Dean's Office Official Model Question Paper

Treasury Management: Front Office vs. Back Office

Treasury management manages a bank’s liquidity, funding structure, interest rate risk, foreign exchange exposure, and investment portfolio to maximize yield while preserving liquidity.

• Front Office (Dealing Room): Actively executes financial market trades (money market borrowing, forex trading, bond investments).
• Back Office: Handles trade confirmation, settlement, reconciliations, regulatory accounting, and statutory reserve reporting.

Macaulay and Modified Duration

Macaulay Duration is the weighted-average time until a bond’s cash flows (coupons and principal) are received. Modified Duration measures the percentage change in bond price for a 100-basis-point (1%) change in yield-to-maturity:

$$\% \Delta P \approx -\text{Modified Duration} \times \Delta y$$

Net Interest Margin (NIM)

$$\text{NIM} = \frac{\text{Interest Income} - \text{Interest Expense}}{\text{Total Earning Assets}} \times 100$$

It measures how profitably a bank invests its earning assets relative to its funding costs.

Asset-Liability Committee (ALCO)

ALCO is a senior executive management committee (comprising the CEO, Treasury Head, Chief Risk Officer, and CFO) responsible for managing balance sheet interest rate risk, liquidity gaps, capital adequacy, and pricing structures.

Repo vs. Reverse Repo

• Repurchase Agreement (Repo): Selling government securities to the central bank with an agreement to repurchase them at a specified future date and price to borrow short-term cash.
• Reverse Repo: Purchasing government securities to absorb excess liquidity, earning short-term interest.

Gap Analysis in Asset-Liability Management (ALM)

Gap analysis measures a bank’s exposure to interest rate risk by comparing Rate-Sensitive Assets (RSA) against Rate-Sensitive Liabilities (RSL) across specific repricing maturity buckets.

$$\text{Repricing Gap (GAP)} = \text{RSA} - \text{RSL}$$

$$\Delta \text{NII} = \text{GAP} \times \Delta r$$

1. Positive Gap (RSA > RSL / Asset-Sensitive)

• Interest Rates Rise ($\Delta r > 0$): Assets reprice faster than liabilities $\implies$ Net Interest Income (NII) increases.
• Interest Rates Fall ($\Delta r < 0$): Assets reprice down while liabilities remain high $\implies$ NII decreases.

2. Negative Gap (RSA < RSL / Liability-Sensitive)

• Interest Rates Rise ($\Delta r > 0$): Liabilities reprice up faster than assets $\implies$ NII decreases (margin squeeze).
• Interest Rates Fall ($\Delta r < 0$): Cost of funds drops faster than asset yields $\implies$ NII increases.

3. Strategic Balance Sheet Immunization

• To immunize the bank against interest rate swings, ALCO adjusts duration by buying floating-rate assets or using interest rate swaps to bring the Gap close to zero.

Foreign Exchange Risk Management in Bank Treasury

Banks maintain foreign currency inventories to facilitate international trade, exposing them to exchange rate volatility.

1. Net Open Position (NOP)

• The net algebraic sum of all foreign currency assets, liabilities, and forward contracts in a specific currency.
  • Long Position (Assets > Liabilities): Bank gains if foreign currency appreciates; loses if it depreciates.
  • Short Position (Liabilities > Assets): Bank gains if foreign currency depreciates; loses if it appreciates.
• Central banks mandate strict aggregate NOP limits (e.g., capped at 20% of core capital).

2. Value at Risk (VaR) in Forex

• A statistical measure estimating the maximum expected financial loss on a foreign currency portfolio over a defined holding period (e.g., 1 day) at a specified confidence level (e.g., 99%).

3. Currency Swaps

• Financial agreements where two parties exchange principal and interest payments in different currencies at inception and reverse the exchange at maturity, eliminating exchange rate volatility.

Money Market Instruments in Bank Treasury

Money markets trade short-term, highly liquid debt instruments with maturities under one year.

1. Treasury Bills (T-Bills)

• Short-term sovereign debt securities issued by Nepal Rastra Bank on behalf of the government (28-day, 91-day, 182-day, and 364-day maturities).
• Issued at a discount and redeemed at full face value, carrying zero credit risk and eligible for statutory liquidity ratio (SLR).

2. Interbank Call Money

• Short-term, unsecured loans between commercial banks with maturities ranging from overnight to 7 days, used to manage immediate daily reserve and clearing liquidity.

3. Certificates of Deposit (CDs)

• Negotiable, interest-bearing term deposit receipts issued by banks to corporate investors for large deposits.

4. Commercial Paper (CP)

• Unsecured, short-term promissory notes issued by highly rated corporations to fund seasonal working capital, offering higher yields than government paper.

Basel III Liquidity Standards: LCR and NSFR

Basel III introduced structural liquidity ratios to prevent sudden bank runs and structural funding maturity mismatches.

1. Liquidity Coverage Ratio (LCR - Short-Term Resilience)

$$\text{LCR} = \frac{\text{High-Quality Liquid Assets (HQLA)}}{\text{Total Net Cash Outflows over 30-day Stress Scenario}} \ge 100\%$$

• Ensures banks hold sufficient cash and unencumbered sovereign bonds to survive a severe 30-day liquidity stress event.

2. Net Stable Funding Ratio (NSFR - Long-Term Structural Funding)

$$\text{NSFR} = \frac{\text{Available Stable Funding (ASF)}}{\text{Required Stable Funding (RSF)}} \ge 100\%$$

• Promotes structural funding resilience over a 1-year horizon, requiring illiquid long-term assets (like 20-year mortgages) to be funded by stable long-term liabilities (equity and multi-year fixed deposits).

Case Analysis: Asset-Liability Management and Gap Analysis for Himalayan Merchant Bank

a. Periodic and Cumulative Repricing Gap Computation (Rs Millions)

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b. Impact of 150 bps (+1.50%) Rate Hike on Net Interest Income ($\Delta \text{NII}$)

$$\Delta \text{NII} = \text{Periodic GAP} \times \Delta r \times \left( \frac{\text{Remaining Days in Year}}{365} \right)$$

Assuming uniform full-year impact for simplicity:

• Bucket 1 (1 - 30 Days): $-10{,}000 \times (+0.0150) = \mathbf{-150.0 \text{ Million}}$
• Bucket 2 (31 - 90 Days): $-2{,}000 \times (+0.0150) = \mathbf{-30.0 \text{ Million}}$
• Bucket 3 (91 - 180 Days): $+4{,}000 \times (+0.0150) = \mathbf{+60.0 \text{ Million}}$
• Bucket 4 (181 - 365 Days): $+9{,}000 \times (+0.0150) = \mathbf{+135.0 \text{ Million}}$

Net Annual Impact on NII:

$$\Delta \text{NII}_{\text{Annual}} = -150.0 - 30.0 + 60.0 + 135.0 = \mathbf{+15.0 \text{ Million}}$$

• Over the full cumulative 1-year horizon, because the 1-year cumulative gap is positive (+Rs 1,000M), the bank will gain Rs 15 Million over 12 months.
• However, in the first 90 days, the bank suffers a sharp immediate margin contraction of Rs 180 Million because short-term liabilities reprice before longer-term assets.

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c. Sensitivity Analysis

• Short-Term (0 - 90 Days): The bank is strongly Liability-Sensitive (Negative Gap of -Rs 12,000M). A rate hike causes immediate severe margin compression.
• Medium-to-Long-Term (1 Year): The bank shifts to slightly Asset-Sensitive (Positive Cumulative Gap of +Rs 1,000M).

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d. ALCO Immunization Action Plan

1. Introduce Flexible Floating-Rate Retail Loans: Convert fixed-rate term loans in Bucket 1–90 days into base-rate-linked floating loans that automatically reprice immediately upon central bank rate adjustments.
2. Lock in Term Funding in Short Buckets: Replace short-term callable 30-day deposits with 1-year and 2-year non-callable fixed deposit certificates to reduce RSL in Bucket 1.
3. Interest Rate Swaps (IRS): Enter into pay-fixed, receive-floating interest rate swap contracts to convert short-term floating liabilities into fixed-rate obligations, neutralizing the negative gap.