We know that main business of any bank is accepting deposit from its customers and lend it at a higher rate to generate income. But in last 20 years or so banking business has crossed many boundaries and ventured into many different kind of business to make profit. For executing so many different activities, banks have recruited huge manpower and they works in different departments across different offices. However, amongst the various departments present in banks, treasury is one among the most important department and at the same time the least understood one. In most of the banks, treasury is attached to their corporate offices and people with highly specialized knowledge and skills work in it. In this article, we will provide a brief overview of these treasury operations and also learn how this department has evolved as a profit making machine for most of these banks in our country.
Bank Treasury in Initial Days:
Traditionally, the role of the Treasury in Indian banks was limited to ensuring the maintenance of the RBI stipulated norms for Cash Reserve Ratio (CRR) which mandates that a minimum proportion of defined demand and time liabilities be kept as deposit with the central bank without any return and Statutory Liquidity Ratio (SLR) which obliges banks to invest a specified percentage of their liabilities in notified securities issued by the Government of India and State Governments with some returns attached to it.
Earlier, treasury’s activities in foreign exchange were also confined to meeting merchants’ and customers’ requirements for imports, exports, remittances and deposits. Furthermore, Indian Money Market was also not structured and easily accessible. Therefore, hardly any banks were dealing is this market. Following the recommendations of the Committee headed by Shri Sukhamoy Chakravarty in 1985 to Review the working of monetary system and later in 1987 by the Working Group headed by Chairman Shri N. Vaghul on Money Market, RBI had initiated various measures to reform the money market and to develop the necessary institutional infrastructure and instruments needed to widen and deepen the money market.
Entering into New Era:
Later the inroads to different kind of other profit making businesses opened for banks with RBI intervention and liberalization of the Indian economy. Slowly but steadily banks started venturing into new markets and dealing in different instruments like capital market, money market, foreign exchange market, bond market and derivatives market instruments to garner profit.
Further, steps such as increasing the number of instruments by introducing commercial paper and certificate of deposits greatly contributed to the development of money market.
Delivery versus Payment (DVP) system that involves simultaneous transfer of securities and funds in government securities transactions was introduced with effect from July 1995 to alleviate counterparty settlement risk and this also infused confidence into the bank treasuries to trade aggressively.
The central bank then began using tools to monitor and control the liquidity in the economy and monetary flow, such as repos and open market operations (OMOs) to manage liquidity in the financial system and to make the determination of interest rates on government securities more transparent and competitive by holding auctions.
Treasury as Profit Centre:
For banks, investments are now viewed as an alternative to credit; the traditional premier source of profits till sometimes back. Further investments, being easily tradable assets, offer both interest spread as well as capital appreciation. So treasury’s income can be divided into two parts, interest income and non-interest income.
Interest Income: Income received half yearly or annually in the form of interest rate (coupon) on long term investments (bond) mainly kept in held to maturity category are treated as interest income.
Non Interest Income: Income generated from appreciation in value of assets held due to change in yield, income from arbitrage and dividend received on shares are treated as non interest income.
In most of the commercial banks in India deposits are maintained at higher level than advances. So after fulfilling the minimum regulatory investment criteria in CRR & SLR, banks deploy the rest of the fund in income generating advances and investments. Let us understand this with one illustrative example.
Suppose a bank is having Rs 100 in deposit portfolio. Now after maintaining Rs 4 (assuming CRR @ 4%) in CRR and Rs 18 (assuming SLR @18%) in SLR (which is also maintained by treasury only), bank is left with Rs 78. Now this Rs 78 may fully be deployed as advances during high growth of economy for consumption purpose or a part of it may only be lent out when the economy is not doing so good. So in the second case there is excess liquidity in the system with less demand of loan like the situation of this Covid-19 pandemic. Let us assume that out of these Rs 78, Rs 60 is lent to customers. Now Rs 18 is left idle with the bank which must be deployed in most effective manner as bank has to bear a cost of deposit on total Rs 100 which has to be recovered and profits to be made. After all banks are profit making organizations. So this amount lands at treasury for making the most of it. Apart from it bank may borrow from market for profitable investments as well. Let us keep that aside to keep it simple. Now treasury has many options like investing this Rs 18 in SLR (excess over minimum requirements), Non-SLR bonds, in Reverse REPO, Capital Market, Forex Market etc. to maximize the return on asset. Now these investments are leveraged to optimum level by treasuries and generate a good amount of profit to strengthen the balance financials of the banks.
We have already discussed earlier that with time various markets, instruments became available for banks. Now we will see how these markets are being used by bank treasuries to generate profit.
Post liberalization and financial market reforms, a vibrant bond market has evolved in our country. This has enhanced the relative importance of investments and the investment portfolio in the balance sheets of the banks.
Just like equity prices and foreign exchange markets, interest rates (yields) on debt instruments are determined through the interplay of various economic, financial and political factors like liquidity, inflation, government’s/RBI’s policies, growth, forex demand and supply, domestic vis-a-vis global interest rates etc. The recent hit of pandemic took the yields to one of the all time low level and bond prices soared as both these are inversely proportional to each other. Given this, as in the case of equities and forex rates, bond yields can also vary every moment and with that the bond prices also move up and down.
So treasuries make most of it by dealing in every possible way. In a rising market they can buy at lower prices and sell at higher prices by booking profit. In a falling market bank can short-sells at higher prices and then buys later at lower prices, thus books profit once again. But it is never easy to book such profits always as market can change it direction any time depending upon the factors discussed above. So the inherent risk is also being managed by risk management department attached to treasury. Apart from this sometimes banks just prefer to receive the coupon by holding the gilts till maturity.
The volatility in interest rates (yields) is at the heart of the transformation of bank treasuries from mere CRR and SLR keepers to a profit centre.
Similarly, the rupee’s exchange rate has become volatile. There is sufficient fluctuation both intraday and inter-day prices enabling one to earn trading profits on buying and selling the currency. Cross-currency (dollar/yen, sterling/dollar, dollar/Swiss franc) trading opportunities have also come to life in Indian banks after liberalization.
For executing these activities properly treasuries have well equipped and high tech dealing rooms. The Dealing Room, which acts as the bank’s interface to international and domestic financial markets, is known as the front office of a treasury. The officers posted in dealing rooms are known as dealers and they are responsible for managing the investment and market risksProfit as per the instructions of the investment committee and asset-liability committee (ALCO) of the bank.
Profit Generating Activities of Treasury:
i) Proprietary Trading: In this, the focus is entirely on short- term, as opposed to investment which is long term. The aim is to earn trading profits from movements in security and forex prices during a day or a few days of trading. These are mostly directional trades.
Under this, a dealer may buy (say) 8% Government of India security 2030 at Rs.116.50 at a yield of 6.56% in anticipation of the yield falling to 5.90%, on fundamental or technical grounds. If this happens, the bond appreciates and the bank exits the position with a profit.
Forex trading is also directional, involving, for example, buying dollar/yen in the expectation that the dollar will appreciate, or selling euro/dollar hoping that the euro will decline.
ii) Investments: Here banks earns a higher yield than its cost of funds. An example is buying a corporate bond yielding 8% and maturing in three years, financed by deposits which are being received in branches costing only 6%.
iii) Subscribing to IPO: Banks treasuries are also allowed to subscribe for initial public offerings as Qualified Institutional Bidders (QIBs) and exit the position after listing at a higher price.
iv) Spreads: In his treasuries leverage the spreads between the rates of source of fund and the use of fund. In money market The bank may, for instance, borrow short- term for 5% and deploy in commercial paper with returns of 6%.
v) Arbitrage: Arbitrage is an activity where the bank or for that matter any trader or investor exploits anomalies in market prices. It allows the investors to buy at lower prices in one market and sell it in other with high prices without taking any risk. The bank may have an ‘AAA’ bond, which yields only 6%, compared to another with the same rating and maturity, but of a different issuer, which offers 6.5%. It is worthwhile to sell the first bond and invest in the second and improve the yield by 50 bps without any incremental risk, as both bonds have the same credit quality.
In another form of arbitrage banks may enter into a buy/sell swap agreement in the forex market, where the bank converts its rupee funds into a dollar deposit, earns LIBOR, if LIBOR plus the forward premium on dollar/rupee is more than the domestic interest rate and gets back rupee on deposit maturity. This generates a risk-free profit.
vi) Customer Services: Bank treasuries offer their products and services to customers/non-banking customers. The income of banks from these activities comprises fees for and/or margins on trade execution. Profits would be higher on structured (i.e. non-standard) transactions compared to plain vanilla (e.g. a straightforward buy sell USD/INR) deals.
Treasuries are also involved in investment banking where their responsibility covers trade execution on behalf of the bank’s clients in the cash or derivatives markets. These may generate good margins, depending on the complexity and skills required to design and put through customized structures in the market.
Profits Made by Some PSUs Treasury:
In the above figure, net profits (amount are in crores) of some of the large PSBs of last FY 2020-21 are plotted against the income generated by the treasuries by trading activity and from commissions (excluding interest incomes from investments) of the same banks. It is very apparent from the chart that treasury has made an immense contribution towards the profit of the banks and without the profit made by the treasuries all the banks would have incurred net loss.
But at the same time we have to understand that last FY was a pandemic hit year and things including banking were not normal. Where the loan demands were very low, the bond prices soared like anything due to an all time low yields. This has played a big role in increased profit of treasury which may not be repeated in the coming years. But the fact cannot be denied that treasury has made its own place as a large component of bank’s income book.
Other Services of Treasury:
Capital and Reserve Requirements: As already discussed, Treasury in banks is also responsible for setting aside reserves to meet the reserve requirements prescribed by the Central Bank. Also, the capital requirements prescribed by the Basel norms have to be met. Failing to meet these requirements has detrimental consequences since penalties are levied by the Central Bank. Apart from these during infusion of capital by government into public sector banks, transactions take place through treasury only and they also deals with the deployment of such funds.
Asset Liability Management: It is the job of the treasury department in cooperation with Asset Liability Committee (ALCO) to prepare various financial models which help on forecasting the amount of net interest income that the bank plans to achieve. It is also the job of the treasury department to predict exactly how sensitive this non-interest income is to external shocks like changes in the interest rate.
The treasury department collates this critical information and then passes the same on to decision makers who then decide the kind of assets that they want on the banks balance sheet. These decisions are then further translated into loan targets which bank officials have to meet. Also, based on the information received from the treasury, the bank refrains from using certain kinds of deposit liabilities. Hence, treasury department profoundly influences both deposit taking and loan sanctioning functions of the bank.
Risk Management: As treasury deals with high volumes at highly volatile market, it associates itself with very high risk. So managing various risk like counterparty risk (risk of payment default by counterparty), market risk, operational risk automatically becomes an integral part of treasury. This task is being executed by treasury mid-office in close association with Risk Management department of the banks.
Liaison with Regulatory Bodies: The treasury department of banks is highly regulated. Since they are the ones that are supposed to maintain the capital adequacy ratios and reserve ratios, they are also the ones that are supposed to maintain cordial relationship with regulatory agencies like RBI, SEBI and Finance Ministry etc. Executives from the treasury department are usually invited by the government when decisions regarding the banking industry need to be made.
Back Office Functions: Treasury departments also have to perform a lot of normal back-office activities. They are supposed to regularly communicate with their branches regarding the extent of deposits that have been taken and the extent of loans that can be made. Back office also settles all the deals made by the dealers at the end of the day and reconcile the data.
The treasury department has, therefore, become the heart of the banking industry. It contributes substantially nowadays towards the profits of the banks. Officers working in this department get a bird’s eye view of the operations of a bank that are spread out over cities, nations and even continents. These experts understand the concept of cost of funds and oversee its application. In coming days, it is expected that this department will grow much bigger, more people will understand the complexities of its business and trading will emerge as one of the prime activity in banks.