified and monitored through Treasury.
Treasury makes use of derivative instruments and other means to bridge the liquidity and rate sensitive gaps which arise due to mismatch in the residual rnattuity of various assets and liabilities in different time buckets.
Treasury itself is exposed to market risk due to its trading positions in forex and securities market.
With development of financial markets, certain credit products are being substituted by treasury products (in place of cash credit, the emergence of commercial paper by large companies). Treasury products are marketable and help in infusion of liquidity in times of need.
Use of Derivatives in ALM
Derivative instruments are used to reduce the liquidity and interest risk or in structuring new product to mitigate market risk. These are used due to following reasons:
1_ Derivatives replicate the market movements and can be used to counter the risks inherent in regular transactions. For example, if stocks that are highly sensitive to market movement are purchased, the Treasury can sell the index futures as a hedge against fall in stock prices.
2. Derivatives require small capital as there is no funds deployment, except margin requirement.
3. Derivatives can be used to hedge high value individual transactions or aggregate risks as reflected in the assets liability mismatch. For example, if a bank is funding a term loan of 3 years (having higher rate of interest),
with a deposit of 3-months duration (having very low rate of interest) by rolling over the deposit, it has to be rolled over 12 times and every time the bank is exposed to interest rate risk. To take care of this, the bank may swap the 3--month interest rate into a fixed rate of 3 years, so that interest cost is fixed and the spread on the loan is protected.
Treasury can also protect the foreign currency obligations of the bank from exchange risk by buying call options where it has to deliver foreign exchange and by buying put option where it has to receive the foreign currency payment The options help the bank to protect rupee value of the foreign currency receipts and payments.
Treasury helps the bank in structuring new products to reduce the mismatch in the balance sheet, such as floating rate deposits and loans, where the interest rate is linked to a bench mark rate. similarly, the corporate debt paper can be issued with call and put option. The option improves the liquidity of the investment. (A 5-year bond issued with a put option at the end of 3"1 year is as good as a 3-year investment).
Treasury and Credit risk & Credit derivatives
Credit risk in Treasury business is largely contained in exposure limits and risk management norms. Treasury gets exposed to credit risk in the following ways:
Investment in treasury products such as corporate commercial paper and bonds (instead of lending, investing through these debt instruments). But, the credit risk in a commercial paper being similar to a cash credit advance, the commercial paper is tradable due to which it is a liquid asset. Hence bank has an easy exit route. Hence the non-SLR portfolio supplements the credit portfolio and at the same time is more flexible from ALM point of view.
The products like securitization convert the traditional credit into tradable treasury products. For example, the housing loans secured by mortgage, can be converted into pass through certificates (PTCs) and sold in the market (which amounts to sale of loan assets).
Credit derivative instruments such as credit default swaps cr credit linked notes transfer the credit risk of the lending bank to the bank (called protection seller) which is able to absorb the credit risk, for a fee. Credit derivatives are transferable instruments due to which the bank can diversify the credit risk.
Treasury and Transfer Pricing
Transfer pricing refers to fixing the cost of resources and return on -assets of the bank in a rational manner. Treasury buys and sells the deposits and loans of the bank, notionally, at a price which becomes the basis of assessing the profitability of the banking activity. The price is fixed by Treasury on the basis of :
market interest rate,
cost of hedging market risk and
cost of maintaining the reserve assets.
After implementation of transfer pricing, the Treasury takes care of the liquidity and interest rate risk of the bank.
Policy environment
For the ALM to be effective, the bank should have an appropriate policy in place.
It should be approved by Board of Directors.
.2 .It should comply with RBI & SEBI regulations
.3 .It should comply with current market practices and code of conduct evolved by FIMMDA or FEDAI.
.4 . It should be subject to periodical review.
Components of integrated Risk rated Risk management ::
ALM Policy ::: Composition of ALCO, operational aspect of ALM 'Such as risk measures, risk monitoring, risk
neutralization, product pricing, MIS etc.
Liquidity policy::: Minimum liquidity level, -funding of reserve assets, limits on money market exposure, contingent
funding, inter-bank credit lines.
Derivative policy::: Norms for use of derivatives, capital allocation, restrictions on derivative trading, valuation norms,
exposure
Investment policy::: Permissible investments, norms relating to credit rating, SLR and non-SLR investment, private placement,
trading in securities and repos, accounting policy.
Transfer pricing:::: Methodology, spreads to be retained by Treasury, segregation of administrative cost and hedging cost, allocation of cost to branches etc.
Banks accept deposits from customer the maturity of which ranges from 7 days to 10 years. The banks return these deposits on maturity for which the depositors have the comfort that banks will not default in repayment on time. These funds are partly invested in cash to meet CRR requirement, in Govt_ securities to meet the SLR requirements, and in loans and advances of various maturities. Banks however, do not have similar type of comfort for receiving these funds back, particularly from the borrowers.
For example, a bank raised a term deposit of 3-years at 7% and lends the amount repeatedly for a 3-months bills discounting at 9%. After every 3 months the bank will face the liquidity problem besides other risk. Similarly, if by that time there is decline in the interest rate (say it comes down from 9% to 8%), the bank will also face interest rate risk. Hence, the risk arises out of mismatch of assets and liabilities of the bank and the ALM manages such balance sheet risk.
Liquidity Risk vs Interest Rate Sensitivity Risk
Liquidity and interest rate risks: Banks are sensitive to liquidity risk because they cannot afford to default on their payment obligation towards the depositors as that may lead to a run on the bank. Banks have to roll over the deposits and advances on market determined terms. Any mismatch in the maturity profile will not only lead to liquidity risk but to interest rate risk. Liquidity : Liquidity refers to a positive cash flow in the form of cash or cash like assets. The available cash resources are compared with the immediately due liabilities or liabilities in a given time range (called bucket). The difference between these sources and uses of funds in specific time buckets is the liquidity gap which may be negative or positive_ Hence the liquidity gap arises out of mismatch of assets and liabilities. RBI has prescribed 11 maturity time bands (called buckets) beginning from next day to more than 5 years for measuring and monitoring the liquidity gap.
Interest rate: Interest rate risk is measured by the gap between the interest rate sensitive assets and liabilities in a given time band. Rate sensitive assets and liabilities: Assets and liabilities are called to be rate sensitive when their value changes in the reverse direction corresponding to a change in the market rate of interest. For example, if a bank has invested in a bond having 8% coupon and later on the market interest rate increases to 9%, the value of the bond would decline. The difference between rate sensitive assets-and liabilities in each time band, either in absolute amount or as sensitivity ratio, is indicative of the risk arising out of interest rate mismatch.
Role of Treasury in ALM
Treasury maintains the pool of funds of the bank and its core function is funds management. Hence its activities expose the bank to liquidity and interest rate risk. Treasury Head in a bank is normally an important member of ALCO. Risk management has become integral part of Treasury, due to the following reasons:
Treasury operates in financial market directly by establishing a link between the core banking functions (of
collecting deposits 4: lending) and the market operations. Hence, the market risk is identified and monitored through Treasury.
Treasury makes use of derivative instruments and other means to bridge the liquidity and rate sensitive gaps which arise due to mismatch in the residual rnattuity of various assets and liabilities in different time buckets.
Treasury itself is exposed to market risk due to its trading positions in forex and securities market.
With development of financial markets, certain credit products are being substituted by treasury products (in place of cash credit, the emergence of commercial paper by large companies). Treasury products are marketable and help in infusion of liquidity in times of need.
Use of Derivatives in ALM
Derivative instruments are used to reduce the liquidity and interest risk or in structuring new product to mitigate market risk. These are used due to following reasons:
1_ Derivatives replicate the market movements and can be used to counter the risks inherent in regular transactions. For example, if stocks that are highly sensitive to market movement are purchased, the Treasury can sell the index futures as a hedge against fall in stock prices.
2. Derivatives require small capital as there is no funds deployment, except margin requirement.
3. Derivatives can be used to hedge high value individual transactions or aggregate risks as reflected in the assets liability mismatch. For example, if a bank is funding a term loan of 3 years (having higher rate of interest),
with a deposit of 3-months duration (having very low rate of interest) by rolling over the deposit, it has to be rolled over 12 times and every time the bank is exposed to interest rate risk. To take care of this, the bank may swap the 3--month interest rate into a fixed rate of 3 years, so that interest cost is fixed and the spread on the loan is protected.
Treasury can also protect the foreign currency obligations of the bank from exchange risk by buying call options where it has to deliver foreign exchange and by buying put option where it has to receive the foreign currency payment The options help the bank to protect rupee value of the foreign currency receipts and payments.
Treasury helps the bank in structuring new products to reduce the mismatch in the balance sheet, such as floating rate deposits and loans, where the interest rate is linked to a bench mark rate. similarly, the corporate debt paper can be issued with call and put option. The option improves the liquidity of the investment. (A 5-year bond issued with a put option at the end of 3"1 year is as good as a 3-year investment).
Treasury and Credit risk & Credit derivatives
Credit risk in Treasury business is largely contained in exposure limits and risk management norms. Treasury gets exposed to credit risk in the following ways:
Investment in treasury products such as corporate commercial paper and bonds (instead of lending, investing through these debt instruments). But, the credit risk in a commercial paper being similar to a cash credit advance, the commercial paper is tradable due to which it is a liquid asset. Hence bank has an easy exit route. Hence the non-SLR portfolio supplements the credit portfolio and at the same time is more flexible from ALM point of view.
The products like securitization convert the traditional credit into tradable treasury products. For example, the housing loans secured by mortgage, can be converted into pass through certificates (PTCs) and sold in the market (which amounts to sale of loan assets).
Credit derivative instruments such as credit default swaps cr credit linked notes transfer the credit risk of the lending bank to the bank (called protection seller) which is able to absorb the credit risk, for a fee. Credit derivatives are transferable instruments due to which the bank can diversify the credit risk.
Treasury and Transfer Pricing
Transfer pricing refers to fixing the cost of resources and return on -assets of the bank in a rational manner. Treasury buys and sells the deposits and loans of the bank, notionally, at a price which becomes the basis of assessing the profitability of the banking activity. The price is fixed by Treasury on the basis of :
market interest rate,
cost of hedging market risk and
cost of maintaining the reserve assets.
After implementation of transfer pricing, the Treasury takes care of the liquidity and interest rate risk of the bank.
Policy environment
For the ALM to be effective, the bank should have an appropriate policy in place.
It should be approved by Board of Directors.
.2 .It should comply with RBI & SEBI regulations
.3 .It should comply with current market practices and code of conduct evolved by FIMMDA or FEDAI.
.4 . It should be subject to periodical review.
Components of integrated Risk rated Risk management ::
ALM Policy ::: Composition of ALCO, operational aspect of ALM 'Such as risk measures, risk monitoring, risk
neutralization, product pricing, MIS etc.
Liquidity policy::: Minimum liquidity level, -funding of reserve assets, limits on money market exposure, contingent
funding, inter-bank credit lines.
Derivative policy::: Norms for use of derivatives, capital allocation, restrictions on derivative trading, valuation norms,
exposure
Investment policy::: Permissible investments, norms relating to credit rating, SLR and non-SLR investment, private placement,
trading in securities and repos, accounting policy.
Transfer pricing:::: Methodology, spreads to be retained by Treasury, segregation of administrative cost and hedging cost, allocation of cost to branches etc.
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