The Hindu Business Line : Risk management of Treasury operations in banks

BANK managements are highly sensitive to Treasury risks, as they arise out of the high leverage of the Treasury business. The risk of losing capital is much higher than, say, in the credit business. The second reason for managements' concern is the large size of the transaction done, at the sole discretion of the treasurers. The conventional control and supervisory measures, mostly in the nature of preventive steps, can be divided into three parts:

Organisational controls: This refers to the checks and balances within the system. Treasury is divided in two parts — the front and back office. The front office generates deals and the back office settles trades only after verifying compliance with the internal controls.

Exposure limits: These caps are put in place to protect the bank from credit risk, which, in Treasury, may be of defaulters and counter party.

Internal controls: The most important of the internal controls are position and stop-loss limits. The trading limits are of three kinds:

a) on deal size,

b) on open positions, and

c) Stop-loss.

Treasury faces Market Risk (which broadly covers that of liquidity, interest rate, exchange rate and equity price); credit risk, and operational risk.

Market risk management

Treasury investments are categorised into government securities, other approved securities, shares, debentures and bonds, commercial papers, and mutual funds. In line with international best practices, the investments are classified into three categories — Held to Maturity, Available for Sale and Held for Trading. The investments made to earn profits from the short-term price movements are classified under the Held-for-Trading Category, whereas the securities contracted basically on account of relationship or for steady income and statutory obligations are classified under Held-To-Maturity (HTM) category. The securities, which do not fall under these categories, are classified as Available-for-Sale. The securities Held-for-Trading (HFT) and Available-for-Sale (AFS) are to be marked-to-market periodically. As per the RBI, Trading Book includes HFT and AFS and Banking Book refers to HTM.

Held-to-Maturity

The risks inherent in the HTM portfolio:

Price risk if the acquisition cost is above par. The premium over the par value will be amortised annually till maturity.

Re-investment risk due to reinvestment of high yielding security inflow at lower yields.

Held-for-Trading

Classification as HFT should be an explicit management decision considering the intention, the trading strategies, the risk management capabilities, the capital position and the manpower skills. Securities classified HFT are to be sold within 90 days (defeasance period). Shifting of securities from HFT to AFS is permitted only under exceptional circumstances such as tight liquidity conditions, extreme volatility or exceptional market conditions. The shifting requires the approval of Board of Directors/ALCO/Investment Committee.

Available-for-Sale

These assets in the Trading Book are held for generating profit on differential interests/yields. Ideally, the securities held in the Trading Book are marked-to-market on a daily basis.

Investment Fluctuation Reserve

This is maintained to guard against any possible reversal of interest rate environment on unexpected developments. It is prudent to transfer maximum amount of gains realised on sale of securities to the IFR. Banks are free to build IFR up to 10 per cent of the investment portfolio under HFT and AFS with the approval of the Board of Directors

Interest rate risk

Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches of various rate-sensitive assets and liabilities. The interest rate risk is measured from earnings and economic value perspective.

Earnings perspective involves analysing the impact of changes in the interest rate on accrual or reported earnings in the near term, measured by changes in the Net Interest Income. Economic Value perspective involves analysing the changes of impact of interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance-sheet items. The level of interest rate changes is an important factor to choose fixed/floating interest rate assets/liabilities, their maturities and hedging decisions.

Interest rate risks in the Trading Book arise due to:

i) The volatility in the interest rate; this will have an impact on exercising the embedded options, ii) Different benchmark interest rates not moving up or down by same basis points, iii) Different currency interest rates not moving up or down by the same basis points, iv) The impact on the interest costs/yield of debt instruments not be equal due to non-parallel shift in the yield curve, v) A the highly inflationary economy; managing interest rates in such a situation is a big challenge, vi) Competition and business compulsions; the bank may change the interest rates opposite to the general market movement of interest rate.

Middle Office: One of the important organisation structures in Risk Management, it is responsible for the critical functions of independent market risk monitoring, measurement, analysis and reporting for the bank's ALCO. Middle Office should independently report to ALCO.

Liquidity risk

The liquidity risk in Treasury manifests in different dimensions:

i) Funding Risk: It arises due to replacement of liabilities withdrawn, ii) Time Risk: It arises due to the need to compensate for non-receipt of expected inflows of funds, that is, performing assets turning into non-performing assets; and iii) Call Risk: It arises on the crystallisation of contingent liabilities and the inability to leverage profitable business opportunities when desirable.

Exchange risk

Available accounting information do not provide a reliable base to calculate exposure and the actual risk a bank faces, which depends on its future cash flows and their associated risk profiles. There is the distinction between the currency in which cash flows are denominated and the that which determines the size of the cash flows. For example, a borrower selling jewellery in Europe may keep his records in rupees, invoice in euros, and collect euro cash flow, only to find that its revenue stream behaves as if it were in US dollars. Trading in the forex market is fraught with `market risks'. With rupee moving towards full convertibility and the reduced `direct' intervention by the central bank, USD/INR has increased volatility in the forex market. Rupee, which was firming up from the 49/dollar levels (during September 2000) in the past, has started rebounding from 43 (July 2005) levels to 46.40 levels (as of December 5) on the back of recovery of the dollar globally. Added to this, the dollar gained strength on account of 12 successive increases in rates, by 25 bps each from June 2003 (an increase from 1 pct to 4 pct). The forward market has also been moving in tandem with Spot INR, easing up a bit for every gain of the rupee against the USD. Six months annualised premia, which was at 2.91 pct in November 2004 was down to 0.27 pct in September 2005. However when the rupee started to move south, Forwards too tracked it for the six months forwards to go.

Measurement of interest rate risk

The methods to measure of Interest Rate Risk in trading book are:

i) Duration Gap analysis: Duration is a value and time weighted measure of maturity that considers the timing of all cash inflows from assets and all cash outflows associated with liabilities. It measures the average maturity of a promised stream of future cash payments. In effect, duration measures the average time needed to recover the funds committed to an investment.

ii) Convexity: Convexity is the rate of change of duration. Compared to duration, it is a better measure of price sensitivity for larger change in interest rates.

iii) Simulations: Simulations are computer-generated scenarios about the future that permit banks to analyse interest rate risk and business strategies in a dynamic framework. Given such information, banks may evaluate the desirability of various courses of action. The scenarios are based on assumptions, such as changes in interest rates, shape of yield curve, pricing strategies, growth volume and mix of assets and liabilities and hedging strategies.

iv) VaR based methodology: VaR is an estimate of potential loss in a position or asset/liability or portfolio of assets/liabilities over a given holding period at a given level of certainty.

The Bank of International Settlements has accepted VaR as a measurement of market risks and provision for capital adequacy for market risks.

VaR is used as a MIS tool in the trading portfolio to "slice and dice" risk by levels/products/geographic/level of organisation etc.

(To be continued)

Edited excerpts from D. Rangaswamy Memorial Endowment Lecture delivered by K. C. Chakrabarty, CMD, Indian Bank, on December 19.