0701014 domestic treasury operations and risks involved


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0701014 domestic treasury operations and risks involved

  1. 1. A PROJECT REPORT ON “DOMESTIC TREASURY OPERATIONS AND RISKS INVOLVED” FOR BANK OF MAHARASHTRA BY SHARMILA A. CHOUDHARY MBA-II 2007-2009 UNDER THE GUIDANCE OF Dr .SHARAD JOSHI Submitted To UNIVERSITY OF PUNE In partial fulfillment of the requirement for the award of the degree of Master of Business Administration (MBA) Through Vishwakarma Institute of Management PUNE – 48 1
  2. 2. ACKNOWLEDGMENT It’s a great privilege that I have done my project in such a well-organized and diversified organization. I am great full to all those who helped and supported me in completing the project. I express my gratitude to Mr. SANJAY ARYA (D.G.M.), who gave me this opportunity to undergo summer training at Bank of Maharashtra. He has been a great mentor and supplemented my study with requisite sources and inputs. He has been a constant source of knowledge, information, help and motivation for me. The project has been a great experience and I am indebt to Ms. INDRAYANI DEEKSHIT (A.G.M) and Mr. ABHAY SHAHAPURKAR (CHIEF MANAGER) for their time and efforts. I am also thankful to all the officials who helped me during the training. I am thankful to our director and my project guide Dr. SHARAD JOSHI for helping me in completing the project. Last but not least, I am also thankful to all college staff and my friends for helping me directly or indirectly in my project. 2
  4. 4. 1 Sr. No. Topic Page No. 1 Executive summary 1 2 Company Profile 3 3 Objective of Project 7 4 Research Methodology 9 5 Data Presentation  Introduction to treasury  Working of a Treasury department  Domestic Treasury products 11 6 Data Analysis & Findings  Risk Management 44 7 Conclusion of the study 60 8 Suggestion & Recommendation 62 9 Limitation 65 10 Bibliography 67
  6. 6. EXECUTIVE SUMMARY Efficient funds management, sail an organization or an economy for that matter, through even the toughest times. It is regarded as one of the most crucial functions. Banking industry is a backbone of economy in every country. It is banks, through which government can steer the monetary stability and long-term sustainability within the geographical boundaries. Banks deal purely in money. The industry holds the cash for the investors and lends it in turn. Thus, cash (or funds) management becomes vital function at the banks. Apart from meeting various statutory reserve requirements, a treasury department explores various other investment options both in the domestic and international forays. Risk can be defined as “Possibility of suffering losses”. “The chance of something happening that will have an impact upon objectives. It is measured in terms of consequences and likelihood”. 3
  7. 7. 4
  9. 9. PROFILE OF THE ORGANIZTAION Profile of Bank of Maharashtra The Birth Registered on 16th Sept 1935 with an authorized capital of Rs 10.00 lakh and commenced business on 8th Feb 1936. The Childhood Known as a common man's bank since inception, its initial help to small units has given birth to many of today's industrial houses. After nationalization in 1969, the bank expanded rapidly. It now has 1375 branches (as of 31st March 2008) all over India. The Bank has the largest network of branches by any Public sector bank in the state of Maharashtra. The Adult The bank has fine tuned its services to cater to the needs of the common man and incorporated the latest technology in banking offering a variety of services. Our Philosophy Technology with personal touch. Our Emblem The 3 M's Symbolizing • Mobilization of Money 6
  10. 10. • Modernization of Methods and • Motivation of Staff. Our Aims Bank wishes to cater to all types of needs of the entire family, in the whole country. Its dream is "One Family, One Bank, Bank of Maharashtra ". The Autonomy The Bank attained autonomous status in 1998. It helps in giving more and more services with simplified procedures without intervention of Government. Our Social Aspect The bank excels in Social Banking, overlooking the profit aspect; it has a good share of Priority sector lending having 38% of its branches in rural areas. Other Attributes Bank is the convener of State level Bankers committee. Bank offers Depository services and Demat facilities at 131 branches. Bank has a tie up with LIC of India and United India Insurance Company for sale of Insurance policies. All the branches of the Bank are fully computerized. Bank of Maharashtra – Important Landmarks 7
  11. 11. 1935 - Registered on 16th Sept. 1958 – Bank’s shares listed on Bombay Stock Exchange. 1960 – License to deal in all foreign currencies. 1969 – Nationalised on 19th July. 1975 – Tax consultancy cell launched. 2002 – Record profit rose by 222% amounting to Rs.145.41cr. Following chart depicts the review of performance in the past 3 financial years. Parameter Mar-06 Mar-07 Mar-08 (Rupees in Crores) Total Deposits 26906.2 33919.3 41758.3 Aggregate Deposits 26527.4 33663.2 41580.4 Gross Advances 17079.8 23462.3 29798 Net Bank Credit 16872 23220.9 23462.3 CD ratio 64.39 69.7 71.66 % of Priority Sector Adv. to Net Bank Credit 42.71% 41.24 48.63 % of Agricultural Adv. To Net Bank Credit 16.3 16.73 21.04 Total Investments 11354.3 11298.4 12283 Gross NPAs 944.08 820.28 766.27 % to Gross Advances 5.53 3.5 2.57 Net NPAs 334.06 277.38 254.05 % to Net Advances 2.03 21.21 0.87 Operating Profit 364.07 613.2 672.63 Net Profit 50.79 271.84 328.39 Other Income 177.24 265.05 280.17 Capital Adequacy Ratio 11.27 12.06 10.75 Per Employee Business ( in lacs ) 306.18 413.03 526.54 No. of Branches 1300 1345 1375 Of which Metro 248 264 351 8
  12. 12. Urban 269 290 257 Semi Urban 197 202 251 Rural 586 589 516 9
  14. 14. OBJECTIVES OF THE PROJECT  Introduction of Treasury Department.  To comprehend Various Functions of a Treasury Department.  To study the operations of Treasury Department.  To examine the scope of the Dealing (Various Domestic Treasury Instruments).  To identify the Potential Risks Involved At Various Stages of Operations.  To manage and reduce the identified risks. 11
  16. 16. RESEARCH METHODOLOGY The report is prepared with better understanding of the Bank’s Treasury- DOMESTIC segment and its settlement process. This was possible as I received training from trained and specialized dealers in the dealing room as well as the officers in the Back Office and Mid office. When I decided the topic for the project there were many questions that came to my mind, which are as follows: What is treasury? What are the functions of treasury? Why does treasury play such an important role? What are the various risk involved and how can they be minimized? Based on the questions I made the rough framework of the project and decided to approach the officers of the bank. I have also read the Investment policy, Treasury manual, circulars, documents and visited various websites to enhance my knowledge. I have included what I have seen and learnt during my training period in my project. 13
  17. 17. Report will focus on the Domestic Treasury products and also on the Risks Involved at Various Stages of Operations. CHAPTER 5 DATA PRESENTATION 14
  18. 18. DATA PRESENTATION TREASURY OPERATIONS - INTRODUCTION Idle funds are usually source of loss, real or opportune, and, thereby need to be managed, invested, and deployed with intent to improve profitability. There is no profit or reward without attendant risk. Thus treasury operations seek to maximize profit and earning by investing available funds at an acceptable level of risks. Money is one of the essential driving forces of any business. In order to employ and deploy these monetary resources effectively and efficiently, not only banks but also the corporate entities have realized the need for a specialized department to look after these operations. That’s how the treasury department has gained the importance in recent times. In the further parts of this project, we will have an inclusive look at the treasury operations in a bank. Treasury forms a vital part of any commercial bank’s activities. It is the window through which the Bank raises funds from or places funds in either financial or interbank markets. The treasury unit acts as the custodian of cash and other liquid assets. Apart from employment and deployment of funds, the department also has to take care 15
  19. 19. of the liquidity i.e. managing the availability of the monetary resources whenever they are required. The art of managing, within the acceptable level of risk, the consolidated fund of the bank optimally and profitably is called treasury management. Traditionally, in banks in India, the role of Treasury was limited to ensuring the maintenance of the RBI – stipulated norms for Cash Reserve Ratio (CRR) – which mandates that a minimum proportion of defined liabilities must be kept on deposit with the central bank – and the Statutory Liquidity Ratio (SLR), which obliges banks to invest a specified percentage of their liabilities in notified securities issued by the Government of India and State Governments or guaranteed by them. RBI- The central bank of India, uses the instruments like CRR and SLR along with some others viz. repos (and reverse repos), open market options, etc. to manage the liquidity in the economy. Activity in foreign exchange was confined to meeting merchants’ requirements for imports and exports and customers’ deposits. The rupee’s exchange rate has become volatile. There is sufficient fluctuation both intraday and interday to earn trading profits on buying and 16
  20. 20. selling the currency. The forward market in India is another potential source of profits as, more or often than not, it deviates from interest parity conditions (which state that forwards will differ from spot rates exactly to the extent of the interest differential). Cross–currency (dollar/yen, sterling/dollar, dollar/Swiss franc) trading opportunities are, of course, older and have come to life in Indian banks after liberalization. Traditionally the banks used to accept the deposits and lend the money keeping the margin (interest rates) in between. After meeting the mandatory deposit requirements (SLR & CRR), the surplus money demands an efficient and effective employment. Thus, banks lately have started exploring various options like investment in the capital, bond markets, foreign exchange, etc. in order to get the returns on it. An active Treasury also ‘arbitrages’ (earns profits without risk) by borrowing cheap and investing high in money and bond markets. New products, such as derivatives, enable spotting and capitalizing on such opportunities. Another key function of Treasury is asset-liability management and hedging (i.e., insulating) the Bank’s balance sheet from interest and exchange rate fluctuations. This involves reordering the maturity and interest rate pattern of assets and liabilities, either through direct portfolio actions or 17
  21. 21. derivatives (e.g., swaps and futures) to reduce, minimize or eliminate the risks arising from mismatches between the two sides of the balance . ROLE OF TREASURY OPERATIONS OF TREASURY:  Reserve Management & Investment: It involves:  Meeting CRR/ SLR obligations 18 Integrated role Merchant dealing Independent FX role Corporate FX trading Proprietary trading Derivatives (non-INR) dealing Overseas Borrowings / Investment ALM & Term money Equities trading Securities trading SLR / Non-SLR investments Liquidity & CRR and SLR Mgt Funds Mgt Independent Investment/ Treasury Derivatives INR dealing FCNR Swap Mgt Arbitrage
  22. 22.  Having an appropriate mix of investment portfolio to optimize yield and duration.  Duration is the weighted average 'life' of a debt instrument over which investment in that instrument is recouped. Duration analysis is used as a tool to monitor the price sensitivity of an investment instrument to interest rate changes.  Liquidity & Funds Management: It involves:  Analysis of major cash flows arising out of asset- liability transactions  Providing a balanced and well-diversified liability base to fund the various assets in the balance sheet of the bank  Providing policy inputs to strategic planning group of the bank on funding mix (currency, tenor & cost) and yield expected in credit and investment.  Asset Liability Management & Term Money: ALM calls for determining the optimal size and growth rate of the balance sheet and also prices the Assets and Liabilities in accordance with the prescribed guidelines. Successive reduction in CRR rates and ALM practices by banks increase 19
  23. 23. the demand for funds for tenor of above 15 days (Term Money) to match duration of their assets.  Risk Management: Treasury manages all market risks associated with a bank's liabilities and assets. The market risk of liabilities pertains to floating interest rate risk and assets & liability mismatches. The market risk for assets can arise from (i) unfavorable change in interest rates (ii) increasing levels of disintermediation (iii) securitization of assets (iv) emergence of credit derivatives etc. While the credit risk assessment continues to rest with Credit Department, the Treasury would monitor the cash inflow impact from changes in asset prices due to interest rate changes by adhering to prudential exposure limits.  Transfer pricing: Treasury is to ensure that the funds of the bank are deployed optimally, without sacrificing yield or liquidity. Treasury unit has an idea of the bank's overall funding needs as well as direct access to various markets (like money market, capital market, forex market, credit market). Hence, ideally treasury should provide benchmark rates, after assuming market risk, to various business 20
  24. 24. groups and product categories about the correct business strategy to adopt.  Derivative Products: Treasury can develop interest rate swaps and other rupee based/ cross-currency derivative products for hedging bank's own exposures and also sell such products to customers/ other banks.  Capital Adequacy: This function focuses on quality of assets, with Return on Assets (RoA) being a key criterion for measuring the efficiency of deployed funds. SOURCES OF PROFITS OF TREASURY:  Investments: where the Bank earns a higher yield than its cost of funds. An example is buying a corporate bond maturing in three years and yielding 7%, financed by deposits of the same maturity costing 6%. 21
  25. 25. The investments made by the treasury department can be categorized as follows:  Spreads: Spreads between yields on money market assets and money market funding. The Bank may, for instance, borrow short-term for 5% and deploy in commercial paper returning 6%.  Arbitrage: A classic example is a buy/sell swap in the forex market, where the Bank converts its rupee funds to a dollar deposit, earns LIBOR and gets back to rupee on deposit maturity. This generates a risk – free profit (“arbitrage”), if LIBOR plus the forward 22 INVESTMENTS Held Till Maturity Held For Trade Available For Sale
  26. 26. premium on dollar/rupee is more than the domestic interest rate.  Relative Value: This is a form of arbitrage in which the Bank exploits anomalies in market prices. The Bank may have an ‘AAA’ bond, which yields only 6%, compared to another with the same rating and maturity, but of a different issuer, which offers 6.5%. It is worth selling the first bond and investing in the second to improve the yield by 0.5% without any incremental risk, as both bonds have the same credit quality.  Proprietary Trading: The focus of proprietary trading is entirely short-term, as opposed to investment. The aim is to earn trading profits from interday (or even intraday) movements in security and forex prices. They are mostly directional trades. Treasury may buy (say) 9.81% Government of India security 2013 at Rs.129.50 at a yield of 5.89% in anticipation of the yield falling to 5.80%, on fundamental (or technical) grounds. If this happens, the bond appreciates and the Bank exits the position with a profit. 23
  27. 27.  Forex trading: is also directional, involving, for example, buying dollar/yen in the expectation that the dollar will appreciate or selling euro/dollar hoping that the euro will decline.  Customer Services: Bank Treasuries offer their products and services to (generally) non-bank customers. The income to banks in these activities comprises fees for and / or margins on trade execution. Profits would be higher on structured (i.e., non- standard) transactions compared to plain vanilla (e.g., a straightforward buy/sell USD/INR) deals. Treasuries are also involved in Investment Banking where their responsibility covers trade execution on behalf of the Bank’s clients in the cash or derivatives markets. These may generate good margins, depending on the complexity and skills required to design and put through customized structures in the market. Integrated Treasury Operations Broadly, Treasury department deals into to verticals viz. domestic and forex (i.e. Foreign Exchange). Traditionally, the forex dealing room of a bank managed the foreign exchange dealings mainly arising out of merchant transactions (FX buying from & selling to customers) and 24
  28. 28. consequent cover operations in inter-bank market. The domestic treasury/ investment operations were independent of forex dealings of a bank. Treasury operations were treated as cost centre, specifically devoted to reserve management (CRR & SLR) and consequent fund management. Treasury also undertook investment in both government and non-government securities. The need for integration of forex dealings and domestic treasury operations has arisen in the backdrop of interest rate deregulations, liberalization of Exchange Control, development of forex market, introduction of derivative products and technological advancement in settlement systems and dealing environment. The integrated treasury performs not only the traditional roles of forex dealing room and treasury unit but also many other functions as described above. Apart from that, an integrated treasury is a major profit centre. It has its own P&L measurement. TREASURY DEPARTMENT SET-UP AT BANK OF MAHARASHTRA 25
  29. 29. The Treasury Division has a clear cut demarcation between Front office, Mid office and Back Office functions. The Front Office shall undertake actual Treasury operations while the Back Office shall undertake all accounting and related operations in terms of the guidelines issued in the Investment Management Policy. The Mid Office shall track the magnitude of market risk on a real time basis and shall not be involved in the day to day management of Treasury. The Mid Office shall report to ALCO/Treasury about adherence to various prudential and risk parameters and provide an aggregate of the total market risk exposures assumed by the Bank. The dealing rooms either of domestic treasury fall under front office. Dealers in the dealing room are responsible to undertake and execute the investment decisions. There are proper guidelines and the norms laid down to govern the dealings in both domestic treasury. Domestic dealing room has to take the decisions regarding right mix of the instruments available for investment in domestic market. Banks put more emphasis on the ‘fixed interest bearing securities’. Some of these securities are classified as ‘SLR Securities’ whereas, some are classified as ‘NON-SLR Securities’. Possession of SLR Securities would contribute towards the statutory SLR maintenance. There are also some other factors that are being taken into 26
  30. 30. consideration even while investing into the Fixed Interest Securities. The rate of the interest, duration of maturity, current market scenario, credit rating of the instrument, etc. needs to be looked into. Before concluding any deal the Dealer has to ensure the following:  He holds the sanction from the competent authority.  The security to be purchased/ sold should not be under shut period There is sufficient stock of the security/securities to be sold and ensure that the existing balance at the time of deal is mentioned in the deal slip. The dealer will ensure that at no point of time there will be oversold position in any security. However, in terms of RBI, Banks successful in the auction of Govt. Securities, may enter into contracts for sale of the allotted securities, on the day of auction, in accordance with the following terms and conditions:  The contract for sale can be entered into only once by the allot-tee bank on the basis of an authenticated allotment advice issued by RBI. The selling bank should make suitable noting / stamping on the allotment advice indicating the 27
  31. 31. sale contract number etc., the details of which should be intimated to the buying entity. The buying entity should not enter into a contract to further resell the securities until it actually holds the securities in its investment account.  The contract for sale of allotted securities can be entered into by banks with and between entities maintaining SGL Account / CSGL Account with RBI for delivery and settlement on the next working day through the Delivery versus Payment (DVP) System.  The face value of securities sold should not exceed the face value of securities indicated in the allotment advice.  The sale deal should be entered into directly without the involvement of brokers.  Separate record of such sale deals should be maintained containing details such as number and date of allotment advice, description and the face value of securities allotted, the purchase consideration, the number, date of delivery and face value of securities sold, sale consideration, the date and details of actual delivery i.e. SGL Form No., etc. This record should be made available to RBI for verification. Bank should immediately 28
  32. 32. report any cases of failure to maintain such records.  Such type of sale transactions of Govt. securities allotted in the auctions for primary issues on the same day and based on authenticated allotment advice should be subjected to concurrent audit and the relative audit report should be placed before the Investment Committee / Chairman & Managing Director once every month. A copy thereof should also be sent to DBOD (Department of Banking Operations and Development), RBI Mumbai.  Banks will be solely responsible for any failure of the contracts due to the securities not being credit to their SGL A/c on account of non-payment / bouncing of cheque etc. RBI has now permitted sale of a government security already contracted for purchase, provided:  The purchase contract is confirmed prior to the sale  The purchase contract is guaranteed by CCIL or the security is contracted for purchase from the Reserve Bank 29
  33. 33. RBI has advised to adopt a standardized settlement on T+1 basis of all outright secondary market transactions in Government Securities effective May 24, 2005. Standardizing the settlement period to T+1 would provide participants more processing time for transactions and hence will help better funds management as well as risk management. In the case of Repo transactions in Government Securities, however, market participants will have the choice of settling the first leg on either ‘T+0’ basis or ‘T+1’ basis, as per their requirements. So far as purchase of securities from the Reserve Bank through Open Market Operations (OMO) is concerned, no sale transactions should be contracted prior to receiving the confirmation of the deal/advice of allotment from the Reserve Bank. Ready forward (Repo) transactions in government securities, which are settled under the guaranteed settlement mechanism of CCIL, may be rolled over, provided the security prices and Repo interest rate are renegotiated on roll over.  All the deals should be concluded by the dealer on receipt of relative sanction (sanction may be on telephone or oral to be confirmed in writing 30
  34. 34. subsequently) based on delegated authority. In any deal or transactions, the dealer may negotiate the terms of sanction with the counter party/broker for better advantage to the bank and the same may be subsequently reported to the respective sanctioning authority for information.  The deals should as far as possible be done through approved brokers on our panel subject to 5% limit per broker on the basis of yearly business through brokers(both purchase and sales) as per R.B.I guidelines. Where the limit of 5% is required to be exceeded because of a more advantageous offer, the matter should be reported to Board for ratification. The existing panel is to be used for capital market purposes also.  The brokerage is to be paid as per Stock Exchange/s guidelines. The brokerage on the deal payable to the broker, if any, (if the deal was put through with the help of a broker) should be clearly indicated on the notes/ memoranda put up to the top management seeking approval for putting through the transaction and a separate account of brokerage paid, broker-wise, should be maintained. 31
  35. 35.  The deal should be settled through BSE/NSE, OTCEI or any other recognized stock Exchange as per rules.  For any transaction/deals done by trading desk, the respective dealer should prepare a deal slip containing all the relevant information. The deal slip should contain nature of deal, name of counter party, direct deal or through broker, name of broker, details of security, amount, price, YTM, contract date, time, terms of payment, name of the Stock Exchange, etc. Every deal slip should be serially numbered and controlled separately to ensure that each deal slip has been properly accounted for.  Once the deal is concluded, the broker and the counter party bank should not be substituted. Like wise the security sold/purchased in the deal should not be substituted by another security. The dealer should immediately pass on the deal slip to the Back Office for processing. 32
  36. 36. ROLE OF CLEARING CORPORATION OF INDIA Ltd (CCIL) The Clearing Corporation of India Ltd. (CCIL) was set up in April, 2001 for providing exclusive clearing and settlement for transactions in Money, Govt. Securities and Foreign Exchange. The prime objective has been to improve efficiency in the transaction settlement process, insulate the financial system from shocks emanating from operations related issues, and to undertake other related activities that would help to broaden and deepen the money, debt and forex markets in the country. The company commenced operations on February 15, 2002 when the Negotiated Dealing System (NDS) of RBI went live. CCIL started providing the settlement of forex transactions since November 2002. CCIL launched the Collateralized Borrowing and Lending Obligation (CBLO) in January 2003, a money market product based on Gilts as collaterals. It has developed a forex trading platform “FX-CLEAR” which went live on August 7, 2003. CCIL has started the settlement of cross-currency deals through the CLS Bank from April 6, 2005. At the request of RBI, CCIL developed and currently manages the NDS-OM and NDS-CALL electronic trading 33
  37. 37. platforms for trading in the government securities and call money. Excerpts from Investment Policy regarding NON-SLR Investments: “In addition to the prudential limits prescribed by the RBI, the bank will observe following limits/ Sub limits, caps in respect of Non SLR Investment- 1. The investment in Non-SLR category shall be to the extent of 25% of the Gross Investments (excluding Recapitalization Bonds). 2. The investment in Bonds/Debentures under Non SLR category shall be to the extent of 15% of the Gross Investments. (Excluding Recapitalization Bonds). 3. The investment in Private Corporate Bonds shall not exceed 40% of the investment in Bonds/Debentures. 4. Total holding in AA-Rated Bonds/Debentures should not exceed 5% of Total Non-SLR. 5. The bank will continue to invest in rated privately placed issues of Bonds/ Debentures under Non SLR category. 6. The investment in Bonds guaranteed by central/ state governments issued under Non SLR category 34
  38. 38. (unsecured) shall not exceed 1/3 of the total investments in Bonds. 7. The investment under Non SLR category in any industry will not exceed 3% of gross Investments. This cap is not applicable to the exposure under Inter-Bank Deposits. As per RBI guidelines the aggregate exposure of a bank to the capital markets in all forms (both fund based and non- fund based) should not exceed 40 per cent of its net worth as on March 31 of the previous year. Within this overall ceiling, the bank’s direct investment in shares, convertible bonds/ debentures, units of equity- oriented mutual funds and all exposures to Venture Capital Funds (both registered and unregistered) should not exceed 20 per cent of its net worth. Recently the RBI has increased the CRR rates by 75 basis points in a gradual progression, it has also increased the REPO rate (the rate at which banks borrows money from RBI and vice versa for REVERSE-REPO). This led to the interest rate hike in loans by the leading lending banks like HDFC. Though it seems that the implications end there but it has so many micro and macro indirect implications. If HDFC has increased the lending rate for housing loans, it will also lead to fall in the revenues of the most interest rate sensitive industry – Real Estate. So, 35
  39. 39. if someone wants to invest in DLF (Real Estate), he needs to consider all the direct and indirect factors concerning the industry as whole and the company itself. Real Time Gross Settlement (RTGS) is an online system for settling transactions of financial institutions, especially banks. RTGS is a large value funds transfer system whereby financial intermediaries can settle inter-bank transfers for their own account as well as for their customers. The system effects final settlement of inter- bank funds transfers on a continuous, transaction- by- transaction basis throughout the processing day. The statistics of transactions for the month of March 2004 shows that in the inter-bank market transactions involving 45000 instruments and aggregating Rs. 179,000 crore were settled. High value instruments (317,000) settlement aggregated Rs. 274,000 crore. However, settlement of MICR instruments (145 lakhs) accounted for only Rs. 54,000 crore. RTGS will eliminate settlement risk in the case of inter-bank and high value transactions. The deals are undertaken into the dealing rooms. The notion of "trading room" (sometimes used as a synonym of "trading floor") is widely used in financial markets to refer to the office space where market activities are concentrated in investment banks or brokerage houses. Financial trading rooms often consists of open-space large 36
  40. 40. offices where financial workers (often referred to as "traders") monitor the markets, develop financial products, or engage into trading activities with other counterparties (through the telephone or through electronic interfaces). Contemporary trading rooms are highly technological spaces. The different trading or sales desks are equipped with financial data technologies such as the ones provided by companies such as Bloomberg or Reuters. The Mid-Office in TIBD, Bank of Maharashtra performs under the Risk Management department which is responsible for identifying and managing the risks centrally. This department takes into account the whole of the banks’ operations. The duty of the mid office is to look after the compliance and control matters. It reports to the Risk Management department and not the DGM at TIBD. This reporting matrix ensures the non prevalence of the collective malpractices. As mentioned earlier, each dealer is assigned a particular limit within which he’s allowed to trade. It’s the duty of the mid office executive to look after whether the dealer is acting in the permissible limits or not. He also sees to it that the settlement is being made through proper channels and as per the set norms by both RBI and Banks policies. He also ensures that the accounting and record keeping is being done properly and is reviewed periodically. The dealings usually happen 37
  41. 41. over the phone. So, to keep the track of these dealings, the calls are recorded for compliance purposes. If any issue arises regarding the deal, both the parties to the deal can go back to these tapes and verify the matter. Mid office has to make sure that these tapes are preserved for the minimum period prescribed by norms. If an executive of mid office happens to come across any deviation from the set doctrines, he escalates the matter to the Risk Management department. Subsequent actions are taken into the matter by the department. Mid office also does the calculation of the permissible limits of the risks. On a daily basis it reports the risk involved in any instrument. E.g. Value-at risk is calculated in order to determine what would be the permissible limit of risk that can be allowed, if the decision is to be made for the investment in a particular instrument. 38
  42. 42. DOMESTIC TREASURY PRODUCTS The Domestic operations of Treasury can be broadly classified in to three categories as mentioned below:  Money Market Operations  Debt Market Operations  Capital Market Operation MONEY MARKET OPERATIONS The Money market provides an avenue for equilibrating the short-term lending and borrowing needs of participants for periods ranging from O/N up to a year. In this process, it provides a focal point for the RBI to influence the liquidity in the system and thereby transmit the monetary policy impulses. The instruments traded in the money markets are close substitutes for money and are less risky, marketable and liquid. Money Market operations facilitate effective management of short-term asset-liability miss- matches for the bank. It enables the bank to reduce the cost of liquidity by deploying their short-term surpluses and thereby maintaining the liquidity position at an optimum level. The most commonly traded money market instruments are as under: Call/Notice Money: Call/ Notice Money is a liquidity management tool whereby commercial banks, cooperative 39
  43. 43. banks, primary dealers lend and borrow between themselves. Non-bank institutions are not permitted in the call/notice money market. The call/notice money market forms an important segment of the Indian Money Market. Under call money market, funds are transacted on overnight basis and under notice money market funds are transacted for the period between 2 days and 14 days. The need arises mostly for covering short-term liquidity mismatches as well as for covering shortfall in maintenance of Cash Reserve Ratio (CRR). Specific Risk Factors • Operational Risk Empowered authorizations of deals before settlement activities commence. Complete, updated records of counterparty signatures/powers of attorney of counterparties should be maintained. • Financial Risk Credit risk relating to counterparties exists. Collateralized Borrowing and Lending Obligation (CBLO): CBLO is a money market instrument operationalised by Clearing Corporation of India in January 2003. It is a discounted instrument with maturity ranging from 1day up to 1year, backed by collaterals, and redeemable at par. CBLOs are traded 40
  44. 44. electronically, on-line, on an anonymous order matching system facilitating price discovery and transparency. Banks, financial institutions, primary dealers, mutual funds, NBFCs and corporate can be members. What is CBLO? CBLO is explained as under: • An obligation by the borrower to return the money borrowed, at a specified future date; • An authority to the lender to receive money lent, at a specified future date with an option/privilege to transfer the authority to another person for value received; • An underlying charge on securities held in custody (with CCIL) for the amount borrowed/lent. Treasury Bills: These are the instruments of short-term borrowings of Government issued in the form of promissory notes at a discount and redeemable at par. Treasury Bills are liquid and the same are issued by RBI on behalf of the Government. RBI presently issues Treasury Bills in three maturities, i.e., 91 days, 182 days and 364 days. Treasury Bills have a Primary as well as a Secondary market. Specific Risk Factors • Documentation Risk Authencity of document and counterparty signatures / powers of attorney. 41
  45. 45. • Credit Risk In case of default on a rediscounted bill, the discounting bank has (ownership) rights to the underlying bill. • Interest Rate Risk Price is sensitive to short-term interest rates. Commercial Paper: Commercial Paper (CP) is a short term unsecured money market instrument issued at a discount in the form of a promissory note. CP’s are issued by reputed companies that carry high credit rating, have a strong financial background and facilitate borrowing short-term resources from the market. RBI has made it mandatory to issue CPs in electronic/ dematerialized form with effect from 30 June 2001. Corporate, Primary Dealers, Satellite Dealers and All-India Financial Institutions that are permitted to raise short-term resources under the umbrella limit fixed by RBI are eligible to issue CP and are called the “Issuers”. CP's can be of any maturity between 15 days to 364 days. CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by single investor should not be less than Rs.5 lakh (face value). Specific Risk Factor 42
  46. 46. • Liquidity Risk Arises if there is no buyer of the paper before maturity. May happen if there is a sudden significant credit downgrade or money market becomes tight. • Interest Rate Risk If money market rates shoot up, existing CP will suffer price losses as these are short-term instruments whose prices are determined by the short-end (up to one year) portion of the yield curve. Certificate of Deposit: CDs are securitized, tradable term deposits issued in demat form or as a Usance promissory (UP) note. Banks can issue CDs with a minimum maturity of 7days to 1yr, whereas FIs can issue for periods not less than 1year and not exceeding 3 years. CDs are issued in denominations size of Rs.1lakh or multiples thereof. This instrument provides an avenue for investments at better rate of interest. Moreover, the CD market is very liquid and provides ample opportunities for trading. CDs can be issued to individuals, corporations, companies, trusts, funds, associations. Specific Risk Factors • Credit Risk 43
  47. 47. CD issues are sometimes rated by credit rating agencies. Otherwise, one has to go on image, reputation and financials of issuing bank or FI. • Liquidity Risk Liquidity suffers on credit/market downgrade of the issuing bank. • Interest Rate Risk CD prices are sensitive to movements in short-term interest rates (up to 1 year). Repos/Reverse repos: Repos are re-purchase agreements or ready forward contracts, whereby the counter parties agree to sell and buy back the same security at an agreed price at a future date. It is a combination of security trading (purchase/sale) and money market (borrowing/lending) operations.  Repo transaction is a collateralized borrowing by pledging approved securities and the borrower is under obligation to buy back the securities at a specified date. Repo transaction is a secured form of lending, the underlying securities being the collateral. Under a Repo transaction there are 2 counter parties, a lender and a borrower. The Borrower in a Repo borrows cash and pledges (sells) securities. The Lender lends cash and 44
  48. 48. purchases the securities and is said to enter into a Reverse Repo transaction, hence borrowing by pledging securities is a Repo transaction and lending by accepting the pledge is a Reverse Repo transaction. Securities received under Reverse repo cannot be sold during the tenure of Reverse Repo. Securities sold under Repo should be recon trolled at the same holding rate.  Repo and Reverse Repo transactions are undertaken to manage liquidity and/or for SLR maintenance. The borrower in the transaction is short of cash and has excess of SLR and hence lends securities and borrows cash. The lender in a Repo transaction has excess of cash and/or is short in SLR and hence lends cash and borrows security. Liquidity Adjustment Facility (LAF): Liquidity Adjustment Facility has emerged as one of the important tool of liquidity management for RBI. Presently Reserve Bank of India conducts Overnight Reverse Repo auctions @6.00% (for absorption of liquidity) and Overnight Repo auctions @8.50% (for injection of liquidity) on a daily basis from Monday to Friday once a day. All Scheduled Commercial Banks and PDs having Current and SGL Account with RBI are eligible to participate in the auction. Reverse Repos/Repos 45
  49. 49. will be undertaken in all SLR-eligible GOI dated Securities/Treasury Bills and SDLs. A margin will be uniformly applied in respect of the above eligible securities i.e.5% for GOI/TB and 10% for SDLs. RBI has the right to accept or reject the bids under LAF either wholly or partially. Securities received under Reverse Repo will count for SLR purpose and vice versa. DEBT MARKET OPERATIONS The Debt market operations include the banks participation in debt issued by the Central Government, State government, PSUs, and corporate, primarily with a view to enhance the interest income for the bank and also to trap trading gains. The debt market can be broadly divided into the SLR and Non SLR market. SLR: In terms of Section 24 of Banking Regulation Act, 1949 (10 of 1949) every scheduled commercial bank is required to maintain SLR @ 25 per cent of the total net demand and time liabilities in India as on the last Friday of the second preceding fortnight, in the form of: (a)Cash (b) Gold valued at a price not exceeding the current market price, or (c) Unencumbered investment in the following instruments which will be referred to as 'statutory liquidity ratio (SLR) securities’:  Central Government securities (G-Sec)  State Development Loans (SDL)  Treasury Bills (TB)  OTS Central  OTS State 46
  50. 50.  Shares of Central Government Corporations.  Shares of State Government Corporations. Government of India Securities (also called G-Secs, Gilts, Treasury bonds, Guvvies) Government of India securities are sovereign obligations of the Union of India. They are defined by:  Redemption Value The price at which the bond is redeemed (i.e., repaid to the holder/investor). Invariably the same as the face value of Rs.100.  Coupon is the interest payable semi-annually on the face value of the security.  Maturity/Redemption Date The date on which the bond repays to its holders. TYPES OF G-Secs  Fixed Rate G-Secs are generally fixed rate (coupon) bonds.  Floating Rate The RBI has issued floating rate bonds (FRBs), in which the coupon is reset every six months or annually. An issue in May 2003 had the following terms:  Issued at par of Rs.100 face value. 47
  51. 51.  Tenor: 11 years (issue date: May 20 2003, redemption at par on May 20 2014).  Interest will be paid half-yearly.  Coupon will comprise a variable base rate plus spread.  Put and Call Options These are bonds, which can be redeemed before maturity at the option of the investor (put) or issuer (call). A straight bond with put and call options was issued enabling Government to redeem the issue at par after five years and at intervals of six months thereafter. In effect, the bond has an initial certain life of only five years (even though it is issued for ten years). If it is not called after five years, it will survive for six month – periods, with the call exercise still with the Government at six-month intervals. The same privileges have been given to bondholders. They can demand premature redemption of the issue (a put option) after five years or exercisable at six-monthly intervals thereafter, if the first put after five years is not exercised. State Government Securities Bonds issued by States of the Indian Union. Also called State Development Loans (SDLs) to denote their original purpose of raising funds for the economic development of 48
  52. 52. States. Thus, 7.8% Karnataka SDL 2012 refers to a Karnataka State Government security maturing in 2012 and carrying a coupon of 7.8%. Mostly, issues of State Government securities are of the fixed interest rate (coupon) type. Primary Issues Through the RBI. Generally offered on tap at a fixed price (usually face value). However, the RBI has, of late, been conducting auctions of State Loans; especially those perceived as economically sounder by the market and propose to allow them to borrow directly from the market. In the case of weaker States, the RBI uses moral suasion to ensure that their issues are fully invested. It has also been proposed that the Government of India borrow on behalf of such States and lend to them. New issues are regulated and scheduled by the RBI. The amount to be raised annually and their tranches are determined for each State by the Finance Ministry and Planning Commission, Government of India in consultation with the RBI, which implements the market programme. The allotment to each State depends on its Plan size and means of financing, decided upon by the Government of India and the respective State Governments. 49
  53. 53. G-Secs and State Government securities are evaluated on the basis of the following:  Current yield  Yield to Maturity  Duration Current Yield Measures the return without taking into account the capital gain or loss on redemption. (If the security is bought for less (more) than its redemption value, there is a capital gain (loss). Thus, if the coupon is 8% and Bank buys the bond for Rs.105 (including accrued interest), the current yield is 8/105 = 7.62% p.a. Yield to Maturity (YTM) also called Internal Rate of Return (IRR) The interest rate which equates the future coupon and principal redemption cash flows from the bond with its current market price. Solve for Y in the formula (formula assumes 180 days coupon intervals and 360 days in a year): C C C C C + F 50
  54. 54. P = --------- + ------------------- + -------------------- + ------------- + …+ ------------------- d/180 (d + 180)/180 ( d + 360)/180 (d+540)/180 (d+(n.180))/180 (1 + Y) (1 + Y) (1+Y) (1+Y) (1+Y) Where: P = current market (dirty, i.e., including broken period interest) of the bond C = semi-annual coupon d = no. of days to next coupon n = no. of coupons left including the final F = redemption value of the bond Y= YTM, i.e., cash flow-equating rate of interest (also called internal rate of return). An important assumption in the above calculation is that the coupon cash flows before maturity are reinvested at the IRR. The actual (post-facto) IRR will invariably be different as the coupon reinvestment rates will not be the same as the YTM calculated today. For example, Bank buys 7.40% 2012 maturing May 3 2012 on April 28 2003 for Rs.110.30. Settlement is same day. Last coupon was paid on November 3 2002. Clean price = Rs.110.30 Dirty price should include accrued interest for: November 28 December 30 January 30 51
  55. 55. February 30 March 30 April 27 Total 175 This works out to: Rs.(175/180 x 3.7) = Rs.3.60 Dirty price = Rs. (110.30+3.60) = Rs.113.9 The YTM formula is: C C C C C + F P = ------------- + -------------------- + -------------------- + ---------------- + …. + ---------------- d/180 (d + 180)/180 (d + 360)/180 (d+540)/180 (d+(nX180))/180 (1 + Y) (1 + Y) (1+Y) (1+Y) (1+Y) P = Rs.113.9 C = Rs.3.7 (semi-annual coupon) F = Rs. 100 d = 5 (175 days since last coupon) n = no. of coupons left till maturity Y = yield to maturity Substituting and solving: Y = 2.95% (semi-annual) or 5.98% annualized. 52
  56. 56. Duration Duration measures the interest rate sensitivity of a bond. The formula for duration (also called Macaulay duration) is: 1 1 C 2 C 3 C n (C + F) + + + +… P (1 + Y) (1 + Y)² (1+Y)³ (1+Y)n Where: C = semi-annual coupon 53
  57. 57. F = redemption price of the bond Y = YTM (semi-annual) P = market (dirty) price of the bond Take the same data as in YTM Example C = Rs.3.7 Y = 2.95% or 0.0295 P = Rs.113.90 F = Rs.100 Applying the formula, (Macaulay) duration is = 13.8694 (in half years) Annualized Macaulay duration = 13.8694/2 = 6.93 years Modified duration is a more accurate measure of interest rate sensitivity for which Macaulay duration is divided by the semi-annual yield. Modified duration= 6.93/1.0295 years = 6.74 years (Macaulay) duration is divided by the YTM to get modified duration. The modified duration of 6.74 years in the Modified Duration Example means that every 0.01% change in YTM will lead to a 0.0674% change in the price of the bond, either upward or downward, depending on whether the YTM falls or rises. For the bond considered in the Modified Duration Example, the price increase will be Rs. (0.0674 x 113.90) 54
  58. 58. = 7.68 paisa, if the yield falls 0.01% (as yield and price are inversely related). This is also called the Price Value of a Basis Point (PVBP). Modified duration is an accurate estimate of price sensitivity of a bond only for small changes in yield. The duration of bond portfolio is the weighted average of the durations of individual bonds in the portfolio. However, this will not accurately measure the interest rate change impact on the portfolio, unless the yield curve shift (upwards or downwards) is entirely parallel. Duration is the spot measure of interest rate sensitivity. It keeps changing with YTM and time. Yield Curve If the YTMs of bonds are plotted in ascending order of maturity, with maturities on the x-axis and yields on the y- axis, we get a yield curve. The normal yield curve represents the yield pattern on coupon – bearing G-Secs, while the spot yield curve is the zero coupon yield pattern on G-Secs. The spot yield curve is also referred to as the term structure of interest rates. It shows the hypothetical yields on G-Secs if they do not pay any interest till maturity. Thus, the 3-year zero coupon yield would be the pure yield for that maturity as there is no reinvestment risk from the need to reinvest coupons as in a coupon – bearing bond, whose holding period yield is not known 55
  59. 59. with certainly at the time of investment because the reinvestment yields on the coupons are unknown. Yield curves come in different shapes:  Ascending (upward sloping)  Descending (downward sloping)  Flat In an ascending yield curve, medium and long-term yields are higher than short-term yields, while the opposite is true of descending yield curves. Most of the time, yield curves are upward sloping, but at times when inflation is high and monetary policy is tight, short-term interest rates may be above medium and long-term. The shape of the yield curve actually reflects market expectations on future interest rates: an ascending yield curve means the market thinks rates will go up and vice- versa. 56
  60. 60. CAPITAL MARKET OPERATIONS Capital Market Operations are undertaken by the bank both in the Primary as well as the Secondary markets. The bank deals in the Scrips of different companies with in the specifications laid down by the RBI and the Treasury Policy. Classification: Investment in equity shares is classified into 'Available for Sale' and 'Held for Trading' categories. Investment in subsidiaries/Joint Ventures (a joint venture would be one in which, Bank along with its subsidiaries, holds more than 25% of the equity) is classified into ‘Held to Maturity’ category. Specific Risk Factors  Debt Funds  Quality of investment portfolio of the fund  Quality of portfolio management of the fund  Market Risk 57
  61. 61.  Interest Rate Risk Money market funds are much less risky than debt funds as they invest mostly in short-term instruments.  Equity Funds  Quality of investment portfolio of the fund  Quality of portfolio management of the fund  Market Risk 58
  63. 63. DATA ANALYSIS & FINDINGS The investment function at bank demands a careful examination of various factors. Besides calculating the expected rate of returns, executives must consider the risks involved in it and try to cushion it up by cover operations. Bank has a document dedicatedly talking about the potential risks involved in investments. This Risk Management Policy is framed, recognizing the need to effectively identify measure and manage these risks in view of their implication on the Bank’s Investment Portfolio. In the era of liberalization and globalization of the Economy and resultant Economic Scenario in India, the Investment Portfolio of the Bank is faced with the challenge of managing a variety of financial and non- financial risks, viz.,  Credit Risk  Interest Rate Risk  Liquidity Risk  Equity Risk  Operational Risk CREDIT RISK  Description: This is one of the oldest of all financial risks. In its simplest form, it refers to the possibility of the issuer of 60
  64. 64. a debt instrument being unable to honor his interest payments and / or principal repayment obligations. But, in modern financial markets, it includes non-performance by counterparty in a variety of off-balance sheet contracts such as forward contracts, interest rate swaps and currency swaps and counterparty risk in the inter-bank market. These have necessitated prescribing maximum exposure limits for individual counterparties for fund and non-fund exposures. • Mitigation (sample for non-bank counterparties/instruments)  Credit Appraisal  Investment only in rated instruments  Risk Pricing  Credit enhancement through margin arrangements  Guarantees/letters of comfort from rated entities  Adequate financial and / or physical assets as security  Exposure limits by counterparty, industry, location, business group, on and off balance sheet  Diversification by industry, sector, location, etc. • Mitigation (sample for bank counterparties) 61
  65. 65.  Exposure limits for individual bank counterparties for funded/non-funded assets  Reputation and image of counterparties  Collateralization of transactions through repos 62
  66. 66. MARKET RISK MANAGEMENT Market Risk is a generic term to describe both interest rate risk and event (“systemic”) risk. • Event Risk  Description The risk that an unexpected happening, which is extreme, sudden or dramatic (e.g. the September 11 terrorist attacks), will cause an all-round fall in market prices.  Mitigation Increase proportion of assets in risk-free, high quality investments of short maturity. • Interest Rate Risk – Investment/Trading Book The prices of bonds are affected by changes in interest rates. When interest rates come down, their prices go up. The opposite happens when interest rates rise. The most price – affected bonds in response to rate movements are those of long maturity – indeed maturity and price changes are strongly positively correlated. Duration measures the price sensitivity of a bond to changes in interest rates. Increasing duration makes the bond portfolio more sensitive to interest rates while decreasing duration reduces it. As bond prices and interest rates are inversely related, if the Bank expects interest rates to fall, it will increase duration by buying long-dated securities. Per 63
  67. 67. contra, in anticipation of a rise in interest rates, the Bank will lower duration by selling long-dated securities. 64
  68. 68.  Liquidity Risk:  Description • The risk that an asset cannot be converted into cash when needed is termed as Liquidity Risk. It’s quite characteristic of the vast majority of bonds. • The risk of scarcity of funds in the market to borrow arises for number of reason. E.g. when the RBI deliberately tightens liquidity • When a bank’s creditworthiness becomes suspect, there may be no willing lenders, even though there is no liquidity shortage in the market.  Mitigation • Increase proportion of investments in liquid securities • Increase proportion of investments in near-maturity high quality instruments. • Maintain credit rating, reputation and image. • Securitization of loan portfolio of large as well as small borrowers. Let’s now have look at the market risks in the context of investments. Market risk arises from adverse changes in market variables such as interest rates, forex rate, equity price and commodity price. Even a small change in these variables 65
  69. 69. can cause substantial changes in the income and economic value of the Portfolio. Market risk takes the following forms — 1. Liquidity Risk 2. Interest Rate Risk 3. Equity Risk 4. Foreign Exchange Risk Liquidity Risk: Liquidity Risk arises essentially from funding long term assets by short term liabilities, thereby subjecting the liabilities to roll over or refinancing risk and manifests itself in different dimensions such as –  Funding Risk – need to re place net out-flows.  Time Risk __ need to compensate for non-receipt of expected in-flows  Call Risk – due to crystallization of contingent liabilities. The liquidity management prescriptions spelling out funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting / reviewing are laid down in the ALM Policy. INTEREST RATE RISK: The management of interest rate risk is critical to market risk management especially in a deregulated environment, which has exposed the Banking system to 66
  70. 70. the adverse impacts of interest rate risk. Interest Rate risk can be of following types –  Basis Risk Market interest rates of various instruments seldom change by the same degree during a given period of time. The situation prevails in the Bank also as the changing interest rate on advances are immediately given effect, the change does not affect deposits/investments to a great extent as they continue at the contractual rates.  Yield curve risk The pricing of Investments are based on different benchmarks i.e. Treasury Bill Yield, G- Sec Yield, Call Money Rates, LIBOR/MIBOR etc. In a floating interest rate scenario, the Yield Curve Risk is high. 67
  71. 71. Interest Risk Management:  In a rising interest rate scenario, long dated low coupon securities can be sold and short dated high coupon securities can be purchased to protect the value of holding Portfolio.  In a falling interest rate scenario, short dated high coupon securities can be sold and long dated low coupon securities can be purchased to enhance the value of holding Portfolio.  Trading in volatile securities should be undertaken with due caution and within the laid down prudential limits.  All deal settlements should be tracked till their conclusion.  In the event of a fall in prices of the Securities, the stop loss principle shall apply.  VaR limits on the Trading book of Investments [all AFS-SLR/Non-SLR (excluding overdue investments, Equity, Mutual Funds and COD securities) and HFT portfolio]: The following VaR limits are fixed for the different time span on the Trading book of Investments [all AFS- SLR/Non-SLR (excluding overdue investments, Equity, Mutual Funds and COD securities) and HFT portfolio] as under: 68
  72. 72. Trading Portfolio: The Trading Portfolio of the Bank shall be managed in accordance with the Investment Management policy guidelines, which spell out the volume, maximum maturity, holding period, Duration, Stop Loss, Rating standards etc. for classifying securities in the Trading Book. The securities held in Trading Portfolio should be reviewed on a daily basis to evaluate increase / diminution in their value and to trigger appropriate sale / purchase action while the Trading Portfolio would be marked to market on monthly basis for providing depreciation, if any, in the Portfolio. Price risk and market risk are to be estimated by adopting the VAR model. Securities in the Trading Portfolio should be sold at the earliest opportunity to book profit or minimize loss within the outer limit of 90 days and such trading shall be undertaken within the powers delegated to the functionaries. Stop loss limit: While monitoring the Portfolio Stop loss limits as prescribed for cutting losses that may arise be exercised. 69 Time span 1 Day 10 Days 30 Days VaR Limit 1% of the Trading book of Investments 3% of the Trading book of Investments 6% of the Trading book of Investments The limit may be reviewed on Half-yearly basis. Any incident of abnormal volatility and exceeding the VaR limit should be immediately reported to the ALCO by the treasurer so that prompt remedial action can be taken.
  73. 73. To enable the authorities to exercise the powers judiciously, the Board has delegated 1% stop loss limit on the holding cost to the Deputy General Manager TIBD and above 1% but up to 2% to the General Manager. Similarly in the case of purchase for Trading Portfolio, the movement of value of the Security in the preceding month should be reckoned along with future price forecast while deciding upon the same. The Bank has in place an Asset Liability Management Policy, duly approved by the Board on an annual basis to address and deal with the above risk issues. The policy prescriptions and operating guidelines as laid down in the ALM Policy shall be followed in Market Risk management as it articulates the market risk management policies, procedures, prudential Risk limits, review mechanism , reporting and audit system. The ALM Policy addresses the Bank’s exposure on a consolidated basis and articulates risk measurement systems to be adopted, which would capture all sources of market risk and the impact thereof on the Bank. The market risk faced by the Bank would be essentially managed by the Integrated Treasury. EQUITY RISK MANAGEMENT: Bank undertakes buying and selling of shares to earn profit. In order to minimize the risk associated with the capital market, the bank adopts the following risk management strategies: 70
  74. 74.  The shares purchased will be sold only after getting the delivery in demat form.  The shares will be sold on getting a reasonable profit.  The Dealers will take a view regarding sale of equity shares /equity oriented mutual fund when their market value goes below the average holding cost.  The loss/depreciation will be restricted to 10% of the average cost.  The overall exposure to Capital Market will be kept within limits prescribed by RBI.  The Trading Equity Portfolio will be valued on Weekly basis.  It should be ensured that the exposure to stockbrokers is well diversified in terms of number of broker clients, individual inter-connected broking entities. 71
  75. 75. Operational Risk Management: Operational Risk arises in situations involving settlement or payment risks or business interruptions or administrative and legal risks. However, the most serious type of operational risk arises when there is a break down in internal controls and corporate governance. Operational Risk differs from other banking risks in that it is typically not directly taken in return for an expected reward but is implicit in the ordinary course of corporate activity and has the potential to affect the risk management process. Identification of operational risk is, therefore, crucial to the management. Various areas have been identified regarding operational risk as under:  Non-adherence to laid down procedure  Non-adherence to compliance required by the System  Non-adherence to policy guidelines  Lack of control over security items / numbered stationery  In-adequate checks / accuracy and processing of transactions  In-adequate supervision over accounting system  In-correct reporting of data 72
  76. 76.  Delayed action in circumstances warranting immediate action  Incorrect / improper /delayed handling of transactions  Observance of maximum brokerwise limits in transactions. 73
  77. 77. The Basel Committee has identified the following types of operational risk events as having the potential to result in substantial losses:  Internal fraud  External fraud  Employment practices and workplace safety  Clients, products and business practices  Damage to physical assets  Business disruption and system failures  Execution, delivery and process management. Monitoring / Control and Management of operational risk assumes significance for the Bank and the risk is sought to be managed in the following manner  Defining of responsibilities and accountability of various functionaries, segregation of duties, clear management reporting lines and adequate operating procedure.  Concurrent audit of the Investment Portfolio on monthly basis.  Dealers must operate strictly within the single deal, portfolio and prudential limits by instrument 74
  78. 78. and counterparty. Stop loss and risk norms of duration and value at risk should be adhered to at all times.  No deviation from approved and implemented work and document flows should be allowed.  The necessary authorizations must accompany documents as they pass from one stage of the transaction cycle to the next.  Delegations of powers must be strictly adhered to. Deals or transactions exceeding powers must be immediately and formally ratified in accordance with management/ Board edicts on ratification.  The prescribed settlement systems in each product/instrument and market must be followed. Deviations from delivery and payment practices should not be allowed.  Computer systems – hardware, networks and software – should have adequate backups. They should be put through periodic stress tests to determine their ability to cope with increased volumes and outlying data combinations.  Custodian’s creditworthiness is paramount in demat systems of records of ownership and transfer. Custodial relationships should be only with those with the highest credit rating. 75
  79. 79.  Counterparty authorizations/powers of attorney must be kept current.  The list of approved brokers should be reviewed periodically to satisfy the Bank’s credit standards and ethics.  Deal, transaction and legal documentation should be adequate to protect the Bank, especially in one-off transactions and structured deals. 76
  80. 80. Value-at-Risk (VaR) Value-at-risk is the maximum loss which will be suffered in a specified period and at a specified confidence level due to a fall in the price of a security (or exchange rate), given historic data on the price behavior of the security (exchange rate) or assessment of likely future market movements. The concept is applied to calculate the risk content of an individual security, a foreign exchange position, an equity share, a derivative or a portfolio of these instruments. The following are the steps involved in the calculation of VaR for an individual security: Value at Risk (VaR) is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time. Although VaR is a very general concept that has broad applications, it is most commonly used by security firms or investment banks to measure the market risk of their asset portfolios (market value at risk). VaR is widely applied in finance for quantitative risk management for many types of risk. VaR does not give any information about the severity of loss by which it is exceeded. Other measures of risk include volatility/standard deviation, semi variance (or downside risk) and expected shortfall. VaR has three parameters:  The time horizon (period) to be analyzed may relate to the time period over which a financial institution is committed to holding its portfolio, or to the time required to liquidate assets. Typical periods using VaR are 1 day, 10 days, or 1 year. A 77
  81. 81. 10 day period is used to compute capital requirements under the European Capital Adequacy Directive (CAD) and the Basel II Accords for market risk, whereas a 1 year period is used for credit risk.  The confidence level is the interval estimate in which the VaR would not be expected to exceed the maximum loss. Commonly used confidence levels are 99% and 95%. Confidence levels are not indications of probabilities.  Value at risk (VaR) is given in a unit of the currency. The following are the steps involved in the calculation of VaR for an individual security: Take a price series of the asset for which VaR is required. Example: Asset (8.85% 2015 Government of India bond) DAY (From yesterday) PRICE (Rs.) 1 101.24 2 101.50 3 101.45 4 101.42 5 101.55 6 101.70 7 101.90 8 101.80 9 101.75 10 101.85 a) Calculate the natural logarithm of a day’s price divided by the previous day’s price and their mean. DAY PRICE (Rs.) Natural Logarithm 78
  82. 82. Price of Day (n/n-1) 1 101.24 2 101.50 0.00256 3 101.45 -0.000493 4 101.42 -0.000296 5 101.55 0.00128 6 101.70 0.00148 7 101.90 0.00196 8 101.80 -0.000982 9 101.75 -0.000491 10 101.85 0.000982 MEAN 0.006 79
  83. 83. b) Calculate difference of each natural logarithm from the mean and square the difference. Sum up the squares of the differences. Total of (diff) ² Calculate variance = ------------------ Data less one 0.000 2686 = --------------- 9-1 = 0.0000336 Calculate standard deviation = variance = 0.0000336 = 0.0058 80 DAY Natural logarithm of Price diff. Diff. from Mean (Diff.) ² ½ 0.00256 -0.00344 0.0000118 3/2 -0.000493 -0.00649 0.0000421 4/3 -0.000296 -0.00630 0.0000397 5/4 0.00128 -0.00472 0.0000223 6/5 0.00148 -0.00452 0.0000204 7/6 0.00196 -0.00404 0.0000163 8/7 -0.000982 -0.00698 0.0000487 9/8 -0.000491 -0.00649 0.0000421 10/9 0.000982 -0.00502 0.0000252 TOTAL 0.0002686
  84. 84. Multiply the standard deviation by 1.65 to obtain the 95% confidence level for maximum loss. This is 1.65 X 0.0058 = 0.00957. Assuming the acquisition cost of the bond is Rs.110, the maximum loss in the next 24 hours at 95% confidence level and based on historical data is Rs.110 X 0.00957 = Rs.1.05. (A bigger loss is not ruled out if something unexpected or unusual occurs, which did not in the past 10 days). Of course, the VaR is a function of the standard deviation of relative price changes (i.e., the price change from one day to the next). Whether historical data or a forecast should be used for this purpose is entirely the judgement of the user. A forecast is better if the immediate future is going to be very different from historical data. VaR can be calculated for any period as desired. In every case, the standard deviation as calculated above is multiplied by the number of working days in the period for which the VaR is required. The number of working days in a year is 252 (forex market) and 300 (securities market), while in a month it is 22 (forex) and 26 (securities).Thus, the annual VaR in the above example is 0.0058 x √ 300 = 10.05%. At 95% confidence, this is Rs. (110 X 0.1005) = Rs. 11.05. 95% of the time, annual loss should not exceed this. Monthly VaR is similarly calculated as 0.0058x √ 26 = 2.96% or Rs. (110 X 0.0296) 81
  85. 85. = Rs.3.26. Thus, in a month, the loss should be within Rs. 3.26, 95% of the time. The same methodology can be followed to calculate the VaR of other assets like foreign exchange and equity shares. To calculate the VaR of a portfolio, simply add the VaR of the individual instruments in the portfolio (on the assumption that their price movements are wholly uncorrelated). Otherwise, to calculate the VaR of a portfolio, its daily change in value must be used to calculate the volatility and VaR as above for a single security. CHAPTER 7 CONCLUSION OF THE STUDY 82
  86. 86. 83
  87. 87. CONCLUSION OF THE STUDY Conventionally, the Treasury function was confined to funds management- maintaining cash balances to meet day to day requirements, deploying surplus funds generated in the operations, and sourcing funds to bridge occasional gaps in cash flow. Owing to economic reforms and deregulation of markets over the last decade, the scope of Treasury has expanded considerably. Treasury has since evolved as a profit centre, with its own trading and investment activity. Till recently, investment in securities and foreign exchange business constituted two separate departments in most of the Indian banks. These two functions are now become part of the integrated treasury, thus adding new dimension to treasury activity. With increasing deregulation and more exposure opportunities over the globe, banks should make the maximum out of this with the help of Risk management. This project has helped me to appreciate the role and functions of Treasury, its global dimensions and typical organizations of treasury activity in a bank. 84
  89. 89. SUGGESTIONS AND RECOMMENDATIONS The Bank’s Domestic Treasury is functioning within the RBI regulations and comes across as a well managed Treasury. Based on the information gathered during the completion of my project I wish to suggest the following which the Bank may look to implement. 1. Operational Risk: The Mid Office reporting should cover aspects of operational risk on a regular basis, even though operational risk cannot be directly taken in return for an expected reward but is implicit in the ordinary course of corporate activity and has the potential to affect the risk management process. 2. Stop Loss: Bank has prescribed Stop Loss limits for its Held for Trading portfolio. The percentage of Bank’s holding in its Held to Trading portfolio on an ongoing basis is about 0.1% of its total investments. Thus to have effective risk mitigation it is suggested that Bank should look into prescribing a suitable stop loss limits for its Available for Sale portfolio. The Available for Sale portfolio is required, as per Regulatory Norms, to be marked to market on a periodical basis. An effective stop loss implemented on a timely basis will help the 86
  90. 90. Bank to mitigate the Mark to Market Losses in Available for Sale portfolio. 3. Take profit levels: Bank can document the take profit levels which can be reviewed periodically. During the course of my study I did not come across any such document where the take profit levels where documented. 87
  91. 91. 4. Benchmark rates: Being very much in the market, the Treasury should provide the benchmark rates for various activities on a regular basis. As per present practice TIBD on a daily basis informs prevailing rates on selected Money and Debt market instruments but is not directly involved in the finalizing of the Bank’s rates. 5. Transfer Pricing: Treasury being an independent Branch unit should come under the ambit of transfer pricing. At the moment the Transfer pricing for TIBD is effected at CO. 6. Client business is nil. 7. Bank has very less involvement in derivative products. 8. Bank can try making the process more automotive rather than being manual. 9. More professional people are required. 88
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  94. 94. LIMITATIONS • The treasury department plays the most vital role; hence the data used by them was very confidential and critical, so couldn’t have much access to overall data. • The project report scope pertains only to this organization and is not applicable elsewhere. • Due to the time constraint, it was not possible to get all the minute details about the domestic treasury department. • The limited working hours was a constraint, because of which the officers were not able to give enough time for training. • The data provided by the staff can’t be held true as 100% correct. 91
  96. 96. BIBLIOGRAPHY 1) www.rbi.org.in 2) www.ccilindia.com 3) www.amfiindia.com 4) http://www.hdfcbank.com/wholesale/sme/ Custody_Services.htm 5) http://en.wikipedia.org/ 6) Investment Risk Management Policy, 2007-08, Bank of Maharashtra. 7) http://www.bankofmaharashtra.in 8) www.iib-online.org 9) www.fedai.org.in 93
  97. 97. 94