Banks' treasury departments have a wide variety of functions. The primary role of any treasury function is to manage bank's assets and liabilities, and existent risk arising from them. The responsibility of treasury includes efficient management of reserves, balance sheet, meeting the bank's capital and liquidity requirements.
A bank's treasury manages and monitors interest rate risk, as adverse interest rate move could impact the asset and liability side of balance sheet. Therefore, the function of a treasury is of critical importance regardless of the type of institution, be it financial institution, corporate or central bank.
Since managing a balance sheet is a huge responsibility, almost every bank or financial institution has a committee, which is commonly known as ALCO (Asset/Liability Management Committee). The function of ALCO is to formulate a risk guideline that could take decisions and manage investments and associated risks in line with the objectives of the institution.
Commercial bank's treasury performs several key functions, which could include managing of liquidity or cash management and managing of exchange rate risk. Fund management is another key area that requires the treasury to proactively manage short-term, medium-term and long term investment and liquidity requirements.
From an advisory perspective, commercial banks treasuries also provide support to corporate finance and provide input on mergers and acquisitions and also when deciding on capital structures. In addition, treasury plays vital role in establishment of transparent Funds Transfer Pricing (FTP) process, which is essential for banks to measure the funding utilization mechanism to evaluate the efficiency of the liquidity provider, the user of liquidity and the manager of funds. A transparent FTP helps evaluate pricing and the performance of the contributor.
But the biggest challenge is managing a bank's risk involved in its capital protection and funding of its balance sheet. Hence, the treasury head has a huge responsibility, as the treasurer, he/she has to a play the role of a watchdog for financial management to safeguard the bank's finances.
Treasury head of a bank has to manage all types of risk which could include currency risk, interest rate risk, liquidity risk or credit risk.
Similarly, the central bank's treasury plays a vital role in the development and smooth functioning of the country's financial system. It is required to ensure that it formulates such a policy mix that it is able to contain inflation, maintain price stability and help boost economic growth.
To make it possible, the central bank should use its monetary tools effectively. It is expected that the central bank would maintain stable foreign exchange rate and the exchange rate policy would be consistent to support export growth.
Commercial Bank's Treasury/Dealing Room
Treasury/Dealing room of commercial banks plays vital role, as it has to manage bank's assets and liabilities and to protect the institution from interest rate and liquidity risk. Liquidity management is the key to ensure that funds are available to meet the bank's obligations and to maintain mandatory reserves and liquidity ratios.
The job includes maximising bank's earnings over and servicing bank's relationships with efficient pricing of all its products, be it foreign exchange, deposit, advances or pertaining to fixed income instruments. By virtue of its trading activities from customer flows, the treasury function is expected to add to the institution's bottom-line and to ensure that all financial risk is appropriately managed.
Daily commentary and market report should be made available to the customers, which would further strengthen the relationship between the bank and its customer. Treasury functions should be broadly segregated as the corporate desk plays a vital role. It must ensure that all customer related transactions are properly deployed and maximum return is extracted with calculated risk by the ALM funding desk according to the ALCO guideline, which looks after the bank's balance sheet.
Role of SBP Treasury:
State Bank of Pakistan as the central bank of the country works as an independent entity that is responsible to regulate all the monetary and credit systems of the country to ensure stability in the economy. SBP has a board that formulates monetary policy and credit policy with the coordination of Ministry of Finance.
Like a treasury's role within any financial institution, the central bank as well plays vital role in ensuring stability in the domestic financial market. But the major difference is that the central bank is the regulator and supervisor and hence, has to ensure the smooth functioning of the financial market. SBP has to make sure that it uses its entire available tools like Open Market Operations (OMOs), foreign exchange activity and reserve requirement effectively.
SBP's treasury department is playing a key role for the development of financial markets that has produced positive results to a great extent and has helped in the period of distress. Its initiative with calendarization of government securities, re-opening of past issues is a move in the right direction. Electronic bond trading platform was introduced to increase trading activities and bringing more transparency of information, which is yet to make inroads.
RTGS system (Real Time Gross Settlement System) was launched by the SBP, which became fully operative in March 2009, and allows direct payment to banks instead of cheques for inter-bank transactions and all security transactions that has certainly brought efficiency into the payment system.
While, the economy was facing hardships due to drop in foreign investments, liquidity constraints, rising inflation and slow growth, SBP introduced a corridor with the objective of providing opportunity to anchor short-term interest rates, to help extend the yield curve and improve monetary policy transmission.
This was an unnecessary move, which gave no respite and instead choked the inter-bank market. Despite high interest rate environment and with a 3 percent spread, the inter-bank money market activity continued to hover around the mid-point making it least attractive for trading purposes. It had failed to deliver the desired result, as there is no genuine liquidity in the market, since the deposit had dried in the absence of fresh money.
Furthermore, all the available liquidity generated through interest accruals is easily absorbed by banks for the purchase of government securities, which offer lucrative return. Market estimates are that the inter-bank trading volume fell by around 35 to 40 percent. This is quite a serious issue, which requires immediate attention.
Some more measures taken by the SBP are debatable, as they do not suit our market conditions, though the central bank may have a different perspective. Discontinuation of forward cover for import is not a market friendly move, as it has adversely impacted the inter-bank foreign exchange market and money market due to sharp fall in foreign exchange trading volume.
There could be two reasons, because soon after discontinuation of forward cover, SBP was aggressively engaged in a Buy/Sell (B/S) swap and forward outright trades. B/S swap means injection of Rupee liquidity in the inter-bank market and it simultaneously fattens the central bank reserve position. The other factor is that SBP B/S swap provides cheap forward cover to foreign currency (F/C) borrowers, which could be annually 5 percent costlier if cross border hedge is obtained due to country risk and customer risk.
Corridor as a monetary tool could only be successful in a zero or low interest rate environment. But in Pakistan, where the discount rate has been hovering in double digits for the last four years, it had pushed the yield on government securities lower, which makes it extremely attractive for the banks to invest in low risk papers and thus introduction of corridor in a higher interest rate scenario is a blessing for the bank.
Corridor is also one of the hindering factors for the failure of Electronic Bond Trading (EBND), as banks have a floor available to make last moment investment with their excess money.
Hence, it is suggested that SBP should consider lowering the floor to 5 percent to match with PLS Rate. This would force banks to buy government securities from the inter-bank market and EBND trading will pick up. Or SBP should raise the PLS floor to 10 percent and maintain adjusting the advance/deposit spread of 4 percent in line with discount rate move that will certainly tempt the depositor, which will not only see a halt in the rise of currency in circulation, but would also encourage the depositors to put their money in banks that offer lucrative return, resulting in a rise in the national savings ratio.
(The writer is the CEO of Currency Market Associates - a financial services company. He can be reached at asadrizwi@gmail.com.)