1.

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/deposit ratio has by far overtaken credit/deposit ratio. 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:  Poor credit off-take coupled with high increase in NPAs.  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 size ably 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, 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. 2. FUNCTIONS OF THE TREASURY DEPARMENT 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 and 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. 3. 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 (25 per cent now) 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. What impact does a cut in CRR have on interest rates? From time to time, RBI prescribes a CRR, or the minimum amount of cash that banks have to maintain with it. The CRR is fixed as a percentage of total deposits. Following the half percentage point reduction in CRR last week, banks are now required to maintain 10.5 per cent of their deposits with RBI. The deposits earn around 4 per cent interest, which is less than half of the average cost of funds for banks. At present, the total amount of deposits with banks is Rs 6,90,000 crore. Therefore, every one percentage point cut in CRR means the banking system will have nearly Rs 7,000 crore more available for lending. As more money chases the same number of borrowers, interest rates come down. Does a change in SLR impact interest rates? SLR reduction is not so relevant in the present context for two reasons: One, as a part of the reforms process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared with the earlier days for their statutory investments in Government securities. Second, banks are still the main source of funds for the government. Which means despite a lower SLR requirement, banks investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be higher than 30 per cent despite RBI bringing down the minimum SLR to 25 per cent a couple of years ago. Therefore, for the purpose of determining the interest rates, it is not the SLR requirement that is important but the size of the government-borrowing programme. As government borrowing increases, interest rates, too, look up. Besides, gilts also provide another tool for RBI to manage interest rates. RBI conducts open market operations by offering to buy or sell gilts. If it feels interest rates are too high, it may bring them down by offering to buy securities at a lower yield than what is available in the 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 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). The investors in government securities are mainly banks, FIs, insurance companies, provident funds and trusts. These investors are required to hold a certain part of their investments or liabilities in government paper. Foreign institutional investors can also invest in these securities up to 100% of funds-in case of dedicated debt funds and 49% in case of equity funds. Till recently, a few of the domestic players used to trade in these securities with a majority investing in these instruments for the full term. This has been changing of late, with a good number of banks setting up active treasuries to trade in these securities. Perhaps the most liquid of the long term instruments, liquidity in gilts is also aided by the primary dealer network set up by RBI and RBI's own open market operations. Features: RBI, as an agent of the Government, manages and services these securities through its Public Debt Offices (PDO) located at various places. At present, there are dated securities with a tenor up to 20 years in the market. These securities are open to all types of investors including individuals and there is an active secondary market. These securities are eligible for SLR requirements. These securities are repoable. 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. Features:  The call market enables the banks and institutions to even out their day-to-day deficits and surpluses of money.  Commercial banks, Co-operative Banks and primary dealers are allowed to borrow and lend in this market for adjusting their cash reserve requirements.  Specified All-India Financial Institutions, Mutual Funds and certain specified entities are allowed to access Call/Notice money only as lenders.  It is a completely inter-bank market hence non-bank entities are not allowed access to this market.  Interest rates in the call and notice money markets are market determined.  In view of the short tenure of such transactions, both the borrowers and the lenders are required to have current accounts with the Reserve Bank of India.  It serves as an outlet for deploying funds on short-term basis to the lenders having steady inflow of funds. 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.     Features:     A considerable part of the government's borrowings happen through T-bills of various maturities. Based on the bids received at the auctions, RBI decides the cut off yield and accepts all bids below this yield. The usual investors in these instruments are banks who invest not only to part their short-term surpluses but also since it forms part of their SLR investments, insurance companies and FIs. FIIs so far have not been allowed to invest in this instrument. These T-bills, which are issued at a discount, can be traded in the market. Most of the time, unless the investor requests specifically, they are issued not as securities but as entries in the Subsidiary General Ledger (SGL), which is maintained by RBI. The transactions cost on T-bill are non-existent and trading is considerably high in each bill, immediately after its issue and immediately before its redemption. The yield on T-bills is dependent on the rates prevalent on other investment avenues open for investors. Low yield on T-bills, generally a result of high liquidity in banking system as indicated by low call rates, would divert the funds from this market to other markets. This would be particularly so, if banks already hold the minimum stipulated amount (SLR) in government paper. 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. The declining spread in lending operations, the volatility in the call money market with accompanying risks in running asset/liability mismatches, the growing desire for fixed interest rate borrowing by corporates, the move towards fuller integration between forex and money markets, etc. are all the driving forces for the development of the term money market. These, coupled with the proposals for Nationalization of reserve requirements and stringent guidelines by regulators/managements of institutions, in the asset/liability and interest rate risk management, should stimulate the evolution of term money market sooner than later. The DFHI, as a major player in the market, is putting in all efforts to activate this market. The development of the term money market is inevitable due to the following reasons  Declining spread in lending operations  Volatility in the call money market

  

Growing desire for fixed interest rates borrowing by corporate Move towards fuller integration between forex and money market Stringent guidelines by regulators/management of the institutions

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. Features: Allowed in 1989, CDs were one of RBI's measures to deregulate the cost of funds for 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.  The secondary market for this instrument does not have much depth but the instrument itself is highly secure.  CDs are issued by banks and FIs mainly to augment funds by attracting deposits from corporates, high net worth individuals, trusts, etc. the issue of CDs reached a high in the last two years as banks faced with a reducing deposit base secured funds by these means.  The foreign and private banks, especially, which do not have large branch networks and hence lower deposit base use this instrument to raise funds.  The rates on these deposits are determined by various factors. Low call rates would mean higher liquidity in the market. Also the interest rate on one-year bank deposits acts as a lower barrier for the rates in the market. 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.  

Who can issue Commercial Paper (CP)? Highly rated corporate borrowers, primary dealers (PDs) and satellite dealers (SDs) and all-India financial institutions (FIs) which have been permitted to raise resources through money market instruments under the umbrella limit fixed by Reserve Bank of India are eligible to issue CP. A company shall be eligible to issue CP provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s. Rating Requirement All eligible participants should obtain the credit rating for issuance of Commercial Paper, from either the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit =Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the Duff & Phelps Credit Rating India Pvt. Ltd. (DCR India) or such other credit rating agency as may be specified by the Reserve Bank of India from time to time, for the purpose. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. Further, the participants shall ensure at the time of issuance of CP that the rating so obtained is current and has not fallen due for review. Maturity CP can be issued for maturities between a minimum of 15 days and a maximum up to one year from the date of issue. If the maturity date is a holiday, the company would be liable to make payment on the immediate preceding working day. Denominations CP can be issued in denominations of Rs.5 lakh or multiples thereof. Investment in CP CP may be issued to and held by individuals, banking companies; other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the 30 per cent limit set for their investments in debt instruments. Mode of Issuance CP can be issued only in a dematerialised form through any of the depositories approved by and registered with SEBI.CP can be held only in demateralised form. CP will be issued at a discount to face value as may be determined by the issuer. Banks and All-India financial institutions are prohibited from underwriting or co-accepting issues of Commercial Paper. Payment of CP On maturity of CP, the holder of the CP will have to get it redeemed through the depository and receive payment from the IPA. 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. Features  The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counter party. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate.  The Repo rate is negotiated by the counter parties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions. The motivation for the banks and other organizations to enter into a ready forward transaction is that it can finance the purchase of securities or otherwise fund its requirements at relatively competitive rates. On account of this reason the ready forward transaction is purely a money lending operation. Under ready forward deal the seller of the security is the borrower and the buyer is the lender of funds. Such a transaction offers benefits both to the seller and the buyer. Seller gets the funds at a specified interest rate and thus hedges himself against volatile rates without parting with his security permanently

(thereby avoiding any distressed sale) and the buyer gets the security to meet his SLR requirements. In addition to pure funding reasons, the ready forward transactions are often also resorted to manage short term SLR mismatches. Internationally, Repos are versatile instruments and used extensively in money market operations. While inter-bank Repos were being allowed prior to 1992 subject to certain regulations, there were large scale violation of laid down guidelines leading to the securities scam in 1992; this led Government and RBI to clamp down severe restrictions on the usage of this facility by the different market participants. With the plugging of loophole in the operation, the conditions have been relaxed gradually. RBI has prescribed that following factors have to be considered while performing repo: 1. Purchase and sale price should be in alignment with the ongoing market rates 2. No sale of securities should be affected unless the securities are actually held by the seller in his own investment portfolio. 3. Immediately on sale, the corresponding amount should be reduced from the investment account of the seller. 4. The securities under repo should be marked to market on the balance sheet date. The relaxations over the years made by RBI with regard to repo transactions are: 1. In addition to Treasury Bills, all central and State Government securities are eligible for repo. 2. Besides banks, PDs are allowed to undertake both repo/reverse repo transactions. 3. RBI has further widened the scope of participation in the repo market to all the entities having SGL and Current with RBI, Mumbai, thus increasing the number of eligible non-bank participants to 64. 4. It was indicated in the Mid-Term Review of October 1998 that in line with the suggestion of the Narasimham Committee II, the Reserve Bank would move towards a pure inter-bank (including PDs) call/notice money market. In view of this non-bank entities will be allowed to borrow and lend only through Repo and Reverse Repo. Hence permission of such entities to participate in call/notice money market will be withdrawn from December 2000. 5. In terms of instruments, repos have also been permitted in PSU bonds and private corporate debt securities provided they are held in dematerialised from in a depository and the transactions are done in a recognised stock exchange. Apart from inter-bank repos RBI has been using this instrument effectively for its liquidity management, both for absorbing liquidity and also for injecting funds into the system. Thus, Repos and Reverse Repo are resorted to by the RBI as a tool of liquidity control in the system. With a view to absorbing surplus liquidity from the system in a flexible way and to prevent interest rate arbitraging, RBI introduced a system of daily fixed rate repos from November 29, 1997. Reserve Bank of India was earlier providing liquidity support to PDs through the reverse repo route. This procedure was also subsequently dispensed with and Reserve Bank of India began giving liquidity support to PDs through their holdings in SGL A/C. The liquidity support is presently given to the Primary Dealers for a fixed quantum and at the Bank Rate based on their bidding commitment and also on their past performance. For any additional liquidity requirements Primary Dealers are allowed to participate in the reverse repo auction under the Liquidity Adjustment Facility along with Banks, introduced by RBI in June 2000(Details given below). The major players in the repo and reverse repurchase market tend to be banks who have substantially huge portfolios of government securities. Besides these players, primary dealers who often hold large inventories of tradable government securities are also active players in the repo and reverse repo market. The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills, Central/State Govt securities). Uses of Repo  It helps banks to invest surplus cash  It helps investor achieve money market returns with sovereign risk.  It helps borrower to raise funds at better rates  An SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously.  RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system. 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 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. The RBI introduced the Bills Market scheme (BMS) in 1952 and the scheme was later modified into New Bills Market scheme (NBMS) in 1970. Under the scheme, commercial banks can rediscount the bills, which were originally discounted by them, with approved institutions (viz., Commercial Banks, Development Financial Institutions, Mutual Funds, Primary Dealer, etc.). With the intention of reducing paper movements and facilitate multiple rediscounting, the RBI introduced an instrument called Derivative Usance Promissory Notes (DUPN). So the need for physical transfer of bills has been waived and the bank that originally discounts the bills only draws DUPN. These DUPNs are sold to investors in convenient lots of maturities (from 15 days upto 90 days) on the basis of genuine trade bills, discounted by the discounting bank. 4. RISK MANAGEMENT INSTRUMENT 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 floating rates of interest. Accordingly, on each payment date that occurs during the swap period-cash payments based on fixed/floating and 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 authorisation of swap deals and signatures of authorised persons should be obtained and scrutinised. 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 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. In India, the post liberalization witnessed a rapid industrial growth, which has further stimulated the growth in the fund raising activities. With the rise in the demand for funds, there has also been a remarkable shift in the features of the sources and uses of funds of the banks. However in the deregulated environment, competition has narrowed down the spread of banks. This not only has led to the introduction of discriminate pricing policies, but has also highlighted the need to match the maturities of the assets and liabilities. The changes in the profile of the sources and uses of funds are reflected in the borrowers profile, the industry profile and the exposure limits for the same, interest rate structure for deposits and advances, etc. The developments that have taken place since liberalization have led to a remarkable transition in the risk profile of the financial intermediaries. 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 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, parameterisation of various associated market risks, and frequency of evaluation of exposure. 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. The present interest rate restructuring taking place in the Indian markets is a very good example of this aspect. The Reserve Bank of India which is the apex body regulating the Indian monetary system, has been lowering the Statutory Cash Reserve Ratio for banks in a phased manner from 12% to 8% since 1996. Every time the CRR is lowered, there is an increase in the liquidity which further results in lowering of the interest rate levels. A 2% cut in the CRR from 10% to 8% in the Busy Season Credit Policy announced in October 1997 was immediately followed by a cut in the PLR/interest rates of Banks and FIs. The risk that arises due to this reduction can be understood from the fact that the revised rates of interest will be applicable to all the new deposits, which will lower the marginal costs of funds. However, the affect will be seen on all the existing assets. Consequently the loss of interest income on assets is likely to be higher than the reduction in the interest cost of deposits leading to lower spreads. 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. The 1994 volatility witnessed in the Indian call money market explains the presence and the impact of volatility risk. The interest rate in the call money market, which generally hovered around 5-7 %, zoomed to 95% within a couple of weeks during September, 1994. While some banks defaulted in the maintenance of CRR, many banks borrowed funds at high rates, which had substantially reduced their profits. Thus, it can be seen that the affect of fluctuations in the short term have a greater impact since the adjustment period is very short. 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. 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 prevailing 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 banks 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. 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  Duration Analysis  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 periodsThe first step is Thus-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 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. 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 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 effect the interest paid on savings bank.

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 than the Maturity Gap methodology. In this approach all the rate sensitive asset's and liabilities will he adjusted by assigning weights based on the estimated change in the rate for the different assets/liabilities for a given change in interest rates. Duration Analysis One of the limitation of the Maturity Gap approach is that it ignores the time value of money for the cash flows while determining the gap. Attending to this limitation of the Maturity Gap approach is the Duration Gap Method. Duration Analysis concentrates on the price risk and the reinvestments risk while managing the interest rate exposure. While managing these two risks, Duration Analysis studies the affect of rate fluctuation on the market value of the assets and liabilities and net interest margins (NIM), with the help of duration. As seen earlier, the concept of duration helps in immunizing the interest rate risk by holding an investment till the end of duration instead of maturity Having determined the duration, the affect of rate fluctuation on the NIM and the market value of the assets/liabilities of a bank can be assessed further by computing the Duration Gap for the portfolio of its assets and liabilities. In the first case, to monitor the impact of rate fluctuation on NIM using duration. the method followed is similar to the one used in maturity gap approach. However, the Rate Sensitive Gap calculated in Duration Analysis is based on the duration and not the maturity of the assets and liabilities. Consider the following illustration 3.4 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 log-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. 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. Efficient matching of prices to manage the interest rate risk does not suffice to meet the ALM objective. Price matching should be coupled with proper maturity matching. The interlinkage between the interest rate risk and the liquidity of the firm highlights the need for maturity matching. The underlying implication of this interlinkage is that rate fluctuations may lead to defaults severely affecting the asset-liability position. Further in a highly volatile situation it may lead to liquidity crisis forcing the closure of the bank. Thus, while management of the prices of assets and liabilities is an essential part of ALM, so is liquidity. Liquidity, which is represented by the quality and marketability of the assets and liabilities, exposes the firm to liquidity risk. Though the management of liquidity risk and interest rate risks go hand in hand, there is, however, a phenomenal difference in the approach to tackle both these risks. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable, while elimination risk does result in long-term sustenance. Before attempting to analyze the elimination of liquidity risk, it is essential to understand the concept of liquidity management. 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 I flows 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, which eve suite the situation. 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 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 in the deposits withdrawals credit accommodation etc. Thus apart from assessing the liquidity requirements, it also advises the bank on its investments and borrowing requirements well in advance. Discussed below are these two models of technical approach used for liquidity risk management. 1. Working Funds Approach: Under this approach, liquidity position is assessed based on the quantum of working funds available to the bank. Since working funds reflect the total resources available with the bank to execute its business operations, the amount of liquidity is given as a percentage to the total working funds. The bank can arrive at this percentage based on its historical performance. This approach of forecasting liquidity requirement takes a broad overview of the liquidity position since the working funds are taken as a consolidated figure. The working funds comprise of owned funds, deposits and float funds. Instead of a consolidated approach, the bank can have a segment-wise break up of the working funds to arrive at the percentage for maintaining liquidity. Based on the position of the limit arrived as above and the available liquidity, the bank will have to invest borrow the surplus/deficit balances to adjust the liquidity position. In this approach, the bank will have to assess the liquidity requirements for each of the components of working funds. The liquidity for the owned funds component, due to its very nature of being owners capital will be nil. The second component of working funds is deposits, the liquidity requirements of which depend on the maturity profile. Thus, prior to assessing the liquidity requirements of these deposits, the bank should categorize them into different segments based on the withdrawal pattern. All deposits based on their maturity fall under the following three categories:  Volatile Funds  Vulnerable Funds  Stable Funds Volatile funds include those deposits, which are sure to be withdrawn during the period for which the liquidity estimate is to be made. These include, short-term deposits like the 30 days deposits, etc. raised from the corporate high net worth clients of the bank. The probability of these funds being withdrawn before or on their maturity is high. Included in this category of volatile funds are current deposits of corporates that also have a high degree of variability. Due to the nature of the volatile funds, they demand almost 100 percent liquidity maintenance since the demand for funds can arise at any time. Deposits, which are likely to be withdrawn during the planning tenure, are categorized as vulnerable deposits. A very good example of this type of deposits is the savings deposits. However, the entire quantum of savings deposits cannot be considered as vulnerable. On an average, it can be observed from the operations of the bank, that there will be a certain level up to which the funds are stable i.e. the level below which the funds will not be

withdrawn. Hence, the liquidity requirements to meet the maturity of the vulnerable funds will be less than 100 percent and varies depending upon the risk-return policy of the bank. Finally, the residual of the deposit base after segregating them into the above two categories will fall under the stable funds category. These deposits have the least probability of being withdrawn during the planning period and hence the liquidity to be maintained to meet the maturing stable deposits will also be lower when compared to the other two types of deposits. As explained above, the stable portion of the savings deposits fall under this category. Most of the term deposits, by their nature fall under this category. Float funds, which are the third component of the working funds, are much similar to the volatile funds. These funds are generally in transit and comprise of DDs, Bankers cheques, etc. which may be presented for payment at any time. However, this segment also has a minimum level over and above which the variability occurs. Hence, 100 percent liquidity will have to be provided for the variable component. Based on the working funds, consolidated or component-wise, the bank will have to assess the cash balances/ liquidity position in the following manner:  Lay down the average cash and bank balances to be maintained as a percentage of total working funds.  Lay down the range of variance that can be taken as the acceptance level. Having obtained the consolidated/component-wise working funds, the bank will now have to estimate the average cash and bank balances that are to be maintained. This average balance can be maintained as a percentage to the total working funds. This percentage level is based on forecasts, the accuracy levels of which vary depending on the factors affecting the cash flows. Hence, it is advisable for the bank to set up a variance range for acceptance depending on its profitability requirements. Thus, as long as the average balances vary within this tolerance range, profitability and liquidity are ensured. Any balance beyond this range will necessitate corrective action either by deploying the surplus funds or by borrowing funds to meet the deficit. This acceptance level is, however, a dynamic figure since it depends on the working funds that may keep changing from time to time. 2. Cash Flows Approach: This method of forecasting liquidity tries to eliminate the drawback faced in the Working Funds approach by forecasting the potential increase/decrease in deposits/credits accommodation. To tackle such a situation, trend can be established based on historical data about the change in the deposits and loans. Before proceeding to discuss about the cash flows approach it is essential to understand two important parameters that relate to the approach. Firstly, it is the decision regarding the planning horizon for the forecasts and secondly, the costs involved in forecasting. The planning horizon of a bank may be a financial year or a part of it i.e. a few months to a quarter/half-year period. The bank should ensure that the planning horizon for estimating the liquidity position should neither be too long or too short if the benefits of forecasting are to be reaped. There are various factors both external and internal to the bank which have an impact on the forecasted cash flows. Thus, when the forecasts are made for a long period they might actually not remain the same thereby affecting all the decisions that have been taken based on such forecasts. Similarly when the planning horizon is too short, decisions relating to borrowings and investments may not be effective enough to increase profitability. Considering these factors, the bank should decide on a period which will not affect the forecasted cash flows to a large extent and at the same time will enable it to make optimal investment-borrowing decisions. Forecasting cash flows to assess and manage the liquidity position of the bank, however, involves expenditure. These forecasting costs can further be classified into recurring costs and non-recurring costs. Non-recurring costs are those, which occur when the bank initiates the cash forecasting process. These include cash outflows for installation of the necessary information system that collates and maintains the data necessary for forecasting. On the other hand, there are certain recurring costs occurring on a regular basis, which include the man-hours spent, data transmission costs and the maintenance of the systems used for this process. These costs incurred in forecasting further depend on three important factors viz. branch networking, forecasting periods within the planning horizon and the details of information required for forecasting. By nature, these three factors have a direct influence on the forecasting costs. This can be explained by the fact that if the bank has a wide branch network, it will definitely have to incur more expenditure since data has to be collated from such a wide network accurately and at regular intervals. Similarly, when the bank plans to forecast its cash position for every month during the planning horizon of, say a year, the cost of forecasting will be more as compared to the expenditure incurred for forecasting will be more as compared to the expenditure incurred for forecasting for every quarter/half-yearly period. Higher costs are involved when detailed information is sought, which needs no explanation. The bank should first decide on the planning horizon that suits its operational style and then based on the cost constant decide on the number of forecasting periods and other such details. Following such decisions will be the assessment of the liquidity position based on the forecasts made for the cash inflows and outflows. The basic steps involved in this process are as follows:  Estimate anticipated changes in deposits  Estimate the cash inflows by way of loan recovery  Estimate the cash outflows by way of deposit withdrawals and credit accommodations  Forecast these for the end of each period  Estimate the liquidity needs over the planning horizon The most critical task of liquidity management is predicting the expected cash inflows coming by way of incremental deposits and recovery of credit and the outflows relating to deposit withdrawals and loan disbursals. In this process, accuracy levels when a bank forecasts cash outflows by way of deposit withdrawals and credit disbursals are fairly high, when compared to the cash inflow forecasts relating to loan repayments and deposit accretion. This difficulty in the forecasting of cash flows coupled with the mismatches arising due to the maturity pattern of assets and liabilities result in the liquidity risk. Thus the process of forecasting cash flows with a high degree of accuracy holds the key to risk management. All estimates are generally given as at the beginning of the month or at the end of the month and are silent upon the fluctuations that may occur during the month, when the forecasting period is chosen as a month. In order to manage the intra-month liquidity problems, there should always be a surplus balance. In such a scenario, it is always better for the bank to consider that the deficit occurs at the beginning of the period while the surplus occurs at the end of the period. Thus, funds should be provided to meet the deficit balance at the beginning of the forecasting period. 5. INVESTMENT BORROWING DECISIONS Assessment of the liquidity gap based on the forecasts is essentially one aspect of the liquidity management. The other major task of liquidity management is to manage this liquidity gap by adjusting the residual surplus/deficit balances. Considering the high costs associated with cash forecasting, it is essential that the benefits drawn by the bank from such forecasting should be substantially large to give some residual gains after meeting the forecasting costs. This objective can, however, be attained only if the bank makes prudent investment/borrowing decisions to manage the surplus/deficit. There are, however, a few factors which must be considered before deciding on the deployment of excess funds/borrowings for meeting the deficit which are given below:  Deposit Withdrawals  Credit Accommodation  Profit fluctuation

The liquidity level to be maintained by a bank should firstly, provide for deposits withdrawals and secondly to accommodate the increase in credit demands. While deposit withdrawals must be honored immediately, it is also of priority to ensure that legitimate loan requests of customers are met regardless of the funds position. Satisfactory credit accommodation ultimately results in more business for the bank. Liquidity is further influenced by the fluctuation in the business profits of the bank. It has already been explained that any fluctuation in the interest rates may result in an increase decrease in the NIM of the bank. If this fluctuation results in a negative growth i.e. a decrease in NIM, then the bank should review its RSAs and RSLs. It might thus resort to gap management, which might affect its liquidity position. On the contrary when the profits are showing increasing growth rates, the bank would prefer to maintain higher liquidity position by utilizing the cash balances for investments loan disbursals. This further improves its profitability levels. Considering these factors, the bank should adjust its surplus deficit to meet the liquidity gap. While surplus funds can be invested in short/long-term securities depending on the banks investment policy, the shortfalls can be met either by disinvesting the securities or by borrowing funds from the market. This again will depend on the strategical issue of whether the bank prefers to manage its liquidity risk using asset management or liability management. If the bank decides to go for liability management then the investment policy ill be long term. Consider illustration 3.8 where the planning horizon is six months and the forecasting period is one month. If the bank opts for liability management, then the surplus of Rs 19 cr. arising at the end of April will be invested for the next five months and to meet the deficit arising at the beginning of may the bank will borrows Rs 4 cr. for 2 months i.e. May and June- as there is a surplus arising at the end of June. On the other hand, if the bank adopts asset management and hence opts for short term investment policy then the bank will adjust the deficit arising in May with the surplus of April and invest the remaining funds (i.e. 19-4 = Rs 15 cr.) for May and June (since there is again a deficit arising at the beginning of July). Influencing the strategic issues of banks investments are the tactical issues. While the bank may use asset management or liability management in their investment decisions they may nevertheless face certain critical charges in their operational environment which make the strategic policies unsuitable. Implies that if the banks strategic policy is liability management, in an increasing interest rate scenario, such a policy will not be advisable. In such a case, the bank will have to go for asset management and the time the interest rates stabilize and revert back to the liability management. Thus, while the bank can take its investment decisions based on its strategic policy the same will have to be reviewed to adopt tactical policy to suit the changes in the operating environment. The important criteria in taking such decisions will also be the yields on investments and the cost of borrowing. Surplus Balance: In case of a surplus balance, the bank has the option of either maintaining cash balances or investing these excess funds in securities/loans. Though holding adequate cash reserves can eliminate the liquidity risk completely, the cost involved in doing so could be prohibitive, especially for a bank. Hence the bank should make optimum use of its idle funds by investing in such a way that the yields earned are greater. There are generally 2 options available to the ban while it makes its investment decisions. It can invest either for a short term and roll over until the funds are required for some other purpose of, invest for a longer period after properly assessing the cash requirements through the forecasting process. IN this decision making process one has to, however, consider/understand the behavior of the yield curves on the long/short-term investments. Yield curves often are sloping upwards since higher interest rates are associated with long term and relatively less liquid assets. For the, expectations theory which explains the relation between the interest rates and the investment period does not hold good in reality. These occurrences explain the fact that the long-term investments do give higher yields than short-term investments. The firm will also have to consider the transaction cost involved while converting its marketable securities. Deficit Balance: The second important question that the bank will have to face is, how to meet the deficit cash balances. The only alternative available to meet its deficit is by borrowing funds from the market. While doing this, the aim of the bank should be to keep its cost of raising such short-term funds as low as possible. The bank also has an option of meeting its deficit by internal sources by adjusting against surplus balances obtained earlier. In this option, the number of forecasting periods plays a vital role. Internal funds can be effectively used when the cost of borrowing is relatively high. There are various models that discuss the suitable ratio that can be maintained between the cash balances and the investments. Two models, which have been commonly used, are the Baumol Model and the Miller and Orr Model. The cash management model given by Baumol extends the Economic Order Quantity concept used in inventory management to discuss the d\cash conversion size, which influences the average cash holding of the firm. This model analyses the income foregone when the firm holds cash balances (rather than investing the same in the marketable securities), against the transaction costs incurred when the marketable securities are converted into cash. The Miller and Orr model considers that there will be different cash balances at different periods and thus a firm should accordingly decide on the amount and the timing for the transfer of funds from marketable securities to cash. Thus, the criteria while taking such decisions will be to increase yields on investments and lower the costs of borrowings. Thus there should be optimization in the investment deposit ratio to ensure that the level of idle funds at any point of time is not as high so as to cut into profitability of the bank. This trade off decision of the bank depends upon its attitude towards the liquidity policy i.e. aggressive/conservative. Depending on the liquidity position to be maintained, the risk preferences and risk factors, management can have a policy which has a relatively large/small amount of liquidity. 6. SECURITIZATION Yet another method of imparting liquidity into the system by way of securitisation. There is, however, a remarkable difference in this strategy used in this approach when compared to the earlier models. Distinguishing itself from the earlier methods, which resort to a sale of securities/borrowings as and when the need for funds arises, securitisation can impart liquidity on a continuous basis and has little or no relation to be surplus deficit balances. The loan profile of the bank will generally be long term in nature. Large volumes of funds get blocked in project financing and asset financing activities of the institution. Securitisation is an effective way to release these funds for further investments. In securitisation the future cash flows from the advances made by the bank are repackaged into negotiable securities and issued to the investors. This arrangement induces liquidity into the system by imparting liquidity to the highly illiquid asset. In the process of enhancing liquidity, securitisation also reduces the interest rate exposure for the bank since risk associated to the risk fluctuations will also be eliminated. Securitisation can in fact be taken up on a continuous basis to supplement the other approaches. 7. CASE STUDY State Bank of India TREASURY Profile

Profile India's largest bank is also home to the country's biggest and most powerful Treasury, contributing to a major chunk of the total turnover in the money and forex markets. Through a network of state-of-the-art dealing rooms in India and abroad, backed by the assured expertise of informed professionals, the SBI extends round-the-clock support to clients in managing their forex and interest rate exposures. SBI's relationships with over 700 correspondent banks are also leveraged in extracting maximum value from treasury operations. SBI's treasury operations are channeled through the Rupee Treasury, the Forex Treasury and the Treasury Management Group. The Rupee Treasury deals in the domestic money and debt markets while the Forex Treasury deals mainly in the local foreign exchange market. The TMG monitors the investment, risk and asset-liability management aspects of the Bank's overseas offices. Rupee Treasury The Rupee Treasury carries out the banks rupee-based treasury functions in the domestic market. Broadly, these include asset liability management, investments and trading. The Rupee Treasury also manages the banks position regarding statutory requirements like the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR), as per the norms of the Reserve Bank of India. Products and Services  Asset Liability Management (ALM): The ALM function comprises management of liquidity, maturity profiles of assets and liabilities and interest rate risks.  Investments: SBI offers financial support through a wide spectrum of investment products that can substitute the traditional credit avenues of a corporate like commercial papers, preference shares, non-convertible debentures, securitized paper, fixed and floating rate products. SBI invests in primary and secondary market equity as per its own discretion. These products allow you to leverage the flexibility of financial markets, enable efficient interest risk management and optimize the cost of funds. They can also be customized in terms of tenors and liquidity options. SBI invests in these instruments issued by your company, thus providing you a dynamic substitute for traditional credit options. The Rupee Treasury handles the banks domestic investments. Trading The banks trading operations are unmatched in size and value in the domestic market and cover government securities, corporate bonds, call money and other instruments. SBI is the biggest lender in call. Forex Treasury (FX) The SBI is the countrys biggest and most important Forex Treasury, both in the Interbank and Corporate Foreign Exchange markets, and deals with all the major corporates and institutions in all the financial centers in India and abroad. The banks team of seasoned, skilled and professional dealers can tailor customized solutions that meet your specific requirements and extract maximum value out of each market situation. The banks dealing rooms provide 24-hour trading facilities and employs state-of-the-art technology and information systems. SBIs relationships with over 700 correspondent banks and institutions across the globe enhance the strength of the Forex treasury. The FX Treasury can also structure and facilitate execution of derivatives including long term rupee-foreign currency swaps, rupee-foreign currency interest rate swaps and cross currency swaps. OVERSEAS TREASURY OPERATION Treasury Management Group The Treasury Management Group (TMG) is a part of the International Banking Group (IBG) and functions under the Chief General Manager (Foreign Offices). As the name implies the department monitors the management of treasury functions at SBIs foreign offices including asset liability management, investments and forex operations. Products and Services  Asset Liability Management (ALM): The ALM function comprises management of liquidity, maturity profiles of assets and liabilities and interest rate risks at the foreign offices.  Investments: Monitoring of investment operations of the foreign offices of the bank is one of the principal activities of TMG. The main objectives of investment operations at our foreign offices, apart from compliance with the regulatory requirements of the host country, are (a) safety of the funds invested, (b) optimisation of profits from investment operations and (c) maintenance of liquidity. Investment operations are conducted in accordance with the investment policy for foreign offices formulated by TMG. The activites include appraisal of the performance of the foreign offices broad parameters such as income earned from investment operations, composition and size of the portfolio, performance vis--vis the budgeted targets and the market value of the portfolio.  Forex monitoring: Monitoring of forex operations of our foreign offices is done with the objective of optimising of returns while managing the attendant risks.  Forex and Interest rate (Foreign Currency) derivatives: TMG also plays an important role in structuring, marketing, facilitating execution of foreign currency derivatives including currency options, long term rupee - foreign currency swaps, foreign currency interest rate swaps, cross currency swaps and forward rate agreements. Commodity hedging is one of the recent activities taken up by TMG.  Reciprocal Lines: The department is also responsible for maintenance of reciprocal lines with international banks. Portfolio Management & Custodial Services The Portfolio Management Services Section (PMS) of State bank of India has been set up to handle investment and regulatory related concerns of Institutional investors functioning in the area of Social Security. The PMS forms part of the Treasury Dept. of State Bank of India, and is based at Mumbai. PMS was set up exclusively for management of investments of Social Security funds and custody of the securities related thereto. In the increasingly complex regulatory and investment environment of today, even the most sophisticated investors are finding it difficult to address day to day investment concerns, such as  Adherence to stated investment objectives  Security selection quality considerations  Conformity to policy constraints  Investment returns

The team manning the PMS Section consists of highly experienced officers of State Bank of India, who have the required depth of knowledge to handle large investment portfolios and address the concern of large investors. The capabilities of the team range from Investment Management and Custody to Information Reporting. 8. 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.