FunctionsofLiquidity

Liquidityriskarisesonaccountofbanksinabilitytomeetitspaymentobligationsasandwhenthey
aredemanded.Thedepositsofbanksasliabilitiesandloansandadvancesasassetsofthebankare
theprominentitemsinabanksbalancesheet.Thetypesofdepositsheldandtheinterestrates
offeredonthesedepositsontheonehandandthetypesofloansandadvancessanctionedandthe
interestrateschargedontheotherhandmaynotmatch.Inviewofthisliquidityriskisencountered
bythebanks.

Liquidityriskhasthreecomponents,namelyfundingrisk,timingriskandcallrisk.Stagnantdeposit
positionandincreasingdemandforloansandadvancescreateproblemsforthebank.Ifthebank
reducesinterestratesondepositsitresultsinflyingofdepositstocompetingbanks.Toincrease
returnsmoretermloansaresanctionedandthebanksabilitytocollecttheseloanswillaffectits
profitability.Inthissensethereisconflictbetweenprofitabilityandliquidity.Bankshavetostrikea
balancebetweenthesetwomatchingthecompositionofassetsandliabilities.Manytimesbanks
acquireshorttermdepositsandtrytousethemforfundingtherelongtermassets.Theseare
termedasCASAfundsimplyingusageofcurrentandsavingsaccountdeposits.Thisaffectsthe
liquiditypositionofthebanks.

Theabilityofthebankstoraisefundsdependsonitsareaofoperation,customerprofile,ownership
ofthebankandpublicimageofthebank.

Inordertomitigateliquidityriskbankshavetoreviewonacontinuousbasisthechangesinits
depositstructureandloansandadvances.Toimproveitsliquidityithastolookatpossibilitiesof
extendingmaturityonitsdepositsthroughrenewalsandreducinglongtermloancommitments.It
hastolookatthereliabilityofassetsintermsofrecoveriesfromborrowersandsaleofinvestments.

Theactionplanforliquidityriskmanagementshouldfocusonitscoreactivityofdepositmobilization
andcreditsanctioningandtherelatedriskfactorthatisinterestrateriskshouldalsobeconsidered.
Suchanactionplanshouldlookatshorttermandlongtermimplicationsofthebankingfunctions
anddevisestrategiestoreduceliquidityriskandincreasebankreturns.

Shorttermstrategiesincludeworkingfundsapproachandcashflowapproach.Longtermstrategies
aimatassetandliquiditymanagement.

ReserveBankofIndiahasissuedguidelinesforliquiditymanagementinbanks.Itcallsforfortnightly
statementofstructuralliquidityandfortnightlystatementofshorttermdynamicliquidity.These
statementsaimatcollectingdetailsofchangesinthedepositandloansandadvancesuptoaperiod
of90days.Thishelpsinunderstandingliquiditypositionofthebank.

RBIFormatDynamicLiquidity

114 1528days 2990

days days
A. Outflows
Netincreaseinloansandadvances
Netincreaseininvestments
(i)Approvedsecurities
(ii)Moneymarketinstruments(otherthantreasurybills)
(iii)Bonds/debentures/shares
(iv)Others
Interbankobligations

Offbalancesheetitems(repos,swaps,billsdiscounted)

Others

Totaloutflows
B.Inflows
NetCashposition

Netincreaseindeposits(lessCRRobligations)

Interestoninvestments

Interbankclaims

Refinanceeligibility(Exportcredit)

Offbalancesheetitems(reverserepos,swaps,bills
discounted)
Others

Totalinflows

C.Mismatch(BA)

D.Cumulativemismatch
E.(C)asapercentagetototaloutflows

 LiquidityRiskMeasurement

Banksusecertainaccountingratiostocomputeandmonitorliquidityrisk.Someoftheseratiosare
loansandadvancestototalassets,(desirablelevel60to65%),loansandadvancestocoredeposits
(desirablelevel70to75%),largedepositstoearningassets(desirablelevel50to60%),other
liabilitiestototalassets(desirablelevel10to15%),cashratiothatindicatesthecashandbalance
withRBIandothershortterminvestmentstototalliabilities(desirablelevel30to40%),loanlosses
tonetloans(desirablelevel1to2%).

TwootherindicatorsformeasuringliquidityriskareTobinsQandSharperatio.TobinsQhelpsto
determinetherateatwhichaunitofcapitalisexchangedforaunitofriskexposure.Sharpesratio
helpsbankstochoosetheiroptimalexposuretobankingactivitiesconsideringtheefficientfrontier
basedonriskreturncharacteristicoftheirportfolios.AhigherSharperatioindicatesabetterreturn
foraunitofriskundertakenbythebank.

Liquiditymanagementinvolvesstrategiesthatbuildupinsuranceagainstoutflowofdeposits.These
includeborrowingsfromotherbanks,saleofsecurities,callinorselloffofloansandincreased
reserves.

LiquidityManagement

ReserveRequirement 10% ExcessReserves 10million

Assets Liabilities

Reserves 20million Deposits 100million

Loans 80million BankCapital 10million

Securities 10million

Depositoutflowof10million

Assets Liabilities

Reserves 10million Deposits 90million

Loans 80million BankCapital 10million

Securities 10million

With10%desiredreserveratio,bankstillhasexcessreservesof1million.Hence,nochangesare
neededinbalancesheetfordepositwithdrawal.


ReserveRequirement 10% ExcessReserves 0

Assets Liabilities

Reserves 10million Deposits 100million

Loans 90million BankCapital 10million

Securities 10million

Depositoutflowof10million

Assets Liabilities

Reserves 0million Deposits 90million

Loans 90million BankCapital 10million

Securities 10million

With10%desiredreserveratio,bankwillhavenoreserves.Hencechangeinbalancesheetposition
isnecessaryforthebank.

1.Borrowfromotherbanksorcorporations

Assets Liabilities

Reserves 9million Deposits 90million

Loans 90million Borrowings 9million

Securities 10million BankCapital 10million

2.SellSecurities

Assets Liabilities

Reserves 9million Deposits 90million

Loans 90million BankCapital 10million

Securities 1million

Thesemethodsresultinpossiblealternativesofchangingthebalancesheetforthebank.

3.BorrowfromMarket

Assets Liabilities

Reserves 9million Deposits 90million

Loans 90million Debt 9million

Securities 10million BankCapital 10million

4.CallinorSelloffLoans

Assets Liabilities

Reserves 9million Deposits 90million

Loans 81million BankCapital 10million

Securities 10million

Thesemethodsresultinpossiblealternativesofchangingthebalancesheetforthebank.

TreasuryMarket

Bankskeepcashreservesaspartofstatutoryobligationsaswellasameasureofsecurityfor
uncertainpayments.Ifthebankmaintainslowcashreservesitmayimproveitsprofitabilitybutrisk
levelofthebankincreases.Ifitmaintainsahighercashreserve,itssafetyimprovesbutprofitability
willbeaffected.Thereforebankstrytoplaceexcesscashinshorttermreadilysaleableliquidassets
suchastreasurybillsandgovernmentsecurities.

Theseinvestmentsprovideattractivereturnsandbanksareassuredoffundsastheseareeasily
tradable.ReserveBankofIndiaoffersshorttermtreasurybillsaswellaslongtermgovernment
bonds.Treasurybillsareof91day,182dayand363daydurations.Theseareofferedonaweekly
basisonauctionmode.ThiscanbeusedascollateraltoborrowfundsintheRepo(repurchase
agreements)market.

Governmentbondsareofferedindematerializedformorintheformofphysicalinstruments.There
arevarietyofbondswithdifferentdurationandtermsandconditions.Theyareeasilytradableand
consideredforstatutoryliquidityratiorequirementsofbankswiththeReserveBankofIndia.

SeveraltypesofbondsareavailableforinvestmentinIndiasuchasfixedratebonds,floatingrate
bonds,zerocouponbonds,capitalindexedbonds,bondswithaput/calloptionandwithcertain
specialissuesforthebenefitofoilmarketingcorporation,fertilizercorporation,foodcorporation
andcompensationforsubsidies.

Auctionsystemsfollowedfortheissueoftreasuryinstrumentsareeitheryieldbasedorpricebased
auctions.

Holdingoftreasuryinstrumentscarrieswithitmarketrisk,liquidityriskandreinvestmentrisk.

TreasuryMarketRiskManagement

Treasurymanagementisabroaderconceptthanliquiditymanagement.Itinvolvesmanagementof
liquidityrisk,currencyrisk,exchangerateriskandinterestrateriskalongwithinvestmentriskand
commodityrisk.Generallytreasurymanagementfunctionincludesinsurance,investmentand
investorrelations,pensionfundmanagementandtaxmanagement.Thesefunctionsaretakenup
onlyattheinternationallevel.Thereisscopetoincludeallthesefunctionsastreasurymanagement
functioninIndiainthefuture.

Investmentincludesinvestmentinfinancialassetsandinrealassets.Therearespecificnormsfor
holdingandtradinginfinancialassetsasperBaselcommitteenorms.TheBaselcommittee
disclosurerequirementsofinvestmentsaretobefollowedbyallbanks.

Investmentsareusuallyclassifiedintotwocategoriesonthebasisofholdingperiod.Theyareheldto
maturityandavailableforsale.Bankshavetoclearlyspecifythetypesofinvestmentsheldinthese
differentforms.Usuallyinvestmentsheldformaturityshouldnotexceed25%oftotalinvestment
portfolio.Theintentiontoholdtillmaturityistobedisclosedatthebeginningofthefinancialyear
andthesecannotbealteredduringtheyear.Shiftingofavailableforsaleinvestmentstothoseheld
tomaturityisnotpermittedbyReserveBankofIndia.

ReserveBankofIndiahasissuedguidelinesonthevaluationanddisclosureofinvestments.These
guidelinesspecifythatbanksshouldspelloutitsinvestmentpolicyandprocedures.Theyshouldalso
maintainaninvestmentfluctuationreservetoaccountforvariationsinthevalueofinvestments.

InternalAuditforTreasuryRiskManagement

Internalcontrolsarenecessarytomonitortransactionsforeffectivesupervisionandscrutinyby
internalauditteamofabank.Thetreasurymanagementfunctionistobeproperlystructured
creatingseparateauthoritiesfordealing,riskmanagement,managementinformationandfor
verification.
Thefuncctionalseparrationoftrad
ding,settlem
ment,monito oring,controlandaccounntingensuressthat
internalcontrolsystemofabankkoperateseffectively.Prroperproced duresandsystemsforexxecution
andreco
ordingtransaactionsaretobeestablisshed.Dealinggslipforeacchtransactiongivingdetaailsof
thedeall,counterpaarties,amounntofsecurityy,price,conttractdatean
ndtimearetobeused.

Separateebooksofacccountsarettobemaintaainedintheaaccountssecctionoftheb
bankandperriodical
reconciliationwiththerecordso
ofthepublicdebtoffice((RBI)istobe
ecarriedout..

Detailsaaretoberep
portedtotop
pmanagemeentonaweeklybasis.Bankreceiptso
outstandingfformore
management.
thanoneemontharetobedisclosedtotopm

Treasuryymanageme entandfuncttioningistobeexternallyyauditedpeeriodicallyco
omprisingscrrutinyof
records,,riskexposures,compliancewithreggulationsanddvaluationoofassets.

Guidelinnesonintern
nalcontrolsyystemareintermsofriskkidentificatio
onprocessess,control
environm nagementinfformationsyystem,statuttorycomplianceof
ment,reliabiilityandinteegrityofman
internalregulator,budgetarycontrol,verificationofinveestmenttrad desandcomppliancewithinternal
audit.

Theriskandauditm
matrixhighlightstheneed dforcontrolandlevelofriskprevalentinthebussiness.
Theextrremeriskclassificationin
ndicatestheareawhereaauditrequireementsareccompulsory.
ChecklisstforInternaalAudit

I. General

Policiesforaalltreasuryaactivities.

Policiesintu
unewiththenatureofop
perations.

Responsiblepersonsareeassociatedw
withthepolicies.

Policyspeciffiestypesandpurposeso
ofthefinanccialinstruments.

Policyspeciffiesfrequenccyofreportin
ngandreporrtingauthoriity.

MaintenanceofCashReeserveRatioandStatutorryLiquidityR
Ratiorequireements.

II.Organ
nisationStructure

Treasuryacttivitiesaresu
upervisedbyyanofficerin
ndependentofdaytodaayactivities.

Effectiveseggregationofkeyduties(ttreasurydeaaling,settlem
mentafaccou
unting,recon
nciliation
ofaccounts)).

Policesandproceduresaaredocumen
ntedandeassilyaccessibletoallstaff.

Definedjobdescriptionssanddelegattionsforkeyytreasurypo
ositions.

ofsufficientresourcesto
Availabilityo ooperatetheetreasuryefffectively.

uthorization,,executionaandrecordingoftransacttions.
Segregationbetweenfunctionsofau

III.Perso
onnel:Training,Complian
nceandPerfformance

Trainedperssonnel.

Verificationofemployeeesreferencees.

Verificationofdocumentssignedbyemployeesatthetimeo
ofjoining.
IV.DealExecutionProcess

Confirmationoftransactionsconcludedbythedealingroomwiththebackofficemanager.

Systematicfilingofprocedure.

Examinethirdpartypayment.

Outwardconfirmationsarerecordedinaregister.

V.Limits

Counterpartyexposurelimitforallbrokers,lenders,etc.

Dealinglimits(maximumamount,apersoncantransactwithoutseekinghigherlevel
approval).

Productlimits(maximumexposureinaparticularinstrumentorproduct).

Sectorlimits(maximuminvestmentinaparticularsector).

VI.RecordingControl

i) ControloverDocuments

Timelyandaccurateexecutionofmoneymarketdealsandrecordings.

Receiptofalldocumentsandstatementsfromconcernedparties(brokers,bankers
andlenders,etc.).

Numberingandfilingofcopiesforeasereference.

ii)ControloverAccountingProcedures

Adequatesystemstotrackallmaturedinvestments.

Accuraterecordingandaccountingofpositions.

Countercheckingofrecordsbyanindependentperson.

AlldealsarerecordedintheGeneralLedger.

Accountreconciliationhasbeendoneandtimeframehasbeensetforclearingall
outstandingitems.

Inspectionofsourcedocuments.

VII.ReconciliationofBankAccountsandTreasuryRecordswiththeGeneralLedger

Bankbalancewithbankstatement.

Reconciliationoftreasuryrecordswiththegeneralledger.

VIII.CashManagement
 Effectiveprocedureformonitoringthedailycashposition.

Planningoftheliquidityneedsfornormaloperatingconditionsandemergencysituationsby
management.

Trendanalysisofcashforecasting.

Bankstatements.

Reviewofliquidityposition.

IX.Investment

Reviewandfollowupofinvestmentstrategy.

Authoritylevelandmonetarylimitsaresetforinvestmentindifferentinstrument.

Documentationoflistofinvestments.

Analyseofinvestmentportfoliostatements.

Holdingofinvestmentsinthebanksname.

Bankhasallthedocumentswithregardtoownershipofinvestments.

Bankutilisesthirdpartyinvestmentmanagers.

Controloftheinvestmentmanagersactivities.

Appraisalofinvestmentmanagers

Complianceofinvestmentpoliciesbyinvestmentmanagers.

Evaluationofinternal/externalinvestmentmanagersperformance.

X.DocumentationforDerivativetransactions

(i)UsageofInternationalSwapsandDerivativesAssociation(ISDA)documentation,with
suitablemodifications.

(ii) Confirmationforeachderivativetransactionwithdetailsofthetermsofthecontract
suchasgrossamount,rate,valuedate,etc.
(iii) Individualtransactionconfirmation.
(iv) Evaluationoflegalcapacity,powerandauthorityofthecounterpartytoenterinto
derivativetransactions.
(v) Documentationoftheagreementwiththecounterpartypriortoundertakingany
derivativesbusinesswiththem.
(vi) Documentationregardingcustomersuitability,appropriateness,etc.


XI.InvestmentinDebtSecurities

Frequencyofinterestpayments.
Informationabouttheissuerandthecreditrating.
Termsoftheissuesuchastheuseoftheissueproceeds,themonitoringagency,the
formationoftrustees,thesecuredorunsecurednatureofthebonds,theassetsunderlying
thesecurityandthecreditworthinessoftheorganisation.
ComparisonoftheYieldToMaturity(YTM)ofthedebtsecuritywiththeYTMsofother
comparabledebtsecuritiesofthesameclassandfeatures.

Questions

1. Discusstheimplicationsofliquidityriskinbanks.
2. Explainthefeaturesoftreasurymanagementfunctioninbanks.
3. Whataretheapproachesformeasuringliquidityrisk?
4. Whataretheinternalcontrolsystemsforliquiditymanagement?
5. Explainthecharacteristicoftreasurymarkets.
6. ListtheRBIguidelinesfortreasuryinvestments.
7. WhataretheBaselcommitteenormsforvaluationanddisclosureofinvestments?
8. Explainthestepstobetakenforeffectiveinternalcontroloftreasurymanagementfunction.
9. Whatarethestepsininternalauditfortreasurymanagement?
10. Discusstheimportantguidelinesforinternalaudit.