treasury management operations of bank

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TREASURY MANAGEMENT OPERATIONS IN BANKS

CHAPTER 1: INTRODUCTION1.1 Meaning & Definition

In general terms and from the perspective of commercial banking, treasury refers to the fund

and revenue at the possession of the bank and day-to-day management of the same. Idle

funds are usually source of loss, real or opportune, and, thereby need to be managed,

invested, and deployed with intent to improve profitability. There is no profit or reward

without attendant risk. Thus treasury operations seek to maximize profit and earning by

investing available funds at an acceptable level of risks. Returns and risks both need to be

managed. If we examine the balance sheets of Commercial Banks, we find

investment/deposit ratio has by far overtaken credit/deposit ratio. Interest income from

investments has overtaken interest income from loans/advances. The special feature of such

bloated portfolio is that more than 85% of it is invested in government securities.

The reasons for such developments appear to be as under:

Poor credit off-take coupled with high increase in NPAs.

Banks' reluctance to cut-down the size of their balance sheets.

Government's aggressive role in lowering cost of debt, resulting in high inventory

profit to commercial banks.

Capital adequacy requirements.

The income flow from investment assets is real compared to that of loan-assets, as

the latter is size ably a book-entry.

In this context, treasury operations are becoming more and more important to the banks and

a need for integration, both horizontal and vertical, has come to the attention of the

corporate. The basic purpose of integration is to improve portfolio profitability, risk-

insulation and also to synergize banking assets with trading assets. In horizontal integration,

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dealing/trading rooms engaged in the same trading activity are brought under same policy,

technological and accounting platform, while in vertical integration, all existing and diverse

trading and arbitrage activities are brought under one control with one common pool of

funding and contributions.

Meaning:

Treasury is the glue binding together liquidity management, asset/liability management,

capital requirements and risk management. It has an increasingly important job to do. At one

end of the spectrum it manages balance sheets and liquidity, and does good things to

enhance the yield on assets and minimize the cost of liabilities, mostly through the clever

and intelligent use of derivatives. At the other end of the spectrum, treasury can help

restructure the balance sheet and provide new products.

All banks have departments devoted to treasury management, as do larger corporations.

Treasury management modules are available for many larger enterprise software systems.

Banks do not disclose the prices they charge for Treasury Management products.

Definition:

Treasury management is the management of an organizations liquidity to ensure that the

right amount of cash resources are available in the right place in the right currency and at the

right time in such a way as to maximize the return on surplus funds, minimize the financing

cost of the business, and control interest rate risk and currency exposure to an acceptable

level.

In other words,Treasury management (or treasury operations) includes management of an

enterprise' holdings in and trading in government and corporate bonds, currencies, financial

futures, options and derivatives, payment systems and the associated financial risk

management.

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1.2 Objectives of Study

To have in-depth knowledge about the meaning of Treasury Management.

To know about the functions, organizational structure and objective of Treasury

Management in Banks.

To understand the elements of Treasury Management and the functions of treasurer.

To understand the risk associated with Treasury Management and their mitigation.

To know what are the RBI guidelines formulated for Treasury Management.

To know the future scope involved in Treasury Management.

To have an in-depth knowledge of how SBI Bank & CITI Bank manages its treasury.

1.3 Scope of Study

Treasury management includes the management of cash flows, banking, money market and

capital-market transactions; the effective control of the risks associated with those activities;

and the pursuit of optimum performance consistent with those risks. This definition is

intended to embrace an organizations use of capital and project financings, borrowing,

investment, and hedging instruments and techniques.

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1.4 Review of Literature

Abstract 1:

http://www2.warwick.ac.uk/fac/soc/wbs/subjects/finance/fof2012/programme/managing_of_

treasury_transactions_and_e.pdf /

Managing of Treasury transactions in banking SystemWithin a multi currency

economy

Author: Nidal Rashid Sabri (2012)

Diama K. Abulabn (2012)

Dima W. Hanyia (2012)

The Palestinian economy has no national currency which led to having three currencies in

use for deposits, saving, wealth measurement and trade transactions. Thus leads to make

challenges to the management of banking treasury activities and balances of each single

currency in the Palestinian economy. Therefore, this research aimed to target this issue,

using three research instruments. Three research instruments were used including:

Examining the related laws, imposed by the PMA on banks working in Palestinian economyas well as individual banking regulations, structures interviews with banks treasurers, and a

relevant questionnaires was directed to a selected samples of treasury staff and employees

regarding challenges to the management of banking treasury and closeting of foreign

currency positions. The study found that management of the banks working in the

Palestinian economy imposed more strict levels then that imposed by PMA and decreased it

to 1% to 3%, of the total owner equity instead of 5%, while others (42%) reduced the

maximum permitted surplus of a currency to a value ranged between 200,000 US$ and

500,000 US$. For closing the surplus of currencies, the majority of banks close it in the last

hour of working day. The majority of treasuries' staff strongly agreed that there is a need for

additional legislation to cover all related transactions to facilitate the work of the treasury.

The study recommended to relaxing the maximum ratio of 5% imposed on each single

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currency to be hold more than blatancies, keeping the 20% level from owner equity to the

total of currencies, extending the time of work including Fridays, reducing the restrictions on

investments outside Palestine, permitting trading in options and future transactions including

duke deposits and margins

Abstract 2:

http://www.tanzaniabankers.org/TBA%20-%20Currency%20Risk%20Management.pdf

A STUDY ON THE ROLE OF TREASURY MANAGEMENTON CURRENCY RISK

MANAGEMENT: THE CASE OF SELECTED COMMERCIAL BANKS

Author: Moremi Marwa: (2005)

The increased volatility of the international foreign exchange market generates increased

financial risk especially to commercial banks. Exchange rate change is one of the financial

risks where the increased volatility is reflected to the greatest extent. Therefore, if banks are

to measure, price, and control currency risk, they must establish an appropriate unit

responsible for currency risk management. This paper attempts to show that, commercial

banks in Tanzania have the necessary resources to curb risks associated to currency risks.This paper briefly provide some highlights on the research findings as regards to the role of

treasury management in currency risk management and then poses recommendations and

challenges on the magnitude of sustainability of the registered best practice for currency risk

management in commercial banks. The study employed both primary and secondary data

with a comparative case study orientation. Published financial statements and other desk

materials were collected principally from selected banks. Interviews were also conducted

with responsible treasury managers. There are various ways (economic, translation and

transaction), that the bank can utilize in analyzing and setting the exchange rate risk

management. In this study, transaction and translation exposure were the chosen methods of

analysis.

1.5 Research Methodology

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1.5.1 Formation of problem:

To study the various treasury management operations & risk management techniques.

1.5.2 Methods of Collection of data:

Gathering primary data through meeting key officials from the related area of

Treasury Management, collecting view points from them to arrive at meaningful

conclusion.

Gathering secondary data from books, periodicals, publications, newspaper, survey

reports, journals, websites, and internal website.

Conducting interview with appropriate officials relating to the field of Treasury

Management by designing appropriate questionnaires.

1.5.3 Research Limitation:

Time allotted for making the project is very limited.

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CHAPTER 2: TREASURY

2.1 Organizational structure of treasury

There is no standard structure for treasury department of a bank. Depending on the

responsibilities assigned and power delegated, it can be aptly structured. Typically, banks

maintain three independent tiers at the functional/operational level-

Tier I Dealing Desk (Front Office): The dealers and traders in different markets- money,

stock, debt, commodity, derivatives and forex- operate in their respective areas. They are the

first point if interface with other participants in the market. The number of dealers depends

on the size and frequency of the operations. In case of larger in each bank, operations would

be carried out by separate and independent set of dealers in each market. But, for a relatively

smaller treasury, operations would be done by one or more dealers jointly in all the markets.

Tier II Settlement Desk (Back Office): Once the deals are concluded, it is for the back

office to process and settle the deals. Indeed, the back office undertakes settlement and

reconciliation operations.

Tier III Accounting, Monitoring and Reporting Office (Audit group): This department

looks after the activities relating to accounting, auditing and reporting. Accountants record

all deals in the books of accounts, while auditors and inspectors closely monitor all deals and

transactions done by the front and the back office, and send regular reports to authorities

concerned. This department independently inspects daily operations in the treasury

department to ensure internal/regulatory system and procedures.

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The three departments should be compartmentalized and they act independently. The heads

of each section reports directly to the Head of the Treasury. A treasury can have more

functional desk depending on the size and structure of the bank, and activities undertaken by

the bank.

2.2 Functions of treasury department

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Head of Treasury

Chief Dealer

MarketIntelligence

Research andanalysis

Head ofSettlements

Head of AccountingMonitoring and

Reporting

Manager-Funds/Reserve Manager

SettlementsCustodian

Manager-Settlements

Documentation

Accounts/Monitoring

Audit/Reporting

Dealer- RupeeMoneyMarket.

Department

Dealer- Forex.Currency/Investment

Dealer- CorpoMerchant/

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Since 1990s, the prime movers of financial intermediaries and services have been the

policies of globalization and reforms. All players and regulators had been actively

participating, only with variation of the degree of participation, to globalize the economy.

With burgeoning forex reserves, Indian banks and Financial Institutions have no alternative

but to be directly affected by global happenings and trades. This is where; integrated

treasury operations have emerged as a basic tool for key financial performance.

A treasury department of a bank is concerned with the following functions:

a) Reserve Management & Investment: It involves (i) meeting CRR/SLR obligations,

(ii) having an appropriate mix of investment portfolio to optimise y ield and duration.

Duration is the weighted average life of a debt instrument over which investment in

that instrument is recouped. Duration Analysis is used as a tool to monitor the price

sensitivity of an investment instrument to interest rate charges.

b) Liquidity & Funds Management: It involves (i) analysis of major cash flows

arising out of asset-liability transactions (ii) providing a balanced and well-

diversified liability base to fund the various assets in the balance sheet of the bank

(iii) providing policy inputs to strategic planning group of the bank on funding mix

(currency, tenor & cost) and yield expected in credit and investment.

c) Asset Liability Management & Term Money: ALM calls for determining the

optimal size and growth rate of the balance sheet and also prices the Assets and

liabilities in accordance with prescribed guidelines. Successive reduction in CRR

rates and ALM practices by banks increase the demand for funds for tenor of above

15 days (Term Money) to match duration of their assets.

d) Risk Management: integrated treasury manages all market risks associated with a

banks liabilities and assets. The market risk of liabilities pertains to floating interest

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rate risk for assets & liability mismatches. The market risk for assets can arise from

(i) unfavorable change in interest rates (ii) increasing levels of disintermediation (iii)

securitization of assets (iv) emergence of credit derivates etc. while the credit risk

assessment continues to rest with Credit Department, the Treasury would monitor the

cash inflow impact from changes in assets prices due to interest rate changes by

adhering to prudential exposure limits.

e) Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed

optimally, without sacrificing yield or liquidity. An integrated Treasury unit has as

idea of the banks overall funding needs as well as direct access to various market

( like money market, capital market, forex market, credit market). Hence, ideally

treasury should provide benchmark rates, after assuming market risk, to various

business groups and product categories about the correct business strategy to adopt.

f) Derivative Products: Treasury can develop Interest Rate Swap (IRS) and other

Rupee based/ cross- currency derivative products for hedging Banks own exposures

and also sell such products to customers/other banks.

g) Arbitrage: Treasury units of banks undertake this by simultaneous buying andselling of the same type of assets in two different markets to make risk-less profits.

h) Capital Adequacy: This function focuses on quality of assets, with Return on Assets

(ROA) being a key criterion for measuring the efficiency of deployed funds. An

integrated treasury is a major profit centre. It has its own P&L measurement. It

undertakes exposures through proprietary trading (deals done to make profits out of

movements in market interest/ exchange rates) that may not be required for general

banking.

i) Coordination: Banks do operate at more than one money market centers. All the

centers undertake similar transactions with differing volumes. There is a need to

coordinate the activities of these centers so that aberrations are avoided (situations

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where one center is lending and the other one is borrowing at the same time). The

task of coordination of foreign exchanges positions is no different.

j) Control and Development: Treasury operates as the focal point of dealing

operations. Dealing operations could include cash/spot, forward, futures, options,

interest and currency liability swaps, forward rate agreements and the like. Treasury

is the sole owner and performer of these transactions.

k) Fraud Protection: The decade of nineties has witnessed more frauds in trading than

banking books. The amount and variety of such embezzlements have been directly

relatable to the operational level. The ground level task of this kind is to be

undertaken at the treasury.

2.3 Elements of treasury management

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2.3.1 Cash Reserve Ratio (CRR)

The core business of banks is mobilizing the deposits and utilizing the same for credit

accommodation. However, it should be taken into consideration that the banks are not

allowed to use the entire amount for extending credit. In order to promote certain prudential

norms for healthy banking practices, most of the developed economies require all banks to

maintain minimum liquid and cash reserves. As such, banks are required to ensure that these

statutory reserve requirements are met before directing on their credit plans.

Maintenance of CRR

As per the RBI Act 1934, Scheduled Commercial Banks are required to maintain with RBI

an average cash balance, the amount of which shall not be less than three per cent of the total

of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is

empowered to increase the said rate of CRR to such higher rate not exceeding twenty

percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934. At

present, effective from October 2,2004, the rate of CRR would be 5 per cent of the NDTL.

Thus, all Scheduled Commercial Banks are required to maintain the prescribed Cash

Reserve Ratio based on their NDTL as on the last Friday of the second preceding fortnight.

With a view to providing flexibility to banks in choosing an optimum strategy of holding

reserves depending upon their intra period cash flows, all Scheduled Commercial Banks are

required to maintain minimum CRR balances upto 70 per cent of the total CRR requirement

on all days of the fortnight with effect from the fortnight beginning December 28, 2002. If

any Scheduled Commercial Bank fails to observe the minimum level of CRR on any day/s

during the relevant fortnight, the bank will not be paid interest to the extent of one fourteenth

of the eligible amount of interest, even if there is no shortfall in the CRR on average basis.

Computation of Demand & Time Liabilities

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Liabilities of a bank may be in the form of demand or time deposits or borrowings or other

miscellaneous items of liabilities.

'Demand Liabilities' include all liabilities which are payable on demand and they include

current deposits, demand liabilities portion of savings bank deposits, margins held against

letters of credit/guarantees, balances in overdue fixed deposits and cumulative/recurring

deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts

(DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as

security for advances which are payable on demand.

Time Liabilities are those which are payable otherwise than on demand and they include

fixed deposits, cumulative and recurring deposits, time liabilities portion of savings bank

deposits, staff security deposits, margin held against letters of credit if not payable on

demand, deposits held as securities for advances which are not payable on demand and Gold

Deposits.

Money at Call and Short Notice from outside the Banking System should be shown against

Liability To Others. Loans/borrowings from abroad by banks in India will be considered as

'liabilities to others' and will be subject to reserve requirements. When a bank accepts fundsfrom a client under its remittance facilities scheme, it becomes a liability (liability to others)

in its books. The liability of the bank accepting funds will extinguish only when the

correspondent bank honors the drafts issued by the accepting bank to its customers.

Other Demand and Time Liabilities (ODTL) include interest accrued on deposits,

bills payable, unpaid dividends, suspense account balances representing amounts due to

other banks or public, net credit balances in branch adjustment account, any amounts due to

the "Banking System" which are not in the nature of deposits or borrowing.

Liabilities not to be included for NDTL computation

The under-noted liabilities will not form part of liabilities for the purpose of CRR:

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a) Paid up capital, reserves, any credit balance in the Profit & Loss Account of the bank,

amount availed of as refinance from the RBI, and apex financial institutions like Exim Bank,

IDBI, NABARD, NHB, SIDBI etc.

b) Amount of provision for income tax in excess of the actual estimated liabilities. Amount

received from DICGC (Deposit Insurance and Credit Guarantee Corporation) towards

claims and held by banks pending adjustments thereof.

d) Amount received from ECGC (Export Credit Guarantee Corporation) by invoking the

guarantee.

e) Amount received from insurance company on ad-hoc settlement of claims pending

Judgment of the Court.

f) Amount received from the Court Receiver.

g) The liabilities arising on account of utilization of limits under Bankers Acceptance

Facility

h) Inter bank term deposits/term borrowing liabilities of original maturity of 15 days and

above and upto one year with effect from fortnight beginning August 11, 2001.

Change in CRR as RBI's Strategy

In case of any shortfall banks generally tend to borrow from the call money market to meet

the cash reserve ratio (CRR) requirements, which they should maintain with the Reserve

Bank of India (RBI) every fortnight.

When the Reserve Bank of India (RBI) cuts the CRR rates, the general expectation is that

bankers would greet the news warmly as it provides them an opportunity to retain more

funds, which could be used productively. However, taking into consideration the recent

banking scenario the bankers consider it as a not very fruitful exercise, as the investment

avenues are very minimal and highly risky in nature. Moreover, a decrease in CRR resultsinto lesser funds to be locked up in RBIs vaults and further infusing greater funds into a

system.

When there is a fall in CRR, it increases money with the banks, which could then be used for

productive purposes. However, the question that one needs to ask is "Why infuse more

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money into a system which is already flush with liquidity? The main reason for high

liquidity is increasing number of customers approaching banks to open up deposit accounts.

Moreover, credit risk has always been present in the banking industry because of its very

nature of business. This has gathered momentum in the recent past due to mounting non-

performing assets (NPAs). Almost all the banks are facing the problem of bad loans,

burgeoning non-performing assets, thinning margins, etc. as a result of which, banks are

little reluctant in granting loans to corporates.

This results into a good liquidity position of commercial banks as deposits are showing a

continuous increase whereas, mobilization of funds for productive purposes is much more

restrictive in nature. Also, the bankruptcy of major corporates in recent past has added to

their fear of possible non-recovery of advances.

As such, as and when Reserve Bank of India (RBI) reduces the CRR, it further enhances

loanable funds with the banks and reduces their dependence on the call and term money

market. This will in turn reduce the call rates and the borrowing cost of the government.

Thus the Impact of CRR cut as RBIs strategy creates a terribly uncomfortable situation

from the banks point of view and Reserve Bank of India (RBI) further enhances its liquidity

position, with no productive avenues available for investment purposes.

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2.3.2 Statutory Liquidity Ratio (SLR)

As per the B.R. Act, 1949 all Scheduled Commercial Banks, in addition to the average daily

balance which they are required to maintain u/s 42 of the RBI Act, 1934, maintain1

a) In cash, or

b) In gold valued at a price not exceeding the current market price, or

c) In approved securities valued at a price as specified by the RBI from time to time an

amount of which shall not, at the close of the business on any day, be less than 25 per cent or

such other percentage not exceeding 40 per cent as the RBI may from time to time, by

notification in gazette of India, specify, of the total of its demand and time liabilities in India

as on the last Friday of the second preceding fortnight.

At present, all Scheduled Commercial Banks are required to maintain a uniform SLR of 23%

of the total of their demand and time liabilities in India.

Computation of demand and time liabilities for SLR

The procedure to compute total NTDL for the purpose of SLR is similar to the procedure

followed for CRR purpose. However, it is clarified that Scheduled Commercial Banks are

required to include inter-bank term deposits/ term borrowing liabilities of original maturitiesof 15 days and above and up to one year in 'Liabilities to the Banking System'. Similarly

banks should include their inter-bank assets of term deposits and term lending of original

maturity of 15 days and above and up to one year in 'Assets with the Banking System'

Penalties

If a banking company fails to maintain the required amount of SLR, it shall be liable to pay

to RBI in respect of that default, the penal interest for that day at the rate of 3 per cent per

annum above the bank rate on the shortfall and if the default continues on the next

succeeding working day, the penal interest may be increased to a rate of 5 percent per annum

above the Bank Rate for the concerned days of default on the shortfall.

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CHAPTER 3: INVESTMENTS

3.1 Classification of investments

The entire investment portfolio of the banks (including SLR securities and non-SLR

securities) should be classified under three categories viz. Held to Maturity, Available for

Sale and Held for Trading. However, in the balance sheet, the investments will continue to

be disclosed as per the existing six classifications viz. a) Government securities, b) Other

approved securities, c) Shares, d) Debentures & Bonds, e) Subsidiaries/ joint ventures and f)

Others (CP, Mutual Fund Units, etc.).

Banks should decide the category of the investment at the time of acquisition and the

decision should be recorded on the investment proposals.

3.1.1 Held to Maturity

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The securities acquired by the banks with the intention to hold them up to maturity

will be classified under Held to Maturity.

Investment classified under Held to Maturity category need not be marked to marketand will be carried at acquisition cost unless it is more than the face value. In such a

case, the premium should be amortized over a period remaining to maturity.

The investments included under 'Held to Maturity' should not exceed 25 per cent of

the banks total investments. But Sept 2004 onwards, RBI has revised this norm

allowing banks to park up to 25% of their NDTL in the HTM category.

The following investments will be classified under Held to Maturity but will not be

counted for the purpose of ceiling of 25% specified for this category:

Re-capitalization bonds received from the Government of India towards their

re-capitalization requirement and held in their investment portfolio. This will

not include re-capitalization bonds of other banks acquired for investment

purposes. (The funds that banks received in lieu of equity issued by the

government were invested in government bonds i.e. recapitalisation bonds.

The government serviced these bonds paying interest and banks, in turn, paid

dividends to the government. recapitalisation bonds)

Investment in subsidiaries and joint ventures. [A joint venture would be one

in which the bank, along with its subsidiaries, holds more than 25% of the

equity.]

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3.1.2 Available for Sale & Held for Trading

The securities acquired by the banks with intention to trade by taking advantage of

the short-term price/interest rate movement will be classified under Held for Trading.

The investments classified under Held for Trading category would be those from

which the bank expects to make a gain by the movement in the interest rates/ market

rates. These securities are to be sold within 90 days.

The individual scrips in the Held for Trading category will be revalued at monthly or

at more frequent intervals and net appreciation/depreciation under each classification

will be recognized in income account. The book value of the individual scrip will be

changed with revaluation.

The securities which do not fall within the above two categories will be classified

under Available for Sale

The investments classified under Available for Sale category should be held for

minimum period of 90 days.

Individual scrips in the Available for Sale category will be marked to market at the

year-end. The net depreciation under each classification should be recognized and

fully provided and any appreciation should be ignored. The book value of the

individual securities would not undergo any change after the revaluation

The banks will have the freedom to decide on the extent of holdings under Available

for Sale and Held for Trading categories. This will be decided by them after

considering various aspects such as basis of intent, trading strategies, risk

management capabilities, tax planning, manpower skills, capital position.

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3.1.3 Shifting among categories

1. Banks may shift investments to/from Held to Maturity category with the approval of

the Board of Directors once a year (beginning of the year).

2. Banks may shift investments from Available for Sale category to Held for Trading

category with the approval of their Board of Directors/ ALCO/ Investment

Committee.

3. Shifting of investments from Held for Trading category to Available for Sale

category is generally not allowed. However, it will be permitted only under

exceptional circumstances like not being able to sell the security within 90 days due

to tight liquidity conditions, or extreme volatility, or market becoming unidirectional.

Such transfer is permitted only with the approval of the Board of Directors/ ALCO/

Investment Committee.

4. Transfer of scrips from one category to another, under all circumstances, should be

done at the acquisition cost/ book value/ market value on the date of transfer,

whichever is the least, and the depreciation, if any, on such transfer should be fullyprovided for.

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3.1.4 Investment Fluctuation Reserve (IFR)

With a view to building up of adequate reserves to guard against any possible reversal of

interest rate environment in future due to unexpected developments, banks are advised to

build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the investment

portfolio within a period of 5 years. IFR should be computed with reference to investments

in two categories, viz., Held for Trading and Available for Sale.

RBI GUIDELINES FOR NON- SLR INVESTMENTS

Banks should prescribe minimum disclosure standards as a policy with Board

approval, with regards to the investments made by the treasury department.

Banks should ensure that their investment policies duly approved by the Board of

Directors are formulated after taking into account the following aspects:

The Boards of banks should lay down policy and prudential limits on investments

in bonds and debentures including cap on unrated issues and on private

placement basis, sub limits for PSU bonds, corporate bonds, guaranteed bonds,

issuer ceiling, etc.

Banks should make their own internal credit analysis and rating even in respect

of rated issues and should not entirely rely on the ratings of external agencies

The investments should be well diversified and there should be no concentration

of risk.

The banks should put in place proper risk management systems for capturing and

analysing the risk in respect of these investments and taking remedial measures

in time.

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Due caution should be taken by the bank while investing in bonds, debentures of

companies and should not invest in companies whose name appear in the Defaulters

list. In case a director of a company, in which the bank wants to invest in, is in the

Defaulters list, prior approval from the Board is required.

Direct investment in shares, convertible bonds and debentures etc: Banks are free to

acquire shares, convertible debentures of corporates and units of equity-oriented

mutual funds, subject to a ceiling of 5 per cent of the total outstanding domestic

credit (excluding inter-bank lendings and advances outside India) as on March 31 of

the previous year. Within the overall ceiling of 5 per cent for total exposure to

capital market, the total investment in shares, convertible bonds and debentures and

units of equity-oriented mutual funds by a bank should not exceed 20 per cent of its

net worth. While making investment in equity shares etc., whose prices are subject to

volatility, the banks should keep in view the following guidelines:

Underwriting commitments taken up by the banks in respect of primary issues

through book building route would also be within the above overall ceiling.

Investment in equity shares and convertible bonds and debentures of corporate

entities.

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3.2 Investment Options

A large portion of the banks investment is made in debt instruments i.e. to the extent of 90-

95 % while investment in Equity amounts to hardly 5 % of banks portfolio.

3.2.1 Equity Market

The Banks are permitted to invest in Equity within a limit set up by the RBI, the limit as of

now is 5%. Though the cap is 5% many or almost all banks hardly invest 2-3% in equity.

Now a days banks are also exploring investment opportunities in capital market through

Mutual Funds.

Investing in equity markets include areas like:

Individual companies scrips

Index

Derivatives (Futures, Options, Interest rate swaps, currency rate swaps, commodity)

Mutual Funds offer various products with varied risk levels related to capital market, which

includes options like:

Equity Funds

Growth Funds

Sectoral Funds

Balanced Funds

Value Funds

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3.2.2 DEBT MARKET

Role of Debt Market

The key role of the debt markets in the Indian Economy stems from the following reasons:

Efficient mobilization and allocation of resources in the economy

Financing the development activities of the Government

Transmitting signals for implementation of the monetary policy

Facilitating liquidity management in tune with overall short term and long-term

objectives.

Since the Government Securities are issued to meet the short term and long term financial

needs of the government, they are not only used as instruments for raising debt, but have

emerged as key instruments for internal debt management, monetary management and short

term liquidity management.

The returns earned on the government securities are normally taken as the benchmark rates

of returns and are referred to as the risk free return in financial theory. The Risk- Free rate

obtained from the G-sec rates are often used to price the other non-govt. securities in the

financial markets.

Participants in the Debt Market

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Debt markets are mainly wholesale markets dominated by institutional investors, namely,

Banks

FIs

Mutual funds

Provident funds

Insurance companies &

Corporates.

Many of these participants are issuers of debt instruments.

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VARIOUS DEBT INSTRUMENTS

Debt instruments represent contracts whereby one party lends money to another on pre-

determined terms with regard to rate of interest to be paid by the borrower to the lender. In

India, we use the term bond for debt instruments issued by central & state governments

and public sector organizations and the term debentures issued by private corporate sector.

Short Term Debt Instruments

CALL MONEY

The call money market is a part of money market, where day-to-day surplus funds, mostly of

banks, are traded. The call money market comprises an interbank call market, and the market

between banks on one hand and security brokers and dealers on the other hand. The call

money market is most liquid of all the money market segments and it is also the most

sensitive barometer measuring the liquidity conditions prevailing in the financial markets.

The call money is the money repayable on demand. The maturity of call loans varies

between 1 to 14 days. The money that is lent for one day in the call money market is alsoknown as overnight money. The term notice money also refers to the money lent in the

call market, but a notice is served by the lender for payment in a day or two before payment

date. Duration of notice money is similar to that of call money i.e. upto 14 days. The money

that is lent for more than 14 days is referred to as term money. In call money market any

amount could be lent or borrowed at an interest rate, which is acceptable to both borrower

and lender. These loans are considered as highly liquid; as they are repayable on due date.

Initially, banks were only permitted to deal in this market; it was then referred as Inter bank

market. RBI acts as a regulator of the call money market, but neither borrows from nor

lends to it.

Participants

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Scheduled commercial Banks (private sector, public sector and cooperative banks)

Discount and Finance House of India (DFHI)

Securities Trading Corporation of India Limited (STCI)

Primary Dealers

Financial Institutions

Mutual Funds

Purpose

The short-term mismatches arise due to variation in maturities.

The banks borrow from this market to meet the Cash Reserve Ratio requirements,

which they should maintain with RBI every fortnight.

Money is borrowed in the call/notice market for short periods to discount

commercial bills.

Call Rates

The interest paid on call loans is known as the call rates. Though the rate quoted in themarket is annualized one, the rate of interest on call money is calculated on a daily basis.

These rates vary from day to day, often from hour to hour. High rates indicate a tightness of

liquidity in the financial system while low rates indicate an easy liquidity position in the

market. The rate is largely subjected to influence by the forces of demand and supply for

funds.

TREASURY BILLS

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Government issues Treasury bills (T-bills) and dated securities as a means to raise funds, in

the short term and long term markets respectively. T-bills constitute a major portion of short-

term borrowings by the Government of India.

T-bills are issued in the form of promissory notes or finance bills (a bill which does not arise

from any genuine transaction in goods is called a finance bill) by the government to tide

over short-term liquidity shortfalls. These short-term instruments are highly liquid and

virtually risk free as they are issued by the government. They are the most liquid instruments

after cash and call money, as repayment guarantee is given by the central government. T-

bills do not require any grading or further endorsement like ordinary bills, as they are claim

against the Government. These instruments have distinct features like zero default risk,

assured yield, low transaction cost, negligible capital depreciation and eligible for inclusion

in SLR and easy availability, etc. apart from high liquidity.

Issuer

The RBI acts as a banker to the Government of India. It issues T-bills and other government

securities to raise funds on behalf of Government of India, by acting as an issuing agent.

Investors

Though various groups of investors including individuals are eligible to invest, the main

investor found in T-bills are mostly banks to meet their SLR requirements. Other large

investors include:

Primary Dealers

Financial Institutions (for primary cash management)

Provident Funds (PFs)

Insurance Companies

Non-banking Finance Companies (NBFCs)

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Foreign Institutional Investors (FII)

State Governments.

NRIs and OCBs are allowed to invest only on non-repatriable basis.

Purpose

T-bills are raised to meet the short-term requirements of Government of India. As the

Governments revenue collections are bunched and expenses are dispersed, these bills

enable the Government to manage cash positions in a better way. T-bills also enable the RBI

to perform Open Market Operations (OMO), which indirectly regulate money supply in the

economy.

Banks prefer T-bills because of high liquidity, assured returns, no default risk, no capital

depreciation and eligibility for statutory requirements.

Size

The T-bills are issued for a minimum amount of Rs. 25000 and in multiples of 25000. T-

bills are issued at discount and redeemed at par.

Types

T-bills are issued at various maturities, generally upto one year. Thus they are useful in

managing short-term liquidity. They are:

91-day T-bills - 91-day T-bill- maturity is in 91 days. Its auction is on every

Wednesday of every week. The notified amount for this auction is Rs. 250 cr.

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364-day T-bills - 364-Day T-bill- maturity is in 364 days. Its auction is on every

alternate Wednesday (which is a reporting week). The notified amount for this

auction is Rs. 750 cr.

Categorization of T-Bills based on the nature of issue

Ad hoc Treasury bills: These are issued in favor of the RBI when Government needs

cash. They are neither issued nor available to the public.

On Tap Treasury bills: RBI issues on-tap T-bills to investors on any working day.

They have a maturity of 91 days.

Auctioned Treasury bills: Various T-bills are auctioned on different days. The RBI

issues a calendar of T-bill auctions. RBI also announces the exact date of auction,

the auction amount and the dates of payment. The bids are tendered and accepted at

the auction.

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T-Bills Issuance

Treasury bills are sold through an auction process, in which banks and primary dealers are

major bidders. Non-competitive bids are allowed in the auction, in which provident funds

and other investors can participate. Non- competitive bidders need not quote the rate of yield

at which they desire to buy the T-bills. The Reserve Bank of India allots bids to the non-

competitive bidders at the weighted average yield arrived at, on the basis of the yield quoted

by accepted competitive bid at the auction. Allocation to non-competitive bids is outside the

amount notified for sale. Non-competitive bidders therefore do not face any uncertainty in

purchasing the desired amount of T-bills from the auctions. The RBI issues a calendar of T-

Bills auctions.

The system of underwriting the T-bills by the PDs has been replaced by a system of

minimum bidding commitment. Each PD is required to make a minimum commitment for

auction of T-bills so that they together absorb 100% of the notified amount. Both

discriminatory and uniform method is used for issuance. Auctions for 91-day T-bills are

uniform price auctions where all successful bidders have to pay the cut-off price. Therefore,

in 91-day T-bill auctions, the weighted average is same as the cut-off price.

In case of all other bills, discriminatory auction is followed, where all the successful biddershave to pay the prices at which they had bid for.

Subsidiary General Ledger (SGL) A/C:

SGL A/C is a facility provided by RBI to large banks and financial institutions to hold their

investments in Government securities and T- bills in electronic book entry form. Such

entities can settle their trades in securities held in SGL a/c through delivery versus payment

(DVP) mechanisms, which ensures moment of funds and securities simultaneously .As all

investors do not have access to the SGL system, RBI has permitted such investors to hold

their securities in physical certificate form. They may also open an SGL a/c with any such

entity approved by RBI for this purpose, and thus avail of the DVP settlement system. Such

client accounts are also referred as Constituent SGL A/C.

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Both buyer and the seller have to maintain a Current a/c with the RBI and no overdraft

facility will be provided.

RBI GUIDELINES

All the transactions put through by a bank, either on outright basis or ready forward basis

and whether through the mechanism of Subsidiary General Ledger (SGL) Account or Bank

Receipt (BR), should be reflected on the same day in its investment account and,

accordingly, for SLR purpose wherever applicable. Purchase/ sale of any securities will be

done through SGL A/c under the Delivery Versus Payment (DVP) System.

All transactions in Govt. securities for which SGL facility is available should be putthrough SGL A/cs only.

Under no circumstances, a SGL transfer form issued by a bank in favour of another

bank should bounce for want of sufficient balance of securities in the SGL A/c of

seller or for want of sufficient balance of funds in the current a/c of the buyer.

The SGL transfer form received by purchasing banks should be deposited in their

SGL A/cs. immediately i.e. the date of lodgement of the SGL Form with RBI shall

be within one working day after the date of signing of the Transfer Form.

SGL transfer forms should be signed by two authorised officials of the bank whose

signatures should be recorded with the respective PDOs (Public Debt Office) of the

Reserve Bank and other banks.

Any bouncing of SGL transfer forms issued by selling banks in favour of the buying

bank, should immediately be brought to the notice of the Regional Office of

Department of Banking Supervision of RBI by the buying bank.

If a SGL transfer form bounces for want of sufficient balance in the SGL A/c, the

following penal action against it is taken:

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In case of any default arising in the current a/c, such amount will be penalised

by the RBI @ of 3 % above the Discount and Finance House of Indias

(DFHI) call money lending rate of that day. And if this rate is lower than the

PLR than the penal rate would be 3 % above the current PLR.

If the bouncing of the SGL form occurs thrice, the bank will be debarred from

trading with the use of the SGL facility for a period of 6 months from the

occurrence of the third bouncing. If, after restoration of the facility, any SGL

form of the concerned bank bounces again, the bank will be permanently

debarred from the use of the SGL facility in all the PDOs of the Reserve

Bank.

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COMMERCIAL PAPERS (CPs)

Commercial Papers (CPs) are short-term unsecured usance promissory notes issued

at a discount to face value by reputed corporates with high credit rating and strongfinancial background. Companies issue CPs typically to finance accounts receivable

and inventories at a discount reflecting the prevailing market interest rates.

Issuers: private sector Co., public sector unit, non-banking Co., primary dealers.

Commercial Papers are open to individuals, corporates, NRIs and banks, but NRIs

can invest on non-repatriable / non-refundable basis. FIIs have also been allowed to

invest their short-term funds in Commercial Papers.

CPs have a minimum maturity of 15 days and a maximum maturity of 1 year. They

are available in the denomination of Rs. 5 lakh and multiples of 5 lakh and a

minimum investment is Rs. 5 lakh per investor.

Secondary market trading takes place in the lot in lots of Rs.5 lakh each usually by

banks. The transfer is done by endorsement and delivery.

CPs are issued only if the total cost is lower than PLR of banks.

The features of CPs are:

1. They do not originate from specific trade transactions like commercial bills.

2. They are unsecured.

3. Involve much less paper work.

4. Have high liquidity.

CPs are issued at a discount to the face value. The issue price is calculated as below.

P = Face value / (1 + D * (N / 365))

Where, F= Face/Maturity value P = Issue price of the CP

D= Discount Rate N = Usance period (No. of days)

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Types of Papers

Commercial paper can be issued either directly or through a dealer.

If the paper is issued by the company directly to the investors without dealing withan intermediary, it is referred as direct paper.

If CPs is issued by an intermediary (i.e. dealer / merchant banker) on behalf of its

corporate client, it is known as dealers paper.

In India, the CPs are usually placed with the investors with the help of Issuing & Paying

Agents (IPA). Only scheduled banks can act as IPAs.

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CERTIFICATE OF DEPOSIT (CDs)

Certificate of Deposit (CDs) are usance promissory notes, negotiable and in

marketable form bearing a specified face value and number. Scheduled commercial banks and the major financial institutions can issue CDs

within the umbrella limit fixed by RBI.

Individuals, corporate, companies, funds, associations, trusts and NRIs are the main

investors in the CDs (on non-repatriable basis).

CDs are issued for a period of 14 days to one year (normally one to three years by

the financial institutions) at a minimum amount of Rs. 5 lakh and in multiples of Rs.5

lakhs thereafter with no upper limit.

There is no specific procedure to issue CDs. It is available, on tap, with the bankers.

CDs are the largest money market instruments traded in dollars. They are issued by

either banks or depository institutions, mostly in bearer form enabling trading in the

secondary market.

The features of CDs are:

It is title document to a time deposit, riskless, liquid and highly negotiable

and marketable.

It is issued at a discount to the face value.

It is freely transferable by endorsement and delivery.

CDs are maturity-dated obligations of banks forming a part of time

liabilities, and are subjected to usual reserve requirements.

It does attract stamp duty.

CDs issued are within the limit as specified by Reserve Bank of India (in

case of FIs only).

CDs are also issued in demat forms. Thus various advantages of

dematerialization can be availed.

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The benefits of issuing CDs to the bank are:

Interest can be determined on a case-to-case basis.

There is early maturity of a CD

Rates are more sensitive to call rates.

Discount

CDs are issued at a discount to the face value. Bank CDs are always discount bills, while

CDs of DFIs (Development Financial Institutions) can be coupon bearing as well. The

discount rate is calculated as follows:

DR = F

1 + (I * N)

100*365

Where: DR =Discounted Rate N=Issuance period

F=Face Value I=Effective Interest rate per annum

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BILL FINANCING

Monetary policy and Bill financing refers to the use of the official instruments under

the control of the Central Bank of the country to regulate the availability, cost anduse of money and credit.

The bank standard rate is the rate at which the bank is prepared to buy or rediscount

bills of exchange or other commercial paper eligible for purchases.

A bill of exchange has been defined as an instrument in writing containing an

unconditional order, signed by the maker, directing a certain person to pay a certain

sum of money only to, or to the order of, a certain person or to the bearer of the

instrument.

Bills of exchange can be classified as demand or usance bills, documentary or clean

bills, D/A or D/P bills, inland or foreign bills, supply bills or government bills or

accommodation bills.

Bills can also be classified as traders bills, bills with co-acceptance, bills

accompanied by letter of credit and drawee bills.

Originally discounted bills can be rediscounted by banks for their corporate clients

with financial institutions, as long as such bills arise out of genuine trade

transactions.

RBI has instructed the banks to restrain from rediscounting bills outside the

consortium of banks and initially discounted by finance companies and merchant

bankers. Further discounting should be only for the purpose of working capital /

credit limits and for the purchase of raw materials / inventory. Accommodation bills

are not to be discounted under any circumstances.

The specific features of a negotiable instrument are:

There must be three parties to the exchange, namely drawer, drawee and

payee.

found in the bills of exchange

It should be duly signed by the drawer and presented to the drawee for

acceptance.

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REPOS & REVERSE REPOS

Repo is a money market instrument, which enables collateralized short term borrowing and

lending through sale/ purchase of debt instruments. Under a repo transaction, the seller of

the instrument enters into an agreement with the buyer to repurchase the instrument at a

predetermined price and date. A repo is also called as a Ready Forward transaction as it is a

means of funding by selling a security on spot and repurchasing the same on a forward basis.

The main objective of trading in Repos is to meet temporary short-term liquidity

requirements in the short-term money market.

For the lender of cash, the securities offered by the borrower serve as a collateral; whereas

for the lender of securities, the cash borrowed serves as a collateral. Repos, thus are called as

collateralized short term borrowings.

The lender of the securities (borrower of cash) is said to be doing a repo, whereas the lender

of cash (borrower of securities) is said to be doing a reverse repo.

A reverse repo is a mirror image transaction of a repo. In this transaction, the investor

purchases with an agreement to resell the securities. Hence, whether a transaction is a repo

or a reverse repo depends on who initiated the first leg of the transaction. One factor whichencourages an organization to enter into a reverse repo is to earn some extra income on its

idle cash.

Though there is no restriction on the maximum duration for a repo, generally repo

transactions do not exceed 14 days. It is essential for the participants of the repo market to

hold SGL & current accounts with the RBI. Repo transactions are also reported on the

WDM segment of the NSE.

Consider the following eg:

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Trade date: 13th July 2004

Trade price: 108.5

Total Face value: Rs.100 *1000 = 100000

Security: 9.5 %, maturing on 22nd March 09

Repo rate: 4.5 %

Repo term: 2 days

First leg:

On 13th July the seller of the repo (borrower of cash) receives the following amount:

Value of the security: 108.5/100*100000 =108,500.00

Accrued interest: 9.5/100 * 100000* 112 / 360 = 2955.56

Settlement amount: 108500 + 2955.56 = 111455.56

Second leg:

On 15th July (repo term is 2 days), the seller returns the following amount:

Original borrowing: 108,500.00

Accrued interest: 9.5/100 * 100000 * 114 / 360 = 3008.33

Repo interest: 4.5 /100 * 100000 * 2/360 = 25Settlement amount: 108500 + 3008.33 + 25 = 111533.33

RBI GUIDELINES

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Ready forward contracts may be undertaken only in (i) Dated Securities and

Treasury Bills issued by Government of India and (ii) Dated Securities issued by

State Governments.

Ready forward contracts in the securities specified above may be entered into by

a banking company, a co-operative bank or any person maintaining a Subsidiary

General Ledger Account with Reserve Bank of India, Mumbai.

Such ready forward contracts shall be settled through the Subsidiary General

Ledger Accounts of the participants with Reserve Bank of India or through the

Subsidiary General Ledger Account of the Clearing Corporation of India Ltd.

with Reserve Bank of India, and

No sale transaction shall be put through without actually holding the securities in

the portfolio.

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LONG-TERM DEBT INSTRUMENTS

By convention, these are instruments having a maturity exceeding one year. The main

instruments are Government of India dated securities (GOISEC), State Government

securities (state loans), public sector bonds (PSU bonds), corporate debentures etc.

Most of these are coupon bearing instruments i.e. interest payments (called coupons) are

payable at pre specified dates called "coupon dates". At any given point of time, any such

instrument has a certain amount of accrued interest with it i.e. interest, which has accrued

(but is not due) calculated at the "coupon rate" from the date of the last coupon payment.

E.g. if 30 days have elapsed from the last coupon payment of a 14% coupon debenture with

a face value of Rs 100, the accrued interest will be

100*0.14*30/365 = 1.15

Whenever coupon-bearing securities are traded, by convention, they are traded at a base

price with the accrued interest separate; in other words, the total price would be equal to the

summation of the base price and the accrued interest.

A brief description of these instruments is as follows:

Government of India dated securities (GOISECs):

Like treasury bills, GOISECs are issued by the Reserve Bank of India on behalf of the

Government of India. These form a part of the borrowing program approved by Parliament

in the Finance Bill each year (Union Budget). They are issued in dematerialized form but

can be issued in denominations as low as Rs 100 in physical certificate form. They have

maturity ranging from 1 year to 30 years. Very long dated securities i.e. those having

maturity exceeding 20 years were in vogue in the seventies and the eighties while in the

early nineties, most of the securities issued have been in the 5-10 year maturity bucket. Very

recently, securities of 15 and 20 years maturity have been issued.

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Like T-Bills, GOISECs are most commonly issued in dematerialized form in the "SGL"

account although it can be issued in physical certificate form on specific request. Tradability

of physical securities is very limited. The SGL passbook contains a record of the holdings of

the investor. The RBI acts as a clearing agent for GOISEC transactions by being the

custodian and operator of the SGL account. GOISECs are transferable by endorsement and

delivery for physical certificates. Transactions of securities held in SGL form are effected

through SGL transfer notes. Transfer of GOISECs does not attract stamp duty or transfer

fee. Also no tax is deductible at source on the coupon payments made on GOISECs.

Like T-Bills, GOISECs are issued through the auction route. The RBI pre specifies an

approximate amount of dated securities that it intends to issue through the year. However, it

has broad flexibility in exceeding or being under that figure. Unlike T-Bills, it does not have

a pre set timetable for the auction dates and exercises its judgement on the timing of each

issuance, the duration of instruments being issued as well as the quantum of issuance.

Sometimes the RBI specifies the coupon rate of the security proposed to be issued and the

prospective investors bid for a particular issuance yield. The difference between the coupon

rate and the yield is adjusted in the issue price of the security. On other occasions, the RBI

just specifies the maturity of the proposed security and prospective investors bid for the

coupon rate itself. In either case, just as in T-Bills, the auction is conducted on a French

auction basis. Also, the RBI has wide latitude in deciding the cut off rate for each auction

and can end up with unsold securities, which devolve on itself.

Apart from the auction program, the RBI also sells securities in its open market operations

(OMO), which it has acquired in devolvements or sometimes directly through private

placements. Similarly, it also buys securities in open market operations if it feels fit.

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New types of GOISECs

Earlier, the RBI used to issue straight coupon bonds i.e. bonds with a stated coupon payable

periodically. In the last few years, the RBI has been innovative and new types of instruments

have also been issued. These include:

Inflation linked bonds: These are bonds for which the coupon payment in a particular

period is linked to the inflation rate at that time the base coupon rate is fixed with the

inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate.

Zero coupon bonds: These are bonds for which there is no coupon payment. They are

issued at a discount to face value with the discount providing the implicit interest payment.

State government securities (state loans): These are issued by the respective state

governments but the RBI coordinates the actual process of selling these securities. Each state

is allowed to issue securities up to a certain limit each year, which is decided in consultation

with the planning commission. Though there is no central government guarantee on these

loans, they are deemed to be extremely safe since the RBI debits the overdraft accounts of

the respective states held with it for payment of interest and principal. Generally, the coupon

rates on state loans are marginally higher than those of GOISECs issued at the same time.

The procedure for selling of state loans, the auction process, allotment procedure & transfer

is similar to that for GOISEC. They also qualify for SLR status and interest payment and

other modalities are similar to GOISECs. They are also issued in dematerialized form and no

stamp duty is payable on transfer. In general, state loans are much less liquid than GOISECs.

Primary Issuance Process of G-Secs

RBI announces the auction of G-Secs through a press notification and invites bids. The

sealed bids are opened at an appointed time, and the allotment is based on the cut-off price

decided by the RBI. Successful bidders are those that bid at a higher price than the cut-off

price.

The two choices in treasury auctions widely used are:

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1. Discriminatory Price Auctions (French Auction)

2. Uniform Price Auction (Dutch Auction)

In both these type of auctions, the winning bids are those that exhaust the amount on the

offer, beginning at the highest quoted price (or lowest quoted yield). However, in a uniform

price auction, all successful bidders pay a uniform price, which is usually the cut-off price.

In case of the discriminatory price auction, all successful bidders pay the actual price they

had bid for.

If successful bids are decided by filling up the notified amount from the lowest bid upwards,

such an auction is called a yield-based auction. In such an auction, the name of the security

is the cut-off yield. Such auction creates a new security with a distinct coupon rate every

time an auction is completed. For example, a 10.3% G-Sec 2010 derives its name from the

cut-off yield i.e. 10.3%, which becomes the coupon payable on the bond. The coupon

payment and redemption dates are unique for each security depending on the deemed date of

allotment of the securities auctioned.

If successful bids are filled up in terms of the prices bid by the participants, from the highest

bid downwards, such an auction is called a price-based auction. A price-based auction

facilitates the re-issue of an existing security. The coupon rate and the dates of payment of

coupons and redemption are already known.

RBI moved from the yield-based auction to price-based auction in 1998, in order to enableconsolidation of G-Secs through re-issue of existing securities. The RBI has the authority to

shift to yield-based auctions and notify the same in the auction notification.

GUIDELINES ON TRANSACTIONS IN GOVERNMENT SECURITIES

In the light of fraudulent transactions in the guise of Government securities transactions in

physical format by a few co-operative banks with the help of some broker entities, it has

been decided to accelerate the measures for further reducing the scope of trading in physical

forms. These measures are as under:

For banks, which do not have SGL account with RBI, only one CSGL account can be

opened.

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In case the CSGL accounts are opened with a scheduled commercial bank, the

account holder has to open a designated funds account (for all CSGL related

transactions) with the same bank.

The entities maintaining the CSGL / designated funds accounts will be required to

ensure availability of clear funds in the designated funds accounts for purchases and

of sufficient securities in the CSGL account for sales before putting through the

transactions.

No transactions by the bank should be undertaken in physical form with any broker.

Banks should ensure that brokers approved for transacting in Government securities

are registered with the debt market segment of NSE/BSE/OTCEI.

Public Sector Undertaking Bonds (PSU Bonds): These are long-term debt instruments

issued by Public Sector Undertakings (PSUs). They have maturities ranging between 5-10

years and they are issued in denominations (face value) of Rs1000 each. Most of these issues

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are made on a private placement basis to a targeted investor base at market determined

interest rates.

These PSU bonds are transferable by endorsement and delivery and no tax is deductible at

source on the interest coupons payable to the investor (TDS exempt). In addition, from time

to time, the Ministry of Finance has granted certain PSUs, an approval to issue limited

quantum of tax-free bonds i.e. bonds for which the payment of interest is tax exempt in the

hands of the investor. This feature was introduced with the purpose of lowering the interest

cost for PSUs which were engaged in businesses which could not afford to pay market

determined rates of interest e.g. Konkan Railway Corporation was allowed to issue

substantial quantum of tax free bonds.

Bonds of Public Financial Institutions (PFIs): Apart from public sector undertakings,

Financial Institutions are also allowed to issue bonds, that too in much higher quantum.

They issue bonds in 2 ways through public issues targeted at retail investors and trusts and

also through private placements to large institutional investors. Usually, transfers of the

former type of bonds are exempt from stamp duty while only part of the bonds issued

privately have this facility. On an incremental basis, bonds of PFIs are second only to

GOISECs in value of issuance.

Corporate debentures: These are long-term debt instruments issued by private sector

companies. These are issued in denominations as low as Rs 1000 and have maturities

ranging between one and ten years. Long maturity debentures are rarely issued, as investors

are not comfortable with such maturities. Generally, debentures are less liquid as compared

to PSU bonds and the liquidity is inversely proportional to the residual maturity.

Bond Issuance

Board meeting and approval of issue as an ordinary resolution at the AGM

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Credit rating of the issue (mandatory in case of a public issue)

Creation of security for the bond /debenture through appointment of debenture

trustees (period greater than 18 months)

Appointment of advisors and investment bankers for issuance management

Finalizations of the initial terms of the issue

Preparation of the offer document (for public issue) and Information memorandum

(for private placement.)

SEBI approval for the offer document of the issue

Listing agreement with Stock Exchanges

Offer the issue to prospective investors and/or book-building

Acceptance of the application money/advance deposit for the issue

Allotment of the issue

Issue of letters of allotment and certificate / Depository conformation

Collect final amount from the investors

Refund excess application money / interest on application money.

A key feature that distinguishes debentures from bonds is the stamp duty payment.

Debenture stamp duty is a state subject and the quantum of incidence varies from state to

state. There are two kinds of stamp duties levied on debentures viz issuance and transfer.

Issuance stamp duty is paid in the state where the principal mortgage deed is registered.

Over the years, issuance stamp duties have been coming down and are reasonably uniform.

Stamp duty on transfer is paid to the state in which the registered office of the company is

located. Transfer stamp duty remains high in many states and is probably the biggest

deterrent for trading in debentures resulting in lack of liquidity.

Pass Through Certificates (PTCs): Pass through certificate is an instrument with cash

flows derived from the cash flow of another underlying instrument or loan. Most commonly,

they have been issued by foreign banks like Citibank on the basis of their car loan or

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mortgage/housing loan portfolio. The issuer is a special purpose vehicle, which just receives

money from a multitude of (may be several hundreds or thousands) underlying loans and

passes the money to the holders of the PTCs. This process is called securitization. Legally

speaking PTCs are promissory notes and therefore tradable freely with no stamp duty

payable on transfer. Most PTCs have 2-3 year maturity because the issuance stamp duty rate

of 0.75% makes shorter duration PTCs unviable.

RBI GUIDELINES FOR INVESTMENT BY BANKS

The Reserve Bank of India has issued guidelines on classification, valuation and operation

of investment portfolio by banks from time to time as detailed below:

Investment Policy

i) While framing the investment policy, the following guidelines are to be kept in view by

the banks;

(a) No sale transactions should be put through without actually holding the security

in its investment account. However, banks successful in the auction of primary

issue of Government securities, may, enter into contracts for sale of the allotted

securities.

(b) The brokerage on the deal payable to the broker, if any, should be clearly

indicated on the notes/ memoranda put up to the top management seeking

approval for putting through the transaction and a separate account of

brokerage paid, broker-wise, should be maintained.

For engagement of brokers to deal in investment transactions, the banks

should observe the following guidelines

Transactions between one bank and another bank should not

be put through the brokers' accounts.

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If a deal is put through with the help of a broker, the role of the broker

should be restricted to that of bringing the two parties to the deal together.

While negotiating the deal, the broker is not obliged to disclose the

identity of the counterparty to the deal. On conclusion of the deal, he should disclose

the counterparty and his contract note should clearly indicate the name of the

counterparty.

With the approval of their top managements, banks should prepare a

panel of approved brokers which should be reviewed annually, or more often if so

warranted

A disproportionate part of the business should not be transacted through

only one or a few brokers. Banks should fix aggregate contract limits for each of the

approved brokers. A limit of 5% of total transactions (both purchase and sales)

entered into by a bank during a year should be treated as the aggregate upper contract

limit for each of the approved brokers. However, if for any reason it becomes

necessary to exceed the aggregate limit for any broker, the specific reasons therefore

should be recorded, in writing, by the authority empowered to put through the deals.

Further, the board should be informed of this, post facto. However, the norm of 5%would not be applicable to banks dealings through Primary Dealers.

The concurrent auditors who audit the treasury operations should

scrutinize the business done through brokers also and include it in their monthly

report to the Chief Executive Officer of the bank

(c) Banks desirous of making investment in equity shares / debentures should

observe the following guidelines:

Formulate a transparent policy and procedure for investment in shares, etc.,

with the approval of the Board.

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The decision in regard to direct investment in shares, convertible bonds and

debentures should be taken by the Investment Committee set up by the

banks Board. The Investment Committee should be held accountable for

the investments made by the bank.

(d) A copy of the Internal Investment Policy Guidelines, duly framed by the bank

with the approval of its Board, should be forwarded to the Reserve Bank

certifying that the same is in accordance with the RBI guidelines and that, the

same has been put in place.

While laying down such investment policy guidelines, banks should strictly observe Reserve

Bank's detailed instructions on the following aspects :

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CHAPTER 4: YIELD

Yield is the return you actually earn on the bond-based on the price you paid and the interest

payment you receive. Yield refers to the percentage rate of return paid on a stock in the form

of dividends, or the effective rate of interest paid on a bond or note. There are many different

kinds of yields depending on the investment scenario and the characteristics of the

investment.

T-bills do not carry a coupon rate, but they are issued at a discount. Though the yields on T-

bills are less when compared to other money market instruments, the risk averse banks

prefer to invest in these securities.

Yields on T-bills are considered as benchmark yields. It is considered as a representative of

interest rates in the economy in general, while arriving at the interest rate or yield or any

short-term instruments.

Eg: The yield is calculated on the basis of 365 days a year. If the face value of a 364-day T-

bills is Rs.100, and if the purchase price is 88.24 for a T-bills, then the yield is calculated as

below:

Days * Yield + 1 Face value=

365 Price

Yield = 100 1 365

* = 13.36 %88.24 364

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4.1 Types of yield

There are basically three types of bond yields you should be aware of: current yield, yield to

maturity & yield to call.

Current yield (CY)

Current yield is the yield on the debt instrument based on the current market price. It is

actually the return you earn on the instrument, if you purchase the instrument at the current

market price. It is calculated as follows:

CY = Coupon payment----------------------Current market price

Current Yield is the coupon divided by the Market Price and gives a fair approximation of

the present yield.

Again the thumb rule is that if the CY is more than the required rate of return, invest in the

instrument otherwise not.

Therefore,

Current Yield = Coupon of the Security (in %) x Face Value of the Security-----------------------------------Market Price of the Security

Eg: Suppose the market price for a 10.18% G-Sec 2012 is Rs.120. The current yield on the

security will be (0.1018 x 100)/120 = 8.48%

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Yield to maturity (YTM)

The current yield calculation shows us the return the annual coupon payment gives the

investor, but this percentage does not take into the account the time value of money, or,

more specifically, the present value of the coupon payments the investor will receive in the

future.

Yield to maturity tells you the total return you will receive by holding the bond until it

matures. It also enables you to compare bonds with different maturities and coupons. Yield

to maturity equals all the interest you receive from the time you purchase the bond until

maturity (including interest on interest at the original purchasing yield), plus any gain (if you

purchased the bond below its paR) or loss (if you purchased it above its par value).

It is the discount rate, which equals all the cash flows (coupon payments and the debt

repayment) arising from the instrument with the purchase price. The concept of YTM is

based on following implicit assumptions:

The instrument is held till maturity

The intermediate cash flows are reinvested at the rate of YTM

There is no put and call facility available to investors or the issuers

Given a pre-specified set of cash-flows and a price, the YTM of a bond is that rate which

equates the discounted value of cash flows to the present price of the bond. It is the internal

rate of return of the valuation equation.

For example, if a 11.99% 2009 bond is being issued at Rs.108 and the coupons are paid

semi-annually, we can state that:

108 = 5.995 + 5.995 + + 105.995------- ------- -----------

(1 + r) (1 + r)2 (1 + r)18

The value of r, which solves the equation, will be the YTM of the bond.

The value of r in the above equation is found to be 5.29%, which is the semi-annual rate

and hence YTM of the bond would be 10.58%

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YTM of a Zero Coupon Bond

In case of a zero coupon bond, since there are no intermittent cash flows in the form of

coupon payments, YTM of the bond is the rate that equates the present value of the maturity

or redemption value of the bond to the current market price. For example, if a zero coupon

bond sells at Rs.93.76 issued on February, 5 2001 and matures on 1 st January 2002, its YTM

is computed as

93.76 = 100------------

(1 + YTM) 330/365

= 7.39%

One can compare the YTM with one's required rate to take investment decisions. If the YTM

is more than the required rate of return of an investor, he should invest in the instrument

otherwise not.

Yield-to-Call

Yield to ca

treasury management operations of bank

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