Working Capital Management

Working capital management is a significant in financial management due to the fact that it plays a vital role in keeping the wheel of business enterprises running. Working capital management is concerned with short term financial decision. Shortage of funds for working capital has caused many businesses to fail and in many cases, as retarded their growth. Lack of efficient and effective utilization of working capital leads to low rate of return on capital employed or sustain losses. It is a short term financial management which is concerned with the decisions relating to current assets and current liabilities. The key difference between the long term financial management and the short term financial management is in terms of the timing of cash. Long term financial management involve cash flows over an extended period of time (more than 3 years), short term financial management involve cash flows involves within a year or within the operating cycle of the firm. The lead for skill working capital management has thus become greater in recent years. A firm invests a part of its permanent capital in fixed asset and keeping part of it for working capital i.e. for meeting a day to day requirement. 

Each organization is faced with its own limits on the production capacity and technologies it can employ there are fixed as well as variable costs associated with production goods. The most important areas in the day to day management of the firm, is the management of working capital. Working capital management is the functional area of finance that covers all the current accounts of the firm. It is concerned with management of the level of individual current assets as well as the management of total working capital. Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital. A few key performance ratios of a working capital management system are the Current Ratio, Liquidity/Quick Ratio, Debt-Equity ratio, Inventory T/O ratio, Net Profit ratio, Gross profit ratio, Return on investment, Return on equity, Operating ratio, Current assets to proprietor’s fund ratio, Asset turnover ratio, Return on assets ratio For example, an organization may be faced with an uncertainty regarding availability of sufficient quantity of crucial inputs in future at reasonable price. This may necessitate the holding of inventory ie., current assets. Similarly an organization may be faced with an uncertainty regarding the level of its future cash inflows and insufficient amount of cash may incur substantial costs. This may necessitate the holding of a reserve of short – term marketable securities, again a short term capital asset. The unpredictable and uncertain global market plays a vital role in working capital.

Latest News, Angelina Jolie Marry with Brad Pitt

This week latest & heart breaking news is Angelina Jolie is married at age of 39 with Brad Pitt at the age of 50 after long relation of Nine Years of friendship at France last weekend. Now Angeline has six children’s with her. Most of the young boys are finished with her marriage news because Angelina Jolie has lot of friends over the world & they all love to Angelina Jolie.

Angelina Jolie is famous actress, director, screenwriter and author in America. Angelina is very beautiful, charming & Smart. She has become popular by taking on the title role in the “Lara Croft” series of Block Buster movies. In her life, she faced many problems, she was depressed due to 87% Risk of Breast Cancer. But she was not going into disappointment. She resolved her all problems & make cancer preventing surgery.

Angelina Jolie appeared in various small films like Hackers, Foxfire, True Womens, George Wallace. Her leading role in films The Bone Collector & Girl, Interrupted make her star & reaches to sky. In 2000 Angelina asked for Lara Croft: Tomb Rider. At first stage, she was not interested in this film, but later she is ready to take leading role in this film & take necessary training for the same. In this film, she sees reality of life like nature beauty, culture and poverty in the world from near. She regularly visited Refugees Camps.  Some of her experience is written on his book “Notes from My Travels”. Then, she is involved in International Charity Projects. In this respect, she was appointed as a Goodwill Ambassador for the United Nations High Commissioner for Refugees (UNHCR)

One life changing mode comes at Angelina Jolie’s life, she has signed a film Mr. & Mrs. Smith in 2005. This film makes biggest record in box office. In this film Angelina meets with Mr. Brad Pitt. While film shooting Angelina & Brad Pitts affair is going on. In the mean time, Mr. Pitt is separated from his wife Jennifer Aniston in Jan 2005. After that Angeline was frequently seen in public places with Mr. Pitt. Now after 9 years later she married with Mr. Pitt. 

Microfinance in India

The detailed look at country’s finance and banking sector and its regulation provides the context within which microfinance outlines its constraints and evolution. Developing a good knowledge about the commercialisation of microfinance and its impact on microfinance outreach in India, a clear understanding of India’s poverty, economy and growth is essential.  This section then focuses on the transformation of its financial sector in order to set the background within which to better scrutinize SHARE and BASIC.

India compromise one sixth of world’s population and which is about 1.1 billion in 2007. It is a key emerging market along with Brazil and China. Continues foreign investment gives the picture of growing GDP and creates an environment where wealth is rising for the nation. India being a populous country, its GDP ranks among the top 15 economies of the world. However, approximately 300 million people or about 60 million households are living below the poverty line and only about 20 percent estimated have access to credit from the formal sector. Additionally, the segment of the rural population above the poverty line does not have good access to the formal financial intermediary services, including savings services due to lack of interest shown by formal financial institutions.

“A group of micro-finance practitioners estimated the annualized credit usage of all poor families (rural and urban) at over Rs 45,000 crores, of which some 80 percent is met by informal sources. This figure has been extrapolated using the numbers of rural and urban poor households and their average annual credit usage (Rs 6000 and Rs 9000 pa respectively) assessed through various micro studies.” Microfinance is one development approach that can contribute to achieving the national and international goal of improving the livelihoods of those Indians that are not yet seeing the benefits of growth.

What is Microfinance

Finance is the blood of any organisation or country to survive and remain firm in the long run. Normally inventions and findings in science come from the technologically advanced and financially strong countries. But surprisingly, the most crucial finding in finance has not come from any superpower or from the world of the rich. The hedge fund or the liquid option note were not important but for a developing and a poor country like India the finding that poor can save, can borrow money with an intention to repay it was more important.This is nothing but the world of microfinance. Professor Mohammad Yunus, founder of the Grameen Bank in Bangladesh gave birth of microfinance. Since its birth, the field has evolved tremendously with the adaptation of professor Yunus’ ideas to various countries and context. The private institutions and banks are keeping an eye in the field of microfinance which was originally assumed to be domains of non-government organisation (NGO). Indian banks have become aware of the potential of microfinance and have started to compete with MFIs, particularly in the case of lending to SHGs, which have experienced significant growth since 1999. Despite of the current enthusiasm in the donor community for microfinance programs, Consultative Group to Assist the Poorest (CGAP) estimates that microfinance probably reaches fewer than 5% of its potential clients. This might help in estimating a rough figure of potential client not reached by microfinance institutions. There have lot of innovation in microfinance done in India as a huge population of world poor resides in India. Hence there is a huge untapped market for microfinance institutions.

“IDEAL FAMILY LIEF IN INDIA”.

We are continuously observing in this world that break up of families, divorces of husband & wife etc but one serial is telecast on ETV Marathi is "Mazhe Man Tuzhe Zhale" on time 8.30 pm which shows one of the ideal family.

In this serial, each & every character is showing ideal in the family. There are Seven Character in this serial. Shubhra, Shekhar, Shekhar's Mother, Father, brother, Sister in Law of Shekhar & Anuradha Sister. 

"Mazhe Man Tuzhe Zhale" is a story of modern jolly college going girl of Shubhra who fall in love with his 30 year old teacher of Shekhar. How their relationship are framing is the plot of the story. After marriage, Shekhar's family accept her as a family member because she looks like a good wife for Prof. Shekhar. This serial is depends on how family culture, bonding of families & all together families in India. This serial is shows that how can we manage when we live together in the family. All story is around to Shubhra & Shekhar. Shubhra is smart, beautiful, understand to others feeling, helping to other, hence all family members understand her feelings & respect to her. Shubhra is trying to support her husband means Prof. Shekhar in each & every situation. Prof. Shekhar is very good & ethical person who don't take support from any other. Due to sudden incidence, he lost his job. After lost his job, how his family support him, this serial is showing on this subject. This serial is showing, in some stages of the life, a man need support of his life partner & his family & that stage how family should support to man & hold relations.

Till date this serial is too good for all family members in the family. All family members must see this serial because this serial is showing how hold the relations, respect each other in the family, live together in family. In other side, other serials is showing clashes between husband & wife, affairs of husband & wife, murder, clashes between families, hates in families, depute in court matters. Instead of other serial showing on this channels & other channels, this serial is excellent because this serial is depends on ethics, morals & each aspects on the social family, hence this serial is called “IDEAL FAMILY LIEF IN INDIA”.

Securitization Introduction

Yet another method of imparting liquidity into the system by way of securitization. There is, however, a remarkable difference in this strategy used in this approach when compared to the earlier models.

Distinguishing itself from the earlier methods, which resort to a sale of securities/borrowings as and when the need for funds arises, securitization can impart liquidity on a continuous basis and has little or no relation to be surplus deficit balances.

The loan profile of the bank will generally be long term in nature. Large volumes of funds get blocked in project financing and asset financing activities of the institution.

Securitization is an effective way to release these funds for further investments. In securitization the future cash flows from the advances made by the bank are repackaged into negotiable securities and issued to the investors.

This arrangement induces liquidity into the system by imparting liquidity to the highly illiquid asset. In the process of enhancing liquidity, securitization also reduces the interest rate exposure for the bank since risk associated to the risk fluctuations will also be eliminated.

Securitization can in fact be taken up on a continuous basis to supplement the other approaches.

Dificite balance in Investment Borrowing Decisions

The second important question that the bank will have to face is, how to meet the deficit cash balances. The only alternative available to meet its deficit is by borrowing funds from the market. While doing this, the aim of the bank should be to keep its cost of raising such short-term funds as low as possible. The bank also has an option of meeting its deficit by internal sources by adjusting against surplus balances obtained earlier. In this option, the number of forecasting periods plays a vital role. Internal funds can be effectively used when the cost of borrowing is relatively high.

There are various models that discuss the suitable ratio that can be maintained between the cash balances and the investments. Two models, which have been commonly used, are the Baumol Model and the Miller and Orr Model. The cash management model given by Baumol extends the Economic Order Quantity concept used in inventory management to discuss the d\cash conversion size, which influences the average cash holding of the firm.

This model analyses the income foregone when the firm holds cash balances (rather than investing the same in the marketable securities), against the transaction costs incurred when the marketable securities are converted into cash. The Miller and Orr model considers that there will be different cash balances at different periods and thus a firm should accordingly decide on the amount and the timing for the transfer of funds from marketable securities to cash.

Thus, the criteria while taking such decisions will be to increase yields on investments and lower the costs of borrowings. Thus there should be optimization in the investment deposit ratio to ensure that the level of idle funds at any point of time is not as high so as to cut into profitability of the bank. This trade off decision of the bank depends upon its attitude towards the liquidity policy i.e. aggressive/conservative. Depending on the liquidity position to be maintained, the risk preferences and risk factors, management can have a policy which has a relatively large/small amount of liquidity.

Surplus Balance in Investment Borrowing Decision

In case of a surplus balance, the bank has the option of either maintaining cash balances or investing these excess funds in securities/loans. Though holding adequate cash reserves can eliminate the liquidity risk completely, the cost involved in doing so could be prohibitive, especially for a bank. Hence the bank should make optimum use of its idle funds by investing in such a way that the yields earned are greater. 

There are generally 2 options available to the ban while it makes its investment decisions. It can invest either for a short term and roll over until the funds are required for some other purpose of, invest for a longer period after properly assessing the cash requirements through the forecasting process. 

In this decision making process one has to, however, consider/understand the behavior of the yield curves on the long/short-term investments. Yield curves often are sloping upwards since higher interest rates are associated with long term and relatively less liquid assets. For the, expectations theory which explains the relation between the interest rates and the investment period does not hold good in reality. These occurrences explain the fact that the long-term investments do give higher yields than short-term investments. The firm will also have to consider the transaction cost involved while converting its marketable securities.

INVESTMENT BORROWING DECISIONS

Assessment of the liquidity gap based on the forecasts is essentially one aspect of the liquidity management. The other major task of liquidity management is to manage this liquidity gap by adjusting the residual surplus/deficit balances. Considering the high costs associated with cash forecasting, it is essential that the benefits drawn by the bank from such forecasting should be substantially large to give some residual gains after meeting the forecasting costs. This objective can, however, be attained only if the bank makes prudent investment/borrowing decisions to manage the surplus/deficit. 

There are, however, a few factors which must be considered before deciding on the deployment of excess funds/borrowings for meeting the deficit which are given below:

-  Deposit Withdrawals

-  Credit Accommodation

-  Profit fluctuation

The liquidity level to be maintained by a bank should firstly, provide for deposits withdrawals and secondly to accommodate the increase in credit demands. While deposit withdrawals must be honored immediately, it is also of priority to ensure that legitimate loan requests of customers are met regardless of the funds position. Satisfactory credit accommodation ultimately results in more business for the bank. 

Liquidity is further influenced by the fluctuation in the business profits of the bank. It has already been explained that any fluctuation in the interest rates may result in an increase decrease in the NIM of the bank. If this fluctuation results in a negative growth i.e. a decrease in NIM, then the bank should review its RSAs and RSLs. It might thus resort to gap management, which might affect its liquidity position. On the contrary when the profits are showing increasing growth rates, the bank would prefer to maintain higher liquidity position by utilizing the cash balances for investments loan disbursals. This further improves its profitability levels. 

Considering these factors, the bank should adjust its surplus deficit to meet the liquidity gap. While surplus funds can be invested in short/long-term securities depending on the bank’s investment policy, the shortfalls can be met either by disinvesting the securities or by borrowing funds from the market. This again will depend on the strategical issue of whether the bank prefers to manage its liquidity risk using asset management or liability management. If the bank decides to go for liability management then the investment policy ill be long term. Influencing the strategic issues of bank’s investments are the tactical issues. While the bank may use asset management or liability management in their investment decisions they may nevertheless face certain critical charges in their operational environment which make the strategic policies unsuitable. Implies that if the bank’s strategic policy is liability management, in an increasing interest rate scenario, such a policy will not be advisable. In such a case, the bank will have to go for asset management and the time the interest rates stabilize and revert back to the liability management. Thus, while the bank can take its investment decisions based on its strategic policy the same will have to be reviewed to adopt tactical policy to suit the changes in the operating environment. The important criteria in taking such decisions will also be the yields on investments and the cost of borrowing.

Cash Flow Approach for Liquidity Risk Management

The bank should first decide on the planning horizon that suits its operational style and then based on the cost constant decide on the number of forecasting periods and other such details. Following such decisions will be the assessment of the liquidity position based on the forecasts made for the cash inflows and outflows. The basic steps involved in this process are as follows: 

-  Estimate anticipated changes in deposits

-  Estimate the cash inflows by way of loan recovery

- Estimate the cash outflows by way of deposit withdrawals and credit accommodations

-  Forecast these for the end of each period

-  Estimate the liquidity needs over the planning horizon

The most critical task of liquidity management is predicting the expected cash inflows coming by way of incremental deposits and recovery of credit and the outflows relating to deposit withdrawals and loan disbursal's. In this process, accuracy levels when a bank forecasts cash outflows by way of deposit withdrawals and credit disbursal are fairly high, when compared to the cash inflow forecasts relating to loan repayments and deposit accretion. This difficulty in the forecasting of cash flows coupled with the mismatches arising due to the maturity pattern of assets and liabilities result in the liquidity risk. Thus the process of forecasting cash flows with a high degree of accuracy holds the key to risk management.

 All estimates are generally given as at the beginning of the month or at the end of the month and are silent upon the fluctuations that may occur during the month, when the forecasting period is chosen as a month. In order to manage the intra-month liquidity problems, there should always be a surplus balance. In such a scenario, it is always better for the bank to consider that the deficit occurs at the beginning of the period while the surplus occurs at the end of the period. Thus, funds should be provided to meet the deficit balance at the beginning of the forecasting period.

Working Fund Approach Part II for Liquidity Risk Management

Deposits, which are likely to be withdrawn during the planning tenure, are categorized as vulnerable deposits. A very good example of this type of deposits is the savings deposits. However, the entire quantum of savings deposits cannot be considered as vulnerable. On an average, it can be observed from the operations of the bank, that there will be a certain level up to which the funds are stable i.e. the level below which the funds will not be withdrawn. Hence, the liquidity requirements to meet the maturity of the vulnerable funds will be less than 100 percent and varies depending upon the risk-return policy of the bank.

Finally, the residual of the deposit base after segregating them into the above two categories will fall under the stable funds category. These deposits have the least probability of being withdrawn during the planning period and hence the liquidity to be maintained to meet the maturing stable deposits will also be lower when compared to the other two types of deposits. As explained above, the stable portion of the savings deposits fall under this category. Most of the term deposits, by their nature fall under this category. 

Float funds, which are the third component of the working funds, are much similar to the volatile funds. These funds are generally in transit and comprise of DD’s, Banker’s cheques, etc. which may be presented for payment at any time. However, this segment also has a minimum level over and above which the variability occurs. Hence, 100 percent liquidity will have to be provided for the variable component. 

Based on the working funds, consolidated or component-wise, the bank will have to assess the cash balances/ liquidity position in the following manner:

- Lay down the average cash and bank balances to be maintained as a percentage of total working funds.

- Lay down the range of variance that can be taken as the acceptance level.

 Having obtained the consolidated/component-wise working funds, the bank will now have to estimate the average cash and bank balances that are to be maintained. This average balance can be maintained as a percentage to the total working funds. This percentage level is based on forecasts, the accuracy levels of which vary depending on the factors affecting the cash flows. Hence, it is advisable for the bank to set up a variance range for acceptance depending on its profitability requirements. Thus, as long as the average balances vary within this tolerance range, profitability and liquidity are ensured. Any balance beyond this range will necessitate corrective action either by deploying the surplus funds or by borrowing funds to meet the deficit. This acceptance level is, however, a dynamic figure since it depends on the working funds that may keep changing from time to time.

Working Funds Approach for Liquidity risk management

Under this approach, liquidity position is assessed based on the quantum of working funds available to the bank. Since working funds reflect the total resources available with the bank to execute its business operations, the amount of liquidity is given as a percentage to the total working funds. The bank can arrive at this percentage based on its historical performance. This approach of forecasting liquidity requirement takes a broad overview of the liquidity position since the working funds are taken as a consolidated figure.

The working funds comprise of owned funds, deposits and float funds. Instead of a consolidated approach, the bank can have a segment-wise break up of the working funds to arrive at the percentage for maintaining liquidity. Based on the position of the limit arrived as above and the available liquidity, the bank will have to invest borrow the surplus/deficit balances to adjust the liquidity position. In this approach, the bank will have to assess the liquidity requirements for each of the components of working funds.

The liquidity for the owned funds component, due to its very nature of being owners’ capital will be nil. The second component of working funds is deposits, the liquidity requirements of which depend on the maturity profile. Thus, prior to assessing the liquidity requirements of these deposits, the bank should categorize them into different segments based on the withdrawal pattern. All deposits based on their maturity fall under the following three categories:

-  Volatile Funds

-  Vulnerable Funds

-  Stable Funds

Volatile funds include those deposits, which are sure to be withdrawn during the period for which the liquidity estimate is to be made. These include, short-term deposits like the 30 days deposits, etc. raised from the corporate high net worth clients of the bank. The probability of these funds being withdrawn before or on their maturity is high. Included in this category of volatile funds are current deposits of corporates that also have a high degree of variability. Due to the nature of the volatile funds, they demand almost 100 percent liquidity maintenance since the demand for funds can arise at any time.

Technical Approach - Treasury Management

As mentioned earlier, technical approach focuses on the liquidity position of the bank in the short run. Liquidity in the short run is primarily linked to the cash flows arising due to the operational transactions. Thus, when technical approach is adopted to eliminate liquidity risk, it is the cash flows position that needs to be tackled. The bank should know its cash requirements and the cash inflows and adjust these two to ensure a safe level for its liquidity position. 

Working Funds Approach and the Cash Flows Approach are the two methods to assess the liquidity position in the short run. Of these two approaches, the former concentrates on the actual cash position and depending on the factual data, it forecasts the liquidity requirements. The latter approach goes a step forward and forecasts the cash flows i.e. estimates any change in the deposits withdrawals credit accommodation etc. Thus apart from assessing the liquidity requirements, it also advises the bank on its investments and borrowing requirements well in advance.

Liability Management:

Converse to the asset management strategy is liability management, which focuses on the sources of funds. Here the bank is not maintaining any surplus funds, but tries to achieve the required liquidity by borrowing funds when the need arises. The underlying implications of this process will be that the bank mostly will be investing in long-term securities /loans  (since the short-term surplus balance will mostly be in a deficit position) and further, it will not depend on its liquidity position/surplus balance for credit accommodation/business proposals. Thus in liability management a proposal may be passed even when there is no surplus balance since the bank intends to raise the required funds from external sources. Though it involves a greater risk for the bank, it will also fetch higher yields due to the long-term investments. However, sustenance of such high spreads will depend on the cost of borrowing. Thus, the cost and the maturity of the instrument used for borrowing funds play a vital role in liability management. The bank should on the one hand be able to raise funds at low cost and on the other hand ensure that the maturity profile of the instrument does not lead to or enhance the liquidity risk and the interest rate risk. Of the two strategies available in fundamental approach, it is understood that while asset management tries to answer the basic question of how to deploy the surplus to eliminate liquidity risk, liability management tries to achieve the same by mobilizing additional funds.

Asset Management

Asset management is to eliminate liquidity risk by holding near cash assets i.e. those assets, which can be turned into cash whenever required. For instance, sale of securities from the investment portfolio can enhance liquidity. 

When asset management is resorted to, the liquidity requirements are generally met from primary and secondary reserves. Primary reserves refer to cash assets held to meet the statutory cash reserve requirements (CRR) and other operating purposes. Though primary reserves do not serve the purpose of liquidity management for long period, they can be held as second line of defense against daily demand for cash. This is possible mainly due to the flexibility in the cash reserve balances (statutory cash reserves are required to be maintained only on a daily average basis for a reserve maintenance period). 

However, most of the liquidity is generally attained from the secondary reserves, which include those assets held primarily for liquidity purposes. These secondary reserves are highly liquid assets, which when converted into cash carry little risk of loss in their value. Further, they can also be converted into cash prior to their maturity at the discretion of the management. When asset management is resorted to for liquidity, it will be through liquidation of secondary reserves. Assets that fall under this category generally take the form of unsecured marketable securities. The bank can dispose these secondary reserves to honor demands for deposit withdrawals, adverse clearing balances or any other reasons.

Liquidity Risk Management

While introducing the concept of asset-liability management it has been mentioned that the object of any ALM policy is twofold – ensuring profitability and liquidity. Working towards this end, the bank generally maintains profitability/spreads by borrowing short (lower costs) and lending long (higher yields). Though this process of price matching can be done well within the risk/exposure levels set for rate fluctuations it may, however, place the bank in a potentially illiquid position. 

Efficient matching of prices to manage the interest rate risk does not suffice to meet the ALM objective. Price matching should be coupled with proper maturity matching. The interlinkage between the interest rate risk and the liquidity of the firm highlights the need for maturity matching. The underlying implication of this interlinkage is that rate fluctuations may lead to defaults severely affecting the asset-liability position. Further in a highly volatile situation it may lead to liquidity crisis forcing the closure of the bank.

Thus, while management of the prices of assets and liabilities is an essential part of ALM, so is liquidity. Liquidity, which is represented by the quality and marketability of the assets and liabilities, exposes the firm to liquidity risk. Though the management of liquidity risk and interest rate risks go hand in hand, there is, however, a phenomenal difference in the approach to tackle both these risks. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable, while elimination risk does result in long-term sustenance. Before attempting to analyze the elimination of liquidity risk, it is essential to understand the concept of liquidity management.  

The core activity of any bank is to attain profitability through fund management i.e. acquisition and deployment of financial resources. An intricate part of fund management is liquidity management. Liquidity management relates primarily to the dependability of cash flows, both Inflows and outflows and the ability of the bank to meet maturing liabilities and customer demands for cash within the basic pricing policy framework. Liquidity risk hence, originates from the potential inability of the bank to generate cash to cope with the decline in liabilities or increase in assets.  

Thus, the cause and effect of liquidity risk are primarily linked to the nature of the assets and liabilities of the bank. All investment and financing decisions of the bank, irrespective of whether they have long term or short term implications do effect the asset-liability position of the bank which may further affect its liquidity position. In such a scenario, the bank should continuously monitor its liquidity position in the long run and also on   a day-to-day basis.

Basis Risk, Real Interest Rate Risk in Interest Rate Risks

Basis Risk

When the cost of liabilities and the yields of assets are linked to different benchmarks resulting in a floating rate and there is no simultaneous matching movement in the benchmark rates, it leads to basis risk. For instance, consider that the funds raised by way of 1 yr bank deposits are invested in the Easy Exit Bond of the IDBI flexi bond issue. In this case, the cost of funds for 1 yr bank deposits will be 9%( 1 % less than the prevailing Bank Rate 10%), while the yields from the bonds will be14.55% which is 1.5% over 10 yr government bond of 13.05%. With these floating rates of interest, on the assets and liability spreads of 5.55% (14.55-9) is available. Assume that there is a 1% cut in the bank rate. This will bring down the cost of funds to 8%. Further, assume that the return on 10 yr government bond has also come down to 12.75%, thereby bringing down the return on the Easy Exit Bond to 14.25%. As a result of this interest rate change, the spread will increase to 6.25%. While the bank rate declined by 1%, the yield on 10 yr government security came down only by 30bp.

Thus, when the change in the interest rates, which are set as a benchmark for assets/liabilities, is not uniform, it will lead to a decrease/increase in the spreads.

Real Interest Rate Risk

Yet another dimension of the interest rate risk is the inflation factor, which has to be considered in order to assess the real interest cost/yields. This occurs because the changes in the nominal interest rates may not match with the changes in inflation.

The presence of the above mentioned risk would either individually or collectively result in interest rate risk. These risks will affect the income/expenses of the bank’s asset/liability portfolio. This, further, will also have an impact on the value of assets and liabilities of the bank, thereby affecting even the market value of the bank.

Some of the approaches used to tackle interest rate risk are given below and a discussion on the same is followed.

Volatility Risk & Pre Payment Risk- Type of Interest Rate Risk

In additions to the long run implications of the interest rate changes, there are short term fluctuations which are to be considered in deciding on the mix of assets and liabilities, the pricing policies and thereby the business volumes. However, the risk will acquire serious proportions in a highly volatile market when the impact will be felt on the cash flows and profits. The 1994 volatility witnessed in the Indian call money market explains the presence and the impact of volatility risk. The interest rate in the call money market, which generally hovered around 5-7 %, zoomed to 95% within a couple of weeks during September, 1994. While some banks defaulted in the maintenance of CRR, many banks borrowed funds at high rates, which had substantially reduced their profits. Thus, it can be seen that the affect of fluctuations in the short term have a greater impact since the adjustment period is very short.

 Prepayment Risk

The fluctuations in the interest rate may sometimes lead to prepayment of loans. For instance, in a situation where the interest rate is declining, any cash inflows that arise due to prepayment of loans will have to be redeployed at a lower rate invariably resulting in lowered yields.

Call/Put Risk

Sometimes when the funds are raised by the issue of bonds/securities, it may include call/put options. A call option is exercised by an issuer to redeem the bonds before maturity, while the put option is exercised by the investor to seek redemption before maturity. These two options expose to a risk when the interest rate fluctuate. A call option is generally exercised in a declining interest rate scenario. This will affect the bank if it invests in such bonds since the intermediate cash inflows will have to be reinvested at a lower rate. Similarly, when the investor exercises the put option in an increasing interest rate scenario, the banks, which issue the bonds, will have to face greater replacement costs.

Rate Level Risk - Type of Interest Rate

During a given period there is possibility for restructuring the interest rate levels either due to the market conditions or due to regulatory intervention. This phenomenon will, in the long run, affect decisions regarding the type and the mix of assets/liabilities to be maintained and their maturing periods.

The present interest rate restructuring taking place in the Indian markets is a very good example of this aspect. The Reserve Bank of India which is the apex body regulating the Indian monetary system, has been lowering the Statutory Cash Reserve Ratio for banks in a phased manner from 12% to 8% since 1996. Every time the CRR is lowered, there is an increase in the liquidity which further results in lowering of the interest rate levels. A 2% cut in the CRR from 10% to 8% in the Busy Season Credit Policy announced in October 1997 was immediately followed by a cut in the PLR/interest rates of Banks and FI’s. The risk that arises due to this reduction can be understood from the fact that the revised rates of interest will be applicable to all the new deposits, which will lower the marginal costs of funds. However, the affect will be seen on all the existing assets. Consequently the loss of interest income on assets is likely to be higher than the reduction in the interest cost of deposits leading to lower spreads.

Asset Liability Management

ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. While managing these three risks forms the crux of ALM, credit risk and contingency risk also form a part of the ALM. The significance of ALM to the financial sector is further highlighted due to dramatic changes that have occurred in recent years in the assets (uses of funds) and liabilities (sources of funds) of banks. Thus a comprehensive ALM process aims on profitability and long term viability. The process of ALM has to be carried out against many balance sheet constraints, which amongst others include maintaining credit quality, meeting liquidity needs and acquiring required capital.

In India, the post liberalization witnessed a rapid industrial growth, which has further stimulated the growth in the fund raising activities. With the rise in the demand for funds, there has also been a remarkable shift in the features of the sources and uses of funds of the banks. However in the deregulated environment, competition has narrowed down the spread of banks. This not only has led to the introduction of discriminate pricing policies, but has also highlighted the need to match the maturities of the assets and liabilities. The changes in the profile of the sources and uses of funds are reflected in the borrowers’ profile, the industry profile and the exposure limits for the same, interest rate structure for deposits and advances, etc. The developments that have taken place since liberalization have led to a remarkable transition in the risk profile of the financial intermediaries.

Interest Rate Swaps And Forward Rate

An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a ‘notional principal’ amount on multiple occasions during a specified period. Such contracts generally involve exchange of ‘fixed to floating ‘or’ floating to floating rates of interest. Accordingly, on each payment date that occurs during the swap period-cash payments based on fixed/floating and floating rates, are made by the parties to one another.

A Forward Rate Agreement (FRA) is a financial contract between two parties to exchange interest payments for a ‘notional principal’ amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed bench-mark/ reference rate prevailing on the settlement date. Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs), Mutual funds and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own balance sheet management or for market making. Banks/FIs/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures.

Commercial Bills in Treasury Management

Bills of exchange are negotiable instruments drawn by the seller (drawer) of the goods on the buyer (drawee) of the goods for the value of the goods delivered. These bills are called trade bills. These trade bills are called commercial bills when they are accepted by commercial banks. If the bill is payable at a future date and the seller needs money during the currency of the bill then he may approach his bank for discounting the bill. The maturity proceeds or face value of discounted bill, from the drawee, will be received by the bank. If the bank needs fund during the currency of the bill then it can rediscount the bill already discounted by it in the commercial bill rediscount market at the market related discount rate.

The RBI introduced the Bills Market scheme (BMS) in 1952 and the scheme was later modified into New Bills Market scheme (NBMS) in 1970. Under the scheme, commercial banks can rediscount the bills, which were originally discounted by them, with approved institutions (viz., Commercial Banks, Development Financial Institutions, Mutual Funds, Primary Dealer, etc.).

With the intention of reducing paper movements and facilitate multiple rediscounting, the RBI introduced an instrument called Derivative Usance Promissory Notes (DUPN). So the need for physical transfer of bills has been waived and the bank that originally discounts the bills only draws DUPN. These DUPNs are sold to investors in convenient lots of maturities (from 15 days upto 90 days) on the basis of genuine trade bills, discounted by the discounting bank