Treasury Management in Banking

December 2023 Examination

1. In view of poor Balance of Payment management by Govt/RBI, higher interest rates

and inflation, INR is expected to depreciate further. Suggest ways/ Internal/external
Techniques to manage Currency Risk by Corporates for their ECB’s and Import
payments.

Answer 1:

Introduction:

Managing currency risk is a critical aspect of financial strategy for corporations engaged in
international trade or raising funds through External Commercial Borrowings (ECBs). The
Indian Rupee (INR) is subject to fluctuations due to factors like poor Balance of Payment
management, interest rates, and inflation, which can expose businesses to currency risk. To
mitigate this risk, corporations can employ a range of internal and external techniques to
protect their financial interests. In this essay, we will explore these techniques and how they
can be applied effectively to manage currency risk in the face of a depreciating INR.

Concept and Application:

1. Internal Techniques:

Internal techniques involve actions and strategies that corporations can implement within
their operations to manage currency risk:

Natural Hedging: One of the simplest internal techniques is natural hedging. Corporations
can match their currency inflows and outflows. For instance, if a company earns revenue in
US dollars (USD) and has expenses in euros (EUR), it can use the income in USD to pay for
its EUR expenses, reducing the currency risk exposure.

Billing in Home Currency: Corporations can bill their international customers in their home
currency, such as INR. By doing so, they can eliminate exposure to currency fluctuations and
create a stable revenue stream.
Currency Clauses in Contracts: Including currency clauses in contracts with international
partners can help mitigate risk. These clauses can specify exchange rates or currency
conversion methods that protect both parties from adverse currency movements.

Forecasting and Monitoring: Effective currency risk management begins with understanding
and forecasting potential exchange rate movements. Corporations can utilize financial experts
or software to track and analyze market trends to make informed decisions.

Diversification: Diversifying currency exposure by holding assets in multiple currencies can

reduce risk. This may involve diversifying investments or maintaining bank accounts in
various currencies.

2. External Techniques:

External techniques involve financial instruments and strategies that corporations can employ
to manage currency risk:

Forward Contracts: A forward contract allows a corporation to lock in an exchange rate for a
future date. This is a valuable tool for managing the risk of unfavorable currency movements,
especially for import payments or ECBs. For instance, a corporation expecting to make an
import payment in three months can enter into a forward contract to secure the current
exchange rate.

Options: Currency options provide the right, but not the obligation, to buy or sell a specific
currency at a predetermined price on or before a specified date. For instance, a corporation
can buy a call option to protect against a depreciating INR when they expect to receive
foreign currency income.

Currency Swaps: Currency swaps involve exchanging one currency for another with an
agreement to reverse the exchange at a later date. This can help corporations match their
currency inflows and outflows effectively and reduce currency risk.

Hedging with Derivatives: Corporations can use currency derivatives like futures contracts to
hedge against currency risk. By taking a position in the futures market, they can offset
potential losses from currency depreciation.
Offshore Accounts: Maintaining accounts in offshore banking jurisdictions in various
currencies allows corporations to manage currency risk by holding funds in the currency they
expect to use for international transactions.

External Debt Denominated in Foreign Currency: When raising funds through ECBs,
corporations can consider issuing debt in the same currency as their expected cash flows. This
aligns their liabilities with their income, reducing currency risk.

Conclusion:

Currency risk is a significant concern for corporations operating in a globalized economy,

especially when faced with the potential depreciation of the Indian Rupee (INR). However,
by employing a combination of internal and external techniques, businesses can effectively
manage this risk. Internal techniques such as natural hedging, billing in home currency, and
currency clauses in contracts allow corporations to structure their operations to reduce
exposure. External techniques like forward contracts, options, currency swaps, and offshore
accounts offer financial instruments to hedge against currency risk. When corporations are
raising funds through ECBs or making import payments, it is crucial to use these techniques
judiciously to minimize the impact of currency fluctuations and protect their financial
interests. In a dynamic global market, effective currency risk management is vital for
sustaining profitability and financial stability.

2. Explain the role played by SWIFT, Nostro, Vostro, Special Vostro Account for
settlement of International Trade & Treasury products. Explain the term Globalization
of INR used by Govt / RBI.

Answer 2:

Introduction:

International trade and the global economy have grown immensely in recent decades. This
expansion has been accompanied by increased cross-border financial transactions and an
ever-growing need for efficient settlement mechanisms. In this context, the Society for
Worldwide Interbank Financial Telecommunication (SWIFT) plays a pivotal role, facilitating
secure and efficient communication among financial institutions across the world.
Additionally, the terms Nostro and Vostro accounts, along with Special Vostro Accounts, have
emerged as crucial components of international trade and treasury products settlement.
Moreover, the Indian government, through the Reserve Bank of India (RBI), has embarked
on a journey to globalize the Indian Rupee (INR), thereby expanding its international reach.
This answer aims to provide an in-depth understanding of these concepts and their
applications in international finance.

Concept and Application:

SWIFT (Society for Worldwide Interbank Financial Telecommunication):

SWIFT is a cooperative society that provides a standardized and secure messaging network
for financial institutions worldwide. It enables banks, broker-dealers, corporations, and other
entities to communicate financial information, instructions, and documents quickly and
accurately. SWIFT's role in international trade and treasury products is multifaceted:

a. Secure Communication: SWIFT ensures secure and standardized communication between

parties involved in financial transactions, reducing the risk of errors and fraud.

b. Standardization: SWIFT messages adhere to global standards, making it easier to interpret

and process information across borders, languages, and financial systems.

c. Settlement Instructions: SWIFT messages include settlement instructions, such as payment

orders, trade confirmations, and account transfers, enabling efficient cross-border settlement.

d. Risk Mitigation: SWIFT messages provide transparency and tracking throughout the
transaction lifecycle, which is essential for risk management in international trade and
treasury products.
Nostro and Vostro Accounts:

Nostro and Vostro accounts are integral to international trade and finance. They represent
accounts held by a bank in another bank's currency, serving as a crucial mechanism for cross-
border transactions.

a. Nostro Account: A "Nostro" account is a foreign bank's account held in a domestic bank's
currency. For example, if a U.S. bank has an account denominated in Japanese Yen at a
Japanese bank, it's referred to as a Nostro account for the U.S. bank.

b. Vostro Account: A "Vostro" account is the mirror image of a Nostro account. It is a

domestic bank's account held in a foreign bank's currency. In the previous example, the
Japanese bank's account in U.S. Dollars at the U.S. bank would be a Vostro account for the
Japanese bank.

The interplay between Nostro and Vostro accounts simplifies cross-border transactions. When
a bank receives funds from another bank in its Nostro account, it processes and credits the
corresponding Vostro account of the foreign bank. This mechanism ensures efficient cross-
border settlements and helps banks manage international transactions.

Special Vostro Accounts:

Special Vostro Accounts are a variation of Vostro accounts created by the RBI to facilitate the
globalization of the Indian Rupee (INR). These accounts are used to park INR funds with
offshore banks to enhance liquidity and promote INR internationalization.

a. Offshore Clearing Banks: The RBI authorizes select offshore banks to open Special Vostro
Accounts in INR. These banks serve as clearing banks, helping process INR transactions
outside India.
b. Enhancing Liquidity: By allowing offshore banks to maintain Special Vostro Accounts in
INR, the RBI increases the availability of INR funds internationally. This, in turn, makes it
more convenient for foreign entities to conduct transactions in INR.

c. Expanding INR Usage: Special Vostro Accounts are instrumental in promoting the use of
INR in international trade and finance, facilitating cross-border trade settlements and
investments denominated in INR.

Globalization of INR by Government/RBI:

The term "Globalization of INR" refers to the efforts made by the Indian government,
particularly the RBI, to promote and internationalize the use of the Indian Rupee as a global
currency. This involves a series of measures to make the INR more acceptable and accessible
in international trade and financial markets:

a. Bilateral and Multilateral Agreements: The RBI enters into bilateral and multilateral
agreements with other central banks and financial institutions to facilitate INR transactions
and settlements.

b. Liberalized Exchange Controls: The Indian government has progressively liberalized its
exchange control regulations to make it easier for foreign entities to invest in India and
transact in INR.

c. Promoting INR Denominated Instruments: The issuance of INR-denominated bonds and

other financial instruments in international markets has been encouraged to boost the use of
INR as a trading and investment currency.

d. Cross-Border Trade Settlement: Special Vostro Accounts and initiatives like the INR-
Rupee Trade Arrangement (IRTA) have been established to promote the use of INR in cross-
border trade settlements.
e. Regulatory Support: The RBI provides regulatory support and guidance to banks and
financial institutions to engage in INR transactions, thus promoting INR globalization.

Conclusion:

In conclusion, the role of SWIFT, Nostro, Vostro, and Special Vostro Accounts in
international trade and treasury products settlement cannot be overstated. SWIFT serves as
the backbone of secure and standardized communication, making cross-border transactions
efficient and secure. Nostro and Vostro accounts simplify the process of cross-border
settlements, ensuring that transactions occur seamlessly.

The Special Vostro Accounts introduced by the RBI are pivotal in the globalization of the
Indian Rupee, as they facilitate the use of INR in international trade and finance. These
accounts, in conjunction with various other measures taken by the Indian government and the
RBI, are aimed at promoting the INR as a global currency, expanding its international reach,
and enhancing its usage in international transactions.

As globalization continues to shape the world economy, these mechanisms and initiatives
play a crucial role in facilitating cross-border trade and financial transactions, contributing to
the growth and stability of the global economy.

3.“To control double digit inflation, US & other major Central Banks have increased
interest rates, which resulted in the failure/consolidation of SVC Bank, First Republic
Bank & Credit Suisse?

a. Discuss the impact of increase in interest rates on Treasury Investment Portfolios of

Banks.

Answer 3a:

Introduction:
The recent surge in inflation has prompted major central banks, including the United States
Federal Reserve, to increase interest rates as a measure to control double-digit inflation. This
has not only affected the broader financial landscape but also had a significant impact on the
banking industry, leading to challenges for some financial institutions. In this context, we will
discuss the consequences of rising interest rates on the treasury investment portfolios of
banks, with a focus on SVC Bank, First Republic Bank, and Credit Suisse.

Concept and Application:

An increase in interest rates can have several repercussions on the treasury investment
portfolios of banks:

Valuation Losses: As interest rates rise, the value of existing fixed-income securities in a
bank's portfolio may decrease. This is because these securities typically pay a fixed rate of
interest, and when new securities with higher interest rates become available, the existing
ones become less attractive to investors. This can lead to unrealized losses on the portfolio.

Income Reduction: Banks often hold a mix of fixed-income securities to generate interest
income. When rates increase, the interest income generated from the portfolio may decline as
the yields on these securities become less competitive.

Reinvestment Risk: Higher interest rates mean that when existing fixed-income securities
mature, banks must reinvest the proceeds in new securities with higher yields. However, in a
rising rate environment, finding attractive reinvestment options can be challenging, leading to
lower yields on the portfolio.

Duration Risk: Changes in interest rates can impact the duration of a bank's investment
portfolio. Rising rates can shorten the duration of the portfolio, making it more sensitive to
interest rate changes and potentially leading to higher price volatility.
Liquidity Challenges: As interest rates rise, banks may experience difficulty in selling their
lower-yielding securities at favorable prices, as investors prefer higher-yielding alternatives.
This can affect the liquidity of the portfolio.

In the cases of SVC Bank, First Republic Bank, and Credit Suisse, the impact of rising
interest rates on their treasury investment portfolios may have varied effects. SVC Bank, for
instance, may experience valuation losses and reduced income from its fixed-income
investments, affecting profitability. First Republic Bank, known for its wealth management
services, could face challenges in managing its clients' investment portfolios, particularly if
their investments are sensitive to interest rate changes. Credit Suisse, as a global investment
bank, may be exposed to a range of fixed-income securities and derivatives, making it
susceptible to a complex set of risks and rewards associated with rising rates.

Conclusion:

In conclusion, the decision by major central banks, including the US Federal Reserve, to
increase interest rates to combat double-digit inflation has had a notable impact on the
banking industry, particularly on the treasury investment portfolios of banks. The
consequences of rising interest rates include valuation losses, reduced income, reinvestment
risk, duration risk, and liquidity challenges.

The extent of these impacts can vary from bank to bank, depending on the composition and
sensitivity of their investment portfolios. SVC Bank, First Republic Bank, and Credit Suisse
are likely to experience unique challenges and opportunities in managing their investment
portfolios in response to increasing interest rates. It is crucial for banks to adopt prudent risk
management strategies and adapt their investment policies to mitigate potential losses and
maximize returns in a changing interest rate environment.

b. How the increase in interest rates will control inflation, when there is a huge liquidity
in the system?
Answer 3b:

Introduction:

Central banks often use interest rate adjustments as a tool to control inflation. The logic
behind this strategy lies in the relationship between interest rates, liquidity in the financial
system, and inflation. When there is excessive liquidity in the system and inflation becomes a
concern, increasing interest rates is a common approach. This essay explores how raising
interest rates can control inflation despite a surplus of liquidity in the financial system.

Concept and Application:

Reducing Borrowing and Spending: When central banks increase interest rates, it becomes
more expensive for individuals and businesses to borrow money. Higher borrowing costs can
lead to a reduction in spending, both on personal and investment levels. As borrowing and
spending decrease, demand for goods and services can soften, putting downward pressure on
prices. This is particularly effective in controlling demand-pull inflation.

Attracting Savings: Higher interest rates can make saving money in interest-bearing accounts
more attractive. As a result, people may opt to save more, which reduces the amount of
money circulating in the economy. With less money in circulation, the overall demand for
goods and services decreases, helping to control inflation.

Strengthening Currency: Rising interest rates can attract foreign capital into the country's
financial markets. A stronger currency can reduce the cost of imported goods and services,
which can help counter inflation, especially when it is partially driven by rising import prices.

Market Expectations: Central banks' moves to raise interest rates can signal their commitment
to controlling inflation. This action can influence the expectations of consumers and
businesses, leading them to anticipate lower inflation in the future. Such expectations can, in
turn, affect price and wage-setting behavior, which is crucial in containing inflation.
Conclusion:

While a surplus of liquidity in the financial system can create an environment conducive to
inflation, the central bank's ability to control inflation through interest rate adjustments
remains effective. By raising interest rates, central banks can reduce borrowing and spending,
encourage savings, strengthen the currency, and shape market expectations—all of which
work together to combat inflationary pressures. This demonstrates the central bank's capacity
to manage inflation, even when liquidity is abundant, and highlights the importance of a well-
coordinated monetary policy framework in maintaining price stability.