A PROJECT REPORT

on

Treasury Management in Banks

Submitted by:

VARUN MEWADA

PGDBM 2019-21

Specialization: Finance

Roll No: P19032

Project Guide: Prof. Puneet Tulsyan

SYDENHAM INSTITUTE OF MANAGEMENT STUDIES, RESEARCH AND

ENTREPRENEURSHIP EDUCATION

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 Treasury Management in Banks

This project report in Finance, based on the in-depth study of Treasury Management in Banks, and
is submitted to the Sydenham Institute of Management Studies and Research and Entrepreneurship
Education (SIMSREE), B - Road, Churchgate, Mumbai - 400 020, in partial fulfilment of the
requirements for the award of the two year’s Full Time Post Graduate Diploma in Business
Management approved by AICTE.

Submitted By

NAME: Varun Mewada ROLL NO: P19032

CLASS & BATCH: PGDBM 2019-21

Through

NAME OF THE GUIDE: Prof. Puneet Tulsyan

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 CERTIFICATE

This is to certify that this project report entitled "Treasury Management in

Banks” is submitted to Sydenham Institute of Management Studies and Research and
Entrepreneurship Education (SIMSREE), Mumbai 400020, by Mr. Varun Mewada
bearing Roll No. P19032 Batch (2019 - 2021) in partial fulfilment of the requirements
for the award of the two year’s Full Time Post Graduate Diploma in Business
Management approved by AICTE.

This is a record of his work carried out under my guidance. I am satisfied with the
quality, originality and depth of the work for the above qualification.

PLACE: Mumbai

DATE: (Signature of the

Guide)
Prof. Puneet
Tulsyan

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 INDEX

Sr. No. Particulars Page No.

1 Introduction 5

2 Functions Of Treasury Management 6

3 Elements Of Treasury Management 7

i) CRR/SLR Management
ii) Dated Government Security
iii) Money Market Operations

4 Risk Management Instruments For Treasury Management 10

i) Interest Rate Swap And Forward Rate

ii) Asset Liability Management
iii) Interest rate Risk Management
iv) Liquidity Risk Management

5 Securitization 21

6 Conclusion 26

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ACKNOWLEDGEMENTS

I would like to acknowledge the following for being the idealistic channel and fresh
dimension in the completion of this project.

I take this opportunity to thank Sydenham Institute of Management Studies, Research &
Entrepreneurship Education (SIMSREE) for giving me a chance to do this project.

I wish to appreciate the management for providing the state-of-the-art facilities, Director
Dr. Shriniwas Dhure for his dynamic leadership and the library staff for their support in
providing academic content, and the teaching and supporting staff for providing the
entire state of the art and resources to enable the completion and enrichment of my
project.

I would also like to express my sincere gratitude towards my Project Guide Prof. Puneet
Tulsyan whose guidance and care made the project successful.
Varun Mewada
P19032

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 EXECUTIVE SUMMARY

Since 1990s, the prime movers of financial intermediaries and services have been the policies
of globalization and reforms. All players and regulators had been actively participating, only
with variation of the degree of participation, to globalize the economy. With burgeoning forex
reserves, Indian banks and Financial Institutions have no alternative but to be directly affected
by global happenings and trades. This is where integrated treasury operations have emerged as
a basic tool for key financial performance.

The project starts with the discussion on the elements of treasury management i.e.
management of CRR, SLR, dated government securities, money market operations.

The project is an attempt to understand the risk management instruments for treasury
management –

• Interest rate swap and forward rate

• Asset liability management
• Interest rate risk management
• Liquidity risk management

It was extremely enlightening and encouraging environment which enabled me to proceed

throughout the project with lot of zest and it was indeed a knowledgeable experience for me

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 1.0 Introduction

In general terms and from the perspective of commercial banking, treasury refers to the fund
and revenue at the possession of the bank and day-to-day management of the same. 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. Returns and risks both need to be managed. If we examine the
balance sheets of Commercial Banks (Public Sector Banks, typically), we find investment
growth has by far overtaken credit growth. Interest income from investments has overtaken
interest income from loans/advances. The special feature of such bloated portfolio is that more
than 85% of it is invested in government securities.

The reasons for such developments appear to be as under:

• Banks' reluctance to cut-down the size of their balance sheets.

• Government's aggressive role in lowering cost of debt, resulting in high inventory profit
to commercial banks.
• Capital adequacy requirements.
• The income flow from investment assets is real compared to that of loan-assets, as the
latter is sizeably a book-entry.

In this context, treasury operations are becoming more and more important to the banks and a
need for integration, both horizontal and vertical, has come to the attention of the corporate.
The basic purpose of integration is to improve portfolio profitability, risk-insulation and also
to synergize banking assets with trading assets. In horizontal integration, dealing/trading rooms
engaged in the same trading activity are brought under same policy, hierarchy, technological
and accounting platform, while in vertical integration, all existing and diverse trading and
arbitrage activities are brought under one control with one common pool of funding and
contributions.

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 2.0 Functions of the Treasury Department in Banks

Since 1990s, the prime movers of financial intermediaries and services have been the policies
of globalization and reforms. All players and regulators had been actively participating, only
with variation of the degree of participation, to globalize the economy. With burgeoning forex
reserves, Indian banks and Financial Institutions have no alternative but to be directly affected
by global happenings and trades. This is where integrated treasury operations have emerged as
a basic tool for key financial performance.

A treasury department of a bank is concerned with the following functions:

• Risk exposure management, which embraces credit, country, liquidity and interest rate risk
consideration together with those risks associated with dealing in foreign exchange.

• Asset and liability management, where liquidity, interest rate structures and sensitivity,
together with future maturity profiles, are the major considerations in addition to managing
day-to-day funding requirements.

• Control and development of dealing functions.

• Funding of investments in subsidiaries and affiliates.

• Capital debt/ loan stock raising.

• Fraud protection.

• Control of investments.

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 3.0 Elements of Treasury Management

3.1 Cash Reserve Ratio / Statutory Liquidity Ratio Management

CRR, or cash reserve ratio, refers to the portion of deposits that banks have to maintain with
RBI. This serves two purposes. First, it ensures that a portion of bank deposits is totally risk-
free. Second, it enables RBI control liquidity in the system, and thereby, inflation. Besides
CRR, banks are required to invest a portion of their deposits in government securities as a part
of their statutory liquidity ratio (SLR) requirements. The government securities (also known as
gilt-edged securities or gilts) are bonds issued by the Central government to meet its revenue
requirements. Although the bonds are long-term in nature, they are liquid as they have a ready
secondary market.

3.2 Dated Government Securities

The Government securities comprise dated securities issued by the Government of India and
state governments. The date of maturity is specified in the securities therefore it is known as
dated government securities. The investors in government securities are mainly banks, FIs,
insurance companies, provident funds and trusts. The Government borrows funds through the
issue of long term-dated securities, the lowest risk category instruments in the economy. These
securities are issued through auctions conducted by RBI, where the central bank decides the
coupon or discount rate based on the response received. Most of these securities are issued as
fixed interest bearing securities, though the government sometimes issues zero coupon
instruments and floating rate securities also. In one of its first moves to deregulate interest rates
in the economy, RBI adopted the market driven auction method in FY 1991-92. Since then, the
interest in government securities has gone up tremendously and trading in these securities has
been quite active. They are not generally in the form of securities but in the form of entries in
RBI's Subsidiary General Ledger (SGL).

3.3 Money Market Operations

The bank engages into a number of instruments that are available in the Indian money market
for the purpose of enhancing liquidity as well as profitability. Some of these instruments are as
follows:

A. Call Money Market

Call/Notice money is an amount borrowed or lent on demand for a very short period. If the
period is more than one day and up to 14 days it is called 'Notice money' otherwise the amount
is known as Call money'. Intervening holidays and/or Sundays are excluded for this purpose.
No collateral security is required to cover these transactions.
B. Treasury Bills Market

In the short term, the lowest risk category instruments are the treasury bills. RBI issues these
at a prefixed day and a fixed amount. There are four types of treasury bills.

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• 14-day T-bill - maturity is in 14 days. Its auction is on every Friday of every week. The
notified amount for this auction is Rs. 100 cr.
• 91-day T-bill - maturity is in 91 days. Its auction is on every Friday of every week. The
notified amount for this auction is Rs. 100 cr.
• 182-day T-bill - maturity is in 182 days. Its auction is on every alternate Wednesday (which
is not a reporting week). The notified amount for this auction is Rs. 100 cr.
• 364-Day T-bill - maturity is in 364 days. Its auction is on every alternate Wednesday
(which is a reporting week). The notified amount for this auction is Rs. 500 cr.

C. Inter-Bank Term Money

Inter bank market for deposits of maturity beyond 14 days and up to three months is referred
to as the term money market. The specified entities are not allowed to lend beyond 14 days.
The market in this segment is presently not very deep.

D. Certificates of Deposits
After treasury bills, the next lowest risk category investment option is the certificate of deposit
(CD) issued by banks and FIs. A CD is a negotiable promissory note, secure and short term (up
to a year) in nature. It is issued at a discount to the face value, the discount rate being negotiated
between the issuer and the investor. Though RBI allows CDs up to one-year maturity, the
maturity most quoted in the market is for 90 days.

E. Commercial Paper (CP)

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note. CP was introduced in India in 1990 with a view to enabling highly rated
corporate borrowers to diversify their sources of short-term borrowings and to provide an
additional instrument to investors.

F. Ready Forward Contracts

It is a transaction in which two parties agree to sell and repurchase the same security. Under
such an agreement the seller sells specified securities with an agreement to repurchase the same
at a mutually decided future date and a price. Similarly, the buyer purchases the securities with
an agreement to resell the same to the seller on an agreed date in future at a predetermined
price. Such a transaction is called a Repo when viewed from the prospective of the seller of
securities (the party acquiring fund) and Reverse Repo when described from the point of view
of the supplier of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo
depends on which party initiated the transaction.

G. Commercial Bills

Bills of exchange are negotiable instruments drawn by the seller (drawer) of the goods on the
buyer (drawee) of the goods for the value of the goods delivered. These bills are called trade
bills. These trade bills are called commercial bills when they are accepted by commercial
banks. If the bill is payable at a future date and the seller needs money during the currency of
the bill then he may approach his bank for discounting the bill. The maturity proceeds or face

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value of discounted bill, from the drawee, will be received by the bank. If the bank needs fund
during the currency of the bill then it can rediscount the bill already discounted by it in the
commercial bill rediscount market at the market related discount rate.

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 4.0 Risk Management Instruments for Treasury Management

4.1 Interest Rate Swaps and Forward Rate

An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or
swapping a stream of interest payments for a ‘notional principal’ amount on multiple occasions
during a specified period. Such contracts generally involve exchange of ‘fixed to floating’ or
‘floating to fixed’ rates of interest. Accordingly, on each payment date that occurs during the
swap period-cash payments based on fixed/floating rates are made by the parties to one another.

A Forward Rate Agreement (FRA) is a financial contract between two parties to exchange
interest payments for a ‘notional principal’ amount on settlement date, for a specified period
from start date to maturity date. Accordingly, on the settlement date, cash payments based on
contract (fixed) and the settlement rate, are made by the parties to one another. The settlement
rate is the agreed bench-mark/ reference rate prevailing on the settlement date.

Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs),
Mutual funds and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a
product for their own balance sheet management or for market making. Banks/FIs/PDs can
also offer these products to corporates for hedging their (corporates) own balance sheet
exposures.

➢ Rules for entering into IRS/FRA

The party intending to enter into IRS/FRA will have to collect all information/documents
relating to status of the counter party, duly executed swap agreements etc.

1) Status of the Counter party:

Before entering into a deal, first determine whether the counterparty has legal capacity, power
and authority to enter into an interest rate swap transaction. The Memorandum and Articles of
Association, Board resolution for authorization of swap deals and signatures of authorized
persons should be obtained and scrutinized. Also a suitable counterparty limit for entering into
IRS/FRA has to be fixed.

2) Documentation:

The counterparties should sign ISDA master agreement before entering into a swap deal. The
parties should appropriately change the Schedule to the agreement according to the terms and
conditions settled between them.

3) Accounting of IRS/FRA:

The parties can enter into swap deals for hedging interest rate risk on their own portfolio or for
market making. The parties should make clear distinction between swaps that are entered into
for hedging their own balance sheet positions and more which are entered into for trading. The

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 transactions for market making purposes should be marked to market (at least at fortnightly
intervals), and those for hedging purposes could be accounted for on accrual basis.

4.2 Asset Liability Management

ALM is concerned with strategic balance sheet management involving risks caused by changes
in the interest rates, exchange rates and the liquidity position of the bank. While managing
these three risks forms the crux of ALM, credit risk and contingency risk also form a part of
the ALM. The significance of ALM to the financial sector is further highlighted due to dramatic
changes that have occurred in recent years in the assets (uses of funds) and liabilities (sources
of funds) of banks. Thus a comprehensive ALM process aims on profitability and long term
viability. The process of ALM has to be carried out against many balance sheet constraints,
which amongst others include maintaining credit quality, meeting liquidity needs and acquiring
required capital.

➢ Significance Of ALM

The main reasons for the growing significance of ALM are:

1. Volatility
2. Product Innovations
3. Regulatory environment
4. Enhanced awareness of top management

1. Volatility

The recent times have witnessed an increasing number of free economies, with more and more
nations globalizing their operations. Closely regulated markets are paving the way for market-
driven economies. Such deregulations have changed the dynamics of the financial markets.
The vagaries of such free economic environment are reflected in the interest rate structures,
money supply and the overall credit position of the market, the exchange rates and price levels.
For a business which involves trading and money, rate fluctuations invariably affect the market
value, yields / cost of the assets/liabilities which further affect the market value of the bank and
its Net Interest Income (NII). Tackling this situation would have been a very easy task, in a
setup where the interest rate movements are known with accuracy and where the volatility in
the exchange rates was considerably lower.

2. Product Innovation:

The second reason for the growing importance of ALM is the rapid innovations taking place in
the financial products of the bank. While there were some innovations that came as passing
fads, there were others, which have received tremendous response. In several cases, the same
product has been repackaged with certain differences and offered by various banks.

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Whatever may be the features of the products, most of them have an impact on the risk profile
of the bank thereby enhancing the need for ALM. Consider the flexi deposit facility the banks
are now offering for their term deposits. Earlier, if the depositor who has a term deposit of Rs.
1 lakh was in need of funds, say Rs. 25000 before the date of maturity of the term deposit, then
the depositor would go for a premature withdrawal of the term deposit or raise a loan. In order
to discourage this, banks charge a penalty on the entire amount for premature withdrawal. This
served as a disincentive for premature withdrawals and also reduced the risk for the bank.

However, with the introduction of flexi deposit facility, the deposit of Rs. 1,00,000 will be
segregated into deposits of smaller denominations, say 100 deposits of 1,000 each. This enables
the investor to withdraw the required amount before the maturity since the burden of penalty
is limited. However, it will also enhance the risk of the bank. With the reduction in the penalty
amount, the depositor would make a demand for the premature withdrawal at any time.

To reduce the impact of the asset-liability mismatch that arises due to these early withdrawals
of funds, the bank will have to raise a liability to match the outflow. In such case, the bank will
be faced with a liquidity risk when there is a sudden outflow of funds as well as interest rate
risk since it may have to raise a liability at a higher cost.
3. Regulatory Environment

In order to enable the banks to cope up with the changing environment that has resulted due to
integration of the domestic markets with the international markets, the regulatory bodies of
various financial markets have initiated a number of measures. These measures were taken with
an objective to prevent major losses that may arise due to the market vagaries. One step in this
direction was the increased focus on the management of the banks’ assets and liabilities. At the
international level, the Bank of International Settlement (BIS) provides a framework for the
banks to tackle the market risk that may arise due to rate fluctuations and excessive credit risk.
The RBI is also following in this direction and has recently issued by the regulator on the risk-
based capital to be maintained by the banks in order to tackle credit risk.
4. Management Recognition:

All the above-mentioned aspects forced the managements of the banks to have a serious
thought about the management of the assets and liabilities. The managements have realized
that it is just not sufficient to have a very good franchise for credit disbursement nor it is enough
to have just a very good retail deposit base. In addition to these, the bank should be in a position
to relate and link the asset side with the liability side, and this calls for asset-liability
management.

There is increasing awareness in the top management that banking is now a different game
altogether since all the rules of the game have since changed.

➢ RBI GUIDELINES ON ALM

The Reserve Bank of India in Feb 1999 has issued comprehensive guidelines for banks for
Asset Liability Management. Guidelines inter alia include directions for classification of
various assets and liabilities, parameterization of various associated market risks, and
frequency of evaluation of exposure.

Following three Statements showing position of maturity of assets and liabilities (Inflow and
Outflow of Funds) are required to be prepared by the banks.

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 a) Statement of Structural Liquidity
All assets and liabilities are required to be classified into various time buckets, given below,
on the basis of their expected inflows and outflows. On balance sheet as well as off balance
sheet items are required to be included in the classification.
1 to 14 days
15 to 28 days
29 days to 3 months
3 months to 6 months
6 months to 1 year
1 year to 3 years
3 years to 5 years
5years and above
This statement is required to be prepared, presently at quarterly frequency, as on last reporting
Friday of the quarter. Based on behavioral pattern, Savings deposits and Current Deposits
which form a significant portion of the bank’s deposits are required to be classified into 1 to
14 days and 1 to 3 years time buckets. Term deposits are classified on actual residual maturity.
Similarly based on behavioral pattern cash credit, overdrafts and other loans are required to be
classified into various time buckets depending upon expected inflow of funds.

b) Statement of interest rate sensitivity

All assets and liabilities, on balance sheet as well as off balance sheet, are required to be
classified into various time buckets, given below, based on their maturity for repricing. Thus
the cash credit facility, though perennial in nature which gets repriced with change in prime
lending rate, matures for repricing generally twice in a year, at the time when reserve bank
declares credit policy. For the purpose of classification in this statement this facility is classified
into 3 to 6 months time buckets. Installments falling due in loans are repriced when reinvested.
Thus all repayments are considered due for repricing and are classified accordingly.

c) Statement of Short Term Dynamic Liquidity

This is required to be prepared fortnightly and include expected inflows and outflows in next
3 months classified into 3 time buckets. This classification is capable of reflecting any short
fall in liquidity during next 3 months, hence assumes great importance from ALM angle. The
Board of Directors through a Committee of Directors is required to monitor the process of
ALM in banks.

➢ Asset Liability Committee (ALCO)

Management of market risk should be the major concern of top management of banks. The
Boards should clearly articulate market risk management policies, procedures, prudential risk
limits, review mechanisms and reporting and auditing systems. The policies should address the
bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems
that capture all material sources of market risk and assess the effects on the bank. The operating
prudential limits and the accountability of the line management should also be clearly defined.
The Asset-Liability Management Committee (ALCO) should function as the top operational
unit for managing the balance sheet within the performance/ risk parameters laid down by the
Board.
Successful implementation of any risk management process has to emanate from the top
management in the bank with the demonstration of its strong commitment to integrate basic

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operations and strategic decision making with risk management. Ideally, the organization set
up for Market Risk Management should be as under: -

• The Board of Directors

• The Risk Management Committee
• The Asset-Liability Management Committee (ALCO)
• The ALM support group/ Market Risk Group

➢ ROLE OF ALCO

The Asset-Liability Management Committee, popularly known as ALCO should be

responsible for ensuring adherence to the limits set by the Board as well as for deciding the
business strategy of the bank in line with bank’s budget and decided risk management
objectives.

The role of the ALCO should include, inter alia, the following:

• Product pricing for deposits and advances

• Deciding on desired maturity profile and mix of incremental assets and liabilities
• Articulating interest rate view of the bank and deciding on the future business strategy
• Reviewing and articulating funding policy
• Decide the transfer pricing policy of the bank
• Reviewing economic and political impact on the balance sheet

➢ Purpose Of ALM

• This enhanced level of importance of ALM has led to the change in the nature of its
functions. It is no longer a stand-alone analytical function. While there are macro and
micro-level objectives of ALM, it is, however the micro-level objectives that hold the key
for attaining the macro-level objectives.
• At the macro-level, ALM leads to the formulation of critical business policies, efficient
allocation of capital and designing of products with appropriate pricing strategies.
• And at the micro-level, the objective functions of the ALM are two-fold. It aims at
profitability through price matching while ensuring liquidity by means of maturity
matching.
• Price matching basically aims to maintain spreads by ensuring that the deployment of
liabilities will be at a rate higher than the costs.
• Similarly, liquidity is ensured by grouping the assets/liabilities based on their maturing
profiles.
• The gap is then assessed to identify the future financing requirements. This ensures
liquidity. However maintaining profitability by matching prices and ensuring liquidity by
matching the maturity levels is not an easy task.
➢ Process Of ALM

• Firstly, review the interest rate structure and compare the same to the interest/product
pricing of both assets and liabilities. This to a certain extent will highlight the impending
risks and the need for managing the same.

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• Secondly, examine the loan and the investment portfolios in the light of foreign exchange
risk and liquidity risk that might arise. At the same time the affect of these risk on the value
and cost of liabilities should also be given due consideration.
• Thirdly, examine the probability of the credit risk and contingency risk that may originate
either due to rate fluctuations or otherwise and assess the quality of assets.
• Finally, review the actual performance against the projections made and analyze the reasons
for any effect on spreads.

➢ Target Accounts Of Banks In ALM

• Net Interest Income (NII): The impact of volatility on short term profits is measured by
NII. Hence, if a bank has to stabilize its short-term profits, it will have to minimize the
fluctuations of NII.

• Market Value of Equity (MVE): The market value of the equity represents the long-term
profits of the bank. The bank will have to minimize adverse movements in this value due
to rate fluctuations. The target account will thus be MVE. In the case of unlisted banks, the
difference between the market value of assets and liabilities will be the target account.

• Economic Equity Ratio: The ratio of shareholders funds to the total assets measures the
shift in the ratio of owned funds to total funds. This in fact assesses the sustenance capacity
of the bank. Stabilizing this account will generally come as a statutory requirement.

➢ Asset and Liabilities pricing in deregulated markets

In a deregulated market, since short term, medium term and long term interbank market exists,
asset and liability pricing is relatively easier. This is because a proper yield curve, such as the
one depicted in the figure is obtained. The methodology to be employed in such situation is
described below:
The interbank market curve serves as a benchmark, which is employed by treasury to price
assets and liabilities. The spread ‘A’ net of the cost is the profit to the liability-raising branch.
Similarly, the spread ‘C’ is retained by the corporate department booking the asset. The
treasury makes its profit from bid/offer spread and gap adjustment. The latter exposes treasury
to an interest- rate risk.

Pitfalls of this approach

To maximize its spread, the corporate department might book high-risk high-yielding assets
e.g. junk bonds. Some banks have a credit department, separate from the marketing department,
to keep this from happening. Alternatively, a different approach – Risk-Adjusted
Benchmarking – could be adopted. This would involve attaching a risk premium for each asset
depending on the volatility of the income stream from the asset. This leads to a separate
benchmarking curve for each asset under consideration.
It is possible that the branches might just try to raise the cheapest liabilities at the times of easy
liquidity leading to the bank taking on an asset base which is in fact too large to be supported
by its access to liquidity in times of tight liquidity. In other words, balance sheet growth will
be planned in line with bank’s access to liquidity over the long term, and not in response to
temporary conditions.

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4.3 Interest Rate Risk

Due to the very nature of its business, a bank should accept interest rate risk not by chance but
by choice. And when the bank has to take a risk as a choice, then it should ensure that the risk
taken is firstly manageable and secondly it does not get transformed into yet another
undesirable risk. As stated earlier, the focal point in managing any risk will be to understand
the nature of the risk. This is especially essential for interest rate risk management. Interest rate
risk is the gain/loss that arises due to sensitivity of the interest income/interest expenditure or
values of assets/liabilities to the interest rate fluctuations.

➢ Types of Interest Rate Risks

The sensitivity to interest rate fluctuations will arise due to the mixed affect of a host of other
risks that comprise the interest rate risk. These risks when segregated fall into the following
categories:

1. Rate Level Risk

During a given period there is possibility for restructuring the interest rate levels either due to
the market conditions or due to regulatory intervention. This phenomenon will, in the long run,
affect decisions regarding the type and the mix of assets/liabilities to be maintained and their
maturing periods.

2. Volatility Risk
In additions to the long run implications of the interest rate changes, there are short term
fluctuations which are to be considered in deciding on the mix of assets and liabilities, the
pricing policies and thereby the business volumes. However, the risk will acquire serious
proportions in a highly volatile market when the impact will be felt on the cash flows and
profits.
3. Prepayment Risk
The fluctuations in the interest rate may sometimes lead to prepayment of loans. For instance,
in a situation where the interest rate is declining, any cash inflows that arise due to prepayment
of loans will have to be redeployed at a lower rate invariably resulting in lowered yields.
4. Call/Put Risk
Sometimes when the funds are raised by the issue of bonds/securities, it may include call/put
options. A call option is exercised by an issuer to redeem the bonds before maturity, while the
put option is exercised by the investor to seek redemption before maturity. These two options
expose to a risk when the interest rate fluctuate. A call option is generally exercised in a
declining interest rate scenario. This will affect the bank if it invests in such bonds since the
intermediate cash inflows will have to be reinvested at a lower rate. Similarly, when the
investor exercises the put option in an increasing interest rate scenario, the banks, which issue
the bonds, will have to face greater replacement costs.
5. Reinvestment Risk
The risk can be associated to the intermediate cash flows arising due to the payment of interest,
installments on loans etc. These intermediate cash flows arising from a security/loan are usually
reinvested and the income from such reinvestments will depend on the prevailing rate of
interest at the time of reinvestment and the reinvestment strategy. Due to the volatility in the
interest rates, these intermediate cash flows when received may have to be reinvested at a lower
rates resulting in lower yields. This variability in the returns from the reinvestments due to
changes in the interest rates is called the reinvestment risk.

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 6. Basis Risk
When the cost of liabilities and the yields of assets are linked to different benchmarks resulting
in a floating rate and there are no simultaneous matching movements in the benchmark rates,
it leads to basis risk. For instance, consider that the funds raised by way of 1 yr bank deposits
are invested in the Easy Exit Bond of the IDBI flexi bond issue. In this case, the cost of funds
for 1 yr bank deposits will be 9%( 1 % less than the Bank Rate 10%), while the yields from
the bonds will be14.55% which is 1.5% over 10 yr government bond of 13.05%. With these
floating rates of interest, on the assets and liability spreads of 5.55% (14.55-9) is available.
Assume that there is a 1% cut in the bank rate. This will bring down the cost of funds to 8%.
Further, assume that the return on 10 yr government bond has also come down to 12.75%,
thereby bringing down the return on the Easy Exit Bond to 14.25%. As a result of this interest
rate change, the spread will increase to 6.25%. While the bank rate declined by 1%, the yield
on 10 yr government security came down only by 30bp. Thus, when the change in the interest
rates, which are set as a benchmark for assets/liabilities, is not uniform, it will lead to a
decrease/increase in the spreads.

7. Real Interest Rate Risk

Yet another dimension of the interest rate risk is the inflation factor, which has to be considered
in order to assess the real interest cost/yields. This occurs because the changes in the nominal
interest rates may not match with the changes in inflation.
The presence of the above mentioned risk would either individually or collectively result in
interest rate risk. These risks will affect the income/expenses of the bank’s asset/liability
portfolio. This, further, will also have an impact on the value of assets and liabilities of the
bank, thereby affecting even the market value of the bank.

➢ Interest Rate Risk Management

Mere Identification of the presence of the interest rate risk will not suffice. A system that
quantities the risk and manages the same should be put in place so that timely action can be
taken. Any delay or lag in the follow up action may lead lo a change in the dimension of the
risk i.e. lead to some other risks like credit risk, liquidity risk, etc. and make the situation
uncontrollable.

Initiating the risk exposure control process is the classification of all assets and liabilities based
on their rate sensitivity. For this classification, a bank should first be able to forecast the interest
rate fluctuations. Based on these fluctuations, it should identify the rate sensitive
assets/liabilities within the forecasting period. Thus, all assets/liabilities that are subjected to
re pricing within the planning horizon are categorized as Rate Sensitive Assets (RSAs)/Rate
Sensitive liabilities (RSLs).

The need for re pricing arises from the fact that in a going concern, all assets and liabilities are
replaced as and when they mature- Replacement of these assets/liabilities may subsequently
lead to re pricing especially in the following three situations:
a. When assets/liabilities approach maturity
b. When the assets/liabilities have floating rate of interest
c. When regulations prescribe re pricing.

When an asset/liability is maturing, the changing interest rate structure leads to revision of the
price at which they are replaced. For example, the IDBI Flexi bonds issue consisted of the
regular income bond with a face value of Rs. 5,000 and having a coupon rate of 16 percent p.a.

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payable half-yearly. This bond has a maturity period of 10 years. Once the redemption date
approaches, IDBI will have to replace the same by raising a liability at a rate which will be
either less than/greater than the 16 percent rate level.

Similarly, re pricing becomes invariable when the asset/ liability are priced at floating rate. For
instance, consider the Easy Exit Bond of the IDBI Flexi bonds issue. The coupon rate of this
bond is fixed at 1.5 percent over 10-year Government Bond rate or 2.5 percent over 3-year FD
rate of SBI, whichever is higher. Thus, any change in the Government bond rate/SBI FD rate
leads to a corresponding change in the rate of the Bond.

In addition to these, changes in the regulatory framework in certain cases may lead to re pricing.
Replacement of the assets/liabilities subsequently leads to re pricing which explains their
sensitivity to rate fluctuations. The need for such a classification of assets-and liabilities based
on their sensitivity is essential since a consequential affect of the rate fluctuation is its impact
on the net income of the firm.

There are two aspects that- need to be taken care of in order to understand the total impact of
the rate fluctuation on the net income. These two aspects refer to the effect of the rate changes
on the non-interest income and the interest income. In the first case, there can be a use fall in
the non-interest income since rate fluctuations affect the value of the assets/liabilities, while in
the second case, the interest rate changes will in certain situations create a mismatch in the
pricing of the assets and liabilities which affect the net interest income. Thus, it can be observed
that the effect of rate fluctuation is extended to both the balance sheet and the income statement
of a financial intermediary. However, while measuring the interest rate risk, greater emphasis
is laid on its affect on interest income. This is due to a high degree of correlation between the
rate fluctuations and its affect on RSAs/RSLs, which further gives greater scope for
maneuverability.

Once the bank is exposed to the interest rate risk, the immediate step to be followed is the
quantification of the same by means of a suitable methodology. Some of the approaches used
to tackle interest rate risk are given below and a discussion on the same is followed.

➢ Approaches Adopted To Quantify Interest Rate Risks

• Maturity Gap Method

• Rate Adjusted Gap
• Hedging
• Sensitivity Analysis
• Simulation and Game Theory

Maturity Gap Method

This asset-liability management technique aimed to tackle the interest rate risk, highlights on
the gap that is present between the RSAs and the RSIs, the maturity periods of the same and
the gap period. The objective of this method is to stabilize/improve the net interest income in
the short run over discreet, periods of time called the gap periods. The first step is to select the
gap period which can be anywhere between a month to a year. Having chosen the same, all the
RSAs and RSLs are grouped into 'maturity bucket' based on the maturity and the time until the

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first possible re pricing due to change in the interest rate. The gap is then calculated by
considering the difference between the absolute values of the RSAs and the RSLs, which is
mathematically expressed as:
RSG = RSAs – RSLs ….. Eq. 3.1
Gap Ratio = RSAs / RSLs …… Eq. 3.2
Where,
RSG = Rate Sensitive Gap based on maturity
The gap so analyzed can be used to cut down the interest rate exposure in two ways. As
mentioned earlier, the bank can use it to maintain/improve its net interest income for changing
interest rates; otherwise adopt a speculative strategy wherein by altering the gap effectively,
depending on the interest rate forecasts, net interest income can be improved. In either way,
the basic assumption of this model is that there will he an equal change in interest rates for all
assets and liabilities.

During a selected gap period, The RSG will be positive when the RSAs are more than the
RSLs, negative when the RSLs are in excess of the RSAs and zero when the RSAs and RSLs
are equal. Based on these outcomes, the maturity gap method suggests various positions that
the treasurer can take in order to tackle with the rising/falling interest rate structures. Consider
the following illustration to understand the approach.
Illustration 3.1
In the illustration given below, for the three different gap portion i.e. positive, negative and
zero, the impact of rate fluctuations i.e. a rise or a fall, on the NII are explained-

Option I: Positive Gap

(Rs. Cr)
Liability Rate Increased Decreased Asset Rate Increased Decrease
(%) Rate (%) Rate (%) (%) Rate (%) d Rate
(%)
200 200
1800* 10 11 9 800* 12 13 11
2000 11 11 11 1000* 14 15 13
1000* 16 17 15
1000 18 18 18
4000 4000
Interest 400 418 382 Interest 576 604 548
Expense Income
Net Interest Income** 176 186 166

RSAs: Rs 2800
RSLs: Rs1800
GAP: Rs1000

Option II – Negative Gap

(Rs.
Cr.)
Liability Rate Increased Decreased Asset Rate Increased Decreased
(%) Rate (%) Rate (%) (%) Rate (%) Rate (%)
200 200

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 1800* 10 11 9 800* 12 13 11
2000 11 11 11 1000 14 14 14
1000 16 16 16
1000 18 18 18
4000 4000
Interest 400 418 382 Interest 576 584 568
Expense Income
Net Interest Income 176 166 186

RSAs: Rs 800
RSLs: Rs1800
GAP: Rs 1000
Option III- Zero Gap
(Rs. Cr.)
Liability Rate Increased Decreased Asset Rate Increased Decreased
(%) Rate (%) Rate (%) (%) Rate (%) Rate (%)
200 200
1800* 10 11 9 800* 12 13 11
2000 11 11 11 1000* 14 15 13
1000 16 16 16
1000 18 18 18
4000 4000
Interest 400 418 382 Interest 576 594 558
Expense Income
Net Interest Income 176 176 176

RSAs: Rs 1800
RSLs: Rs 1800
GAP: Rs 0

(* Represents RSAs and RSLs, ** Net Interest Income (NII) = Interest Income – Interest
Expense.)

The following are the implications of an increase/decrease in interest rates for a given
RSG level

1. RSG is Positive
When RSG is positive it is understood that the yield earned in such a situation will be more
than the rate at which the liabilities are serviced. In the illustration given above, option I has a
positive gap of Rs.1000 cr. Initially, the cost of funds is Rs.400 cr., while the total returns is
Rs.576 cr. resulting in a NII of Rs 176cr. This will, however, be affected by changes in the
interest rates. When the interest rates rise/fall by equal amounts, then the increase/decrease in
the interest income will be more than the servicing cost of liabilities, merely due to the fact that
there are more re priceable assets than the re priceable liabilities.

2. RSG is Negative
In the second situation where the RSG is negative, an increase/decrease in the interest rates by
an equal amount will lead to a greater rise/fall in the interest expenses than the interest income
earned. The presence of more RSLs as compared to the RSAs explains this phenomenon.

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Consider option II where the RSAs and RSLs are Rs.800 cr. and Rs.1800 cr. respectively
resulting in a negative gap of Rs. 1000. When there is a negative gap, the consequence of a rate
fluctuation is a decrease in the net interest income when the interest rates rise and increase in
the same when the rates fall.

3. RSG is Nil
As a third option, the bank can maintain a zero gap and thus remain neutral to the interest rate
fluctuations. It can be observed in Option III of the illustration that when the RSAs and the
RSLs are equal to Rs 1800 cr. The NII remains at Rs.176 cr. in a rising/falling interest rate
scenario.

The utility of the Maturity Gap approach is that for a given level of RSG and with a forecast of
a rise/fall in interest rates, the banker can take the following positions to improve the net
income,
• Maintain a positive gap when the interest rates are rising;
• Maintain a negative gap when the interest rates are on a decline,
• Alternatively, maintain a zero gap position for the firm to ensure a complete hedge against
any movements in the future interest rates. Though this policy will reduce the interest rate
risk to a large extent, it will not lead to any speculative gains. While such a situation may
not occur in reality, it will also be unwarranted since there are no major benefits arising
from it.

The process of maturity gap approach discussed above assesses the impact of a percentage
change in the interest rates on the NII.
The relationship is given by:
NII = Gap x r ...... Eq. (3.3)
Where,
NII = Change in net interest income
r = Change in interest rates
Consider Option I of illustration 3.1

Gap Change in interest rate Change in NII

+1000 Increase by 1% 1000 * 0.01 = 10
+1000 Decrease by 1% 1000 * -0.01 = -10

However, the objective of an ALM policy will be to maintain the NIM within certain limits by
managing the risks. And since risks are an inherent quality of the banking business, it implies
that the bank should first decide on the maximum and minimum levels, for the NIM. Following
this will be an ALM technique, which allows a bank to take various risk exposure levels and
still remain within the limits set for NIM. While the above helps in quantifying the interest rate
risk, it is more relevant for a bank to identify the gap, which it should target for a given forecast
of interest rate change. For this purpose one has to go through the following steps:
1. Assess the percentage change in NIM that is acceptable to the bank,
2. Make a forecast for the quantum and direction of interest rate change.
3. Based on the above determine the gap level (positive/negative).

We are aware that NII is affected by the Net Interest Margin (NIM) and the earning Assets.
NII = Earning Assets x NIM ..... Eq. 3.4

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The bank has to decide as a matter of policy the percentage variation in NIM, which is
acceptable/tolerable. Let that percentage be indicated by c. then acceptable variation in the
value of NII is given by
NII = Earning Assets x NIM x c
Since, NII = Gap x r
Gap x r = Earning Assets x NIM x c
Therefore,
Gap = (Earning Assets x NIM x c) / r …… Eq. 3.5
Where,
Earning Assets = Total Assets of the bank
NIM = Net Interest Margin
c = Acceptable change in the NIM
r = Expected change in interest rates

At the outset it must be clear that the above computation of gap is with reference to future and
hence all the above parameters are estimates.

• Earning assets represent the projected level of assets, either absolute or average levels
collected from the bank's short-term forecasts like credit budget.
• NIM represents the margin projected for the relevant period.
• c is a policy variable to be decided by the top management of the bank.
• r is a variable which is obtained by using the forecasting techniques and is provided by the
specialist officer.

Rate Adjusted Gap

The Maturity Gap approach assumes a uniform change in the interest rates for all assets and
liabilities. In reality, however, it may not be the case basically due to two main reasons. Firstly,
the market perception towards the change in the interest rate may be different from the actual
rise/fall in the interest rates. For instance, if the bank rate is cut by 1 percent, according to the
gap method, there will be a 1 percent fall in the rate of interest for both assets and liabilities.
However this may not be the case if the market perception for the decline in the interest rate is
short-term in nature. This might eventually lead to a fall in the interest rate by less than 1
percent. Alternatively, the market may also perceive the rate fluctuations differently for the
long-term interest rates and the short-term interest rates. For instance rate fluctuation may lead
to a 0.75 percent fall in the short term interest rates while the long-term rates may witness a
mere decrease by 0.25 percent.

The second reason for differential rise/fall in interest rates of assets/liabilities can be the
presence of a certain regulation. To explain this further, consider the differential interest rate
loan extended by banks, which has an interest rate of 4 percent. This rate remains constant
irrespective of any amount of fluctuation in the interest rate of the bank. Similarly, it is quite
common to find that the interest rates on term deposits rise/fall with changes in interest rates
though the same does not affect the interest paid on savings account.

Having done away with the assumption of a uniform change in interest rates of assets/liabilities,
the Rate Adjusted Gap methodology seems to be superior to the Maturity Gap methodology.

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In this approach all the rate sensitive assets and liabilities will be adjusted by assigning weights
based on the estimated change in the rate for the different assets/liabilities for a given change
in interest rates.
Rate Adjusted Gap = [RSA1 x WA1 + RSA2 x WA2 +….] - [RSL1 x WL1 + RSL2 x WL2 +…]
.....Eq. 3.6
Where,
W A1, WA2 = Weights of the corresponding RSAs
WL1, WL2 = Weights of the corresponding RSLs

Hedging

It is often felt that a floating rate mechanism can minimize the interest-rate risk. Though this is
true, it should however be noted that the possibility of the interest rate risk getting transformed
into credit risk due to this mechanism is always present. This situation occurs as the floating
rate passes the burden of the interest-rate risk on the borrower.

Yet another means of managing the interest-rate risk is by hedging with the use of derivative
securities, viz. swaps, futures and options. This approach seems to be a better alternative,
especially in a situation where there is a maturity mismatch. For instance, when liabilities are
mostly short-term in nature and assets are long term, the easier method of financing the assets,
rather than trying to match the maturing periods is by the use of derivative securities.

In a situation where there is an unexpected change in the interest-rate structure or when interest-
rate forecasting becomes a difficult task, hedging proves to be an effective method to manage
the interest rate risk. However, there are certain prerequisites for the effective utilization of the
hedging instruments and their relating operations. First and foremost is the existence of a
market that is deep and highly liquid. This again requires a proper benchmark for the interest
rates and also an active floating rate market.

In addition to this, a proper understanding of the hedging mechanism is a must for the effective
usage of the derivative instruments, lest it may lead to an overall increase in the risk.

Sensitivity Analysis

The sensitivity of an asset/liability can be assessed by the quantum of increase/decrease in the

value of the assets/liabilities of varying maturities due to the interest rate fluctuations. Based
on the sensitivity, all the assets/liabilities are regrouped. The sensitivity model then suggests
the assessment of the gap between the assets and liabilities having a similar sensitivity index
to the interest rate fluctuation. Further action will be taken to manage the gap so as to restrict
the interest rate risk.

Simulation and Game Theory

Given the expected changes in the short and the long-term operative environment, Game
Theory simulates and forecasts the future trends. Using this concept the expected risk and
rewards of the different asset and liability classes are given along with the risk sensitivity and
gap between the short, medium and long-term assets and liabilities. Then, simulation is done
by varying the interest rate structures to predict the short/medium/long-term implications of
the same.

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4.4 Liquidity Risk Management
While introducing the concept of asset-liability management it has been mentioned that the
object of any ALM policy is twofold – ensuring profitability and liquidity. Working towards
this end, the bank generally maintains profitability/spreads by borrowing short (lower costs)
and lending long (higher yields). Though this process of price matching can be done well within
the risk/exposure levels set for rate fluctuations it may, however, place the bank in a potentially
illiquid position.

The core activity of any bank is to attain profitability through fund management i.e. acquisition
and deployment of financial resources. An intricate part of fund management is liquidity
management. Liquidity management relates primarily to the dependability of cash flows, both
Inflows and outflows and the ability of the bank to meet maturing liabilities and customer
demands for cash within the basic pricing policy framework. Liquidity risk hence, originates
from the potential inability of the bank to generate cash to cope with the decline in liabilities
or increase in assets.

Thus, the cause and effect of liquidity risk are primarily linked to the nature of the assets and
liabilities of the bank. All investment and financing decisions of the bank, irrespective of
whether they have long term or short term implications do effect the asset-liability position of
the bank which may further affect its liquidity position. In such a scenario, the bank should
continuously monitor its liquidity position in the long run and also on a day-to-day basis.

➢ Approaches

Given below are two approaches that relate to these two situational decisions:
I. Fundamental Approach
II. Technical Approach

These two methods distinguish from each other in their strategically approach to eliminate
liquidity risk. While the fundamental approach aims to ensure the liquidity for long run
sustenance of the bank, the technical approach targets the liquidity in the short run. Due to
these features, the two approaches supplement each other in eliminating the liquidity risk and
ensuring profitability.

I. Fundamental Approach
Since long run sustenance is driving factor in this approach, the bank tries to tackle eliminate
the liquidity risk in the long run by basically controlling its assets-liability position. A prudent
way of tackling this situation can be by adjusting the maturity of assets and liabilities or by
diversifying and broadening the sources of funds. The two alternatives available to control the
liquidity exposure under this approach are Asset Management and Liability Management. This
implies that liquidity can be imparted into the system either by liability creation or by asset
liquidation.

Asset Management
Asset management is to eliminate liquidity risk by holding near cash assets i.e. those assets,
which can be turned into cash whenever required. For instance, sale of securities from the

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investment portfolio can enhance liquidity. When asset management is resorted to, the liquidity
requirements are generally met from primary and secondary reserves. Primary reserves refer to
cash assets held to meet the statutory cash reserve requirements (CRR) and other operating
purposes. Though primary reserves do not serve the purpose of liquidity management for long
period, they can be held as second line of defense against daily demand for cash. This is
possible mainly due to the flexibility in the cash reserve balances (statutory cash reserves are
required to be maintained only on a daily average basis for a reserve maintenance period).

However, most of the liquidity is generally attained from the secondary reserves, which include
those assets held primarily for liquidity purposes. These secondary reserves are highly liquid
assets, which when converted into cash carry little risk of loss in their value. Further, they can
also be converted into cash prior to their maturity at the discretion of the management. When
asset management is resorted to for liquidity, it will be through liquidation of secondary
reserves. Assets that fall under this category generally take the form of unsecured marketable
securities. The bank can dispose these secondary reserves to honor demands for deposit
withdrawals, adverse clearing balances or any other reasons.

Liability Management
Converse to the asset management strategy is liability management, which focuses on the
sources of funds. Here the bank is not maintaining any surplus funds, but tries to achieve the
required liquidity by borrowing funds when the need arises. The underlying implications of
this process will be that the bank mostly will be investing in long-term securities /loans (since
the short-term surplus balance will mostly be in a deficit position) and further, it will not depend
on its liquidity position/surplus balance for credit accommodation/business proposals. Thus, in
liability management a proposal may be passed even when there is no surplus balance since
the bank intends to raise the required funds from external sources. Though it involves a greater
risk for the bank, it will also fetch higher yields due to the long-term investments. However,
sustenance of such high spreads will depend on the cost of borrowing. Thus, the cost and the
maturity of the instrument used for borrowing funds play a vital role in liability management.
The bank should on the one hand be able to raise funds at low cost and on the other hand ensure
that the maturity profile of the instrument does not lead to or enhance the liquidity risk and the
interest rate risk. Of the two strategies available in fundamental approach, it is understood that
while asset management tries to answer the basic question of how to deploy the surplus to
eliminate liquidity risk, liability management tries to achieve the same by mobilizing additional
funds.

II. Technical Approach

As mentioned earlier, technical approach focuses on the liquidity position of the bank in the
short run. Liquidity in the short run is primarily linked to the cash flows arising due to the
operational transactions. Thus, when technical approach is adopted to eliminate liquidity risk,
it is the cash flows position that needs to be tackled. The bank should know its cash
requirements and the cash inflows and adjust these two to ensure a safe level for its liquidity
position.

Working Funds Approach and the Cash Flows Approach are the two methods to assess the
liquidity position in the short run. Of these two approaches, the former concentrates on the
actual cash position and depending on the factual data, it forecasts the liquidity requirements.
The latter approach goes a step forward and forecasts the cash flows i.e. estimates any change

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 6.0 Conclusion

To sum up, the paradigm shift in the risk exposure levels of the financial institutions, has
definitely led to ALM assuming a center stage. Undoubtedly all financial institutions need to
perform ALM. But to have a proper ALM process in place, a thorough understanding of the
various operations on its assets liabilities becomes essential. Such an understanding will enable
the financial institution to identify and unbundled the risks and further aid in adopting and
developing appropriate risk management models to manage risks.

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STUDENT’S PROFILE

Name : Varun Mewada

Program : PGDBM (2019-21)

Email : varunmewada.1921@simsree.org

Contact : 91-9768222396

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