CHAPTER 1
THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL
AN INTRODUCTION TO TREASURY MANAGEMENT Treasury Management in a
financial entity is a principal determinant in the entitys
financial strategy and financial policy enabling the entity to
determine what businesses to invest in, organising the appropriate
funding for the varying business segments, and controlling the risk
in the organisation. Dependent on the inherent risks prevailing in
the current environment in which the entity is operating in,
treasury management seeks to create an appropriate capital
structure of debt and equity in order to fund the entity, getting
the optimum balance between expenses and risk. This translates into
the need to ensure that at all times the entity has the liquidity
and cash to meet its financial obligations as they become due,
taking in funding from equity or debt capital markets activities,
bank borrowings, through to day-to-day cash management and
investment. The Treasury Management process is responsible for risk
identification associated with the entitys varying activities and
for controlling risks that could erode financial strength, using
mitigation and hedging techniques and encouraging a culture of
sound financial practice. In essence treasury management is all
about handling the banking requirements, the funding for the entity
and managing financial risk. It therefore incorporates raising and
managing money, currency, commodity and interest rate risk
management and dealing, and, in some entities the related areas of
insurance, pensions, property and taxation.
Objective 1: Discuss the reasons for the development of treasury
operations; describe the scope of treasury functions in a bank; and
contrast a bank treasury and a corporate treasury.
Role of the TreasurerThe treasury department is concerned with
managing the financial risks of a business. Hence, the treasurer's
job is to understand the nature of these risks, the way they
interact with the business, and to minimize or to offset them. He
must assist and advise the board in its decision-making activity,
based on his understanding of the risks. In order to do this
efficiently many treasurers prefer to organise their department
around treasury processes. This method is very efficient as it
allows for a focus as well as links to similar functions in other
geographic areas of the organisation. The treasury processes
mentioned generally consist of financial planning and reporting,
funding, risk management (FX and money market), credit management,
and cash management.THE FUNCTIONS OF A BANKS TREASURY AND
PRUDENTIAL CONTROL
1
The most operational of these processes are risk management and
cash management. Both these processes require a significant amount
of attention to detail but also differ in one other aspect. Of all
the processes mentioned, these two tend to be the most 'treasury
independent' processes. As such the treasurer has significant
leeway in both the design and implementation of the process. Given
this flexibility and the operational nature of the processes it is
in the best interests of the Treasurer to pay a high level of
attention to the design and implementation of the processes. Not
doing so results in the Treasurer getting caught up in the
execution of a particular transaction, managing staff, and
obtaining resources to support the function. Everything, but his
actual role. Treasury plays a pivotal role in managing risks and
rewards both inside and outside the organisation. As the function
concerned with the provision and use of finance, Treasury typically
handles collections, banking, working capital, short-term
borrowing, foreign currency management, provision of capital and
money market investment. In the past two decades, Treasury has
become more involved in identifying unmanageable organisational
risk and hedging it in open markets. Increasingly, Treasury is
becoming involved in handling operational risks through insurance
mechanisms and, in some leading companies, viable risk/reward
management systems.
Treasury Activities comprise the following:1. Setting corporate
financial objectives strategies, policies, measurement, internal
capital allocation, pricing, reporting and systems; 2. Liquidity
management The treasury function has to ensure that the company has
sufficient liquid funds available to ensure a smooth running of its
operations and to meet short-term financial obligations as and when
due. Moreover, treasury is also responsible for investing surplus
funds, cash flow management, control of funds, working capital,
money transmission, banking relationships and streamlining the
operational flow of funds; 3. Funding management policies,
procedures, types of funds and self-funding mechanisms; 4. Exposure
management currency exposure, international netting/pooling,
exchange dealing, international monetary economics, commodities
markets and hedging; 5. Corporate finance equity capital
management, taxation issues, pension funding, business acquisitions
and disposals, project finance and joint ventures; 6. Corporate
treasury structure information systems support, central/local
procedures, cost-centre/profit-centre management, asset management,
compliance, staffing, controls,THE FUNCTIONS OF A BANKS TREASURY
AND PRUDENTIAL CONTROL
2
risk attitudes, fraud prevention, business unit evaluation and
Treasury performance evaluation. 7. Funding management: The
treasury function has to source and secure funds for the needs of
the business. 8. Debt portfolio management: The treasury function
has to manage the debt portfolio which emerges from the
accumulation of individual financing transactions so as to achieve
an acceptable cost and risk profile for the portfolio over time. 9.
Risk management: The treasury function has to advise on and
implement effective hedging of treasury type risks, especially,
foreign exchange, interest rate and commodity price risks, as well
as liquidity, credit and counterparty risks. 10. Bank, financial
counterparty and rating agency relationship management.
Objective 2: Summarise the treasury management roles of
portfolio management, dealing and settlement, and proprietary
trading.
Treasury Function in an International BankA treasury function in
an international bank is concerned with three main activities: 1.
Dealing, 2. Settlement 3. Control. Globalization of world markets
and the complexities involved in a bank's trading operations have
led to the setting up of a department specializing in the areas of
funding, lending, investment and foreign exchange. Banks felt that
they could operate more profitably by engaging in a function whose
purpose is to minimize funding costs and to maximize returns.
Further, given the need to manage the flow of transactions, a
treasury function is best placed to establish and run the
back-office operations - the settlement office and the control
office. Within the control office, the bank has to demonstrate to
the regulatory authorities and to its own senior management that
the bank is operating ethically, prudently, legally and profitably.
Treasury operations A dedicated treasury operation would normally
be involved in the activities centering around dealing, settlement,
and control. Prudent control maintains the good name of the bank
while it pursues its main function as the provider of the funding
for both the bank's foreign currency investments and for their
international business.THE FUNCTIONS OF A BANKS TREASURY AND
PRUDENTIAL CONTROL
3
Dealing The treasury maintains and develops its dealing
operations, evolving its business and controlling its operations
across the broad range of instruments - for example in futures,
options, cash, swaps and forward-rate agreements. It maintains and
develops the investment portfolios and seeks to utilize the bank's
surplus funds to best advantage for: Day-to-day funding
requirements Funding investments in associated companies and
subsidiaries Raising debt to meet capital requirements
Valeur Compensee (VC) Valeur Compensee (VC) relates to the
aggregate of purchase and sales that mature on any one value date
in the future. The principle that the deal; should be completed on
the same day. Settlement The settlement office is responsible for
processing payments, issuing confirmations, reconciliation of
accounts, custody of securities, systems, and accounting and
statutory returns. This area clears the paperwork following the
purchase or sale of financial products investments, loans or
trading in currency instruments. Sales have to be reconciled in the
bank's back office, clients have to pay or be paid, certificates
have to be exchanged and purchases and sales have to be reconciled.
This is an important part of the bank's operation and requires
skilled managers to ensure that there is a smooth flow of paper to
support the transactions taking place. Heavy dealing in any day or
over a period of time can cause serious bottlenecks which, in turn,
affect the efficiency and even the reputation of the institution.
Recent a dvances in electronic settlement have made the process
quicker and more effective. Control The treasury function takes on
the responsibility for producing a set of policies and procedures
governing the way in which the bank trades in the various
instruments and the levels at which it trades. Risks relating to
credit limits, liquidity, cash flows, interest rates and exchange
rates will also be controlled by the function using a system of
checks and reviews through audits and the examination of returns
required to be made by each of the dealing and settlement
operations. Particular attention should be paid to the possibility
of fraudulent activity, internally or by third parties, which, in
the context of a bank trading in enormous amounts of money each
day, could have catastrophic consequences for the very survival of
the institution as demonstrated by the events that unfolded at the
Bank of International Credit and Commerce and at Barings Bank.THE
FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL
4
Even fraudulent activity on a much smaller scale can impact on
the confidence the financial markets have in an institution. It
undermines the perceived level of control exercised by the bank.
For the purpose of maintaining the bank's capital adequacy
requirements, the treasury control office will be involved in
capital and loan stock issues relating to the bank's own balance
sheet management, a crucial function for the very survival of the
bank. All existing stock also has to be managed and this will be
done through a set of guidelines, policies and procedures. Treasury
functions often need to lead their organisations in understanding
and managing risk and reward. Proprietary Trading This occurs when
a bank trades for direct gain instead of commission dollars.
Essentially, the bank has decided to profit from the market rather
than from commissions from processing trades. Banks that engage in
proprietary trading believe that they have a competitive advantage
that will enable them to earn excess returns. Objective 3:
Differentiate between front-office, middle-office, and
back-office activities from a control perspective.
The Boards Responsibility Prudential management of any bank is
based on the primacy of the board, which has ultimate
responsibility for the sound and prudent management of a bank. In
the management of the treasury area, the board is responsible for
the institutions operations and risk management and for ensuring
that senior management is monitoring the effectiveness of risk
controls. The board is responsible for setting the banks tolerance
for risk or risk appetite, through its approval of market risk
policies, limits and business strategy. Market risk policies should
cover matters such as delegations, reporting, escalation,
revaluations and new products. The board is expected to review
policies and strategy on at least an annual basis. The board should
ensure that the institutions risk controls are effective, the
agreed business strategy is being followed and that the board is
being regularly informed on whether risk policies are being adhered
to. The board should seek active responses to limit breaches. The
board should have a good general understanding of the types of
treasury products and trading strategies used by their institution
and to review new products. This understanding should be reinforced
by board information sessions which explain the inherent risks in,
for example, derivative instruments. Boards are required to be
vigilant and effective in their oversight of risk. For example, it
is expected that boards should understand the aggressive,
competitive and at times frenzied environment in dealing rooms, and
thus the crucial need to maintain clear and strong separation
of
THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL
5
front, middle and back offices. The board is expected to be able
to assess from the reports they receive whether trading is within
the risk appetite it has approved and conforms to the agreed
business strategy. The board should also regularly review stress
tests and back testing results and should ensure, through the Board
Audit Committee, that the internal models and the market risk
management framework is regularly reviewed by the internal audit
function. Senior Management Responsibility Senior management is
responsible for ensuring that risk-taking is done within a
controlled environment which is in keeping with board-approved
policies, limits and strategy. It is their responsibility to ensure
that people, systems and processes are up to the task. In the
dealing area, senior management should have delegated trading
authority from the board and should be accountable for the actions
of dealers under their control. Senior management should ensure
that trading desks are following the board approved business
strategy. For example, if a derivatives desk is meant to be mainly
client-driven, trading with interbank counterparties should
predominantly be for the purpose of reducing risk rather than for
taking large directional positions. Treasury dealer compensation
policies should be consistent with the trading strategy and bonuses
structured to encourage appropriate dealing behaviour. Leave
policies should also include minimum consecutive days of leave each
year, to ensure that a second set of eyes reviews dealers
activities. In addition to day-to-day oversight by senior
management, a senior management committee (market risk committee or
Asset Liability Committee) should review trading activities on a
regular basis. The committees charter should include reviews of
performance and operational issues, usage of market risk capital,
stress tests, back testing performance, trading strategy and the
appropriateness of the risk management framework. New products and
changes to limits and policies should also be agreed by the
committee before being proposed to the board. Senior management of
trading activities should ensure that dealers comply with policies,
limits and strategy on a continuous basis. Senior management should
have an open and constructive working relationship with the market
risk function of the institution and ensure proper segregation of
responsibilities between the front-office and middle/back office
staff. Senior management is expected to guard against a dealing
culture that is biased towards short-term profitability. This
culture results in budget targets stretched beyond dealers
competence and underinvestment in treasury risk management. Senior
management should keep the board fully informed on emerging risk
issues in the treasury portfolio. It should not be a crime to
report bad news to the board! Such a culture is a recipe for
turning small problems into big ones. Front-office Treasury dealers
The front office is the first line of defence against risk in
treasury operations. For this reason, banks strive for the highest
level of professionalism in this area, starting with recruitment
and remuneration practices. In turn, treasury dealers have
responsibility for trading within their delegated mandate and for
conducting their affairs, at all times, with integrity and
honesty.
THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL
6
Treasury dealers should have appropriate systems on the desk for
pricing and processing deals and for monitoring positions against
limits. Front office systems should provide a secure and efficient
platform for entering and pricing deals, checking credit
availability pre-dealing, providing risk analytics and monitoring
risk limit usage. Line management should also have access and the
capability to view dealer positions and monitor dealer, desk and
trading room limit usage. Integrated front office systems provide
the ability to monitor limit usage on a real-time basis. Systems
should be in place to ensure that dealers report their position and
profit and loss on a daily basis to line managers and to finance
personnel, whose task it is to reconcile dealer profit and loss
estimates with independent financial accounts. Treasury dealers
should have written dealing mandates that provide them with a clear
understanding of their dealing authorities. A dealing mandate
specifies the products, currencies, stop loss and position limits
both within the day and at the end of day, as well as any other
conditions such as practices when trading after hours. Limits
should encompass all risks and should be set at levels where a
breach clearly signals that trading has taken place outside the
agreed trading strategy. The bank should ensure that breaches of
limits are reported immediately by the dealer to line management.
The escalation process for reporting and managing limit excesses
should be clear and effective. The culture of the dealing room must
be one in which dealers see risk management as a core competency,
and this must be reinforced by senior management through its
remuneration policies. Dealing rooms that adopt a
catch-me-if-you-can approach to risk management are asking for
trouble. And in the same way, a management that allows such a
culture to emerge, blinded by the lure of short-term profitability,
does so at its peril. Market risk management The Middle Office
Market risk management the middle office is responsible for
ensuring treasury dealers are complying with board-approved
policies and trading within risk limits. Being independent of the
dealers, the middle office provides an objective view of front
office activities and ensures that limits can be monitored and risk
exposures removed from the business. The market risk management
system must be robust and include regular reconciliations to ensure
its completeness and accuracy. An institution which calculates
Value at Risk (VaR) using a model approved by the board, should
regularly review the model assumptions and parameters, including
stress testing scenarios. Back testing of the model should be
performed regularly to ensure that the model remains valid. The
middle office should have staff with sufficient skills and standing
in the institution to be an effective counterbalance to the front
office and to ensure the integrity of reporting and oversight of
trading activities. The area must have clear reporting lines,
particularly in escalating limit breaches. Ideally, the area should
also have the authority to require risk positions to be reduced
when dealers are in breach of limits. To be fully effective, it is
essential that the middle office not be the poor cousin at budget
time. The middle office should not be lagging behind the front
office in terms of investment in systems, people and processes to
measure and manage the risks in existing and new trading
activities. Senior dealing
THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL
7
management should not have any disproportionate influence over
the budget of market risk and support areas, weakening the
effectiveness of the risk management framework. Quantitative
support A number of institutions maintain a quantitative support
group to develop and/or independently validate complex models used
by the front office for pricing and by the middle office for risk
management. The group provides an assurance that model outputs can
be relied upon. Quantitative support should be actively involved in
the development of new products and provide a signoff before the
products are recommended to the board for approval; they might also
suggest conditions to be imposed on the pricing models involved. It
is important that the conditions imposed on products be monitored
on a regular basis by the middle office or the quantitative support
group. There should also be a periodic review of pricing models.
Back office support Back office support is responsible for ensuring
the integrity of deal confirmation, settlement and payment
functions and may also handle financial accounting and regulatory
reporting. The back office ensures that the deal information
reported by the middle office is complete and accurate. The back
office should be alert to large and unusual trades as well as
unusual amendments to trades and/or frequent cancellation of
trades, particularly around the end of day and other key financial
reporting periods. Any unusual activity should be escalated to
senior management. There should be strict controls around deal
amendment and cancellation. For example, dealers should not be able
to change standard settlement instructions (SSI) nor advise the
back office of changes to SSI. Trading positions should be
marked-to-market daily and revaluation rates must be provided
independently of the front office. In addition, to ensure accuracy,
there should be a daily validation of rates in the form of stale
price checks and checks for large and unusual movements. For
complex trading environments, we would expect to see a revaluation
committee which continually reassesses the appropriateness of the
source of revaluation rates and of assumptions and practices used.
On a daily basis, the finance area should calculate profit and loss
for trading activities and compare the figures with dealers
estimates. Differences should be reconciled and unexplained
differences highlighted to risk management and senior management,
and resolved quickly. On a regular basis, source systems should be
reconciled with the general ledger and internal balance sheet and
profit and loss accounts should be reconciled. Where there are
trading activities across multiple branches, there should also be a
reconciliation of internal and inter-company balance sheets and
profit and loss accounts. Though it should go without saying, both
the back office and the finance function should be independent of
the front office and be appropriately resourced. Internal audit
Internal audit is responsible for reviewing the effectiveness of
people, systems and processes which comprise the treasury risk
management framework. By virtue of its independence from executive
management and its direct reporting line to the Board Audit
Committee, internal audit provides assurance to the board that the
front office, market risk and back office support areas are
functioning effectively and that senior management is active in its
risk oversight. The internal audit function should be adequately
resourced, or have access to external qualified resources, to be
able to undertake regular reviews ofTHE FUNCTIONS OF A BANKS
TREASURY AND PRUDENTIAL CONTROL
8
treasury operations. For internal model users, a review of the
overall risk management process should take place at regular
intervals.
Objective 4: Summarise the principles of risk management, and
explain the importance of prudential control, risk management, and
risk-management processes. RISK MANAGEMENT Management of risks has
always been foremost in Treasury Management and the scope has been
foremost in recent years due to the number of banks which has
failed locally and internationally. Treasuries require the ability
to monitor and exercise control in order to ensure that the
information on which dealing decisions were based are accurate.
Operational controls to ensure that the treasury function did not
inadvertently threaten the rest of the organisation were a part of
this control function. Risk management works most effectively when
an enterprise risk management approach is used. All risks across a
financial institution have to be managed together. In financial
institutions, the primary risk management function is to develop,
implement and communicate a consistent framework, support a process
for managing risk across the financial institution. However, the
objective is to help identify and take advantage of varying
opportunities to optimise risk-adjusted return on capital. The
financial Institution business units should have primary
responsibility for and knowledge in managing risk in their own
markets and products. They should manage both risk before an event
and profit and loss after an event. It must be emphasized that
quantifying risk alone is not sufficient. An effective risk
framework must be inclusive of stress-testing capabilities. Only
then will the risk management model be sufficient. Treasury Risk
Treasury Risk is a subset of the overall risk profile of the
institution. Treasury Risk first appears within the array of
Expectation Risk elements. Most institutions forecast future
interest rates, currency differentials, earnings and investment
returns, price indices, and related economic factors. The results
of those forecasts influence potential resources available to
enable the vision of attainable goals for the enterprise. Treasury
Management is also the Management of Risks. With the globalization
of financial markets, financial institutions around the world are
exposed to a multiplicity of risks. Movements in the rates of
interests and volatility of exchange rates in an increasingly
complex environment have made the process of managing risks a
critical aspect of treasury management. The main types of risk
associated with treasury operations are.
THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL
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Financial Risk Credit Risk/Counterparty - Credit risk is most
simply defined as the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with
agreed terms; A credit risk arises where there is a commercial
contract between two parties in which one party has a future
obligation to repay moneys to the other with the risk that those
moneys will not be repaid or a settlement is deferred or
rescheduled. In each case it will result in a loss to the lender or
a significant reduction in the margin on which the transaction was
made. Credit risk otherwise known as bank counterparty risk, is
concerned with counterparty limits between banks and focusing on
acceptable exposure levels. Settlement Risk - the risk that the
completion or settlement of a financial transaction will fail to
take place as expected; Settlement risk includes elements of
liquidity, market, operational and reputational risk as well as
credit risk. The level of risk is determined by the particular
arrangements for settlement. Factors in such arrangements that have
a bearing on credit risk include: the timing of the exchange of
value; payment/settlement finality; and the role of intermediaries
and clearing houses. Market Risk; Price Risk (Interest rate risk,
currency risk, equity, Maturity mis-match risk, Forced Sale risk)
Curve Risk, Basis risk, Correlation risk. Option Specific risk.
Liquidity Risk - Liquidity risk is the current and prospective risk
to earnings or capital arising from a banks inability to meet its
obligations when they come due without incurring unacceptable
losses. Liquidity risk includes the inability to manage unplanned
decreases or changes in funding sources. Liquidity risk also arises
from the failure to recognize or address changes in market
conditions that affect the ability to liquidate assets quickly and
with minimal loss in value. Physical Risk Physical Assets; Real
estate; Manufacturing process; supply chain.
Operational Risk is the risk arising from execution of a banks
business functions. It is a very broad concept which focuses on the
risks arising from the people, systems and processes through which
a company operates. It also includes other categories such as fraud
risks, legal risks, physical or environmental risks.
THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL
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Basel II regulations define Operational risk: as the risk of
loss resulting from the inadequate or failed internal processes,
people, and systems or from external events. Operational Risk
includes legal risks but excludes reputational and strategic risks.
The most important types of operational risk involve breakdowns in
internal controls and corporate governance. Such breakdowns can
lead to financial losses through error, fraud, or failure to
perform in a timely manner or cause the interests of the bank to be
compromised in some other way, for example, by its dealers, lending
officers or other staff exceeding their authority or conducting
business in an unethical or risky manner. Other aspects of
operational risk include major failure of information technology
systems or events such as major fires or other disasters. Sales
Risk Competition Risk - The ever present forces of globalization,
technology, and economic liberalization are combining to make life
harder than ever for established entities. Banks who are able to
effectively lower their costs and possess a comparative advantage
over their competitors will capture a greater market share.
Elasticity risk - the ratio of the percentage change in the price
of a banks product (such loans and deposits) and the percentage
change in demand for that product. The relationship between
movements in interest rates and service cost and the resultant
impact on consumer demand. Predictive Risk Exists when banks use
statistical analysis to predict future trends and behavior
patterns. The core of predictive analytics relies on capturing
relationships between explanatory variables and the predicted
variables from past occurrences, and exploiting it to predict
future outcomes. When a predicted variable behaves contrary to ones
expectation it generates risk to the banks operation. Strategic
Risk - Includes Regulatory Risk, Tax Risk, Catastrophe risk,
Currency Policy. Political Risk Country Risk Relates to that
associated with the credit afforded to the borrowers of a sovereign
country. The risk arises out of the possibility that the borrowers
in that sovereign country may be unwilling or unable to pay their
debts.
Economic Risk - Investment risk associated with the overall
health of the economy of the country or locality in which the
investment is made. It includes the riskTHE FUNCTIONS OF A BANKS
TREASURY AND PRUDENTIAL CONTROL
11
that a bank will not generate sufficient revenues to cover
operating costs and to repay contractual obligations. This may be
realized by disruptions in a strategic operation or process,
emergence of a serious competitor on the market, the loss of key
personnel, the change of a political regime, or natural disasters.
Legal Risk Legal Risk arises from exposure that exists from being
unable to enforce agreements that have been drawn up
incorrectly.
Prudential Controls The prudential control refers to the
regulation of deposit-taking institutions and supervision of the
conduct of these institutions and set down requirements that limit
their risk-taking. The aim of prudential control is to ensure the
safety of depositors' funds and to ensure the stability of the
financial system. A financial institutions treasury function has
grown in importance, largely because of the complex nature of
financial instruments traded across borders. Control is the
responsibility of senior management, not the regulatory
authorities. It is their duty to ensure that all types of risk are
minimized and controlled, and although a slice of the work carried
out by the bank's internal control functions will include the
implementation of the rules laid down under statute, the issue of
internal prudential control should be high on the agenda,
notwithstanding the need to meet its legal requirements. The
internal control function varies from one bank to another in its
form and its brief, but all focus closely on the activities of the
dealing operations because this is where most of the risk lies in
the form of the trading exposures. Risks that exist from volatile
interest rates and exchange rates, plus the credit risks associated
with the ability of counterparties to meet their commitments, can
be difficult to predict, but they are part and parcel of trading.
The risks that can be even more difficult to detect are those
related to internal or third-party fraud, whether these be at the
dealing stage or at the settlement stage. Within the internal
control role specification there should therefore be a framework
for the monitoring of transactions in order to detect fraud at an
early stage. The two ends of the extreme have so far been discussed
- the standard risks involved in running the business and, at the
other end of the scale, the risks associated with fraudulent
activity. In between these two areas of control are the limits
within which traders are allowed to operate, and the integrity they
must demonstrate in order not to place the bank in an exposed
position. Objective 5: Describe the functions of the board of
directors, the Asset and Liabilities Committee (ALCO), and other
risk committees. Board of DirectorsTHE FUNCTIONS OF A BANKS
TREASURY AND PRUDENTIAL CONTROL
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The principal role of the board of directors is to determine
strategy. They set the terms and reference of the varying
sub-committees in the institution and these committees remain
responsible to the board. Asset and Liability Committee Often
boards delegate the setting of the financial institution risk
appetite relating to balance sheet exposure to a special formed
Asset liability Management Committee (ALCO). ALCO plans, directs
and controls the flow, level, mix, cost and yield of the
consolidated funds of the financial institution. They are mandated
to achieve the entities financial goals and controlling financial
risks. ALCO set the framework for treasury activities, in line with
the principles determined by the board of directors. Objective 6:
Discuss the reasons for and processes of internal controls,
including the internal audit function. The Internal Control
Function Given that it is senior management's responsibility to
prudently control the dealing operations of an international bank,
one would expect to see an internal control department specifically
tasked with putting controls in to place. The areas that typically
form part of such a function's responsibility are: To ensure
compliance with directives and policies issued by senior management
To devise and put into place controls To monitor performance
against these controls To ensure the security of the company's
assets To ensure the dealing and settlement functions operate
efficiently To satisfy management and regulators that records are
accurately kept
Internal Audit Internal audit functions have important control
functions. Its role is generally to monitor the appropriateness and
effectiveness of a firms systems and controls. Internal Audit will
demonstrate to their senior managers and to the banking authorities
that they are able to exercise the appropriate level of prudence.
This in itself will keep the regulators at arm's length. What the
banks are unable to control voluntarily the regulators will seize
upon to put their control requirements into statute, or at least
into a code of practice. For example, the FSC will observe the
ability of the Jamaican banks to operate within their own
guidelines or within the guidelines of the central bank. If it is
not then satisfied with the results of this level of intervention
then statute can become a reality. At whatever stage the level of
control has settled the internal control function will take
responsibility for enforcement. The aim, as far as the bank is
concerned, is a common approach that convinces the central banks
that self-regulation is exercised at such a level as to be
satisfactory for their purpose.THE FUNCTIONS OF A BANKS TREASURY
AND PRUDENTIAL CONTROL
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The need to exercise caution and prudence in dealing operations
has been around for as long as trading has existed, but the need
for it has been no better demonstrated than in the late 1980s,
1990s and early 2000s when complex derivative instruments were
embraced by the markets but not always fully understood across the
dealing rooms and among managers. If they are not fully understood
by the management then it is unlikely that awareness of the control
requirements will exist either. If the Financial Services
Commission (FSC) were to review the measures being undertaken by a
bank to keep its own house in order it would expect to see: (a) (b)
(c) Random audits, outside any regular audit cycle. Sensible
targets imposed on dealers in order to ensure that they are not
tempted to compromise the bank in search of their optimistic profit
targets. Random checks with counterparties to confirm that deals,
such as forward contracts, do in reality exist. The internal
auditor would be expected to investigate unusual patterns of
activity such as unusually high levels of business transacted with
one particular third party.
Objective 7: Evaluate the functions of the compliance office.
Basel Committee on Banking Supervision paper on Compliance and the
compliance function in banks Compliance starts at the top. It will
be most effective in a corporate culture that emphasises standards
of honesty and integrity and in which the board of directors and
senior management lead by example. It concerns everyone within the
bank and should be viewed as an integral part of the banks business
activities. A bank should hold itself to high standards when
carrying on business, and at all times strive to observe the spirit
as well as the letter of the law. Failure to consider the impact of
its actions on its shareholders, customers, employees and the
markets may result in significant adverse publicity and
reputational damage, even if no law has been broken. The expression
compliance risk is defined in this paper as the risk of legal or
regulatory sanctions, material financial loss, or loss to
reputation a bank may suffer as a result of its failure to comply
with laws, regulations, rules, related self-regulatory organisation
standards, and codes of conduct applicable to its banking
activities (together, compliance laws, rules and standards).
Compliance should be part of the culture of the organisation; it is
not just the responsibility of specialist compliance staff.
Nevertheless, a bank will be able to manage its compliance risk
more effectively if it has a compliance function in place that is
consistent with the compliance function principles in the paper.
The expression compliance function is used in the paper to
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describe staff carrying out compliance responsibilities; it is
not intended to prescribe a particular organisational structure.
The banks compliance function should be independent. o The
compliance function should have a formal status within the bank. o
There should be a group compliance officer or head of compliance
with overall responsibility for co-ordinating the management of the
banks compliance risk. o Compliance function staff, and in
particular, the head of compliance, should not be placed in a
position where there is a possible conflict of interest between
their compliance responsibilities and any other responsibilities
they may have. o Compliance function staff should have access to
the information and personnel necessary to carry out their
responsibilities.
Objective 8: Evaluate the functions of financial markets, and
discuss the roles of participants in these markets; namely
exchanges and clearing houses, credit institutions, investment
banks, brokers, market makers/dealers, and investors. A financial
market is a market in which financial assets are traded. In
addition to enabling exchange of previously issued financial
assets, financial markets facilitate borrowing and lending by
facilitating the sale by newly issued financial assets. Financial
markets serve six basic functions. These functions are briefly
listed below: 1. Borrowing and Lending: Financial markets permit
the transfer of funds (purchasing power) from one agent to another
for either investment or consumption purposes. 2. Price
Determination: Financial markets provide vehicles by which prices
are set both for newly issued financial assets and for the existing
stock of financial assets. 3. Information Aggregation and
Coordination: Financial markets act as collectors and aggregators
of information about financial asset values and the flow of funds
from lenders to borrowers. 4. Transformation of Risk: Financial
markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
Financial markets reduce risk through risk spreading or risk
pooling. Risk pooling is undertaken by spreading any risky
investment across a sufficiently large number of lenders. 5.
Transformation of maturities and provision of Liquidity: Financial
markets provide the holders of financial assets with a chance to
resell or liquidate these assets. Financial intermediaries have the
ability to hold assets that are less liquid than their liabilities.
6. Transformation of transaction costs: Financial markets reduce
transaction costs and information costs.
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In attempting to characterize the way financial markets operate,
one must consider both the various types of financial institutions
that participate in such markets and the various ways in which
these markets are structured. Major Players in Financial Markets
Exchanges Credit Institutions Investment Banks Brokers Market
makers/dealers Investors and issuers Objective 9: Describe the
processes involved in dealing rooms or front offices, middle
offices, and back offices, and discuss the rationale for, and
practicalities of, the segregation of duties between trading and
settlement functions. Front-office The term front-office is used
for dealing activities. Dealing activities are undertaken by both
market makers and dealers. The difference is that market makers
will quote prices on an almost continuous basis, while dealers will
only be active in the market when it suits them. Market makers are
needed to ensure a market exists while dealers add additional
liquidity to a market. When determining prices, dealers and market
makers will take into account existing demand and supply and how
they are likely to change. Developments in other markets may also
affect prices and participants need to track of what market prices
do to ensure that their own prices do not diverge without good
reason from the market trend. A dealer may either initiate a deal
or, if the dealer quotes prices, may be contacted by other market
participants. Prices will be either on a bid or offer basis. A bid
price is the price at which dealers are prepared to borrow or
purchase. The offer price is the price at which they are prepared
to lend or sell. Contact with dealers and market makers may be
established via telephone or computer screen. The dealer then: 1.
2. 3. 4. 5. 6. Check that the proposed deal does not breach the
internal limits. Agree to the deal as it relates to price, amounts,
maturity and settlement details. Once all the relevant details are
agreed the deal has been done. Details of deal input into the
systems. Deal incorporated in the risk management systems of the
bank. Deal included into banks accounting records
Middle-officeTHE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL
CONTROL
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Middle offices arose from the need for improved risk management.
Middle office functions: 1. 2. 3. 4. 5. Produce risk management
reports Check for compliance with internal limits. Liaise with
back-office Filter queries from the back-offices on deals. Check
valuations for inputting into integrated risk reporting.
Back-office Sometimes the activities undertaken by back-offices
are collectively known as settlement activities. Middle office
functions: 1. 2. 3. 4. 5. 6. Making sure that accounting entries
are correct. Confirmation received Payments are authorized
Accounting records for funds or securities are reconciled with
actual payments/deliveries. Nostro accounts may also have to be
reconciled. Margin payments may have to be made.
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