Functions of Liquidity

Transcription

1 Functions of Liquidity Liquidity risk arises on account of bank s inability to meet its payment obligations as and when they are demanded. The deposits of banks as liabilities and loans and advances as assets of the bank are the prominent items in a bank s balance sheet. The types of deposits held and the interest rates offered on these deposits on the one hand and the types of loans and advances sanctioned and the interest rates charged on the other hand may not match. In view of this liquidity risk is encountered by the banks. Liquidity risk has three components, namely funding risk, timing risk and call risk. Stagnant deposit position and increasing demand for loans and advances create problems for the bank. If the bank reduces interest rates on deposits it results in flying of deposits to competing banks. To increase returns more term loans are sanctioned and the bank s ability to collect these loans will affect its profitability. In this sense there is conflict between profitability and liquidity. Banks have to strike a balance between these two matching the composition of assets and liabilities. Many times banks acquire short term deposits and try to use them for funding there long term assets. These are termed as CASA funds implying usage of current and savings account deposits. This affects the liquidity position of the banks. The ability of the banks to raise funds depends on its area of operation, customer profile, ownership of the bank and public image of the bank. In order to mitigate liquidity risk banks have to review on a continuous basis the changes in its deposit structure and loans and advances. To improve its liquidity it has to look at possibilities of extending maturity on its deposits through renewals and reducing long term loan commitments. It has to look at the reliability of assets in terms of recoveries from borrowers and sale of investments. The action plan for liquidity risk management should focus on its core activity of deposit mobilization and credit sanctioning and the related risk factor that is interest rate risk should also be considered. Such an action plan should look at short term and long term implications of the banking functions and devise strategies to reduce liquidity risk and increase bank returns. Short term strategies include working funds approach and cash flow approach. Long term strategies aim at asset and liquidity management. Reserve Bank of India has issued guidelines for liquidity management in banks. It calls for fortnightly statement of structural liquidity and fortnightly statement of short term dynamic liquidity. These statements aim at collecting details of changes in the deposit and loans and advances up to a period of 90 days. This helps in understanding liquidity position of the bank.

2 RBI Format Dynamic Liquidity 1 14 days days days A. Outflows Net increase in loans and advances Net increase in investments (i) Approved securities (ii) Money market instruments (other than treasury bills) (iii) Bonds/debentures/shares (iv) Others Inter bank obligations Off balance sheet items (repos, swaps, bills discounted) Others Total outflows B. Inflows Net Cash position Net increase in deposits (less CRR obligations) Interest on investments Inter bank claims Refinance eligibility (Export credit) Off balance sheet items (reverse repos, swaps, bills discounted) Others Total inflows C. Mismatch (B A) D. Cumulative mismatch E. ( C) as a percentage to total outflows

3 Liquidity Risk Measurement Banks use certain accounting ratios to compute and monitor liquidity risk. Some of these ratios are loans and advances to total assets, (desirable level 60 to 65%), loans and advances to core deposits (desirable level 70 to 75%), large deposits to earning assets (desirable level 50 to 60%), other liabilities to total assets (desirable level 10 to 15%), cash ratio that indicates the cash and balance with RBI and other short term investments to total liabilities (desirable level 30 to 40%), loan losses to net loans (desirable level 1 to 2%). Two other indicators for measuring liquidity risk are Tobin s Q and Sharpe ratio. Tobin s Q helps to determine the rate at which a unit of capital is exchanged for a unit of risk exposure. Sharpe s ratio helps banks to choose their optimal exposure to banking activities considering the efficient frontier based on risk return characteristic of their portfolios. A higher Sharpe ratio indicates a better return for a unit of risk undertaken by the bank. Liquidity management involves strategies that build up insurance against outflow of deposits. These include borrowings from other banks, sale of securities, call in or sell off of loans and increased reserves. Liquidity Management Reserve Requirement 10%Excess Reserves 10 million Reserves 20 million Deposits 100 million Loans 80 million Bank Capital 10 million 10 million Deposit outflow of 10 million Reserves 10 million Deposits 90 million Loans 80 million Bank Capital 10 million 10 million With 10% desired reserve ratio, bank still has excess reserves of 1 million. Hence, no changes are needed in balance sheet for deposit withdrawal.

4 Reserve Requirement 10%Excess Reserves 0 Reserves 10 million Deposits 100 million Loans 90 million Bank Capital 10 million 10 million Deposit outflow of 10 million Reserves 0 million Deposits 90 million Loans 90 million Bank Capital 10 million 10 million With 10% desired reserve ratio, bank will have no reserves. Hence change in balance sheet position is necessary for the bank. 1. Borrow from other banks or corporations Reserves 9 million Deposits 90 million Loans 90 million Borrowings 9 million 10 million Bank Capital 10 million 2. Sell Reserves 9 million Deposits 90 million

5 Loans 90 million Bank Capital 10 million 1 million These methods result in possible alternatives of changing the balance sheet for the bank. 3. Borrow from Market Reserves 9 million Deposits 90 million Loans 90 million Debt 9 million 10 million Bank Capital 10 million 4. Call in or Sell off Loans Reserves 9 million Deposits 90 million Loans 81 million Bank Capital 10 million 10 million These methods result in possible alternatives of changing the balance sheet for the bank. Treasury Market Banks keep cash reserves as part of statutory obligations as well as a measure of security for uncertain payments. If the bank maintains low cash reserves it may improve its profitability but risk level of the bank increases. If it maintains a higher cash reserve, its safety improves but profitability will be affected. Therefore banks try to place excess cash in short term readily saleable liquid assets such as treasury bills and government securities. These investments provide attractive returns and banks are assured of funds as these are easily tradable. Reserve Bank of India offers short term treasury bills as well as long term government bonds. Treasury bills are of 91 day, 182 day and 363 day durations. These are offered on a weekly

6 basis on auction mode. This can be used as collateral to borrow funds in the Repo (repurchase agreements) market. Government bonds are offered in dematerialized form or in the form of physical instruments. There are variety of bonds with different duration and terms and conditions. They are easily tradable and considered for statutory liquidity ratio requirements of banks with the Reserve Bank of India. Several types of bonds are available for investment in India such as fixed rate bonds, floating rate bonds, zero coupon bonds, capital indexed bonds, bonds with a put / call option and with certain special issues for the benefit of oil marketing corporation, fertilizer corporation, food corporation and compensation for subsidies. Auction systems followed for the issue of treasury instruments are either yield based or price based auctions. Holding of treasury instruments carries with it market risk, liquidity risk and reinvestment risk. Treasury Market Risk Management Treasury management is a broader concept than liquidity management. It involves management of liquidity risk, currency risk, exchange rate risk and interest rate risk along with investment risk and commodity risk. Generally treasury management function includes insurance, investment and investor relations, pension fund management and tax management. These functions are taken up only at the international level. There is scope to include all these functions as treasury management function in India in the future. Investment includes investment in financial assets and in real assets. There are specific norms for holding and trading in financial assets as per Basel committee norms. The Basel committee disclosure requirements of investments are to be followed by all banks. Investments are usually classified into two categories on the basis of holding period. They are held to maturity and available for sale. Banks have to clearly specify the types of investments held in these different forms. Usually investments held for maturity should not exceed 25% of total investment portfolio. The intention to hold till maturity is to be disclosed at the beginning of the financial year and these cannot be altered during the year. Shifting of available for sale investments to those held to maturity is not permitted by Reserve Bank of India. Reserve Bank of India has issued guidelines on the valuation and disclosure of investments. These guidelines specify that banks should spell out its investment policy and procedures. They should also maintain an investment fluctuation reserve to account for variations in the value of investments. Internal Audit for Treasury Risk Management Internal controls are necessary to monitor transactions for effective supervision and scrutiny by internal audit team of a bank. The treasury management function is to be properly structured creating separate authorities for dealing, risk management, management information and for verification.

7 The functional separation of trading, settlement, monitoring, control and accounting ensuress that internal control system of a bank operates effectively. Proper procedures and systems for execution and recording transactions are to be established. Dealing slip for each transaction giving details of the deal, counter parties, amount of security, price, contract date and time are to be used. Separatee books of accounts are to be maintained in the accounts section of the bank and periodical reconciliation with the records of the public debt office (RBI) is to be carried out. Details are to be reported to top management on a weekly basis. Bank receipts outstanding for more than one month are to be disclosed to top management. Treasury management and functioning is to be externally audited periodically comprising scrutiny of records, risk exposures, compliance with regulations and valuation of assets. Guidelines on internal control system are in terms of risk identification processes, control environment, reliability and integrity of management information system, statutory compliance of internal regulator, budgetary control, verification of investment trades and compliance with internal audit. The risk and audit matrix highlights the need for control and level of risk prevalent in the business. The extreme risk classification indicates the area where audit requirements are compulsory.

8 Checklist for Internal Audit I. General Policies for all treasury activities. Policies in tune with the nature of operations. Responsible persons are associated with the policies. Policy specifies types and purposes of the financial instruments. Policy specifies frequency of reporting and reporting authority. Maintenance of Cash Reserve Ratio and Statutory Liquidity Ratio requirements. II. Organisation Structure Treasury activities are supervised by an officer independent of day to day activities. Effective segregation of key duties (treasury dealing, settlement af accounting, reconciliation of accounts) ). Polices and procedures are documented and easily accessible to all staff. Defined job descriptionss and delegations for key treasury positions. Availability of sufficient resources to operate the treasury effectively. Segregation between functions of authorization, execution and recording of transactions. III. Personnel: Training, Compliance and Performance Trained personnel. Verification of employees references. Verification of documents signed by employees at the time of joining.

9 IV. Deal Execution Process Confirmation of transactions concluded by the dealing room with the back office manager. Systematic filing of procedure. Examine third party payment. Outward confirmations are recorded in a register. V. Limits Counterparty exposure limit for all brokers, lenders, etc. Dealing limits (maximum amount, a person can transact without seeking higher level approval). Product limits (maximum exposure in a particular instrument or product). Sector limits (maximum investment in a particular sector). VI. Recording Control i) Control over Documents Timely and accurate execution of money market deals and recordings. Receipt of all documents and statements from concerned parties (brokers, bankers and lenders, etc.). Numbering and filing of copies for ease reference. ii) Control over Accounting Procedures Adequate systems to track all matured investments. Accurate recording and accounting of positions. Counter checking of records by an independent person. All deals are recorded in the General Ledger. Account reconciliation has been done and time frame has been set for clearing all outstanding items. Inspection of source documents. VII. Reconciliation of Bank Accounts and Treasury Records with the General Ledger Bank balance with bank statement. Reconciliation of treasury records with the general ledger. VIII. Cash Management

10 Effective procedure for monitoring the daily cash position. Planning of the liquidity needs for normal operating conditions and emergency situations by management. Trend analysis of cash forecasting. Bank statements. Review of liquidity position. IX. Investment Review and follow up of investment strategy. Authority level and monetary limits are set for investment in different instrument. Documentation of list of investments. Analyse of investment portfolio statements. Holding of investments in the bank s name. Bank has all the documents with regard to ownership of investments. Bank utilises third party investment managers. Control of the investment managers activities. Appraisal of investment managers Compliance of investment policies by investment managers. Evaluation of internal / external investment managers performance. X. Documentation for Derivative transactions (i) (ii) (iii) (iv) (v) (vi) Usage of International Swaps and Derivatives Association (ISDA) documentation, with suitable modifications. Confirmation for each derivative transaction with details of the terms of the contract such as gross amount, rate, value date, etc. Individual transaction confirmation. Evaluation of legal capacity, power and authority of the counter party to enter into derivative transactions. Documentation of the agreement with the counter party prior to undertaking any derivatives business with them. Documentation regarding customer suitability, appropriateness, etc.

11 XI. Investment in Debt Frequency of interest payments. Information about the issuer and the credit rating. Terms of the issue such as the use of the issue proceeds, the monitoring agency, the formation of trustees, the secured or unsecured nature of the bonds, the assets underlying the security and the credit worthiness of the organisation. Comparison of the Yield To Maturity (YTM) of the debt security with the YTMs of other comparable debt securities of the same class and features. Questions 1. Discuss the implications of liquidity risk in banks. 2. Explain the features of treasury management function in banks. 3. What are the approaches for measuring liquidity risk? 4. What are the internal control systems for liquidity management? 5. Explain the characteristic of treasury markets. 6. List the RBI guidelines for treasury investments. 7. What are the Basel committee norms for valuation and disclosure of investments? 8. Explain the steps to be taken for effective internal control of treasury management function. 9. What are the steps in internal audit for treasury management? 10. Discuss the important guidelines for internal audit.