Unit 1 : Introduction

Treasury
Refers to the reserves, funds, or bank account to support day-to-day cash flow need.
Treasury Department

The department that is responsible for managing daily cash flows and liquidity within the bank.

Treasury Management

Concerned with planning, organizing, and controlling of holding, optimization of the firm’s liquidity,
investment of excess cash and reduction of financial risks.
Scope of Treasury Management

Areas that the treasury of a bank covers the liquidity management, corresponding banking, foreign exchange
dealings, and determination of exchange rate, money market dealings and capital market dealings.

Liquidity Management: Includes raising of funds when there is a shortage of liquidity and investment of the
excess of funds.

Corresponding Banking: Refers to an arrangement where one bank (corresponding) deposits on respondent
bank and offers payment and other services to respondent bank.

Foreign Exchange Management: Banks regularly engage in buying and selling foreign currencies. They
trade with foreign currencies on their own account and for their clients to hedge risks and make profits.

Exchange Rate fixation: Treasury department of a bank updates the exchange rates on daily basis as per the
decisions of Foreign Exchange Dealers Association of Nepal (FEDAN).

Money Market: A bank’s treasury also deals with money market instruments – T-bills, repurchase agreement,
commercial paper, certificate of deposits etc.

Capital Market: Deal with capital market instruments, looks for opportunities for investment in the capital
market.

Role and Responsibilities of Treasury Department (TD)

- Implementing various financial decisions

- Cash forecast and management, management of working capital, investment management, risk
management, maintaining relationships with credit rating agencies, raising funds, credit management
and reporting.

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 - Treasury controls refer to the use of standard settlement instructions, regular reconciliations, ensuring
that transactions are appropriate. The measures of treasury controls include segregation of duties,
internal audit, and limit controls.

- Treasury centralization is the process where financial, cash management, investment, foreign
exchange, and other strategic matters are handled by a number of highly skilled manpower.

Principles of treasury management

1. Principles of security

2. Principles liquidity

3. Principles profitability

4. Principles of portfolio

1. Principles of security

The bank should invest the investable funds in safe and secure areas in which default risk will be low.

2. Principles of liquidity

The main objective of liquidity management is to maintain adequate level of liquidity to meet
borrower’s and depositor’s demand

3. Principles of profitability

The bank’s main objective is to maximize profit since it is a profit-making business. Therefore, the bank’s
assets are allocated in such a manner that increase profitability.

4. Principles of portfolio

A portfolio is the combination of investment in two or more than two financial assets. The objective of the
portfolio is to maximize the profit and minimize risk. The treasury department should invest in the portfolio
of various assets with the objective of risk mitigation.

UNIT 2: TREASURY ORGANIZATION AND STRUCTURE

 The organizational structure of corporate treasury department which defines the authority
responsibility relationship of the people responsible for treasury function.
 The organization of TD depends on the volume of activities it handles. The organizational set up can
be divided as per the major functions performed in the treasury.

Front Office
Dealing room where the dealer or trader books the trades and executes them. The money market and foreign
exchange transactions are executed in the dealing room.

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It performs the most public and visible operations of any bank and financial institution as it focuses on areas
like planning, dealing, and trading, investment, risk management, interactions with clients and other banks,
and handling accounts.
Functions of Front Office
 Interaction: It is a contact point between the bank and other organizations with which it conducts
business. The front office can negotiate with other businesses for preferential pricing, works with
business to identify exposures and provides market information and pricing advice to the organization.
 Funding: Planning and decision making about raising funds on cost effective way. Funds can be raised
by issuing shares, borrowing from lenders, or selling bonds. Utilize the relations maintained with
investment bankers and brokers.
 Investments: Excess cash investment should be made in such a way that it becomes matured at the
time the cash could be available.
 Planning: Front office determines the department goals and uses the goals as guide for planning,
specific and measurable objectives, and strategies to achieve those goals.
 Risk Management: Being a profit center, it ensures that the bank is protected against undue market
risks. It deals with risk exposure related with money market, foreign exchange, interest rates and long-
term funding.

Middle Office
The part of treasury office that focuses on control, valuation, and reconciliation of the operation of the front
and back office.
Plays significant role in the processing of securities and financial services, risk management and managing
the implementation of technology across the organization.
Functions of Middle Office
- Limit Monitoring: Sets limit for various exposures and consciously monitors the actual position with
reference to the limit. Monitors the open currency positions and analyzes risk-return. Assured
compliance with trading procedures, including the operational procedure of trading etc.

- Performance evaluation: Monitors the performance of each and every activities/ transaction conducted.

- Risk Reporting: Provides relevant and timely performance data, helps analyzing trading activities and
mitigate the risks. Also measures and monitors the risk undertaken by the front office and reports to
the management.

- Valuation: Focuses on control, valuation, reconciliation of the operations of the front and back office.

Back Office
The office that settles the deals executed by the front office.

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Considered as the engine room of a bank as it plays a key role in ensuring that the organization’s systems are
operating correctly, that people are being supported effectively and compliantly and that trades are settled
properly.

Functions of Back Office

- Account reconciliation: Reconciles general ledger and cash position. It reconciles Nostro/Vostro and
other accounts. Manage Nostro funds and advise on the latest funds position that enables fund officer
to take the decision for the surplus or short fall funds.

- Confirmation: Verifies deal slip, generates the dispatches interbank confirmations and monitors receipt
of conformations from counterparty banks.

- Settlements: Settles the transactions through clearing house or direct through Nostro. Monitors receipt
of conformations of forward contracts and derivatives. Also monitors the receipt of forex funds in
interbank contracts.

- Transaction Processing: Generates the necessary reports, forecast, and control the financial assets and
liabilities of an organization. Corrects any error , if any and protect fraud or loss.

Dealers and Dealing Room

 Treasury Dealer: Works directly under the leadership of the chief treasury officer to select the best
short-term investment.
 Dealing Room: Area within the bank and financial institutions from where dealers trade. It is
controlled by the chief dealer, who is responsible for the daily operation of the dealing room and
ensures it operates efficiently, profitably and within predetermined limits.
 Position Blotter: A record and detail of trades made over a period of time (usually a day).
 Deal Slip: Recording the details of the deal on a slip or memo at the earliest possible time.

Role and Responsibilities of Dealers

1. Act as representative: Represents the bank while dealing with customers. Act professionally and prudently
in entire contracts they make. Dealers should maintain the image of the bank while dealing.
2. Obtain Authority: Dealers need to obtain authority from the higher-level authority. Only authorized dealers
can negotiate deals.
3. Initiation and Response: Responsible to take initiation and make proper response to the dealing from and
to various market counterparties through telephone calls, conversations, and other forms of electronic
communication.
4. Recording the Deals: Responsible to record all the deal immediately after it is concluded with the
counterparty using blotter or deal slip.
5. Compliance of Legislations and Regulations: Ensure every deal is with full compliance with central bank
regulations, treasury rules and international market conventions.

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6. Assist the back office: to resolve pending issues related to trades and positions by the end of the day. For
reconciliation, the treasury dealers provide all the necessary trade details to the back office.

7. Target Achievement: Responsible to generate profitability and revenue for the organization through proper
execution of clients’ orders as well as the hedging client’s position. Also responsible for monitoring bank’s
liquidity position (obligations and fund availability)

8. Customer Relationship Management: Responsible for retaining existing relationships through ensuring
quality and effective response to client’s queries and problems.

UNIT: 3 SOURCES OF FUNDS

• The most common sources of funds for banks and financial institutions are deposit accounts, short-
term borrowings, equity, and long-term borrowings.
• Deposits: Dominant sources of funds for BFIs. Placement of funds by individuals, businesses, and
government with a bank.
• Core Deposits: Deposits received from regular bank customers, business firms, government units and
households.
• Purchased Deposits: Deposit acquired on an impersonal basis from the financial market by offering
competitive interest rate.
• The most common types of deposits are fixed deposits, revolving deposits, interest bearing deposits
and non-interest-bearing deposits.
• Interest bearing deposits include fixed deposits, saving deposits, call deposits, and certificate of
deposits. While non-interest-bearing deposit consists of call deposits and margin deposits.
• Revolving Deposits: Refers to the deposits in which bank depositors do not withdraw the full amount
of deposits every month.

Interest Bearing Deposits

Deposits in which depositors earn interest on their deposited money.
Fixed Deposit: A form of deposit in which depositors commit to provide funds to banks for a definite period
of time at a specified rate of interest.
Negotiable Order of Withdrawal (NOW): Interest bearing deposits which pay lower yield and limited check
writing privilege. Depositors required to maintaining minimum balance.
Money Market Deposit Accounts (MMDA): Short maturity interest bearing deposits which offer limited
check writing privileges and offer a higher yield. Have a term of only a few days, weeks, or months and require
a larger minimum balance and offer a higher yield.
There is no practice of NOW and MMDA in Nepal.
Saving Deposits: Interest bearing deposits primarily offered to household savers (individuals).NRB prohibits
institutional customers (a trading company or businessperson) to open saving accounts. This is payable on
demand. It has limited check writing and offers a yield below fixed deposit.
Call Deposits: Also known as hybrid deposit, is a combination of current and fixed deposits. It is an interest-
bearing deposit with unlimited withdrawals and deposits. Bank pay certain interest rate as negotiated with the
business firms, companies, and BFIs. In Nepal, interest is paid on daily balance and credited half-yearly.

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Non-interest-bearing Deposits
Include demand deposits (non-interest-bearing checking accounts). Checkable deposits which pay no interest
and are withdrawal on demand.
Current Account: A transactional non-interest-bearing account where depositors place their funds for an
unspecified period of time.
Margin Deposits: Those deposit accounts in which customers deposit money to take various facilities from
the bank (L/C, B/G etc.)

Capital or Equity
Funds contributed by the owners which include common stocks, preferred stocks and retained earnings.
The accounting value of common (and preferred) equity is equal to the number of shares outstanding
multiplied by the par value per share.

Reserves and Surplus

Reserves: Represent the funds put aside from current earnings to absorb loan losses and investment
(securities) losses.
Surplus: The excess over par value at which shares of common stocks were issued plus the value. (Nepal SBI
Bank Limited (SBI) had issued 67,768 units of share worth NRS 65.8 million as a part of further public
offering (FPO) at NRS 971 in December 2016. The Issue was at a premium of NRS 871. The amount excess
to par value (67768*871) is the surplus
Retained Earnings: Cumulative net profits of the bank not paid out in the form of dividend to shareholders.

Borrowings
Short-term Borrowings: Refers to the funds borrowed from other banks, the central bank, and other sources
to solve temporary deficiencies.
Federal Funds: Loans a bank borrows from another usually for one to seven days. Also known as inter bank
borrowing.
Repurchase Agreement: Sale of some government securities with a promise to buy them back at a higher
price on a specified date in future. Bank A needs one million for one day. The bank makes a repo agreement
with Bank B. Bank A has T-Bills worth one million and sells them to Bank B promising buy back tomorrow
for NRS 1001000.
Discount Loan: Central bank is the lender of last resort. This is short term loans to banks from central bank
under discount window facilities. The loan is backed by acceptable collateral.
Long Term Borrowings
Long-term source of funds raised to future long-term investments through the issuance of bonds and
debentures.
Long Term Debt: Bond and Debentures. Himalayan Bank had issued bonds in June 2002 as first bond issue
from banking sector in Nepal. NRS 360 million with 8.5percent coupon and 7 years maturity.
Borrowing from institutions

UNIT 4: USES OF FUND

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 • Bank use the funds to provide loan and advances and has dominant role in the asset structure of BFIs.
They make loans and advances to private sector, financial institutions, and government organizations.
• BFIs also hold some funds as liquid funds. It includes cash balance, and money at call. They hold cash
balance in the form of notes and coins, foreign currencies (primary). Bank balance includes balance at
NRB, A class licensed institutions, other financial institutions, and balance in foreign bank in
respective currencies (secondary).
• Similarly, BFIs use their funds to purchase interest-earning securities and investments. BFIs invest on
government securities, shares, and other investments.
• Further, banks also use funds to invest in fixed assets like buildings, land, furniture, fixture, vehicle,
and equipment. These assets do not yield direct earnings but are necessary to carry out the business.
So, fixed assets have minimum role in the asset structure of BFIs
• BFIs also invest on negotiable instruments such as bills purchased and collected bills.
• As per the law of land, BFIs also purchase gold and bullion as their assets.
• Investment on Bit Coins can be the uses of funds. The law of the land is applicable.

Loan and advances

 Loan and advances are the credit extended by banks and financial institutions to borrowers.
 Banks provide loans and advances to individuals and businesses on their ability to repay the loan. So,
loans and advances are the major sources of bank income.
 The interest can be fixed and variable. Loans and advances are better known as liquid assets.
Investments in securities and fixed assets are not convertible into cash quickly.
 Default Risk: Risk that the borrowers will not make obligatory payments (interest and principal) on
the due date.
 Interest rate risk: Associated with extending loan and advances. Frequent changes in interest rates
make the earnings of the banks more volatile.

Advances are the source of finance, which is provided by the banks to the companies to meet the short-term
financial requirement. It is a credit facility which should be repaid within one year as per the terms, conditions
and norms issued by Reserve Bank of India for lending and also by the schemes of the concerned bank. They
are granted against securities which are as under:

 Primary Security: Hypothecation of Debtors, Stock Pro-notes, etc.

 Collateral Security: Mortgage of land and buildings, machinery, etc.
 Guarantees: Guarantees given by partners, directors, or promoters, etc.

Key Differences Between Loans and Advances

The following are the major differences between loans and advances:

 Money lent by an entity to another entity for specific purposes is known as Loan. Money provided by
the bank to entities for fulfilling their short-term requirements is known as Advances.
 The loan is a kind of debt while Advances are credit facilities granted to customers by banks.

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  Loans are provided for a long duration, which is just the opposite in the case of Advances.
 There are many legal formalities in the case of loans as compared to advances.
 Loans can be secured or unsecured whereas Advances are secured by an asset or by a guarantee from
a surety

Credit Products
All types of loan and advances, commitment obligations under which the bank agrees to make payments on
behalf of or for the account of borrowers.

Types of Credit Products

Consumer loan: Consumer loans are made to fulfill the personal financial obligations of an individual
considering their personal or business income.
Business loan: The business loans are made to fulfill the requirements of business. Such loans are secured
with mortgages.
Agriculture Loan: Provided to individuals, firms, and companies for farming and other agricultural
production for short term or long term. Purchase of fixed assets like land, tractor, thresher, harvester, modern
plough, and other equipment. Also working capital loan for crop cultivation and harvesting. Livestock, poultry,
fishery, and insects keeping are other areas for credit. NRB has directed 10% in this sector
Asset-based Lending (Secured Lending): Bank lend against borrowers’ assets. Inventory and receivables
are the assets against which the bank lends. Loan is secured by assets; it is less risky and bank charge lower
interest rate. The borrower can borrow depends on loan-to value ratio. If a loan-to value ratio is 80 percent
implies that the bank is willing to provide a loan of up to 80% of the value of the assets.
Automobile Loan: These loans are non-revolving in nature and provided for the purchase of motor vehicles.
Automobile loans are the retail credit products. The title of the vehicle does not transfer to the borrower unless
the loan is fully paid. Borrowers need to pay 50 percent of the value of the vehicle. EMMI based payment.
Home Equity Credit: Loans that allow homeowners to borrow against the value of property.
Home Equity Credit Lines- is the revolving line of credit where borrowers borrow funds using their homes
as collateral. It allows the borrowers to borrow money as much as they need not exceed their credit limit.
Borrowers are required to make monthly interest payments only on the borrowed amount. Borrowers are
allowed to choose the amount and period for principal payment. Most of these loans charge variable interest
rates.
Home Equity Loans – provide borrowers with a large lump sum of cash for a one-time expense. It charges a
fixed rate of interest. The loan is repaid in equal monthly payments over a fixed term. Borrowers use their
homes as collateral.
Mortgages: Loan that is secured by house or property or real estate. This loan enables borrowers to acquire
real estate using the same real estate as collateral for loan. Also known as real estate loan has maturity of 10
to 15 years.
Overdraft Facilities: An overdraft is a facility in which a bank allows borrowers to withdraw money more
than that available in their bank account but up to the approved limit. The credit limit is determined on the
basis of both commercial and retail customers. Overdraft facilities are extended to both commercial and retail
customers. Interest rate is higher in overdraft loan than other types of personal loans. So, overdraft loans are
expensive.
Project Finance: Involves the financing of capital expenditure required to construct a long-term infrastructure
and industrial projects. Thus, project finance is also called the infrastructure finance. In project finance, the

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finance the project as an individual entity. The project itself provides security for the loans, and the loans are
repaid from the cash flow generated from the project.
Revolving Lines of Credit: Allows borrowers to borrow up to some specified maximum amount of funds
over an indefinite period of time. Borrowers can fund many times up to the specified line of credit and pay off
the loans over a period of time. This type of loan has no definite maturity, and the terms of repayment are
flexible. It is used for temporary or seasonal borrowing requirements.
Syndicated Loan: Loans provided to the borrowers by two or more banks. It is also known as consortium.
The bank which plays a lead role in coordinating with other banks is called lead bank or financer. The interest
payments are shared with other participants in proportion to the amount loan they supplied. This type of loan
is to minimize default risk by one single bank. Any potential loss on syndicated loans is jointly borne by
consortium.

Features of Credit Products

Maturity: Refers to the date on which the final payment on the loan becomes due. Banks grant loans for
immediate use, short-term, medium-term, and long-term basis. Short –term loans have a maturity of less than
one year and used for temporary or seasonal financing needs. Medium-term loans have maturity over one
year to five year and granted for ongoing financing of machinery and equipment for short-term periods. The
long-term loans have a maturity of more than five years and financed for major capital expenditure.
Commitment: On the basis of commitment, the bank credit classified as committed credits and uncommitted
credits.
Committed credits are granted through a formal loan agreement usually for one year or more. The bank charges
a commitment charge if the borrower does not use the committed loan within the stipulated time.
Uncommitted credits are fewer formal arrangements compared to committed credits. It may include a facility
letter which states that funds would be made available on demand. It is comparatively cheaper. The bank may
charge an arrangement fee at each renewal of the uncommitted credit.
Purpose: Borrowers use the borrowed fund for different purposes such as to finance inventory, to purchase
equipment or to address the working capital needs. These are less risky. If the borrowers use the loans to buy
back stocks, to pay dividends, or other social activities, this may create more risk.
Source of payment: Some loans are repaid by converting the assets used as collateral into cash. These loans
are known as asset conversion loans. In the case of loans against inventory or work in progress for short term
financing asset conversion loan is used. But asset-based loan is different –the asset is simply used as collateral
for the loan. If the borrowers fail to repay the loan, the bank takes control of the assets.
Collaterals: Refers to the assets that borrower pledges with the lender to get the loan. It reduces the potential
loss the bank suffers when borrowers default. Collateral can be in the form of like cash or near cash assets
(marketable securities), land, building, plant, machinery, inventory, work-in-progress, personal guarantee etc.
Covenants: Commitment or promise in a formal loan agreement by the borrower to honor an obligation. The
purpose of covenants is to prevent some actions of the borrower that are likely to deteriorate the borrower’s
ability to manage its business. Restricting dividend payments, disposing of assets, or purchasing particular
assets are some examples of covenants.
Repayment of loans: The payments that borrowers make to the lenders include both the contractual interest
payments (fixed interest rate or floating interest rate) plus the principal amount. Fixed interest rate- does not
change over the maturity of the loan; floating interest rate- changes with the change in market interest rates.
Three modes of repayment of loan are:

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Sinking fund amortization: the initial payment is large, when the principal is reduced, the interest payment
on the outstanding balance is reduced. If the loan has a fixed rate of interest, the proportion of interest on loan
payments declines over the life of the loan. In case of floating, interest payments fluctuate.
Level amortization: The size of payments for fixed rate loan is same over the maturity. But the proportion of
interest payment and principal payment differs in each payment. Interest payment is larger at the beginning.
Balloon payments of loan: Large payment on maturity. The payment at maturity includes only the repayment
at maturity includes only the repayment of principal. Interest payment is made periodically.
In some cases, payment consists of all accumulated interest on the loan plus the principal payment.
Interbank Lending
It refers to the transactions that occur between financial institutions in money markets.
These transactions are usually loans between banks with excess reserves and banks in need of capital and have
maturities of less than one year. Most interbank loans are for one week, or less, the maturity being overnight.
Typically, interbank lending occurs for several reasons
 Satisfying reserve requirement of central bank.
 Managing day-to-day needs.
 Increasing reserves to guard against liquidity risks. Protect a bank from insolvency.
 Providing an overleveraged institution with emergency capital to prevent bankruptcy.
Maintaining Reserves
As the regulator of banks and banking institutions, NRB has control over the liquidity position in the financial
system. NRB has to control the money supply and credit supply positively and negatively depending upon the
situation of the economy. For which NRB uses CRR and SLR as indirect tools to have desired control over
the financial market. (Unified Directives 2078)
• Banks and financial institutions in the country now have more funds to invest or extend as credit, as
the changes in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) introduced through the
latest Monetary Policy came into effect.
• The latest monetary policy introduced by Nepal Rastra Bank (NRB) had slashed CRR to five per cent
for commercial banks, 4.5 per cent for development banks and four per cent for finance companies to
promote lending.
• Likewise, SLR has been reduced to 12 per cent for commercial banks, nine per cent for development
banks and eight per cent for finance companies.
• Class 'B' and 'C' financial institutions that do not collect call deposits have to maintain SLR of six per
cent.
• CRR refers to the portion of total deposits that financial institutions have to keep at central bank as
deposit.
• SLR is the portion of total deposits that financial institutions have to maintain as liquid assets such as
cash, government securities and precious metals. Reduction in SLR and CRR has freed some funds of
banks and financial institutions for lending and investment.
• The CCD ratio of 80% indicates that out of every Rs 100 deposit, the banks can lend
APPROXIMATELY Rs 80, the remaining Rs 20 can be used to fulfil the CRR and SLR requirements
as mandated by the Nepal Rastra Bank (NRB).

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INVESTMENT
• Foreign exchange Market
• Treasury Bill
• Government Securities
• Development Bonds
• National Saving Bonds
• Citizen Saving Certificate
• Special Bond
• Shares and Debentures
• Common Stock
• Preferred Stock
• Debenture
Foreign exchange Market
• It is the largest financial market where one currency is traded against another. It is open for buying or
selling a particular currency in exchange of another currency. Mostly the leading currencies used in
internal trade (USD, Yen, Euro, AUD, CAD, GBP etc.) are traded in this market.
• Spot transactions, forwards, swaps, and options contracts are also traded where the underlying
instrument is a currency. It is traded continuously around the world 24 hours a days, five days a week
in major financial centers of the world.
• It is also widely traded in the interbank market. This is the platform where all sized banks trade
currency with each other as per their own requirements on an electronic network.
• Bank facilitates forex transactions for their own operation or desk need or for catering customer needs.
When a bank acts dealer for customers, the bid-ask spread provides profit to the bank whereas
speculative currency trades can also be executed within approved limit for gaining from currency rate
fluctuations.
Treasury Bill
• Treasury bills are an obligation issued by the Government, sold at a discount from the face value. This
is the most liquid or marketable instrument among all money market instruments.
• Treasury Bills are 14 days, 28 days, 91days, 182 days and 52 weeks or 364 days from the date of
purchase. At the expiry, the treasury purchase gets the payment of the face value which was previously
purchased at a discount.
• It is the simplest form of borrowing taken by the Government. Government raises money from selling
this instruments to public. Such bills are offered each week to open for purchase at a discount from the
face value by the bidders.
• In USA, there is a practice of selling USD 10000.00 as a unit and in Nepal we have trend of selling
treasury bill of NPR 25,000.00 per unit.
Salient features of Treasury Bills
• Form: T-bills are issued either in physical form as a promissory note or dematerialized form by
crediting to Subsidiary General Ledger (SGL) Account.

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 • Eligibility: Individuals, firms, companies, trust, banks, insurance companies, provident funds, state
government and financial institutions are eligible to invest in treasury bills.
• Minimum Bid: The minimum amount of bid is Rs. 25000 and in multiples thereof.
• Issue price: T-bills are issued at a discount, but redeemed at par.
• Repayment: The repayment of the bill is made at par on the maturity of the term.
• Availability: Treasury bills are highly liquid negotiable instruments that are available in both financial
markets, i.e., primary, and secondary.
• Method of the auction: Uniform price auction method for 91 days T-bills, whereas multiple price
auction method for 364 days T-bill.
• Day count: The day count is 364 days, in a year, for treasury bills.
Government Securities
NRB issues long term bonds on behalf of the Government in order to take the internal debt for budgetary
deficit. Such instruments are briefed below.
• Treasury notes (T-notes) are intermediate-term bonds maturing in two, three, five or 10 years. They
provide semiannual interest payments at fixed coupon rates. T-Notes typically have a $1,000 face
value; those with two- or three-year maturities have a $5,000 face value.
• Treasury bonds (T-Bonds) are long-term bonds maturing in 10 to 30 years. T-Bonds provide
semiannual interest payments and have a $1,000 face value. The bonds fund shortfalls in the federal
budget, regulate the nation’s money supply, and execute U.S. monetary policy.
• Pros and Cons of Government Securities
• Government securities are exempt from state and local taxes, making government bonds advantageous
for investors in high tax brackets. The bonds are very liquid but have low rates of return. The securities
rarely protect against inflation and have little or no capital gains opportunity.
• Development Bonds
• Long term bonds of 3 to 12 years often raised for development purposes.
• Bonds are sold through competitive bidders and non-competitive bidders at the ratio of 60/40
which may alter as per the open market condition at the time of issue.
• Competitive bidders are all three categories of banking institutions to whom the bonds are
allotted from the highest bid to lower, whereas the rate for non-competitive bond is derived as
per the weighted average of the price of successful competitive bids.
• Such bonds are issued with stock exchange and are treated as instruments eligible for
maintaining SLR.
• National Saving Bonds
• Such bonds are issued for the purpose of raising internal debts from the general public. Non-
banking institutions and individuals are the only eligible parties for purchasing these
instruments which are issued for 5 years period. It is either in the form of stocks or promissory
notes.
• Interest is semiannually paid for such instruments whereas the face amount is returned at
maturity. Before 2058 B.S., the interest income on such bonds was tax exempted but now it is

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 taxable as per nature of the holder. Banks accept such bonds as collateral to extend loans as
well.
Citizen Saving Certificate
• This is an instrument similar to the national saving bond normally issued to the period of 5 years period
but sold only to the Nepalese citizens. It is either in the form of stocks or promissory notes.
• It is a negotiable debt instrument transferable from one person to other and can be taken as collateral
for extending loan also.
• Interest payment is fixed at the time of issue and paid semiannually and subject to tax as per the nature
of the instrument holder. The principal is repaid at the maturity date.
• Interest is semiannually paid for such instruments whereas the face amount is returned at maturity.
Before 2058 B.S., the interest income on such bonds was tax exempted but now it is taxable as per
nature of the holder. Banks accept such bonds as collateral to extend loans as well.
Special Bond
• Special bonds are the bonds issued by a special sector and purpose as per the decision of the
Government. This sort of bond is provided to the stakeholders when the Government or paying
authority has scarcity of funds.
• Initially in the year 2068, the Government had issued special bond named SB2068A which was
provided to the businessperson. The second issue of such bond was by Rastriya Banijya Bank as SB
2069. Such bonds may be interest bearing or non-interest bearing both and can be used as collateral
for extending loans.
• NRB video new monetary policy has allowed specialized banks to issue power bonds and agriculture
bonds investment of which can be calculated as the priority sector lending for power and agriculture
sector.
Shares and Debentures
• Corporate stocks or shares are the ownership stakes in a corporation and claims on its corporate
assets and net profits (no return).They have certain rights and risks. Debenture is the long-term
promissory note issue by the corporations which provides certain return and is riskier than the
Government bonds. There are two types of corporate stocks.
• A unit of ownership that represents an equal proportion of a company's capital. It entitles its holder
(the shareholder) to an equal claim on the company's profits and an equal obligation for the
company's debts and losses.
• Two major types of shares are (1) ordinary shares (common stock), which entitle the shareholder to
share in the earnings of the company as and when they occur, and to vote at the company's annual
general meetings and other official meetings, and (2) preference shares (preferred stock) which entitle
the shareholder to a fixed periodic income (interest) but generally do not give him or her voting rights.
Common Stock
• It is a security that represents ownership in a corporation. Holders of common stock exercise control
by electing a board of directors and voting on corporate policy.
• Stocks should be considered an important part of any investor’s portfolio. They bear a greater amount
of risk when compared to CDs, preferred stock, and bonds.
• However, the greater the risk comes the greater potential for reward. Over the long term, stocks tend
to outperform other investments but are more exposed to volatility over the short term.

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 • There are also several types of stocks. Growth stocks are companies that tend to increase in value due
to growing earnings.
• Value stocks are companies lower in price in relation to their fundamentals. Value stocks offer a
dividend unlike growth stocks. Stocks are categorized by market capitalization in either large, mid, or
small.
• Large-cap stocks are much more traded and are an indication of a more stable company. Small-cap
stocks are newer companies looking to grow, so they are much more volatile compared to large caps.
Preferred Stock
 Preferred stock is a class of corporate shares that are separate from common stock and have specific
rights that are not available to common shareholders.
 You can think of a preferred share as a premium or priority share that the company issues to senior
investors. These shares come with special rights that give these senior investors preferred status over
the common shareholders.

 Cumulative preferred shares have the right to be paid current and past year’s unpaid dividends before
common stock shareholders are paid.
 If dividends are not declared in the current year, the cumulative shares record the unpaid dividends in
an account called dividends in arrears.
 When the board of directors does declare a dividend, it must pay the cumulative preferred shareholders
all of the past year’s dividends in arrears and the current year’s dividend before common shareholders
are paid anything.
 In other words, common stockholders might not receive a distribution depending on how much is
saved up in arrears.
Debenture
• It is a long-term promissory note issued by the corporations. A corporate bond or debenture has more
risk than that of the Government bonds.
• The bond or debenture holders are entitled to get interest payment at the fixed rate and periodicity
whereas the principal part is repaid at the maturity date only.
• The debenture holders are entitled to get their full payment from the proceeds of the liquidation right
before the payment to the preferred stock and common stockholders.
• The debentures’ synonymously called bonds are traded in the organized exchange and OTC market
both.
Maintaining Liquidity
• Liquidity denotes the ability to fund assets and meet financial obligations to the liabilities. Liquidity
is required to meet customers’ withdrawals, to fund the bank’s growth and to compensate for the
balance sheet fluctuations as well.
• Funds management involves estimating liquidity requirements and meeting those needs in a cost-
effective way.
• Management must maintain sound policies and procedures to effectively measure, monitor, and
control liquidity risk.

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 • Managing liquidity denotes estimating fund requirements and meeting those requirements in cost
effective ways.
• Sound liquidity management first evaluates or forecasts the liquidity needs through various routine
and upcoming scenarios including adverse conditions as well. It also maintains a sufficient level of
cash, liquid assets, and prospective borrowing lines to meet expected, unexpected, and contingent
liquidity demands.
• Liquidity risk is the possibility of being unable to raise funds at a reasonable price within the necessary
period to meet its financial obligations. Due to such failure, the brand image of a good bank can be
high risk despite of strong capital and profitability base.
• Some level of liquidity risk is inherent to banking but it should be well administered by implementing
sound policies and procedures to measure, monitor and control.
• An institution’s challenge is to correctly measure and manage liquidity demands and funding. For the
efficient support of daily banking operations and contingent liquidity demand, the bank has to care the
following points.
• Banks have to implement appropriate liquidity and liquidity risk management mechanisms.
• Banks have to ensure the adequacy of the available resources to cater to the ongoing liquidity
needs.
• Banks have to establish a funding structure commensurate with risks.
• Banks have to evaluate their contingent liquidity needs.
• Bank has to ensure the availability of resources to meet such contingent liquidity needs.

Management for off balance sheet items

In some events, off balance sheet items may require funding and convert into items under uses of funds. They
are as follows.
 Loan Commitments
 Loan commitments are the common items which can change into funded assets any time. It
includes unutilized credit lines, unfunded loans, commercial letters of credit, bank guarantees
etc.
 Management must estimate and closely monitor the amount of unfunded commitments which
may require funding over various periods.
 Management should always include the unfunded loan commitments and its anticipated
demands for internal reporting, assessing, and rating liquidity position and contingency
planning.
 'Derivative‘
 A derivative is a financial security with a value that is reliant upon, or derived from,
an underlying asset or group of assets.
 The derivative itself is a contract between two or more parties, and its price is determined by
fluctuations in the underlying asset.

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  Derivatives can either be traded over the counter (OTC) or on an exchange. OTC derivatives
constitute the greater proportion of derivatives and are not standardized. Meanwhile,
derivatives traded on exchanges are standardized and more heavily regulated.
 OTC derivatives have greater counterparty risk than standardized derivatives.
 Contingent Liability
 Contingent liability is a potential liability that may occur depending on the outcome of an
uncertain future event.
 Contingent liability is recorded in the accounting records if the contingency is probable, and
the amount of the liability can be estimated.
 If both conditions are not met, the liability may be disclosed in a footnote on the financial
statements or not reported at all.

UNIT 5: Major Risks in Treasury Management

Meaning and nature of financial risk
Financial risk is the possibility of losing money on an investment or business venture. Financial risk
is a type of danger that can result in the loss of capital to interested parties. For governments, this can
mean they are unable to control monetary policy and default on bonds or other debt issues.
Financial Risk as the term suggests is the risk that involves financial loss to firms. Financial risk arises
due to instability and losses in the financial market caused by movements in stock prices, currencies,
interest rates and more.
Financial risk is the possibility of losing money on an investment or business venture. Some more
common and distinct financial risks include credit risk, liquidity risk, and operational risk.
• Financial risk relates to the odds of losing money.
• The financial risk most commonly referred to is the possibility that a company's cash flow will prove
inadequate to meet its obligations.
• Financial risk can also apply to a government that defaults on its bonds.
• Credit risk, liquidity risk, asset-backed risk, foreign investment risk, equity risk, and currency risk are
all common forms of financial risk.
• Investors can use a number of financial risk ratios to assess a company's prospects.
Banking risks can be broadly classified under twelve categories:
1. Credit risk/counter party default risk
2. Liquidity risk
3. Market risk
4. Sovereign risk
5. Foreign currency risk
6. Interest rate risk
7. Equity risk
8. Commodity risk

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 9. Operational risk
10. Reputational risk
11. Business risk
12. Cyber security Risk
Credit risk/counter party risk
According to the Bank for International Settlements (BIS), credit risk is defined as the potential that a bank
borrower or counterparty will fail to meet its obligations in accordance with agreed terms.
Credit risk is caused by loans, acceptances, interbank transactions, trade financing, foreign exchange
transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and
guarantees, and the settlement of transactions
In simple words, if person A borrows loan from a bank and is not able to repay the loan because of inadequate
income, loss in business, death, unwillingness or any other reasons, the bank faces credit risk.
Similarly, if you do not pay your credit card bill, the bank faces a credit risk.
Hence, to minimize the credit risk on the bank’s end, the rate of interest will be higher for borrowers if they
are associated with high credit risk.
Factors like unsteady income, low credit score, employment type, collateral assets and others determine the
credit risk associated with a borrower.
As stated earlier, credit risk can be associated with interbank transactions, foreign transactions and other types
of transactions happening outside the bank.
If the transaction at one end is successful but unsuccessful at the other end, loss occurs.
If the transaction at one end is settled but there are delays in settlement at the other end, there might be lost
investment opportunities

Steps to Mitigate Your Bank’s Credit Risk

 Loan portfolios typically have the largest impact on the overall risk profile and earnings of community
banks. A strong credit culture provides a platform for the Bank to compete successfully in its market.
Although credit risk is inevitable, banks can mitigate the risk by taking steps to strengthen their lending
program. The following steps can help assist in providing a framework for a sound lending program:
 6C policies: character, capital, collateral, condition, compliance, and capacity
 Written Credit Policies-A well-written and descriptive credit policy is the cornerstone of sound
lending. Credit policies should address the inherent and residual risks in lending.
 Standardized Credit packages-Documented credit request packages should be uniform. Most credit
packages will consist of a request, required supporting documentation, and an analysis/financial
review.
 Loan Approval Authority-The Bank should document loan approval authorities which are approved
by the Board of Directors. In order to maintain a balance between credit quality and profitable loan
portfolio growth, appropriate lending authority controls must exist. Each loan file should contain
documentation of proper approval.
 Well-Managed Credit Risk Rating System-Well- managed credit risk rating systems promote bank
safety and soundness by facilitating informed decision making. The Bank’s risk rating system should
form the foundation for credit risk measurement, monitoring and reporting and should support the
board’s objectives.

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  Accuracy of Loan Documentation-Properly executed loan documentation is necessary to ensure the
bank has an enforceable claim for repayment, including liquidation of collateral or the right to demand
payment. Documentation must be properly drafted, completed, executed, filed, and stamped. A
secondary review of this documentation should be in place
 Monitoring/Reporting Loan Performance-It is important to identify trends within the loan portfolio
and isolate potential problem areas. Reports to senior management should provide sufficient
information for an independent evaluation of risk and trends.
 Problem Asset Management-When collection problems persist and risk ratings deteriorate, many banks
find it beneficial to transfer problem loans to an independent work-out team.
 Adequate Loan Loss Reserve-The ALLL exists to cover any losses in the loan (and lease) portfolio of
all banks. Adequate management of the allowance is an integral part of managing credit risk.
 Independent Loan Review and audit-Periodic objective reviews of credit risk and risk management
processes, as well as independent audits are essential to effective portfolio management.
 Insurance of loan: the bank mitigates the credit risk through the insurance of loan.

WHAT IS LIQUIDITY RISK?

 Definition – The term ‘Liquidity Risk’ means ‘Cash Crunch’ for a temporary or short-term period.
These kinds of situation are having an adverse effect on any Business and Profit-making Organization.
 Unable to meet short-term Debt or short-term liabilities, the business house ends up with negative
working capital in most cases.
 This is a familiar situation which is cyclical in nature and happens during the recession, or when a
particular economy is not doing well. On the other hand, the company has an obligation to pay its
short-term expenses, payment to its Creditors, short term loans etc. on a monthly basis.
Liquidity risk
It is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs
due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the
process.
Mitigate of liquidity risk:
1. Diversify
2. Understand Your Time Horizon
3. Minimize Debt
'MARKET RISK'
Market risk is the risk that the value of an investment will decrease due to changes in market factors.
These factors will have an impact on the overall performance on the financial markets and can only be
reduced by diversification into assets that are not correlated with the market – such as certain
alternative asset classes.
Market risk is sometimes called “systematic risk” because it relates to factors, such as a recession,
which impact the entire market.

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Types of Market Risk
Equity Price Risk
Equity price risk is the risk that arises from security price volatility – the risk of a decline in the value
of a security or a portfolio.
Equity price risk can be either systematic or unsystematic risk. Unsystematic risk can be mitigated
through diversification, whereas systematic cannot be.
In a global economic crisis, equity price risk is systematic because it affects multiple asset classes.
A portfolio can only be hedged against this risk. For example, if an investor is invested in multiple
assets that represent an index, the investor can hedge against equity price risk by buying put options
in the index exchange-traded fund.
Foreign Exchange Risk
Currency risk, or foreign exchange risk, is a form of risk that arises when there is volatility in currency
exchange rates.
Global firms may be exposed to currency risk when conducting business due to imperfect hedges.
For example, suppose a U.S investor has investments in China. The realized return will be affected when
exchanging the two currencies.
Assume the investor has a realized 50% return on investment in China, but the Chinese yuan depreciates 20%
against the U.S. dollar. Due to the change in currencies, the investor will only have a 30% return. This risk
can be mitigated by hedging with currency exchange-traded funds.
Commodity Risk
Commodity price risk is the volatility in market price due to price fluctuation of a commodity. Commodity
risk affects various sectors of the market, such as airlines.
A commodity's price is affected by politics, seasonal changes, technology, and current market conditions.
The company could use futures or options to hedge this risk and minimize the uncertainty of oil prices.
Country risk
It is a term for the risks involved when someone invests in a particular country.
Country risk varies from one country to the next, and can include political risk, exchange-rate risk, economic
risk, and transfer risk.
Country Risk refers to the probability that changes in the business environment in another country where you
are doing business may adversely impact your operations or payment for imports resulting in a financial loss.
Country Risk also includes Sovereign Risk, which is a subset of risk specifically related to the government or
one of its agencies refusing to comply with the terms of a loan agreement.
To effectively control the level of risk associated with international activities, banks should have a risk
management framework that addresses the broadly defined concept of country risk.
The recent debt problems in Europe highlighted sovereign risk issues in Greece and other member states of
the Eurozone when loan defaults were a real concern for banks holding the respective loan paper.
A sound country risk management framework includes
• oversight by the board of directors and senior management.

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• policies and procedures.
• a country exposure reporting system.
• a country risk analysis process.
•a country risk rating system.
• Interagency Country Exposure Review Committee (ICERC) ratings.
• country exposure limits.
• monitoring country conditions.
• stress testing and integrated scenario planning.
• independent risk management, internal controls, and audit.
Interest rate risk
Interest rate risk is the risk of negative effects on the financial results and capital of the bank caused by changes
in interest rates.
Changes in interest rates affect a bank’s earnings by changing its net interest income and the level of other
interest-sensitive income and operating expenses.
Changes in interest rates also affect the underlying value of the bank’s assets.
Interest rate risk arises when there is mismatch between positions, which are subject to interest rate adjustment
within a specified period.
Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and system
or from external events.
Rapid development in the pace of financial innovation is making the activities of bank and their risk profiles
and institution’s activities.
 Internal fraud
 External fraud
 Workplace safety
 Damage to physical assets
Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and system
or from external events.
Rapid development in the pace of financial innovation is making the activities of bank and their risk profiles
and institution’s activities.
 Internal fraud
 External fraud
 Workplace safety
 Damage to physical assets

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Reputational risk
 reputational risk refers to the potential for negative publicity, public perception or uncontrollable
events to have an adverse impact on a company’s reputation thereby affecting its revenue.
 Reputational risk strikes without warning. It shifts your corporate landscape, impacts revenue, and
sparks chaos. Unfortunately, it is often neglected or confused with other types of corporate risk. Let
us look at how they all relate to one another.
 The risk that a company will lose potential business because of its character or quality has been
called into question.
 For example, if it revealed that a company has been cheating customers out of money for years, this
risk would become a stronger possibility due to the company’s reputation.
Impact of reputational risk
 Your business’s reputation is your most valuable asset, especially if you are a bank or financial
institution.
 A negative corporate reputation harms client and investor trust, erodes your customer base and
hinders sales.
 A poor reputation also correlates with increased costs for hiring and retention which degrades
operating margins and prevents higher returns.
 Furthermore, reputation damage increases liquidity risk which impacts stock prices and slashes
market capitalization.
Recent reputational risk examples for banks
• Wells Fargo is the best example of the impact of reputational risk. The bank’s employees opened
millions of fake accounts, overcharged for mortgage insurance, signed up customers for unnecessary
car and pet insurance and accidentally foreclosed on hundreds of homes.
• Those actions prompted the bank to take the following actions to mitigate reputational risk:
• Fired 5,300 workers
• Replaced longtime CEO
• Replaced board chair and directors
• Paid $185 million to atone for shady sales practices
• Reserved $285 million to refund wealth-management clients for pricing and fees
• “There is no question that Wells Fargo’s
Measuring reputational risk
• Step one is to execute a reputational risk assessment to establish the baseline for your company’s
image.
• That will help you determine the public perception of your company and competitors as well as the
industry in which you operate.
• Reputational risk is highly subjective so segment your stakeholders into separate groups to determine
areas of exposure. You may want to include regulators, analysts, investors, clients, or employees.

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Compliance risk
 Is the potential for losses and legal penalties due to failure to comply with laws or regulations.
 In many cases, businesses that fully intend to comply with the law still have compliance risks due to
the possibility of management failures.
1. Environmental Risk
Potential for damage to living organisms or the environment arising out of an organization's activities.
2. Workplace Health & Safety
• Risks related to all aspects of health and safety in the workplace such as accidents or repetitive strain
injuries.
3. Corrupt Practices
• The potential for corrupt practices such as bribery or fraud. Organizations are responsible for the
actions of their employees and agents in this regard.
4. Social Responsibility
• The risk that your business activities will harm your workers or the people in the communities in which
you operate.
5. Quality
• Releasing a low-quality product or service that fails to meet the expected level of due diligence in your
industry or that violates laws and regulations.
6. Process Risk
• The risk that your processes will fail resulting in legal violations such as failure to meet your
responsibilities to your customers or partners. Process failures can also result in reporting or
accounting errors that breach your duties to your investors.

UNIT 6: Pricing of the Product

 Deposits are the main source of funds for a bank. It is like the raw material for any business hence can
be termed as the core source of a bank’s profit and growth.
 It is a symbol of acceptance of the bank by the public as well in the sense that people prefer keeping
deposits in those banks which they trust more.
 Deposits generate new asset creating abilities in a bank and hence the success of a bank (in terms of
profitability and growth) underlies in the success of raising required deposits at comparatively lower
cost.
 Interest rates paid to the depositors vary to the type of deposits they hold with the bank. Bank offers
low rate for demand deposits whereas offers high rates for time deposits.
 The interest rate paid to the same type of deposit also varies among banks. The size and risk exposure
of banks are the determinants of different interest rates being paid for similar types of deposits.
 The final factor of varying interest rates can be the philosophy or goals of the bank as well.
 Bank sells various deposit products designed as per the requirement of the variety of customers. The
saving deposit and time deposit are the most saleable ones. The various types of deposits with a bank
are called the deposit mix.

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  A sound deposit mix for a bank has the following characteristics.
 High demand deposit
 High low yield time deposit
 High sustainability
 High Core Deposit
The above characteristics make deposit mix less vulnerable to economic swings and interest rate changes.
Initially the deposits used to be taken as granted but due to various factors like inflation, deregulation,
cutthroat competition, and education standard of people, have created hard time for banks to procure deposit
and banks are compelled to innovate new ideas with lucrative offers for the customers to be unique from
others.
Deposit Pricing
• Bankers are set free to some level to price their deposit products which has opened creativity about
their deposit pricing strategies. Each bank is keen on competitive pricing of deposit services to offer
so that customers can get the full value of the cost being incurred.
• Now-a-days Customers are also well aware about the cost of such services across the banks and are
continuously giving signals of their money using habit to bankers by opting them.
• To be competitive in the market, banks must set the prices of various services at least at par with the
market otherwise there is a high chance of failure of the products.
The various pricing strategies for deposits related services are as follows.
 Cost Plus Deposit Pricing
 Pooled Fund Approach
 Marginal Cost Pricing
 Market Penetration Pricing
 Conditional Pricing
 Upscale target Pricing
 Relationship Pricing
 Bank Goal Deposit Pricing
Cost plus Deposit Pricing
 The objective of every bank is to maximize its profitability, so banks aim to recover costs and make
margin from each services they provide to the customers.
 In cost plus margin pricing, per unit cost to provide each deposit service is calculated by estimating
per unit operating and overhead cost for handling the deposit and after adding some margin as profit
in the cost, the final rate for certain deposit service is determined.
 The following formula is used in this technique.
Unit Price Charged for Each Deposit Service = Operating Expenses per unit of deposit service +
Estimated Overhead Expenses per unit of deposit service + Planned profit from each deposit unit
from the service

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Pooled Fund Approach
This approach is an updated version of cost-plus margin pricing as it considers the cost of each type
of fund, which is the weighted average of all. This is called a pooled funds approach as all sources
are taken into consideration. This determines the minimum rate of return the bank has to earn before
tax on loans to be at breakeven condition.
• For this the following steps are to be taken.
• Calculate the cost of each source of funds by making necessary adjustment for reserve
required as per NRB, deposit insurance etc.)
Cost for related deposits = interest and noninterest fund-raising cost
(1- reserve requirement in fraction)
Cost for owner’s capital = interest and noninterest fund-raising cost
1
To calculate the proportion or weight
• multiply the individual cost by the weighted average proportion
• The sum of all of no produced the cost of funds
•
To calculate the proportion or weight
Proportion of related deposit = Amount of related deposit
Total amount of source of funds
Proportion of owner’ fund = Amount of owner’s fund
Total amount of source of funds
• Multiply the individual cost by the weighted average proportion
• The sum of all of no produced the cost of funds
Weighted average cost = Proportion of deposit * Cost of deposit + Proportion of owner’s fund * Cost of
owner’s fund
Marginal Cost Pricing
• It is the cost of bringing additional funds. This approach advocates to set pricing just to attract new
funds and still earn a profit on the last rupee of new raised funds although the earning rate is less than
earlier.
• It is a more realistic way of pricing deposits. In a market of falling interest rates, the rate for a new
deposit can be down than the existing average cost of funds hence the bank can give loans on lower
rates in this case. Whereas in a growing market, the marginal rate can be at higher side than the existing
average cost of capital, in such case the rates on loans may be perceived unprofitable in comparison to
the marginal cost of funds.
• The approach takes care about the marginal expected revenue that can be generated from the newly
raised funds.
Marginal cost and its rate are calculated as mentioned below.
• Calculate the marginal cost for each new deposit segment

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 Marginal Cost = New interest rate * total fund raised at new rate - Old interest rate * Total funds
raised at old rate
Marginal Cost Rate = Marginal cost
Additional funds raised
In other way, marginal cost can be computed as below,
Marginal Cost = Current marginal cost – previous marginal cost

• This approach provides a particularly good insight of deposit pricing for enhancing its deposit volume.
When profits are in fall, banks either need to search new sources of deposits with less marginal cost or
new uses or loans with higher yield in order to maintain the profit on same track.
Market Penetrating Pricing
• This technique does not advocate about any cost recovery or profit making in the short run but aims to
book as many as customers and volume in the fold of the bank by offering the higher value to the
customers than prevailing or available in the market.
• The bank thinks that the volume of the accumulated business offsets the lower profit margin being
generated from such deposits due to economy of scale effect. This pricing mechanism is also called
promotional pricing and is motivated by growth-oriented objective instead of making near profit.
• Immediate revenue losses from providing services under market penetration pricing is often treated as
investment rather than the expenditure.
• It aims to grow the market share first in priority then bothering about the less profit margin coming
from the business.
• Once the targeted amount and numbers are achieved, the bank may think about raising prices and fees
later.
Conditional Pricing
• The cost of services is set conditional with the number of uses of the services and the balance
maintained with the account.
• Bank may set least or even no fee for various services for high amount deposit account, but they may
charge for the same services if the balance of such account goes lower than some specified minimum
amount.
• Some fees may be conditional to the number of uses like charges for ATM uses practiced in India.

Relationship Pricing
• Relationship pricing has a philosophy of setting prices attributed to establishment of customer loyalty
to the bank.
• It is not based on a particular product but based on the number of financial services that the customer
is currently enjoying with us.
• The main motto of this pricing strategy is to value the customer relationship with us among the crowd
of walking or other customers.

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 • It is harder to break business relationship easily by the customer once they are the beneficiaries of this
pricing strategy from a bank.
• It ensures prolonged banking relationships with the customers.
Upscale Target Pricing
• Upscale pricing is the strategy to attract high net worth individuals in the bank’s deposit portfolio.
Such a level of people are generally bothered about the quality of service and brand image of the bank
rather than the cost.
• Upscale priced products are carefully promoted through well triggered advertisements to attract the
targeted customers (professionals, business owners, high earning households). Bank may set higher
margin on services for the dedicated services provided to such cluster of customers.
Bank Goal deposit Pricing
• This deposit pricing is a short run motive of increasing bank’s profitability rather than investing for
better future.
• The central concern of strategy is to increase the running profitability instead of adding numbers in
deposit portfolio. Sometime to give attention to a certain class of customers with high value, less
desirable customers can be driven away from this strategy.
• The strategy keeps on changing as per the short run goal of the bank.
Loan Pricing
• Loan pricing is the important and key function of a commercial bank as loans are the major source of
income to the bank.
• Keeping the profitability only in view, bank cannot charge high interest for its loan products as it may
drive the potential good borrowers to the fold of competitors and the bank may compel to book
subprime customers which in high chance may create credit risk in future.
• A bank can come into trouble if the pricing of loan products is not reasonable and even if it does not
cover the actual cost of funds, operations and overhead with certain margin.
• The following strategies are used while pricing the loan products.
• Risk Based Pricing
• Cost Plus Margin Pricing
• Market Based Pricing
• Value Based Pricing
Risk Based Pricing
• It is the pricing of loan products based on the associated risks.
• It targets different pricing strategies for high risk and low risk customers as per their risk rating based
in features and past record.
• High risk customers are charged higher rates whereas low risk customers are charged low interest rate
for same type of loans under this strategy.
• Risk rating of customers is done on the basis of social standing, integrity, repayment capacity, financial
health, past track record, credit rating etc. of the borrowers and promoters behind the borrowing units.

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 • Although risk rating is started to be practiced in Nepalese banking sector, pricing depends upon value
based, cost plus and market-based strategies instead of risk-based strategy.
Cost Plus Pricing
• It is a method of pricing loan products designed to cover all of the operational expenses and give some
margin for profit to the bank.
• It does not care about pricing prevailing in the market for similar products hence not considered as a
competitive pricing strategy.
• As the bank needs to survive in the competitive market, it should not rely on the cost-plus pricing
strategy only while pricing all of the loan products.
Market Based Pricing
• In this strategy, prices are set by the market leader and others just follow the near about the same
pricing irrespective of cost involved in our part.
• It is a situational pricing strategy but cannot be continued for long period as it has tendencies to produce
less profits if we are not near to the strength of the market leader in terms of cost of funds and cost of
operations.
Value Based Pricing
• In this method, pricing of loan product is carried out based on the value we are getting from the
particular customer.
• It generally cares both cost plus approach and market based approach for pricing along with the
assessment of total business coming from the particular customer.
• If a chunk of non-fund-based business and remittance business is coming along with the loan customer,
concessional interest rate, discounted services fees and rebate on exchange rates may be offered to
such customer.
Base Rate
• We all know that commercial banks are responsible profit making institutions, it is obvious that they
have a tendency of fixing the higher rate of interest for the loans. Customers were constantly
complaining about the sudden unexpected rise in interest rates on loans without their consent by
addressing them as a new and suited booted version of traditional greedy money lenders.
• To overcome this situation, NRB has introduced the concept of base rate while pricing the loans. Bank
now charges interest rate which is the addition of the customer/product specific premium rate and the
base rate of the bank.
• The base rate of the bank keeps on changing and the bank need to calculate its base rate using the
formula prescribed by NRB and publish it each month.
• The premium rate once fixed cannot be changed without the consent of the borrower hence the bank
has to lower or increase the interest rate as per the movement of its base rate each quarter.
• Initially banks were eligible to change the whole part of the interest rate but now they cannot change
the premium part without the consent of the borrower and the base rate part also can only be changed
with the change in its computation result.
• Base rate is also the minimum lending rate for bank. Base rate system has brought some transparency
in loan pricing otherwise the various ill practices existed in the banking industry due to cut throat
competition

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 • Interest Rate (Applied to the customer)= Base Rate of the Bank (Changes each quarter) + Premium
rate charged to the party (Constant)
• NRB has prescribed the following formula to compute the base rate.
Base Rate = Cost of fund + Cost of CRR + Cost of SLR + Cost of Operating Expenses + Return on Assets
Where,
Cost of Funds = Monthly Average Cost of Funds of LCY deposits and LCY Borrowings

Cost of CRR= Av. Amount of compulsory deposit * Cost of funds

Average Deployable funds
Average Deployable funds= Avg. LCY deposits + Avg. LCY Borrowings – Average Amount of SLR
Cost of SLR = Net SLR amount * (Cost of funds-Avg. return of Govt Sec.)
Average Deployable funds
Net SLR Amount = Avg. SLR Amount - Avg. CRR Amount
Cost of operating Expenses = Annualized operating cost * 85%
Average Deployable Fund
Return on Assets = 0.75% fixed by NRB

UNIT 7: ASSET-LIABILITY MANAGEMENT (ALM)

• ALM is the process by which BFIs can decide appropriate mix of assets and liabilities in consistent to
the level of risk they are prepared to tolerate. It can be considered as a mechanism to mitigate risk
caused by a mismatch between assets and liabilities resulted from the change in liquidity and market
interest rates.
• In the process of ALM, a bank involves in strategic management of its balance sheet giving due priority
to liquidity risk and interest rate risk.
Maturity Mismatch
• The maturity mismatch between assets and liabilities affects the net interest income of a bank. The net
interest income (NII) of the bank is the difference between interest income and interest expenses.
• In particular, banks make loans with many different maturities and also use deposits with many
different maturities. Therefore, net interest income of banks depends on the interest income on loans,
interest paid on deposits, the amount of loans and deposits, and the earnings mix of loans and deposits.
Suppose a bank has raised funds as follows.
• From Equity Capital : Rs.20.00 Crore
• Eight percent, 90 days deposits : Rs.80.00 Crore
• Out of the fund , the bank invests on 12% fixed interest loan of Rs.100.00 Crore.
• NII= interest income-interest expenses =12-6.4 =5.6 crore
• NIM =NII/Earning asset= 5.6%

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 • After 90 days, when the existing deposit matures and the new deposit costs more i.e.,9% then,
• NII=12-7.2 =4.8 crore, NIM=4.8%
• But if both are at floating rate or of same maturity timing or no mismatch in maturities and interest
rates, what would have been the scenario?
Interest Sensitive Assets and Liabilities
Rate Sensitive Assets (RSA) are those whose interest income changes with the change in market interest rate.
Accordingly, rate sensitive liabilities (RSL) are those whose interest expense changes with the change in
market interest rate. In the case of non-rate sensitive (NRS) assets and liabilities, their interest income and
expenses do not vary with the change in market interest over a given time horizon.
Eventually all the assets and liabilities are rate sensitive.
• The net effect of interest rate change in the balance sheet of a bank is calculated by the calculation of
change in net interest income.
• In the below table: RSA = 85 M and RSL= 115M
Interest Rate Risk
• Interest rate is associated with an adverse change in net interest income of BFIs due to the change
in market interest rate. Such an adverse change in net interest income results due to the maturity
mismatch between interest rate sensitive assets and liabilities.
• Interest rate risk for BFIs arises due to several other risk factors. They are repricing risk, yield curve
risk, interest rate level risk, basis risk, and embedded option risk.
• BFIs can use two approaches in managing interest rate risk. Making on-balance sheet adjustments and
using off-balance sheet derivatives.
• On –balance sheet adjustment refers to the adjustment in bank’s assets and liabilities in the balance
sheet to reduce the impact of interest rate changes.
• A bank can also manage interest rate risk by using off-balance sheet derivatives. These are called off-
balance sheet adjustments because they do not affect assets and liabilities in the balance sheet. Two
popular off-balance sheet derivatives are interest rate swap contract and interest rate future contract.
Determinant of Interest Rate Risk
• Repricing risk: It arises due maturity mismatch of assets and liabilities, for example if a loan of 9%
fixed yield is given for 4 years out of 6%, 6 years fixed deposit and after 2 years the lending rates go
down to 7% as bank will experience decrease in net interest income out of this event, this risk
is repricing risk.
• Yield Curve Risk: Sometime the value of a bank sharply decreases as per the movement of the yield
curve in the economy despite of hedging. Such risk is hard to be managed and called yield curve
risk.
• Interest rate Level Risk : In some instants, changes in market and regulatory intervention may
influence BFIs to restructure the rates
• Basis Risk : Sometimes, risk arises due to mismatch of hedge positions. If there is imperfect correlation
between the rates pattern of various instruments used to hedge risk, the bank is exposed to basic risk.
It is solely associated risk due to the reason that the investment is not exactly offset by the hedge.
• Embedded Option Risk: Optional risk in various loan and deposits are the reason of this type of risk. For
example, deposits can be withdrawn in between whereas loans can be prepaid by paying some charges.

29
 Such a situation again creates repricing risk. Such a risk happens in banking and cannot be avoided as it
is part of the features of the banking products etc. Such risks are called embedded option risk.
Acceptable Level of Interest Rate Risk
• Profitability: Banks need to take some level of interest rate risk in order to make profit. It is
universal for every business that if there is risk there is return and how much risk is to be taken is
related to your risk appetite. If you have sufficient knowledge, experience, and capacity to forecast, it is
better to take the risk in order to maximize the net interest income.
• Customer’s Desire: Sometime in order to cater the preference of the value customers also, bank is exposed
to take interest rate risk. The bank may have made up its mind to increase the portion of RSA, but the
customers may request fixed rate deposits or loans instead. In such a situation, a bank cannot neglect the
choices of the valued customers due to long back and prospective business relations with them.
• Management Expertise and Preference
It is also dependent on the expertise and risk preference of the management of the bank. It is their point of
view to be insulated with such rate change and ensure level of same NII or to gain more profit out of the
opportunities based on efficient forecast and exposure taking in the direction of the interest rate
change. It is all about taking defensive strategy or aggressive strategy.
Management of Interest Rate Risk
From on-balance sheet adjustments
Required adjustments are made to the RSA, RSL regarding maturity, pricing, and payment schedule. For
example, if the bank has invested in fixed long-term loan from short term deposit, if the interest
rate rises, the cost of funds can rise eventually creating shrinkage in net interest income. In such a
condition, the negative movement of the NII can be neutralized by adding long term deposit in liability side
and adding short term loans or loans floating rate loans can be booked.

From off-balance sheet adjustments

Off-balance sheet derivatives can be used to manage the interest rate risk. Interest rate swaps are a method to
change the mode of interest from floating to fixed and fixed to floating. Buying an interest rate future
contract may help to lock the future interest rate which can be an instrument to hedge the effect of the interest
rate risk.
Determination of Interest Rate
• The interest rate is just the price of credit demanded by the lender as compensation for the use of funds.
Banks use public deposits and pay interest as compensation whereas loan customers use the fund from
bank and pays interest as the compensation. The price divided by the amount of the credit is called the
interest rate both for deposits and loans.
• Interest rate is set as per demand and supply position of the loanable funds in the market. As the interest
rate starts to move, a financial institution faces various types of risks due to the movement of the
interest rate and its effect on various assets and liabilities. If RSA is more than RSL, the upward
movement of interest rate produces profit but creates losses if movement becomes just opposite.
On the other hand, the downward movement of interest rate creates profit if RSA is less than
RSL.

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Components of Interest Rate
• Interest is determined by the demand and supply of the loanable fund in the market. It is a complex
phenomenon and accurate forecasting of it is the matter of greater expertise. The interest rate attached
to multiple credit instruments have following parts.
Interest Rate= Risk Free Real rate + Risk Premiums
Risk Premium
• When the economy goes to distress, it creates many problems like reduced business activities, reduced
employment opportunities, more individuals losing their jobs due to which credit default rises. In this
situation the default premium charged to risky borrowers also rises.
• On the other hand, when prices at the market are rising, in such situation due to inflation the purchasing
power of money goes down, to compensate this, bank charges premium for loss of purchasing power
or to compensate inflation effect on their money.
• The interest fixed to various instruments also contains a premium for liquidity risk as these assets
cannot be sold to other borrowers quickly at maturity. Lastly there is a premium for call risk as well
which comes into existence due to borrower right to pay off their obligation before time or maturity,
reducing the expected return to the lender.
Interest Spread
• Interest rate spread is simple the difference between the average rate of interest earning and average
interest rate paid to the interest paying liabilities.
Interest Spread = (Interest Income) - (Interest Expenses)
Earning Assets Interest paying Liabilities
In our banking practice, the following formula is widely used to calculate the interest spread.
Spread = Inc * 365 + Is * 365 Id * 365
d1 d2 - d1 .
C+I D
Where, Ic = Monthly interest on loan
Is = Monthly income from Government securities
Id= Monthly interest expenses on deposits
d1 = days in month
d2=investment period in government securities
C = Average domestic loan outstanding
D= Average domestic deposit outstanding
I = Average investment Government securities
Gap Analysis
It is the extensively used and common technique for assessing interest rate risk. It compares the value of
assets that either mature or are repriced within a given time interval to the value of liabilities being
matured or repriced during the same time frame. The gap of RSA and RSL in a time frame is called GAP.

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If the RSA is more, it is called long position or positive gap and if RSL is more it is short position or negative
gap. If both are equal there is no gap or it is called square position.
• First of all rate sensitive assets and liabilities are segregated in different maturity time frames. The
fixed interest rate instruments of more than one year period of time remaining are not included as
RSAs and RSLs. The assets and liabilities that have short maturities have more interest rate sensitivity
and with long maturities have less rate sensitivity.
• Gap analysis helps the bank to take preferable strategies, if they want to insulate the risk of interest
rate fluctuation, such gap should be managed as zero or near zero, this is called defensive strategy. On
the other hand, if a bank wants to earn from the fluctuating interest rate, the positive gap will help to
increase net earning in rising market whereas negative gap will help to increase net earning when there
is fall in interest rate in the market
Maturity Gap Analysis
• A maturity gap which is also termed as a rupee gap is the difference in rupee amount between rate
sensitive assets and rate sensitive liabilities.
GAP = Rate sensitive assets (RSA)- Rate Sensitive Liabilities (RSL)
• It is expressed in absolute terms hence is not comparable among the different institutions. For it,
relative position of interest rate sensitivity is conducted by calculating the relative gap ratio and
interest sensitive ratio.
Relative Gap ratio = . Gap .
Total Assets
Interest-sensitive ratio = RSA
RSL
At a given point of time, bank may be either asset sensitive and liability sensitive. risk. The gap as well as
relative gap ratio is positive and interest sensitive ratio is more than 1 , the bank is assets sensitive. If
the gap as well as relative gap ratio is negative and interest sensitive ratio is less than 1, the position is
liability sensitive. If there is no gap and the interest sensitive ratio is one, the bank is insulated from
interest rate

Maturity Gap Analysis

Effects of interest rate changes in profitability
Effect of interest rate change is always measured by the change in NII (Net interest Income). Change in NII
(ΔNII) in terms of GAP and change in interest rate (Δi) is calculated by the below formula.
ΔNII = GAP * (Δi)
New NII= Old NII + ΔNII
NIM = New NII
Earning Assets

Managing Interest Rate Risk with Maturity Gap Analysis

• Banks with defensive strategy likes to manage the rate sensitive assets equal to the rate sensitive
liabilities in terms of maturity profile so that any movement of interest rate cannot shake the NII nor
volatility of NII can be maintained at the minimum level.

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 • Bank with aggressive strategy always try to increase NII when interest rate fluctuates. They use
efficient forecasting and analyzing techniques to do so. If the rates are forecasted as rising in future,
the bank increases investment in RSA and tries to maintain positive gap. On the other hand, if interest
rates are forecasted as falling in future, the bank will reduce its RSA and increase RSL creating a
negative gap so that same can be fulfilled with funds at lower rates.
Problems and Limitations with Maturity Gap Analysis
• Problem of time horizon: This method assumes that the liabilities and assets both can be easily repriced
at the date of maturity itself which is not the real scenario of the market. To overcome such
limitation, the analysis should be done on different maturities and different incremental gap rather than the
whole concept. This will also not eradicate the effect completely but take us to the near possible scenario.
• Problem of correlation with the market
In this method, it has been assumed that there is a cent percent correlation between market interest
rate and interest rate in assets and loans. But in the real scenario, many variable or floating rate interest
cannot be adjusted as quickly as expected. For example, loan on home loans being a floating rate, is
practiced being updated after an extended period only. For such a situation, banks can use standardized gap as
a solution. For example, a bank has Rs.100 M in certificate of deposits liability and Rs. 200 M invested in
commercial paper resulting in a positive gap of Rs.100M. Now assume rate of CD is 100% volatile and
rate of commercial paper rate is 40% volatile as 90 days treasury bill. The standardized gap will be -
20M.
• Focus on net interest income only
It considers raising the running year profit rather than increasing the shareholders’ wealth. While adding NII,
volatility may be added resulting in a decrease in share value in the market.

Duration Gap Analysis

Duration gap analysis is the alternative approach of interest rate risk management. It simply refers to the
weighted average time period required to realize cash flows from investment.
Duration gap is the difference between the duration of asset portfolio and liability portfolio of a bank. It
explains, how change in interest rate affects net worth of the bank and its equity price in the market.
Equity is simply the context of duration gap which is the difference between bank’s assets and liabilities.
From the above table:
DA = Weighted average of duration of all assets =( 2*3000/10000) + ( 8*6000/10000)
= 54000/10000=5.4 yrs.
DL = Weighted average of duration of all liabilities= ( 2*5000/9000) + ( 4*4000/9000)
= 26000/9000= 2.89 yrs.
In this case, we can compute duration of equity by the following method or formula,
DE = DA * A - DL*L = (5.4 * 10000/1000 )- (2.89 *9000/10000)
E E
= 54-2.60 =51.40 yrs.
Dgap = DA- WDL = 5.4-(9000*2.89/10000) = 5.4-2.60 = 2.80
In this case Dgap = 2.80 years

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Duration Gap Analysis
More is the positive duration gap, more will be the effect of the interest rate increase on the net worth of the
bank. On the other hand, more is the negative duration gap, more will be the effect of the interest rate decrease
on the net worth of the bank.
In such situation change is net worth is given by below formula,
%Δ net worth = - Dgap * Δi .
1+i
Where, Δi = Change in interest rate
i= current interest rate
For above example, if existing interest rate is 10% and now change in interest rate is 1% then,
%Δ net worth = - Dgap * Δi . = - 2.8 *1 = -2.545%
1+i 1+0.1
It means net worth will decrease by 2.545%, and in amount as below
Δ net worth = %Δ net worth * Total assets= -2.545% * 10000 = -254.54 M
Managing Interest Rate Risk with Duration Gap Analysis
• The direction of change of value of equity in response to given change in market interest rate depends
upon the positive or negative duration gap. A positive duration gap is the situation where the
duration of assets exceeds the same of liabilities and vice versa.
• For a positive duration gap, increase in market interest rate declines the net assets value while
decrease in market interest rate appreciates the net assets value. On the other hand, for negative
duration gap, rising of market interest rate increases the net worth but the falling market interest rate
decreases the net worth. Increase or decrease of net worth has similar movement relation to that of
equity prices in the market.
• Bank with aggressive strategy always try to maintain negative duration gap if it forecasts that the
interest rate are rising and vice versa to take maximum benefit of the opportunity created by the
fluctuations.
• Bank with defensive strategy focuses on minimum difference between duration of assets and
duration of liabilities so that the effect of the market interest rate change could be insulated.

Problems and Limitations with Maturity Gap Analysis

• Problem of effective immunization
Maturity gap analysis will act correctly on the price of equity if the interest rate at all maturities changes by
exactly the same rate in which the market rate changes. But in reality it is not possible, usually short-term
interest rate may move up and down at the required rate but for long term same change magnitude in rates
can’t be possible.
• Absence of linear relationship
There is no clear-cut linear relationship between interest rate change and change in price of equity. It may be
correlated for small changes only. On the other hand, the market responds more while rates are declining
then when rates are rising.
• Problem of linear drift

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Duration drift is another problem of the technique. It is the change in duration of a particular financial
instrument attributable to the passage of time. Due to this feature, zero duration portfolio may have positive
or negative duration. It happens when some items in the portfolio have a faster rate of decrease in duration.

Asset Liability Management Committee- Structure

• Senior management participates in integrating the bank’s basic operations and strategic decision
making with its risk management policy providing limits to risk exposure.
• High level committee of executives to manage assets and liability to maximize profit by managing the
risk arising from maturity mismatch and any change in market conditions is called ALCO. Senior
executives of the key area of the bank are the members of ALCO.
• ALCO ensures the adherence of limits sets by the bank’s board risk management policy.
• ALCO decides the mix of assets and liabilities in terms of business strategy and risk management in
line of predetermined budget and risk management policy.
• ALCO is the decision-making authority regarding the planning of the balance sheet items from the
perspective of expected return and associated risk profile.
• Maintains liquidity and manages interest spread to the maximum possible limit
• ALCO meeting to be held at least quarterly and annually updates the liquidity and fund management
policy of the bank.
• Mainly takes care about market and liquidity risks
• ALCO deals with pricing guidelines of assets and liabilities, setting limits for liquidity and interest rate
risk, ensuring contingency plans to cope up the situation to prevent bank from the funding crisis etc.

Role and Responsibilities of ALCO

• Develops and maintains appropriate risk management policies and procedures, MIS reporting, limits,
and oversight programs.
• Monitors the composition of bank’s asset and liabilities
• Finds out the gap between both
• Develops and identifies maturity profile of assets and liabilities
• Reviews and documents banks funding policy
• Decides the transfer pricing policy of the bank
• Evaluates market risk for new products
• Reviews deposit pricing strategies
• Review reports on liquidity and market risks and do capital management decisions
• Reviews contingency plan for liquidity management
• Identifies balance sheet management issues leading to under performance and reports to the board.
• Reviews deposit policy and ensures sustainable funding for the balance sheet.

Liability mismatch
Outflows are more than inflows. managing the situation is based on time availability.

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  short-term borrowing
 Sell securities, shares etc.
Assets mismatch
 It occurs when inflows are more than outflows. The excess money should be deployed in profit
generating avenues.
 Government bond and securities
 Shares of good companies.
 Any other legal investment.
Definition: CAMELS Rating is the rating system wherein the bank regulators or examiners (generally the
officers trained by RBI), evaluates the overall performance of the banks and determine their strengths and
weaknesses.
 CAMELS Rating is based on the financial statements of the banks, Viz. Profit and loss account, balance
sheet and on-site examination by the bank regulators. In this Rating system, the officers rate the banks
on a scale from 1 to 5, where 1 is the best and five is the worst. The parameters on the basis of which
the ratings are done are represented by an acronym “CAMELS.”
 Capital Adequacy: The capital adequacy measures the bank’s capacity to handle the losses and meet
all its obligations towards the customers without ceasing its operations. This can be met only on the
basis of the amount and the quality of capital, a bank can access. A ratio of Capital to Risk Weighted
Assets determines the bank’s capital adequacy.
 Asset Quality: An asset represents all the assets of the bank, Viz. Current and fixed, loans,
investments, real estate, and all the off-balance sheet transactions. Through this indicator, the
performance of an asset can be evaluated. The ratio of Gross Non-Performing Loans to Gross
Advances is one of the criteria to evaluate the effectiveness of credit decisions made by the bankers.
• Management Quality: The board of directors and top-level managers are the key people who are
responsible for the successful functioning of the banking operations. Through this parameter, the
effectiveness of the management is checked out such as, how well they respond to the changing
market conditions, how well the duties and responsibilities are delegated, how well the compensation
policies and job descriptions are designed, etc.
• Earnings: Income from all the operations, non-traditional and extraordinary sources constitute the
earnings of a bank. Through this parameter, the bank’s efficiency is checked with respect to its capital
adequacy to cover all the potential losses and the ability to pay off the dividend. Return on Assets
Ratio measures the earnings of the banks.
• Liquidity: The bank’s ability to convert assets into cash is called liquidity. The ratio of Cash
maintained by Banks and Balance with the Central Bank to Total Assets determines the liquidity
of the bank.
• Sensitivity to Market Risk: Through this parameter, the bank’s sensitivity towards the changing
market conditions is checked, i.e., how adverse changes in the interest rates, foreign exchange rates,
commodity prices, fixed assets will affect the bank and its operations.
• Thus, through CAMELS rating, the overall financial position of the bank is evaluated and the
corrective actions, if any, are taken accordingly.
• In finance, an asset–liability mismatch occurs when the financial institution's assets and liabilities do
not match. Several types of mismatches are possible.

36
 • For example, a bank that chose to borrow entirely in US dollars and lend in Russian rubles would have
a significant currency mismatch: if the value of the ruble were to fall dramatically, the bank would
lose money. In extreme cases, such movements in the value of the assets and liabilities could lead
to bankruptcy, liquidity problems and wealth transfer.
• A bank could also have substantial long-term assets funded by short-term liabilities, such as deposits.
• If short-term interest rates rise, the short-term liabilities re-price at maturity, while the yield on the
longer-term, fixed-rate assets remains unchanged.
• Income from the longer-term assets remains unchanged, while the cost of the newly re-priced liabilities
funding these assets increases.
• This is sometimes called a maturity mismatch, which can be measured by the duration gap.
• An interest rate mismatch occurs when a bank borrows at one interest rate but lends at another. For
example, a bank might borrow money by issuing floating interest rate bonds but lend money
with fixed-rate mortgages.
• If interest rates rise, the bank must increase the interest it pays to its bondholders, even though the
interest it earns on its mortgages has not increased.
• Mismatches are handled by asset liability management.
Determination of Rate of Interest
• The rate of interest will be determined by the equilibrium between the total demand for loanable funds
and the total supply of loanable funds.

'Asset-Liability Committee - ALCO'

• An asset-liability committee (ALCO), also known as surplus management, is a supervisory group a
company employs for coordinating the management of assets and liabilities with a goal of earning
adequate returns.
• By managing a company's assets and liabilities, executives are able to influence net earnings, which
may translate into increased stock prices.

Assets liability management Committee

 Bank should develop appropriate structure for managing overall liquidity of the bank. An ALCO
performs the function of liquidity risk management.
 Ideally ALCO comprises of senior management from each key area of the bank that assumes and
manages liquidity risk.
 It is important that these members have clear authority over the units responsible for executing
liquidity-related transactions so that ALCO directives reach these line units unimpeded.
 The ALCO should meet on a regular basis. Responsibilities of ALCO include developing and
maintaining appropriate risk management policies and procedures, MIS reporting, limits, and oversight
programs.
 ALCO usually delegates day-to-day operating responsibilities to the bank's treasury department.
 However, ALCO should establish specific procedures and limits governing treasury operations
before making such a delegation.

37
  To ensure that ALCO can control the liquidity risk arising from new products and future business
activities, the committee members should interact regularly with the bank's risk managers and
strategic planners.
 Liquidity Risk Management Process An effective liquidity risk management includes systems to
identify, measure, monitor and control its liquidity exposures.
 Management should be able to accurately identify and quantify the primary sources of a bank's
liquidity risk in a timely manner.
 To properly identify the sources, management should understand both existing as well as future risk
that the bank can be exposed to.
 Management should always be alert for new sources of liquidity risk at both the transaction and
portfolio levels.
 Key elements of an effective risk management process include an efficient MIS, systems to measure,
monitor and control existing as well as future liquidity risks and reporting them to senior management

Management Information System

An effective management information system (MIS) is essential for sound liquidity management decisions.
A bank should be able to monitor its day-to-day liquidity position and Risk Management.
Liquidity MIS should be developed keeping crisis monitoring in mind. Accuracy and timeliness of information
are important elements for monitoring liquidity.
Since bank liquidity is primarily affected by large, aggregate principal cash flows, detailed information on
every transaction may not improve analysis.
• An appropriate mechanism for monitoring activities helps in proper identification of liquidity risks
through early warning indicators, which have the potential of igniting the problem.
• Management should develop systems that can capture significant information. The content and format
of reports depend on a bank's liquidity management practices, risks, and other characteristics.
• Management should regularly consider how best to summarize complex or detailed issues for senior
management or the board. Besides several types of information important for managing day-to-day
activities and for understanding the bank's inherent liquidity
• Asset quality and its trends.
• Earnings projections.
• The bank's general reputation in the market and the condition of the market itself.
• The type and composition of the overall balance sheet structure.
• The type of new deposits being obtained, as well as their source, maturity, and price.

UNIT 8: DERIVATIVES INSTRUMENTS

Definition of 'Derivatives'
A derivative is a contract between two parties which derives its value/price from an underlying asset.
The most common types of derivatives are futures, options, forwards, and swaps.
Stocks, bonds, currency, commodities, and interest rates form the underlying asset.

38
A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to
purchase the asset on a specific date at a specific price.
Derivatives are often used for commodities, such as oil, gasoline, or gold. There are derivatives based
on stocks or bonds.
The contract's seller does not have to own the underlying asset
Derivative securities may be traded on exchange or over-the- counter.
Derivatives are often traded as speculative investments or to reduce the risk of one's other positions.
Features of derivatives
1. Two parties
2. Underlying assets
3. Future contract
4. Expiration date
5. Future transaction
6. Exercise price
7. Right and obligation
8. Zero sum game
1. Two parties
Derivatives are the financial contracts between two parties. Therefore, derivative contract involves the contract
of two party’s buyer and seller of contract.
2. Underlying assets
The value of financial derivatives depends on the value of other assets. The other assets are called underlying
assets. The value of financial derivatives increases or decreases depending upon the price of the underlying
asset. Underlying assets include financial assets and commodities.
3. Future contract
Financial derivatives are the agreement between two parties to buy or sell certain assets on a certain date at
the price agreed today. All the terms and conditions of the trade are fixed today and written on a contract paper.

4. Expiration date
The length of time period of the financial contract is known as expiration date. Financial derivatives will
expire after a period of time.
5. Future transaction
Derivatives are an agreement for a future transaction. The life of a derivative contract is determined at the
time of contract. The actual transaction delivery of assets and cash payment takes place in future date. This
date is known as exercise date.
6. Exercise price
The price at which the asset will be purchased or sold is also determined at the time of contract. This price is
called exercise price or delivery price.

39
6. Zero sum game
Since there is a buyer and a seller in the contract, the payoff of these two parties is oppositely related. Neither
both parties can gain and bear loss simultaneously. The gain of one party is equal to the loss of another party.
If the payoff of both is summed up, the result is always zero.

7. Right and obligation

By contract, derivatives are obligatory for the two parties. However, there are some derivatives which give
right to one party and obligation to another party. The buyer must buy the underlying and seller must sell.

Types of financial derivatives

Options
An option is a contract between two parties a buyer and a seller that gives the buyer the right, but not the
obligation, to purchase or sell something at a later date at a price agreed upon today.
The option buyer pays the seller a sum of money called the price or premium. The option seller stands ready
to sell or buy according to the contract terms.
Most of the options are traded on organized exchanges.
An option to buy something is referred to as a call option and an option to sell something is called a
put.
Features of option
1.strike price(Exercise price)
2. The option buyer
3. The option seller( option writer)
4.Expiration date
5. Underlying assets
6. Moneyness.
• An option is classified as either in the money, at the money or out of money.
• It is called at the money if the strike price equals in market price of the stock.
• MPS> strike price: In the money
• MPS< strike price: out of money
Types of options
1.Call option
2. Put option
• A call option or call contract grants the holder the right to buy an underlying assets for a fixed exercise
price before a specified date.
• Put option: Put option gives the right to sell the underlying assets at a specified price within a specified
period of time.

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A forward contract is a customized contractual agreement where two private parties agree to trade a
particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded
privately over the counter, not on an exchange

Forward contracts have the following features.

• The delivery of assets and payment will be in predetermined future date.
• Realization of gain/loss happens in the same future date
• Any term can be negotiated between the parties hence is not standardized.
• Since not standardized, it can be traded in OTC market not through organized exchange.
• Credit and default risk is high as there is no involvement of the exchange in between. The party
involved in the contract can breach the contract. Since it is a private contract between two parties,
margin is also not required which further increased the risk factor.
• They tend to be held till maturity and produce no liquidity in between.
• Being private contract, there is no regulatory agency. Terms and conditions are fixed and amended by
the involved parties. It is a very flexible instrument.
• It is done from OTC market by dealers. Dealers quote both buy and sell price. The bid ask spread can
be treated as compensation for unbalanced position or cost of forward contract.
Forward Rate Agreement
• A forward rate agreement is an over-the-counter agreement between borrower and lender to lock in the
interest rate for some short period. The lock-in starts for a period up to three months which begins after
a predetermined future date.
• FRA protects borrowers from rising interest rates and lenders from falling interest rates. Counterparties
of FRA can continue their borrowing and lending through normal channels after entering into an FRA.
Points to be remembered
• The time prior to the beginning of FRA is called its forward term.
• The contract term is the actual period covered by the FRA contract.
• The settlement rate is the reference rate at the maturity of FRA contract.
• Reference rates are fixed on the basis of references from companies like LIBOR and MIBOR.
A futures contract — often referred to as futures — is a standardized version of a forward contract that is
publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon
price and time in the future to buy or sell an asset — usually stocks, bonds, or commodities, like gold.
• Futures contracts have the following features.
• It is carried out in organized exchange instead of OTC market.
• The delivery of assets never takes place other than virtual settlement between the parties for
difference in cash between contracted price and actual price at the given maturity date.
• A future contract requires a margin to be posted at the contract initiation and realization of
gain/loss happens on a daily basis or money must be added to cover the daily losses thereon.

41
 • It is done in standardized manner with standard specified quantity, grade, coupon rate , maturity
as decided by the exchange or general practice. Standardization of the contract fetches more
respective buyers and sellers. For example, a unit of one hundred shares of a company can be
a future contract.
• Credit and default risk is zero as the obligation of both parties is with the organized exchange.
In practice, the clearing house acts as the counter party for all future contracts hence there is
no issue of default or credit risk. The transactions are transparent, and the future market is
regulated by the Government.
• Future contracts are liquid as they can be traded any time before maturity with the exchange.

The main differentiating feature between futures and forward contracts — that futures are publicly traded
on an exchange while forwards are privately traded — results in several operational differences between them.
This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market,
price transparency, and efficiency.

Forward Future

1. A forward contract is an agreement 1. A futures contract is a standardized

between two parties to buy or sell an asset contract, traded on a futures exchange, to
(which can be of any kind) at a pre-agreed buy or sell a certain underlying instrument
future point in time at a specified price. at a certain date in the future, at a specified
price.
2. Usually no initial payment required. 2. Standardized. Initial margin payment
Usually used for hedging. required. Usually used for speculation.
3. Negotiated directly by the buyer and 3. Quoted and traded on the Exchange
seller
4. Not regulated 4. Government regulated market (the
Commodity Futures Trading Commission
5. High counterparty risk 5. Low counterparty risk

6. No guarantee of settlement until the date of 6. Both parties must deposit an initial
maturity only the forward price, based on the guarantee (margin). The value of the
spot price of the underlying asset is paid operation is marked to market rates with
daily settlement of profits and losses.

7. Forward contracts mature by delivering the 7. Future contracts may not necessarily
commodity. mature by delivery of commodity.
8. Primary & Secondary 8. Primary

Swap
• A swap is an agreement for a financial exchange in which one of the two parties promises to make,
with an established frequency, a series of payments, in exchange for receiving another set of payments

42
 from the other party. These flows normally respond to interest payments based on the nominal amount
of the swap to some notional amount.
• It involves payments in different dates. The contract date is the initiation date, the end date of contract
is termination date and dates, in which payments are made, are settlement dates and period between
settlement dates is called settlement period.
• Swap does not need initial upfront payment and it is of zero value at the issuance, but its value may
move upward or downward along with the settlement dates to come for the swapped instrument.
• It is traded with OTC market hence bears counterparty default or credit risk.
• In many respect, it is similar to forward contracts other than the fact that forward contracts end with a
single payment, but swap contains series of payments.
• Forward and swaps are the instrument designed to hedge anticipated risk for individuals and
corporations towards projected future from interest rate change and change in currency value.

Features of Swap
• There is always involvement of two parties.
• It is traded in the Over-the-Counter market hence bears a high degree of counterparty default risk.
• Its initial value is zero, but the value may increase or decrease upon future events.
• Settlement is made in multiple payments throughout the period.
• It is unregulated and privately traded. No margin is required for the transaction. It does not produce
liquidity in between.

Termination of Swap
• The involved customer can enter in other offsetting swaps with other parties.
• Executing cash settlement with the counter party.
• Selling the swap to other party by obtaining permission from the counter party.
• Swaption: giving right to enter into another swap at the term decided in advance
Types of Swap
• Interest Rate Swap
• Exchange Rate Swap or Currency Swap

Interest Rate Swap

• It is a contractual agreement in which two parties agree to exchange the interest payments for an agreed
period to a notional amount in a specified currency. No exchange rate effect should be considered as
the swap is arranged for two payment series but in the same currency. By entering into an interest rate
swap, one firm may exchange a fixed rate debt obligation into floating rate debt obligation with another
party and vice versa.
• Such an exchange can be done with exchanging payments on the basis of fixed and floating interest
rates and both floating interest rates but formulated with different bases like LIBOR, treasury bills etc.
• It is the exchange of one interest rate payment with another interest rate payments for the same amount
of principal amount in a particular currency. The gain/loss can be calculated at the time of settlement.

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 • It gives flexibility to a company with good cash flow to opt for fixed interest payment in case of
floating rate and the counter company to opt floating interest rate instead of fixed interest rate by
entering into a contract.

Exchange Rate Swap

• It is a contractual agreement between two parties to exchange loans, interest payments and repayment
of principal of the loan obtained in different currencies. The motive of the swap is to be safe from
exchange rate change.
• In a well-developed market, there is the existence of swap banks (intermediary) where each
counterparty can make their contract and there is no need of wandering around in search of other
company who is willing to swap their certain currency debt obligation in which we want to change our
debt exposure and vice versa.
Credit Derivatives and Credit Default Swap
• Credit derivative allows to shift the credit risk to the third party. In this case the third party acts similar
to the insurance company. Credit default swaps are the commonly used example of credit derivative.
• In this type of derivative product, the lender goes to another party (other than the borrower) to enter
into a contract that the lender will be paid by the party if the original borrower defaults on the loan. In
this case, the involved third-party acts as insurance company and charges premium or commission to
enter into such contract. Another party of the contract will be obliged to pay the lender the total
unrecovered principal and interest in the even only if the original borrower fails to pay it.
• Big business houses and money rich corporates enters into such contract against risky assets like
investment in non-Government commercial papers and bond and foresee credit risk from the part of
the bond issuer.
Risk Associated with Derivative Products
• Counterparty Default Risk
This sort of risk arises when one party to the contract is unable to perform as per contract. As most of
the derivative’s transactions are done on the OTC market, there is always a high chance of occurrence of
counter party default risk due to absence of structured exchange house as the transaction intermediary. A
trading exchange house always helps to facilitate the contract performance by requiring a margin which needs
to be adjusted daily on a marked to market basis.
• Market Risk
Market risk refers to the risk of loss with the change in price of the underlying asset. Every investment
decision is carried out by forecasting market condition based on assumption and interpreting how our
investment will perform in such an anticipated situation. Hence, there is always a chance of negative effect or
loss if market movement happens to be in the direction other than the predicted one.
• Liquidity Risk
It is applicable to those investor who plan to close out a derivative trade prior to maturity. Such investor
needs to consider if it I difficult to close out the trade or if existing bis-ask spreads are so large as to represent
a significant cost.
• Interconnected Risk
Some analysists have expressed deep concern about the possibility of chain reaction or snowball effect to the
overall stability of market of financial derivatives when one major player in the market comes into a
problem. This sort of risk is termed as interconnected risk

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CHAPTER-9: INVESTMENT PORTFOLIO AND LIQUIDITY
MANAGEMENT
 Investment portfolio is the combination of different assets.
 It is a collection of investment instruments like common stock, preferred stock, bond, FD, and other
cash equivalent assets.
 Portfolio management practice runs on the principle of minimum risk and maximum return
 A portfolio is constructed on the basis of income, budget, risk bearing level etc.

Objectives of portfolio investment

• Income
– To earn income from the invested securities.
– To stabilize the income of the bank when other income falls with optimum use of funds
• Appreciation
– The value appreciation is other form of income from the investment. It is just the increase in
book value and materializes when it is liquidated.
• Safety and Liquidity
– Investment is more liquid earning asset than loans and advances
– In case of the urgency of liquidity, such instruments can be easily sold or kept as security to
manage funds.
• Hedge against inflation
– Keeping funds only for liquidity without making investment will deprive investors not only
from the running income but also exposes to inflation effect which devaluates the purchasing
power of money.
• Tax planning
– Investment in CIT, life insurance and PF for individuals are tax exempted to a level , hence it
is used for tax planning especially by the salary getters.

Importance of portfolio
• Diversification and flexibility
– It aids diversification and flexibility in the assets and liability structure of a bank. Bank can
restructure its asset liability position by altering the investment which can be added or
liquidated more easily than loan and advances
• Potential
– Individual investors can open potential for future growth through small amount investment
from their early days of employment. Otherwise, the salary or earning of a normal investor will
end up with the job life leaving no amount for future. SIP is an example of it, which we should
stat from early days for glorious future.
• Stability or assistance in Income

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 – By building an appropriate investment portfolio, an investor can ensure medium of regular
income.
– Bank can also ensure additional income from the idle fund if efficiently managed in the
investment portfolio
• Liquidity
– The investment made in financial instruments can be made liquid in nominal time if required.
Funds can also be borrowed against the collateral of such securities.
• Others
– Funds can also be borrowed against the collateral of such securities.
– Provides hedge for risk arising from change in market interest rate
– It being quality instruments increases the financial health of a bank.

Investment instrument
Money Market Instruments
The segment of the financial market which deals with short-term debt instruments is called the money market.
The average maturity period of money market instruments is up to one year. Due to shorter maturities, they
are highly marketable and near to money financial instruments. For example, treasury bills, commercial paper,
certificate of deposit etc. Various money market instruments have the following common features.
o They are of larger denominations
o Have maturities up to 1 year.
o Have extremely low default risk hence return may also be low
Capital Market Instruments
The segment of the financial market which deals with long-term financial instruments is called capital market.
In this market debt instruments of more than 1 year period and equity instruments are traded. It also facilitates
as the financial intermediary to transfer funds from surplus sector to deficit sector in the economy. The
existence of such a market has made the liquidity of long-term instruments possible where they are traded
between buyers and sellers. Such instruments are common stock, preferred stock, bonds, dentures, treasury
bond, government bond, municipal bonds etc.
• Treasury Bills
Treasury bills are the short-term instrument issued by the Government. It is termed as a highly liquid and risk
free money market instrument. It is issued with the four maturities: one month, three months, six months and
one year period. Treasury bills do not have fixed interest rate or any coupon rate. It is issued at a discount from
face value and the investor will be paid with the face value at maturity, the discount is the benefit or
compensation while investing in treasury bills.
• Commercial papers
Commercial papers ae the short-term instruments issued up to the period of 270 days by the big corporate
houses in order to cater their working capital requirements. Only reputed and creditworthy corporates are
eligible to issue this instrument at the money market. It is slightly riskier than the treasury bills. Commercial
paper has fixed coupon interest rate and issued at discount. Commercia papers can be directly purchased from
the issuer or from the dealer.
• Banker’s Acceptance

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It is a draft accepted by banks and used in financing domestic and foreign trade. The buyer ensures payment
to the seller through its bank by issuing written promise on its behalf, authorizing the seller to draw a time
draft (specified amount at specified date) on the bank for the payment of the sold goods. Letter of credit is an
instrument under banker’s acceptance. It is traded in discount.
• Certificates of deposits
It is evidence of the funds deposited at the depository institutions for the specified period at a specified interest
rate. Banks purchase such certificates of deposits as a lower risk investment. They can be of smaller and larger
denominations. They are negotiable instruments and can be sold in between. It gives slightly higher yields
than the treasury bills. High denomination CDs are traded through the dealer also.
• Open Market Operations
It is a money market instrument exercised by the central bank only on its own account to control the liquidity
or money supply in the market. It sells Government securities in the market if there is need to absorb excess
liquidity prevailing in the market. On the other hand, the central bank buys the Government securities from
the licensed financial institutions if it sees that liquidity or money supply is low in the economy.
• Interbank Lending
It is the management of excess liquidity within the banking sector. If a bank needs fund temporarily at the
same time another bank may be at the position of surplus. In such conditions, they lend and borrow from each
other to meet the short-term liquidity requirement and earn from surplus money. The rate of interbank
transactions is fixed by negotiation between the banks on the basis of scarcity of the funds (demand and supply
of position). It is provided for overnight but may last for a week also.

Capital Market Instruments

• Treasury Bonds and Notes
It is the various types of long-term bonds issued by the Government. They are commonly known as national
development bonds and are issued up to the period of 5 o 7 years in Nepal. Contrary to this, in the US, such
bonds are issued up to the period of 30 years, such instruments if issued with maturity periods up to 10 years
are called treasury notes in US. Since it is a long-term instrument, it has a higher coupon rate than the treasury
bill. Banks invest in this instrument due to applicable zero capital charge and being a credit risk free
instrument. They pay interest on a semiannual basis. Some of such instruments may have callable features as
well.
• Treasury Inflation Protection Security
This is the next variant of treasury security. The interest rate is fixed for such securities via auction process.
On the other hand, the face amount of the securities is adjusted to the inflation rate semiannually, which keeps
on increasing. Hence the investors can arrange a hedge of inflation on its principal and some additional risk
free interest earned from the investment. This instrument is not in practice in our country but widely used in
the US.
• Agency Bonds
It is the long-term bond issued by the Government owned agencies. The bonds issued by NRB can be treated
under this segment. On the other hand, Government sponsored organizations also issues such instruments,
likewise Nepal Electricity Authority had issued such bonds few years back which have been now fully repaid.
• Municipal Bonds
It is issued by the local government in order to finance various infrastructure projects. They are issued if for
the purpose of financing priority infrastructures, interest earned from such instrument is subject to tax
exemption, but capital gain is subject to applicable tax. Such bonds are of two types.

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 – General Obligation Bond
• Bonds issued on full faith of the local Government
– Revenue Bond
• Bonds issued to be repaid by the revenue of the particular project
• Corporate Notes and Bonds
It is long term bonds and notes issued by corporations with sound financial health and creditworthiness.
Corporate notes mature by 5 years period whereas the corporate bonds get matured above 5 years. They have
predetermined coupon interest rate to be paid in predetermined periodicity and fixed date of getting the
principal back. Compared to treasury bonds, the securities have higher return as the credit risk is more. There
are various types of corporate bonds like debenture, mortgage bonds and income bonds etc. Debentures are
unsecured, mortgage bonds are backed by mortgages of physical assets and income bond holders can get
interest if earnings of the issuer have the ability to pay.
• Common Stock
Shares are the ownership instruments for any company. The common shareholders are the ultimate owners but
their liability towards the company is limited only to the value of the shares they hold. The common
shareholders have claim on residual assets only, but they have right to vote for the election of members for
Bod. They come at the last position in the priority list to get repaid for their holding if the company is
liquidated. Common shares are listed with stock exchange, and they are traded at the price fixed by the demand
and supply position in the market.
Shareholders are entitled to get two form of benefits.
• Cash Dividend
• Capital gain
Stocks are of two types
• Income stock provides higher cash dividends
• Growth stock provides higher capital gain

Open market operation

Central bank purchase securities Central bank sales securities

Bank reserves increase Bank reserves decrease

Loanable funds increase Loanable funds decrease

Interest rate declines Interest rate increases
Liquidity management
• Liquidity management is the managing asset in such a way that it can be sold in a short time without
any shrinkage in its value. When the bank is concerned, liquidity management is the ability to pay
deposit obligations, loan commitment and other expenses without having to liquidate other assets of
the bank.
• Although credit or loans and advances is the highest earning asset for a bank, bank does not invest all
of its fund in it but keeps a portion in cash and near cash assets to meet the liquidity demand. Liquidity

48
 is the main feature of the bank and an important reason for the trust of people. The focus of liquidity
management is to reduce the liquidity risk in the bank.
• There are two key functions of a bank while managing liquidity.
– Estimating liquidity needs
– Approaches to Managing Liquidity

Estimation of liquidity
Banks and financial institutions attempt to forecast their liquidity needs using several approach.
1. The sources and uses approach
2. Structure of deposit approach
3. Liquidity indicator approach
4. Market signal(discipline) approach
5. Managing mandatory requirement

The sources and uses approach

 Banks’ liquidity rises as deposits increase and vice versa.
 This approach is based on the existence of a liquidity gap between sources and uses of funds.
 If the sources and uses do not match, the bank has a liquidity gap measured by the size of the total
difference between its sources and uses of funds.
 When sources of liquidity exceed uses of liquidity, the bank will have a positive liquidity gap. Its
surplus funds must be invested in earning assets until they are needed to cover future needs.
 On the other hand, when uses of funds exceed, the bank faces a liquidity deficit, or negative liquidity
gap. The bank must raise funds from the cheapest source.
Three steps involved in this process
1. Forecast the loans and deposits for a given planning period
2. Calculate the estimated change in loans and deposits.
3. Estimate the net liquidity fund’s surplus or deficit for time period.
Estimated liquidity = estimated change in deposit- estimated change in total loans.
2. Structure-of-deposits method
The structure of funds approach is a method for estimating a bank’s liquidity needs by dividing its borrowed
funds into categories based on their probability of withdrawals and therefore lost to the bank.
The bank’s deposit and non-deposit liabilities divided into three categories.
1. Hot money: hot money liabilities are deposits and other borrowed funds that are very interest sensitive
deposits and borrowed funds that expected to be withdrawn in current period.
2. Vulnerable funds: deposits of substantial portion, 25-30% is likely to be withdrawn in current period.
3. Stable funds: management considers them most unlikely to be withdrawn in the current period.
4. A common rule of thumb for vulnerable deposit and non-deposit liabilities to hold a fixed percentage
of 30% of their total amount in liquid reserves.

49
 5. Liability reserves=0.95x(hot money funds-legal reserves)+0.30x(vulnerable funds-legal reserve
held)+0.15x(stable funds-legal reserve held)

2. Liquidity indicator approach

This approach estimates liquidity needs by relying on the use of experience and industry average.
• Liquidity Indicator Approach
In this approach, different liquidity indicators are used.
 Cash position indicator :
 cash and deposits due from depository institutions/total assets
 Higher the ratio, better is the liquidity
 Liquid Security indicator :
 Government Securities/total assets
 Higher the ratio, better is the liquidity
 Capacity ratio :
 Net loans and leases/total assets
 Higher the ratio, less is the liquidity
 Pledge Security Ratio :
 Pledged Securities/total securities
 Higher the ratio, less is the liquidity
 Hot money Ratio :
 Money market assets/Money market liabilities
 Higher the ratio, better is the liquidity
 Core Deposit Ratio :
 Core Deposit/total assets
 Higher the ratio, better is the liquidity
 Deposit Composition Ratio :
 Demand Deposit/Time Deposit
 Higher the ratio, more will be liquidity required

3. Market signal approach

This is a qualitative approach to measuring liquidity requirements of banks. It is a technique that centers on the
discipline of the financial marketplace, which subject banks to series of market tests.
I. Public confidence
II. Stock price behavior
III. Risk premium on CDs and other borrowings
IV. IV. loss sales of assets
V. V. Meeting commitments to credit customers
VI. VI. Borrowings from the central bank.

Management of Liquidity Needs

• Asset management approach
In this approach, banks focus on holding cash near cash liquid assets whenever there is liquidity surplus and
liquidate the same securities to manage liquidity position by raising funds from them. The assets liquidity
management plays the below important roles for banks and Fis.

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 – Alternative source of funds
Whenever managing liquidity is concerned, it can be managed by selling near cash assets or raising liquidity
by issuing short-term instruments like certificates of deposits or by other means like raising interbank
borrowing. If the liability to be raised in scare conditions, it always attracts a higher interest rate on
additional liabilities to be issued. In such a situation, asset liquidity management gives us an efficient and
less costly method of raising liquidity. The Liquidity raised by assets management is called internal liquidity
whereas the same if carried out from issuing additional liabilities is termed as external liquidity.
– Reserve against borrowed funds
It also acts as a reserve against borrowed funds. When bank finds itself poor at obtaining sufficient
borrowing from the market due to lack of confidence, in such situation, disposing of liquid assets is the best
source of arranging liquidity which prevents banks from being insolvent
• Liability management approach
In this approach, the bank focuses on issuing liability instruments for raising brokered deposits and other
liability instruments like interbank borrowings. Raising liquidity from money market liability instruments
differs for banks of various sizes and brand images. Larger banks can easily raise such liquidity whereas the
smaller bank may pay more cost to raise liquidity from this method.
Liability management arranges liquidity from money market instruments which is at a lower cost but raising
RSL may create additional interest rate risk to the balance sheet and profit and loss account of the bank. So
the cost factor is needed to be duly analyzed with associated exposed risk before making any decision
regarding liquidity management.
• Funds management approach
In this approach management of assets and liabilities both are taken into consideration. It evaluates the
bank’s strength in view of total liquidity sources. For its indicators like loan to deposit ratio, loan to non-
deposit labilities, unencumbered liquid assets to non-deposit labilities, near cash assets to large
denominations liabilities etc. Fund management also has to focus on changing the situation by applying the
following formula.
Liquidity ratio = Liquid assets and liabilities in period 1
Estimated Liquid assets and liabilities in period 1
If the value of the above ratio is below 1 in any period then it suggests that the bank is in hard time
managing liquidity and a more effective alternative strategy needs to be intervened.

4.Managing mandatory requirement-CRR, SLR

• Cash Reserve Ratio
– Cash with NRB 4% of total deposits
• Standing Liquidity Ratio
– Cash and cash equivalent Government bonds 12%
– Inclusive of CRR
• Liquid asset to total deposit ratio
– Twenty percent of total local currency deposit should be invested in cash and cash equivalent
assets
• Credit to deposit Ratio (CD Ratio)

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 – Only 90% of local deposit amount can be extended as credit (loans and advances)

CRR RESERVE REQUIREMENT

A Class 6%
B Class 5
C Class 4

SLR Reserve %

A 12%
B 9
C 8

 Investment portfolio is the combination of different assets.

 It is a collection of investment instruments like common stock, preferred stock, bond, FD, and other cash
equivalent assets.
 Portfolio management practice runs on the principle of minimum risk and maximum return
 A portfolio is constructed on the basis of income, budget, risk bearing level etc.

Optimum Liquidity Level of the Bank

• Managing optimum liquidity position in a bank is the task of greater challenge and expertise as it is a
dynamic concept and there is no single thumb rule to be specialized.
• If liquidity is inadequate, the bank will be unable to discharge its payment obligations to depositors
and creditors with committed credit line, hence ultimately creates the deterioration of its brand image
on the other hand managing excess liquidity increases the cost of the bank finally reducing its profit.
• Holding cash and near cash instruments for the shake of managing liquidity reduces the income as
liquidity is always embedded with associated cost.
• Bank should maintain liquidity adequate enough to address its forecasted liquidity needs. Bank
maintains all regulatory requirements imposed by NRB for maintaining liquidity in banks also
maintains some buffer to have adequate liquidity in case of any negative movements experienced in
terms of liquidity level.

UNIT 10: TREASURY MANAGEMENT FUNCTION IN NEPALESE BANKING

 The treasury department is the financial center of a bank.
 The key role of treasury is the safeguarding and stewardship of an organization’s financial assets and
the management of an organization’s financial liabilities.
 A treasury’s role is often focused on external issues like financial markets, investors, creditors,
financial institutions, rating agencies, and debt issuers.

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  Treasury is responsible for implementing various financial decisions made by management and board.
 It focuses on financial assets and liabilities management.
 It has an important role in risk reduction and mitigation.
Scope of Treasury
 Management of corporations has become increasingly transparent, and shareholders and stakeholders
are aggressive in their demands for adequate financial accountability.
 Companies are much more global in their activities.
 Financial markets are more volatile than they were 30 years ago. Changes in exchange rates, interest
rates, and commodity prices can quickly and adversely impact a profitable company.
 The treasury function in any corporate has always been important in making sure that the business has
sufficient liquidity to meet its obligations, managing payments, receipts, and financial risk effectively.
 Treasury departments need to cover the complete financial environment; from capital structure and
long-term investments to liquidity and working capital management.
Opportunities
 Current trends in global trade and supply chains are focused on changing trading patterns, volatile
commodity prices, risk mitigation and access to liquidity.
 In volatilities markets larger can become concerned about risk in their supply chains but may also
themselves have good access to liquidity and market information, while smaller companies will often
have limited liquidity, and have to carry the cost of the supply chain, with the traditional sources of
supplier funding being both expensive and inefficient.
Challenges
• Turbulent economic situation
• Globalization Effect
• Requirement of Automation
• Size of Allocated workforce
• Cost of Treasury Management System
• Complexity of System and adequate knowledge
• Routine Tasks Vs Job Retention
• Changing regulatory perspectives
Foreign exchange dealers’ association of Nepal(FEDAN)
• Established by authorized dealers to abide by the Forex regulations of NRB (NRB being the
regulator of the foreign currency management in Nepal)
• A self-regulated organization registered in the District Administration Office, which was established
in the year 1996.
• Established in order to lay down some rules in trading foreign exchange
• FEDAN has also developed some rules to protect the interests of exporters, importers, the public and
dealers.

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 • Consists of treasury dealers working in different commercial banks and other member institutions.
• Maintains close contact and bonding between dealers
• Also deals with NRB and MOF in forex issues from the part of commercial banks
Functions of FEDAN
1. To provide the platform for the treasury dealers(FEDAN’s members) to make authentic deals with
each other.
2. Timely reporting of US dollar mid-rate of FEDAN’s member to NRB at 10:00 am and 2:00 pm.
3. To deal with NRB on behalf of banking sector of Nepal, an issue relating with foreign exchange and
money market in Nepal.
4. To represent the country in front of foreign delegate concerning about the issue relating with foreign
exchange and money market in Nepal.
5. To provide the dealer membership to the treasury dealers from banks of Nepal.
6. FEDAN also conducts the timely meeting and get-together functions of their member banks treasury
dealers to discuss relevant issues relating with foreign exchange and the money market as well as to
make dealers familiar with each other’s.
7. FEDAN also acts as the dispute settlement body in case any dispute arises among the dealers.
Duties of FEDAN
1. To enlist the bank treasury dealers as authenticate for treasury deal.
2. Timely fulfill the reporting requirement of NRB
3. Deal with regulators on behalf of the banking sector in the issue of foreign exchange.
4. Represent the Nepalese sector in front of foreign delegates in the national and international seminars.
5. Conduct timely meetings of banks treasury dealers.
6. Conduct training and development activities of the bank’s treasury dealers of Nepal.
Responsibilities of FEDAN
• To report MID USD rate to NRB and member dealers by 10 AM to 2 PM each day except holiday.
• Update and enlist the authorized treasury dealers in Nepal
• Conduct regular meetings of dealers to discuss contemporary and new issues
• Timely settlement of dispute between dealers
• Work closely with NRB and MOE in case of FCY and money market
• Ensure all FEDAN members to comply the compliances relating to FCY and money market in Nepal
Concept of Nostro, Vostro & Loro Account
• Nostro Account
– Nostro Account means our account with you.
– Derived from Latin word “Noster,” which means ours
– Always in foreign currency for transaction settlement

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 – Dollar account of Nabil Bank with Amex, New York is nostro account for Nabil Bank.
• Vostro Account
– Vostro Account means your account with us.
– Derived from Latin word “Voster,” which means yours
– Always in home currency
– Dollar account of Nabil Bank with Amex, New York is vostro account for Amex, New York.
• Loro Account
– Loro Account means your account with them.
– Dollar account of Nabil Bank with Amex, New York is loro account for Citi Bank, New York.
Central bank’s regulation regarding ALM and Treasury
Nepal Rastra Bank has issued risk management guidelines 2010 for the purpose of providing guidelines to
all commercial banks on risk management.
A class commercial banks to make the risk management process efficiently.
Every bank shall endorse appropriate policies and procedures to identify, measure, monitor and manage
different types of risks.
ALCO
ALCO should have members from each area of the bank that significantly influences liquidity risk.
Central Bank’s Regulations on Liquidity Risk
• For effective liquidity risk management, a bank needs an appropriate organizational structure,
strategies, policies & procedures, limits and indicators and reliable monitoring and reporting
mechanisms. In addition, it needs an adequate information system to ensure effective monitoring of its
liquidity including those involving the loss or impairment of both secured and unsecured funding
sources.
• To ease NRB in analyzing the liquidity risk, banks should classify assets and liabilities in different
time intervals on the basis of maturity profile and such report as per form no 5.1 should be sent to
the Supervision Department within 15 days of each quarter end.
• To minimize liquidity, risk the ratio of credit to deposit (CD ratio) should not exceed 90%. The
interbank deposit should be omitted while calculating CD ratio.
• To minimize the liquidity, risk the ratio of liquid assets to deposit ratio should not come below 20%.
• The monitoring of CD ratio should be done on daily basis and the penalty shall be levied if CD ratio
exceeds the prescribed limit on monthly average basis.
• For overall management of a bank’s liquidity, a specific infrastructure like the Asset Liability
Committee should be formed. The meeting of ALCO should be carried out on regular intervals, and it
should review the liquidity position and should prevail in all necessary ways to maintain liquidity risk
at the acceptable limit. The agenda of ALCO meetings should be reported to the board also.
• The bank should have contingent funding plans to reduce the liquidity pressure.
Central Bank’s Regulations on Price and Interest Rate Risk

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 • The banks should have necessary policy and guidelines for managing fundamental market risk
exposure that arises due to the change in price and interest rate indicators
• The banks should establish treasury middle office for the supervision, monitoring and analysis of
treasury management risks. Middle office should be independent from treasury functions and should
report to risk management department or unit.
• The banks should establish a practice of conducting gap analysis by considering the interest rate
sensitive assets and liabilities only so that the maturity mismatch can be maintained at minimum or
desirable level.
• The banks should submit the statement of interest rate sensitive assets and liabilities to the Supervision
Department of NRB after grouping under various maturity dates as prescribed in form no 5.2 within
15 days of each quarter end.
• The banks would determine the gap between rate sensitive assets and liabilities for each interval of
time and also work out the cumulative gap for corresponding time interval.
• The banks should also measure the possible changes in interest rates and work out the impact of a 1%
change in interest rate on profit and loss of the bank. (Sensitivity Analysis)
• At the time of designing the new product, an evaluation of the impact of interest rate change on the
bank’s balance sheet should also be conducted. The banks are encouraged to formulate and implement
pricing and repricing methods and competitive analysis techniques considering interest rate risk.
Central Bank’s Regulations on Foreign Exchange Risk
• The banks should have appropriate policy and guidelines for managing and addressing the risk caused
by fluctuation in foreign exchange rates. It should evaluate the possible impact of exchange rate
fluctuations on banks revenue and capital. The evaluation report as per form no 5.3 should be submitted
to concern Supervision Division of NRB every month within seven days from the month end.
• The bank should maintain the prescribed level of exchange fluctuation reserve to control the possible
risk caused by exchange rate fluctuations.
• The banks should classify foreign exchange on the basis of both short-term and long-term holdings
and show the net position of the bank for both periods.
• The limit of the daily net position of foreign exchange should not exceed 30% of the primary capital.
If such limit is exceeded, the bank should maintain it as per limit within one month period otherwise
NRB can initiate the punishment as powered by NRB act. The bank should also adjust the amount of
foreign currency deposit liability, foreign exchange forward contract and other derivatives to count the
net position.
• The banks should be able to measure evaluate and manage the foreign exchange risk caused by on
balance sheet and off balance sheet activities both.
Major responsibilities
 Monitoring the structure of bank’s assets and liabilities.
 Developing maturity profile and mix of incremental assets and liabilities.
 Determining interest rates.
 Reviewing and documenting bank’s funding policy.
 Deciding the transfer pricing policy of bank.
 Evaluating market risk involved in launching new products.

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 Receiving and reviewing reports on liquidity risk, market risk and capital management.
 Reviewing liquidity contingencies plan for the bank.
 ALCO should ensure that risk management is not limited to collection of data only. Rather, it will
ensure that detailed analysis of assets and liabilities is carried out so as to assess the overall balance
sheet structure and risk profile of the bank.
 The ALCO should meet on a regular basis.
 Developing and maintaining appropriate risk management policies and procedures, MIS reporting.
 ALCO is a senior management level committee responsible for supervision of market risk.

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