CU-BBA-SEM-IV-Treasury Management

The business also has bills payables to the vendors, creditors, middlemen and other parties. They have to bargain with them to get cash discounts and better credit terms. 4. Information Management Information is shared in both electronic and physical format,(figures, paper credentials, electronic manuscripts, audio, video).Information Management facilitates forcentralized and efficient cash management with technology. Technology helps to minimize the cost incurred in cash management. The organizational structure must be abletohandle this information during its life cycle for dissemination through multiple channels. 5. Liquidity management Cash is the liquid asset. Higher the cash, Higher will be the liquidity and lower the cash, the lower will be the liquidity. Liquidity is the degree to which a security can be quickly procured or sold in the market at a price reflecting its current value. The proper management of liquidity makes the company to be healthy by ensuring lifelong profitability and insolvency. 6.Account services A chief role of the accounts department is to converse with clients such as banks, credit card companies, financial services businesses and marketing agencies and to gather feedback and resolve problems. The accounts department plays a prominent role in managing the cash resources and liquidity. 3.10 SUMMARY  Liquidity planning is crucial, and involves finance and treasury managers’ ability to look to the company’s balance sheet and convert funds that are tied up in longer-term projects into cash for the firm to use in its day to day operations.  Companies use liquidity ratios to gauge their liquidity and measure their financial health. The three most important ratios to measure liquidity are: current ratios, quick ratios and cash ratios.  Working capital is the difference between a company’s short-term assets, such as cash and its short-term liabilities, such as its debts or bills which acts as a measure for liquidity.  The two components of working capital are called current assets and current liabilities help the company to manage the liquidity position to achieve the objectives of profitability.  The company with positive working capital can perform successfully in the market rather than company with negative working capital. 51 CU IDOL SELF LEARNING MATERIAL (SLM)

 Inventory Management, Receivables Management, Payables Management, Information Management and Account services are the vital functions of cash management.  A company can develop its working capital by receiving their accounts receivables from the customers quicker or asking suppliers for a short-term extension dates for their accounts payables. A number of factors affect working capital needs, including asset purchases, past-due accounts receivable being written off, and differences in payment policies. 3.11KEYWORDS  Liquidity- the degree to which a security can be quickly procured or sold in the market at a price reflecting its current value  Accounting Liquidity- It measures the company's ability to meet its short-term obligations using its most liquid assets.  Positive working capital- A company that has an excess of current assets to meet its current liabilities  Current assets- Theyare the assets that a company owns that are expected to be used up within the next 12 months.  Current liabilities- Short-term debts or bills that a company owes within the next 12 months.  Working capital- It is the difference between a company’s short-term assets, such as cash and its short-term liabilities, such as its debts or bills.  Inventory – the amount of stock (Raw materials, semi-finished and finished goods) which the company holds for sales.  Cash Cycle- The lead time between transforming the raw materials into cash is called as Cash cycle or cash conversion cycle.  Liquidity management is a cornerstone of every treasury and finance department. It is basic concept of the access to readily available cash in order to fund short-term investments, cover debts, and pay for goods and services 3.12LEARNING ACTIVITY 1. Define liquidity ___________________________________________________________________________ ___________________________________________________________________________ 2. What are the methods of measuring liquidity? 52 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________________________________ 3.13UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are the types of liquid assets? 2. Define Commercial bill. 3. Differentiate liquidity and profitability 4. State the significance of liquidity planning. 5. List out the current liabilities. Long Questions 1. “Liquidity is considered to be the blood of the enterprise’. Justify. 2. Explain the necessity of holding inventory. 3. What are the methods of measuring liquidity? 4. Discuss the role of working capital in liquidity management. B. Multiple Choice Questions 1. Money must be kept to meet unforeseen situations and emergenciesis known as a. Transaction motive b. Precautionary motive c. Speculative motive d. All of these 2. The three most important ratios to measure liquidity are: a. Current ratio, net profit ratio, quick ratio b. Current ratios, quick ratios and cash ratios. c. Net profit ratio, debt equity ratio, gross profit ratio d. Inventory turnover ratio, gross profit ratio, cash ratio 3. Dividends payable is an example for___________. 53 a. Current assets b. Current liability CU IDOL SELF LEARNING MATERIAL (SLM)

c. Short term debt d. None of these 4. The two components of ________________ are called current assets and current liabilities. a. Working capital b. Liquidity c. Cash d. All of these 5._________________the strict approach to ensuring that clients and customers maintain payments in a timely and orderly fashion. a. Receivables Management b. Working capital Management c. Liquidity Management d. Financial Management Answers 1-b, 2-b, 3-b. 4-a, 5-a 3.14 REFERENCES References books  Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, 2009.  Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2 Textbooks  Chandra, P., Financial Management—Theory and Practice, New Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p. 3. Websites  http://www.diva-portal.org/smash/get/diva2:409560/fulltext01 54 CU IDOL SELF LEARNING MATERIAL (SLM)

 https://www.investopedia.com/ask/answers/100915/does-working-capital-measure- liquidity.asp  file:///C:/Users/ADMIN/Desktop/urgent/UNIT%203/UNIT%203/section6-1.pdf 55 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 4: BUSINESS RISK MANAGEMENT STRUCTURE 4.0 Learning Objectives 4.1 Introduction 4.2 Definition of Risk 4.2.1 Business risk 4.2.2 Characteristics of Business Risk 4.2.3 Main Types of Business Risk 4.2.4 Other Types of Risks 4.2.5 Causes of Business Risks 4.3 Risk Management 4.3.1 Importance of Risk Management 4.3.2 Five characteristics of a strong risk management programme 4.4 Steps in the Risk Management Process 4.5 Risk Management Strategies 4.6 Summary 4.7 Keywords 4.8 Learning Activity 4.9 Unit End Questions 4.10 References 4.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Understand risk and its types  Identify causes of risk  Comprehend the risk management steps  Know mitigation strategies 4.1 INTRODUCTION Running a business comes with many types of risk. Every business and organization faces the risk of unexpected, harmful events that can cost the company money or cause it to 56 CU IDOL SELF LEARNING MATERIAL (SLM)

permanently close. The systematic and timely approach of handling risks will prevent the damagesto the business and/or costly and time-consuming repair task. Risk management allows organizations to prepare for the unexpected by minimizing risks and extra costs before they happen. 4.2 DEFINITION OF RISK A \"risk\" is defined as a function of three variables:  The probability that there's a threat,  The probability that there are any vulnerabilities, and  The potential impact. The types of risk vary from business to business. Some risks may be insured while others cannot be insured.E.g., Property insurance, vehicle insurance etc., Some business can not insured because likelihood of loss is very high. 4.2.1 Business risk It refers to a threat to the company’s ability to achieve its financial goals. Figure 4.1 Business Risk 57 CU IDOL SELF LEARNING MATERIAL (SLM)

4.2.2 Characteristics of Business Risks Figure 4.2 Characteristics of Business Risk i. Every entrepreneur takes risk as it is closely associated with the reward. Therefore it is part of every business. ii. The degree of risk varies with the business size. iii. The outcome of every risk is profit. iv. The unforeseen events may cause severe damages to the business and it has to be managed prudently. v. As the competition in the market increases, the risk also increases in business. 4.2.3Main Types of Business Risk Risks come in various forms. There are different types of business risks. a) Strategic Risk b) Compliance Risk c) Operational Risk d) Financial Risk e) Reputational Risk a)Strategic Risk It occurs any time. For example, a company manufacturing anti-mosquito lotion may suddenly see a decline in its sales because Peoples preferences have changed and now want a spray mosquitoes repellent. To deal with such risks they conduct survey to understand the needs and wants of customers. b)Compliance Risk 58 CU IDOL SELF LEARNING MATERIAL (SLM)

There is a need to comply with laws, regulations, standards and codes of practice that are set by the government or by a regulatory body. It involves companies having to comply with new rules. For example there may be a new minimum wage to be implemented immediately. c)Operational Risk Operational risk occurs within the business systems or processes. For example one of its production machines break down when the target output is still unmet. What will the company do when the workers undergo strike? d)Financial Risk Financial risk is about the financial health of the company. Can it handle business operations when two or three customers are not able to make their payments on time? How many customers can it offer such an installment scheme? e)Reputational Risk This occurs when media reports rumours, false information and negative news about the company which is detrimental for the reputation of the company. Figure 4.3 Types of Business Risk 4.2.4 OtherTypes of Risk Broadly speaking, there are two main categories of risk: systematic and unsystematic. Systematicrisk is the market uncertainty of an investment, meaning that it represents 59 CU IDOL SELF LEARNING MATERIAL (SLM)

external factors that impact all (or many) companies in an industry or group. Unsystematic risk represents the asset-specific uncertainties that can affect the performance of an investment. Below is a list of the most important types of risk for a financial analyst to consider when evaluating investment opportunities:  Systematic Risk – The overall impact of the market  Unsystematic Risk – Asset-specific or company-specific uncertainty  Regulatory Risk – The impact of political decisions and changes in regulation  Financial Risk – The capital structure of a company (degree of financial leverage or debt burden)  Interest Rate Risk – The impact of changing interest rates  Country Risk – Uncertainties that are specific to a country  Social Risk – The impact of changes in social norms, movements, and unrest  Environmental Risk – Uncertainty about environmental liabilities or the impact of changes in the environment  Operational Risk – Uncertainty about a company’s operations, including its supply chain and the delivery of its products or services  Management Risk – The impact that the decisions of a management team have on a company  Legal Risk – Uncertainty related to lawsuits or the freedom to operate  Competition – The degree of competition in an industry and the impact choices of competitors will have on a company 4.2.5 Causes of Business Risks a.National causes National causes of risk include flooding, earthquakes, cyclones and other natural disasters that can lead to the loss of lives and property. The ship carrying crude oil from gulf countries met with accident due to cyclone is a loss for the company. They need to take comprehensive insurance coverage. b.Human causes Human causes of risk refer to negligence at work, strikes, work stoppages and mismanagement. c.Economic causes 60 CU IDOL SELF LEARNING MATERIAL (SLM)

Economic causes involve things such as rising prices of raw materials or labour costs, rising interest rates for borrowing and competition. 4.3 RISK MANAGEMENT Risk management is the process of identifying, assessing and controlling threats to an organization's capital and earnings. The sources of risk arise from financial uncertainty, legal liabilities, Mismanagement, accidents and natural disasters. 4.3.1 Importance of Risk Management The company establishes procedures to avoid potential threats minimize their impact and cope with the results. There should be strong corporate governance principles that focus specifically on risk management. These are the benefits of the risk management strategies.  It creates a safe and secure work environment for all staff and customers.  It increases the stability of business operations anddeclining legal liability.  Safeguard the environment by minimising unforeseen circumstances like accidents, fire breakdown, harmful smokes etc.,  To protect the company assets and premises for the welfare of the employees. 4.3.2 Five characteristicsof a strong risk management programme  Effective risk management programs include all the people in the organization at every department. It pervades through the entire people involved in operations of the business.  Risk management programs objectives, process and strategies are communicated to all staff and results are shared with all the company’s stakeholders. There should be a transparency in risk management affairs to all those involved in the company.  It should cover all the areas right form risk identification, minimizing, management and also avoidance of risk in future.  Effective risk management programs are proactive in nature which focuses on the non- occurrence of risks in the company operations. 4.4STEPS IN THE RISK MANAGEMENT PROCESS According to C. Arthur Williams Jr. and Richard M. Heins in their book “Risk Management and Insurance, the risk management process” typically includes six steps. These steps are a) Determining the objectives of the organization b) Identifying exposures to loss c) Risk Measurement d) Selecting alternatives 61 CU IDOL SELF LEARNING MATERIAL (SLM)

e) Implementing a solution f) Monitoring the results. Figure 4.4 Risk Management Process a.Determining the objectives of the organization Every organization should have the goal for its existence. The example may be growth, profitability, corporate social responsibility etc., while the company strives for its attainment, it faces some obstacles. These may be related to various functional areas like production, Human Resource,Marketing and Finance. Identifying exposures to loss Business risks have to be identified as it causes some extent of loss to the company. For example, customers may shift their choices due to changes in taste and preferences and technologyetc., which affect the sales of the company.They should continuously monitor and track new and existing risks. c.Risk Measurement 62 CU IDOL SELF LEARNING MATERIAL (SLM)

After the risks have been identified, they must be prioritized in accordance with an evaluation of their probability. The company should establish a possibility scale for the purposes of risk assessment.For example, risks may:  Be very expected to occur  Have some possibility of occurring  Have a small possibility of occurring  Have very little possibility of occurring Other risks must be prioritized and managed in accordance with their likelihood of occurring. Figure 4.5 Risk Management Process d.Selecting alternatives Businesses have numerous alternatives for the management of risk including avoiding, assuming, reducing, or transferring the risks. Through employee safety trainingthe company attempts to avoid risk which is supposed to be proactive in nature.The acceptance of loss and readiness to pay the consequences is known as assumption of risks. Reducing risks or loss reduction means taking steps to lessen the likelihood or the intensity of a loss Example erection of fireExtinguisher,Earthquake Shock Absorbers for buildings.Risk transference refers to the practice of transferring the responsibility for a loss on another party through contract. For instance insurance allows a company to pay a small monthly premium in exchange for protection against vehicle accidents, burglary or devastation of property, 63 CU IDOL SELF LEARNING MATERIAL (SLM)

employee disability, or a range of other risks.A final risk management tool is self-retention of risks sometimes referred to as \"self-insurance.\" e.Implementing a solution Any combination of these risk management tools may be applied for the process, implementation. f.Monitoring the results The final step, monitoring includes a regular review of the company's risk management tools to determine if they have obtained the desired result or modification. 4.5 RISK MANAGEMENT STRATEGIES The seven key internal controls are to be considered as to mitigate treasury management risk. 1.Fraud prevention: Since the treasury department controls the company's bank account, it's the last resort of defense against deceptive activity. It considers limiting accessibility of the company's bank accounts or authorize transfers to and from them. It's also imperative to have processes to detect fraudulent invoices or payment scams and a response protocol for these instances to limit exposure. 2.Quality assurance for information:The executives make a set of key decisions based on the information that the treasury management team provides. If that data is inaccurate or insufficient, it hurdles the business activities. They have to double-check all data and recommendations the treasury management team produces to avoid any issues. 3.Trading limits:There should be atleast two people enter into trade and review a potential trade before completing it.The monitoring committee should properly check it. 4.Segregation of duties:There should be a split up of the duties concerned in trading and other activities to provide checks and balances. 5.Strategy implementation: A plan is only as good as its execution. Therefore it's essential to have an implementation plan for policies in everyday business operations and then follow through. 6. Error reduction and prevention: Because of the morenumber of financial transactions that a treasury management team deals with, there will be errors. It's dangerous to have a process in place to discover errors, correct information, and remove any wrong data from the system. 7.Treasury audit: Regular internal and external audits facilitateand determine which processes work and which processes need strengthening. 64 CU IDOL SELF LEARNING MATERIAL (SLM)

4.6 SUMMARY  A risk can be defined as an event or circumstance that has a negative effect on the business, for example, the risk of having equipment or money stolen as a result of poor security procedures. Types of risk vary from business to business.  The primary objective of an organization, growth, for example will determine its strategy for managing various risks. Identification and measurement of risks are relatively straightforward concepts.  Businesses have several alternatives for the management of risk, including avoiding, assuming, reducing, or transferring the risks. Avoiding risks, or loss prevention, involves taking steps to prevent a loss from occurring, via such methods as employee safety training.  Fraud prevention, Quality assurance for information, Trading limits, Segregation of duties, Strategy implementation, Error reduction and prevention and Treasury audit are the seven key internal controls are to be considered. 4.7 KEYWORDS  Risk Management- It is the process of identifying, assessing and controlling threats to an organization's capital and earnings.  Treasury audit- Regular internal and external audits facilitate determine which processes work and which processes need strengthening.  Reputational Risk-This occurs when media reports rumours, false information and negative news about the company which is detrimental for the reputation of the company.  Human risk- It refer to negligence at work, strikes, work stoppages and mismanagement.  Environmental Risk – Uncertainty about environmental liabilities or the impact of changes in the environment  Operational Risk – Uncertainty about a company’s operations, including its supply chain and the delivery of its products or services  Management Risk – The impact that the decisions of a management team have on a company  Legal Risk – Uncertainty related to lawsuits or the freedom to operate  Competition – The degree of competition in an industry and the impact choices of competitors will have on a company 65 CU IDOL SELF LEARNING MATERIAL (SLM)

 Business risk-It refers to a threat to the company’s ability to achieve its financial goals.  Financial risk- It is about financial health of the company 4.8 LEARNING ACTIVITY 1. Define Risk ___________________________________________________________________________ _____________________________________________________________________ 2. State the need for Risk Management. ___________________________________________________________________________ _____________________________________________________________________ 4.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define Risk management 2. What are the types of Business risk? 3. Mention the causes of risks 4. What do you mean by strategic risk? 5. List out risk prevention strategies. Long Questions 1. Describe the steps in Risk Management. 2. Discuss the importance of Risk management 3. Write short notes on risk monitoring. 4. Explain the risk management strategies B. Multiple Choice Questions 1.______________is the process of identifying, assessing and controlling threats to an organization's capital and earnings. a. Risk monitoring b. Risk management c. Risk identification 66 CU IDOL SELF LEARNING MATERIAL (SLM)

d. Risk mitigation 2. There is a need to comply with laws, regulations, standards and codes of practice that are set by the government or by a regulatory body. a. Strategic Risk. b. Compliance Risk. c. Operational Risk. d. Financial Risk. 3.Tracking new and existing risks is part of a. Risk management process b. Risk management strategies c. Risk identification d. None of these 4.among the following which is the characteristic(s) of Risk Management? a. Inclusive b. Proactive c. Transparent d. All of these 5. How many steps are stated in risk management process? a. 4 b. 5 c. 6 d. 7 Answers 1-b, 2-b, 3-c, 4-d, 5-c 67 CU IDOL SELF LEARNING MATERIAL (SLM)

4.10 REFERENCES References books  Chapman, C., & Ward, S. (1997): Project risk management. JOHN WILEY & Sons.  Courtney, H., Kirkland, J., and Viguerie, P. (1997): Strategy under uncertainty. Harvard Business Review. November/ December Textbooks  Knight, F. H. (1921): Risk, Uncertainty, and Profit. Houghton Mifflin Company.  Peter Romilly, P. (2007): Business and climate change risk: a regional time series analysis. Journal of International Business Studies.  Ephraim Clark, E., Marois, B. (1996): Managing Risk in International Business. Intl Thomson Business Press.  Oetzel, J.M., Bettis, R.A. and Zenner, M. (2001): Country Risk Measures: How Risky Are They? Journal of World Business Website  https://www.aiu.edu/publications/student/english/business%20risk%20mana gement.html  https://www.smallbusiness.wa.gov.au/business-advice/insurance-and-risk- management/risk-management 68 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 5: CORPORATE LIQUIDITY RISK 69 MANAGEMENT STRUCTURE 5.0 Learning Objectives 5.1 Introduction 5.2 The concept of liquidity 5.2.1 Definition 5.2.2 Sources of liquidity 5.2.3 Sources of liquidity and business health 5.2.4 Liquidity Planning 5.2.5. Fundamentals of well-built Liquidity Management 5.2.6Strategies for improving Liquidity 5.3 Role of liquidity in risk management 5.3.1 Liquidity Risk -Definition 5.3.2 Types of liquidity Risk 5.3.3 Other Types of liquidity Risk 5.3.4 Liquidity Risk in Financial Institutions 5.4 Measuring and managing liquidity risk 5.5 Mitigate to risk 5.6 Summary 5.7 Keywords 5.8 Learning Activity 5.9 Unit End Questions 5.10 References 5.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  To explain the definition of liquidity risk  To identify the causes of liquidity risk CU IDOL SELF LEARNING MATERIAL (SLM)

 To know how to mitigate the liquidity risk 5.1 INTRODUCTION Unlike other risks liquidity risk is normal aspect of everyday management of financial institutions. At extreme cases, liquidity risk may lead to insolvency. Some financial institutions are highly exposed to Liquidity risk. The depository institutions are highly exposed. Mutual funds, pension funds and property –casualty insurers have relatively low liquidity risk. 5.2 THE CONCEPT OF LIQUIDITY As all financial institutions are affected by changes in the economic climate, the monitoring of economic and money market trends is the key to liquidity planning. Sound financial management can minimize the negative effects of these trends while accentuating the positive ones. The importance of liquidity management cannot be understated. Liquidity risk, which treasurers and finance department managers constantly attempt to downplay, can lead to a variety of problems and pull a company into ill health.  Effective liquidity management serves five important functions:  It demonstrates the market place that the company is safe and therefore capable or repaying its borrowings.  It facilitates the company to meet its previousformal or informal. loan commitments  It enables the company to avoid the unprofitable sale of assets. This functions permits to avoid sale of asset at fire sale prices, as opposed to going concern values to generate funds.  It lowers the size of the default risk premium the company must pay for funds. This function focuses on the reasonable price aspects of the definition of liquidity management. Companies with strong balance sheets will be perceived by the market place as being reflecting their perceived credit worthiness. 5.2.1 Definition Liquidity refers to the ability of the company to transform its assets to cash without much time and effort. 70 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 5.1Cash Conversion Cycle 5.2.2 Sources of liquidity Broadly speaking, two major sources of liquidity for a company are classified as The primary sources of liquidity, which are either cash or other assets that can be converted into cash very easily; and The secondary sources of liquidity, which usually can’t be converted into cash as easily and fast as the primary sources and may mean asset sales or other actions that would affect a company’s operations. Figure 5.2 Sources of liquidity 71 a.Primary Sources of Liquidity CU IDOL SELF LEARNING MATERIAL (SLM)

Primary sources of liquidity can be easily used to generate liquidity for the company. They are generally cash and other near-cash assets. More specifically, they include: i. Cash balances (generally in a bank account) They can be either actual cash already stored in bank accounts or cash that can be generated by the liquidation of short-term securities (which comes with a maturity of less than 90 days). On the balance sheet, such sources of liquidity are generally indicated by the item “cash and cash equivalents.” ii.Short-term funds They include commercial credit (i.e., trade payables), bank credit, and short-term securities not maturing within 90 days. iii.Cash flow management They are related to the company’s ability to manage cash effectively and the level of decentralization of cash inflows and outflows. For example, a company with a highly decentralized collection system may find it more difficult to access cash resources promptly. b.Secondary Sources of Liquidity Unlike the primary sources of liquidity, the secondary sources usually cannot be converted into cash without an effect on the company’s operations. For example, it can be the case of a company that has run out of cash and near-cash assets and needs to liquidate assets, such as inventory, plants, and equipment, to pay its bills.More specifically, a company’s secondary sources of liquidity include: i. Negotiating its debt obligations A company can generate liquidity by getting more favorable terms on its debt, i.e., by renegotiating maturities, the size and timing of principal repayments, and interest rates. ii.Liquidating assets It can involve relatively liquid assets, such as inventory, or other less liquid assets, such as plant, equipment, and real estate properties. The urgency with which the cash is needed in the situations where liquidation is necessary generally implies that the assets are sold at a discount to their usual price. Bankruptcy protection and reorganization 5.2.3 Sources of Liquidity and Business Health Liquidity is a key factor in assessing a company’s creditworthiness. To fully pay what it owes on time, a company must have access to proper sources of liquidity. Generally speaking, a financially healthy company should be able to meet its obligations relying on its primary sources of liquidity. 72 CU IDOL SELF LEARNING MATERIAL (SLM)

If access to secondary resources is needed, it means that the company has experienced, or is experiencing, liquidity issues. While it can be due to temporary conditions, it’s often a sign of deeper fundamental problems in the business In order to keep a regular grasp of the firm’s liquidity risk, managers will monitor the liquidity ratio – in which firms will compare their most liquid assets (those that can be converted into cash easily and quickly), with short term liabilities, or near-term debt obligations. 5.2.3Kinds of Liquidity Liquidity falls into different categories a. Immediate Liquidity obligations The company meets day to day transactions like payment of raw materials, wages to labours, fuel cost and transport costs etc., with the help of liquidity. b. Seasonal Short-Term Liquidity Needs The companies with seasonal products have fluctuations in demand. The liquidity needs of the company also depends on the demand pattern. c. Trend Liquidity Needs The regular liquidity needs of the company is analysed by using the time series method and they can be utilized from internal and external sources of funds. 5.2.4 Liquidity Planning The overall aim of successful liquidity planning is to ensure that the company has adequate funds to meet the financial obligations as they become due. i.Short Term Liquidity planning The purpose is to manage the legal reserve position that meets the minimum reserve position that meets the minimum requirement at lower cost. ii.Long-Term Liquidity Planning The company will be determined for long term through forecasting cash inflow and out flow depending upon the existing and future cash resources, annual growth, expansion and diversification plans etc., 5.2.5 Fundamentals of well-built Liquidity Management 1. Good Management Information System Themanagement Information system provides the centralised storing, preserving and retrieving the data whenever required. All the cash transactions are recorded and taken in a computerised system which facilitates the cash inflows and outflows in an effective way. 73 CU IDOL SELF LEARNING MATERIAL (SLM)

2.Central Liquidity control The excess and deficit liquidity endanger the company in terms of profitability and insolvency. These three principles are having contradicting objectives and they have to be managed in an effective way. The centralised liquidity control assist in managing and utilising liquid assets efficiently. 3.Analysis of net funding requirements under alternative scenarios The company should analyse the requirements for new proposals in alternative ways in order to ensure the required level liquidity. 4. Diversification of funding sources The company determines the various choices of funding sources for yielding regular return so that the liquidity position of the company is healthy and safe. 5. Contingency planning The company should plan to improve the liquidity in cases of emergency situations like flood, lock down, demand fluctuations, international crisis etc., 5.2.6 Strategies for improving Liquidity  Rapid Stock Turnover  Negotiating with suppliers  Better Accounts Receivables  Invoice Discounting  Disposal of unnecessary Assets  Sales of loss making Divisions and Brands  Conversion of Debts into shares  Becoming Growth Oriented Company  Dealer Deposits /Customer Deposits 74 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 5.3 Sources of liquidity 5.3 ROLE OF LIQUIDITY IN RISK MANAGEMENT 5.3.1 Liquidity Risk -Definition Liquidity risk precisely funding liquidity risk refers to risk of running out of cash or unable to raise additional funds to meet the financial claims from its liability holders to honour the asset purchase agreement. It arises due to a. Unable to fulfil short term debts b. Incapable to convene proper funding within specific time frame c. Rise of manufacturing expenses 5.3.2 Types of liquidity Risk Liquidity risk is the risk that when a company lack funds to meet its financial obligations in a timely manner. The two core fundamentals of liquidity risk are short-term cash flow risk and long-term funding risk. All businesses need to manage liquidity risk to ensure that they will be solvent. There are three types of liquidity risk 1. Funding risk 2. Asset Liquidity risk 3. Interest Rate risk 1.Funding Risk It depends on the perception of the market of the credit standing of the bank. A bank approaching the market with unexpected and frequent needs for funds would have adverse effect on the willingness of the market to lend and raises the cost of funds which is the prime 75 CU IDOL SELF LEARNING MATERIAL (SLM)

driver of profitability. The need for unanticipated withdrawal/non-renewal of deposit (wholesale and retail) emerges due to  Fraud causing substantial loss  Systemic risk  Loss of confidence  Liabilities in foreign currencies Funding liquidity risk can be heightened through the following factors:  Seasonal fluctuations in revenue generation  Business disruptions  Unplanned capital expenditures  Increased operational costs  Poor working capital management  Poor matching of asset duration to debt duration  Limited financing facilities  Poor cash flow management  Mismanagement  Lack of appropriate liquid policy and contingent plan  High level of Non-Performing Assets  Over extension of credit 2.Asset Liquidity Risk It arises when assets are not readily tradable. The rationale of liquidity ratio is to make banks hold more short-term assets than short-term liabilities. Liquidity risk arises when maturities of assets exceed those of liabilities. 3.Interest Rate Risk Liquidity risk is closely related to interest rate risk. If a bank desires to have more interest sensitive liabilities than assets it reduces the liquidity position of banks. When a bank structure its portfolio in order to achieve a positive duration gap (assets>liabilities), the liquidity of the assets is reduced. If interest rates increase the value of long-duration assets will decline more than short-duration assets and assets sales would involve losses. 76 CU IDOL SELF LEARNING MATERIAL (SLM)

5.3.3 Other types of liquidity risks a.Time risk: Need to compensate for non-receipt of expected inflows of funds which arises due to: a) Severe deterioration in the assets quality b) Standard assets turning into non-performing assets c) Temporary problems in recovery d) Time involved in managing liquidity b.Call risk: Crystallization of contingent liabilities and inability to undertake profitable business opportunities when desirable. It arises due to:  Conversion of non-fund based limit into fund based  Swaps and options c. Credit risk It is a potential loss occurs due to failure of the borrower to meet the financial obligations on agreed terms and conditions as per financial contract. d. Market risk It is a potential loss occur due to changes in the market conditions such as inflation, GDP growth, changes in interest rates, changes in interest rates, changes in equity shares etc.,. e. Operational risk It is the risk of loss resulting from failure of internal processes, people or systems or from external events. The factors relating to operational risk are  Improperly documented transactions  Failure of computer systems, software or equipment  Inadequate employee training and employee errors  Fraud 5.3.4Liquidity Risk in Financial Institutions Financial institutions depend upon borrowed money to a considerable extent, so they're commonly scrutinized to determine whether they can meet their debt obligations without realizing great losses, which could be catastrophic. Institutions, therefore, face strict compliance requirements and stress tests to measure their financial stability. The Federal Deposit Insurance Corporation (FDIC) released a proposal in April 2016 that created a net stable funding ratio. It was intended to help increase banks’ liquidity during periods of financial stress. The ratio indicates whether banks own enough high-quality assets 77 CU IDOL SELF LEARNING MATERIAL (SLM)

that can be easily converted into cash within one year. Banks rely less on short-term funding, which tends to be more volatile. During the 2008 financial crisis, many big banks failed or faced insolvency issues due to liquidity problems. The FDIC ratio is in line with the international Basel standard, created in 2015, and it reduces banks’ vulnerability in the event of another financial crisis. Liquidity Risk in Companies Investors, managers, and creditors use liquidity measurement ratios when deciding the level of risk within an organization. They often compare short-term liabilities and the liquid assets listed on a company’s financial statements. If a business has too much liquidity risk, it must sell its assets, bring in additional revenue, or find another way to reduce the discrepancy between available cash and its debt obligations. Example A $500,000 home might have no buyer when the real estate market is down, but the home might sell above its listed price when the market improves. The owners might sell the home for less and lose money in the transaction if they need cash quickly so must sell while the market is down. Investors should consider whether they can convert their short-term debt obligations into cash before investing in long-term illiquid assets to hedge against liquidity risk. The aim of liquidity risk management is to reduce the risk that the company will not have enough liquidity and/or credit lines to meet its present or potential monetary obligations regardless of unpredicted changes in trade and market position.Some companies ponder all obtainable liquidity centrally, while others use regional attention. The strategies of the companies vary . Liquidity can be mobilised internally or externally. Each source of liquidity has its individual risks which need to be measured and managed. Indicator of a company’s funding liquidity risk Liquidity ratios, such as the current ratio and quick ratio, can be used as an indicator of a company’s funding liquidity risk. The current ratio, the most common ratio used to measure such a risk is shown below: Where: 78 Current Assets are possessions that are likely to be converted into cash within a year. Current Liabilities are obligations that are likely to be due within a year. CU IDOL SELF LEARNING MATERIAL (SLM)

Additional ratios such as the interest coverage ratio, debt to gross cash flows, quick ratio, etc., should be used to provide a improved picture of a company’s funding liquidity risk. Managing Liquidity Risk The main risks to a company/group's liquidity that need to be assessed and managed are:  Intra-day liquidity exposures  Contingency risks from unforeseen changes in cashflow predictions and the calculatio nsof how much liquidity will be available from cash and working capital  Structural risk from non-conformance of funds flow and positions  FX rate fluctuations and impact on payment flows and liquidity  Risks inherent in each of the different types of funding Counter party risks from the banks and financial institutions providing funding and investment s. Following steps are necessary for managing liquidity risk: a. Establishment of Risk Management Framework b. Setting maximum Tolerance Level c. Assessing and monitoring liquidity risk a. Establishment of Risk Management structure It is a professional approach of setting up and handling the cash assets of an organization. The quantitative and qualitative targets are to be formulated as a part of liquidity strategy. Care should taken in keeping the consistency with the strategic objectives of the financial Institution. The strategy of management of liquidity risk should be informed to all the departments and they should act according to the prescribed policies and procedures. The timely review and feedback will be useful in understanding the liquidity issues and act wisely. The companies should establish an ample liquidity risk management scheme with a completeawareness of the coverage, features and kinds of risks, and the tools of identification, measurement, monitoring and rule regarding liquidity risk.The current status of liquidity risk management should be studied and policy can be reviewed and a specific measure has to be taken. The policy on setting of liquidity risk limits the department dealing with risk management. The policy on identification, assessment, monitoring, control and mitigation of liquidity risks –Eg. Policy on liquidity catastrophe management. The policy guidelines changes time to time as changes in business environment incurs. Therefore it has to be revised on time. Liquidity Risk Management Rulesclearly specify the activities concerning liquidity risk management. 79 CU IDOL SELF LEARNING MATERIAL (SLM)

The board of Directors will approve the Liquidity Risk Management Rules after ensuring with the compliance with the policy. b.Setting maximum Tolerance Level They establish appropriatefunding gap limits after considering scale and nature of the institution’s business and its risk summary, monetary conditions and fund-raising ability. Managers should be knowledgeable and experienced to oversee these divisions and enablethe staff to execute by handing over them the necessary authority. The sufficient number of staff should be allocated in the department for executing the assigned work.The supervisors may lay down the limit. For example to administer liquidity and to stay on solvent by maintaining short term cumulative gap up to one year (short term liabilities –short term assets) at 15% of total out flow of funds. c.Assessing and monitoring liquidity risk There are two approaches a. Stock approach b. Flow approach a. Stock approach depends on the quantity of assets and liabilities as well as balance sheet exposure on particular date. b. Flow approach has three dimensions.  Measuring and managing net funding requirements  Managing market access  Contingency planning 5.5 MITIGATE TO RISK In unfavorable economic conditions such as recession, a large gap may arise between the demand for an asset and its supply. Lack of demand forces the asset price to fall. Thus, such market inefficiency may result in liquidity risk. Because the holder of the asset may not be willing to sell the assets at such a low value. Effective Risk Mitigation Strategies  Identifying risk is an important first step. It is not sufficient though.  Taking steps to deal with risk is an essential step. Knowing about and thinking about risk is not the same as doing something about risk. 80 CU IDOL SELF LEARNING MATERIAL (SLM)

 Risk will occur. Some good, some bad. Some minor, some catastrophic. The ability to mitigate risk allows to proactively acknowledge and accommodate risks. There are four different strategies to mitigate risk: avoid, accept, reduce/control, or transfer. a.Avoidance If a risk presents an unwanted negative consequence, you may be able to completely avoid those consequences. By stepping away from the business activities involved or designing out the causes of the risk you can successfully avoid the occurrence of the undesired events.One way to avoid risk is to exit the business, cancel the project, close the factory, etc. This has other consequences, yet it is an option.Another approach is to establish policies and procedures that assist the organization to foresee and avoid high-risk situations. By not starting a project that includes a high unwanted risk successfully avoids that risk. Testing or screening of products that may have a latent defect which may lead to unwanted and unacceptably high field failures is an option. Screening is not 100% effective yet may reduce the risk of field failures sufficiently.Design out of a product or process the elements that permit an unwanted risk to arise. A product design change to a more robust material avoids unwanted failures due to unacceptable wear of a less robust material. Implementing engineering design reviews in the product lifecycle process may help identify high-risk areas of a new product or process prior to the decision to start shipping. b.Acceptance Every product produced has a finite chance of failing in the hands of the customer. When that risk is at an acceptable level, sufficiently low estimated field failure rate, then ship the product. Accept the risk. When the decision to accept the risk is in part based on an estimate or prediction, there is the risk the information incorrectly forecasts the future. Therefore, for high consequence related field failures, closely monitoring field performance or establishing early warning systems may be prudent. c.Reduction or control FMEA, hazard analysis, FTA, and other risk prioritization tools focus help you and your organization identify and prioritize risks. Reducing the probability of occurrence or the severity of the consequences of an unwanted risk (say product failure) is a natural outcome of risk prioritization tools. If it is not possible to reduce the occurrence or severity, then implementing controls is an option. Controls that either detect causes of unwanted events prior to the consequence occurring during use of the product, or the detection of root causes of unwanted failures that the team can then avoid. 81 CU IDOL SELF LEARNING MATERIAL (SLM)

Controls may focus on management or decision-making processes. Improving the ability to find design flaws or to improve the accuracy of field failure rate prediction both improve the ability to make the appropriate decisions concerning risk. Another method to reduce or control risk is to diversify. Thinking through the mix of products, technologies, markets, operations, and supply chains permit the team the ability to limit the high-risk opportunities to a manageable or acceptable level. Finally, unwanted events or high field failure rates will occur. Think through both how you will detect the onset of the event and how to respond. It may be wise to stop production and shipping when a product failure, even one, has a major consequence (starts a home on fire, for example).Acting quickly and appropriately may reduce the exposure to more failures/adverse consequences. d.Transference This strategy is to shift the burden of the risk consequence to another party. This may include giving up some control, yet when something goes wrong your organization is not responsible. This approach may not work to protect your brand image if the product is associated with your organization. Even if the power supply vendor pays for all damages due to failures in their unit, the customer only knows that your product has failed and caused damage. Use this approach with caution. A conventional means to transfer risk to another organization is with the purchase of insurance. This may require a careful analysis of the presenting risks and probabilities yet is a viable option in some situations. Contract terms with suppliers, vendors, contractors, etc may provide a means to shift risk away from the organization. For example, if a power supply fails in an expensive server causing the loss of revenue for a customer, in typical situations, the company might ask for and receive a replacement power supply. Or, the company would require the power supply vendor to cover the cost of the entire server (which the power supply caused to fail) and the loss experienced by the customer. I. Operational Risk: This covers the entire gamut of the transaction cycle from dealing to custody. Operational risk can again be divided into those arising from:  System deficiencies, authorizations, based on approved delegation of powers, must integrate with work and document flows. This ensures that individual payments and deliveries by the bank are entirely deal/transaction supported;  Non-compliance with laid-down procedures and authorizations for dealing, settlement and custody;  Fraudulent practices involving deals and settlements; 82 CU IDOL SELF LEARNING MATERIAL (SLM)

 IT involving software quality, hardware uptime; and  Legal risks due to inadequate definitions and coverage of covenants and responsibilities of the bank and counterparty in contracts and agreements. Mitigation:  Dealers must operate strictly within the single deal, portfolio and prudential limits set for the instrument and counterparty. Stop loss and risk norms of duration and value at risk should be adhered to at all times.  No deviation from approved and implemented work and document flows should be allowed.  The necessary authorizations must accompany documents as they pass from one stage of the transaction cycle to the next.  Delegation of powers must be strictly adhered to Deals or transactions exceeding powers must be immediately and formally ratified in accordance with management/board edicts on ratification.  The prescribed settlement systems in each product/instrument and market must be followed. Deviations from delivery and payment practices should not be allowed.  Computer systems – hardware, networks and software – should have adequate backups. They should be put through periodic stress tests to determine their ability to cope with increased volumes and external data combinations.  Custodian’s creditworthiness is paramount in demat systems of records of ownership and transfer. Custodial relationships should be only with those with the highest credit rating.  Counterparty authorisations/powers of attorney must be kept current.  The list of approved brokers should be reviewed periodically to satisfy the bank’s credit standards and ethics. In equity transactions, the broker is the counterparty. Settlement must be of the delivery against payment type.  Deal, transaction and legal documentation should be adequate to protect the bank, especially in one-off transactions and structured deals. II.Financial Risks: The following identifies and defines individual financial risks: Credit Risk: This refers to the possibility of the issuer of a debt instrument being unable to honour his interest payments and/or principal repayment commitment. But, in modern financial markets, it includes non-performance by a counterparty in a variety of off- balance sheet contracts such as forward contracts, interest rate swaps and currency swaps and counterparty risk in the 83 CU IDOL SELF LEARNING MATERIAL (SLM)

inter-bank market. These have necessitated prescribing maximum exposure limits for individual counterparties for fund and non-fund exposures. Mitigation:  Better Credit appraisal. Careful analysis of cash flows of the business before investing.  Investing only in rated instruments.  Risk pricing.  Credit enhancement through margin arrangements, escrow accounts etc.  Guarantees/letters of credit from rated entities.  Adequate financial and/or physical assets as security.  Exposure limits by counterparty, industry, location, business group, on and off balance sheet.  Diversification by industry, sector, location and so on.  Exposure limits for individual bank counterparties for funded/non-funded assets.  Reputation and image of counterparties.  Collateralization of transactions through repos. III. Liquidity Risk: An asset that cannot be converted into cash when needed is liquidity note which is the normal characteristic of the vast majority of bonds.There is also the risk of scarcity of funds in the market. This could happen, for example, when the RBI deliberately tightens liquidity, by increasing CRR, selling securities or forex. A third situation is when a bank’s creditworthiness becomes suspect and there are no willing lenders, even though there is no liquidity shortage in the market. Mitigation:  Increase the proportion of investments in liquid securities.  Increase the proportion of investments in near-maturity high quality instruments.  Maintain credit rating, reputation and image.  Securitize loan portfolio of large as well as small borrowers. III. Market Risk: A generic term to describe both interest rate risk and event (“systemic”) risk. Event Risk: 84 CU IDOL SELF LEARNING MATERIAL (SLM)

The risk that an unexpected happening, which is extreme, sudden or dramatic (e.g., the September 11 terrorist attacks, tsunami), will cause an all-round fall in market prices. Mitigation: Increase the proportion of assets in risk-free, high quality investments of short maturity. Interest Rate Risk (Balance Sheet): This affects both the assets and liabilities of a bank. On an overall basis, the maturity gaps between assets and liabilities lead to the risk of a contraction of spreads if interest rates fall and assets mature before liabilities, or interest rates rise and liabilities mature before assets. 5.6 SUMMARY  Liquidity risk is a normal aspect of day-to-day management of companies and financial institutions. But in extreme conditions it may lead to insolvency. Some financial institutions are more exposed to liquidity risk than others.  Liquidity risk is the risk that when a company lack funds to meet its financial obligations in a timely manner. The two core fundamentals of liquidity risk are short- term cash flow risk and long-term funding risk. All businesses need to manage liquidity risk to ensure that they will be solvent.  Depository institutions are highly exposed. Mutual funds, pension funds and property casualty insurers have relatively low liquidity risk.  The policy on identification, assessment, monitoring, control and mitigation of liquidity risks –Eg. Policy on liquidity catastrophe management. The policy guidelines changes time to time as changes in business environment incurs. Therefore it has to be revised on time. 5.7 KEYWORDS  Liquidity –The risk of running out of cash or unable to raise additional funds to meet the financial claims from its liability holders to honour the asset purchase agreement.  Credit risk -It is a potential loss occurs due to failure of the borrower to meet the financial obligations on agreed terms and conditions as per financial contract.  Market risk -It is a potential loss occur due to changes in the market conditions such as inflation, GDP growth, changes in interest rates, changes in interest rates, changes in equity shares etc.,.  Operational risk-It is the risk of loss resulting from failure of internal processes, people or systems or from external events.  Liquidity Risk-An asset that cannot be converted into cash when needed. 85 CU IDOL SELF LEARNING MATERIAL (SLM)

 Transference-This strategy is to shift the burden of the risk consequence to another party  Current Assets are possessions that are likely to be converted into cash within a year.  Current Liabilities are obligations that are likely to be due within a year. 5.8LEARNING ACTIVITY 1. Define liquidity risk. ___________________________________________________________________________ ___________________________________________________________________________ 2. State the causes of liquidity risk ___________________________________________________________________________ ___________________________________________________________________________ 5.9UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define Liquidity risk? 2. What are the types of liquidity risks? 3. Elaborate the sources of Liquidity risks? 4. What are the steps in liquidity risk management? Long Questions 1. Explain the factors influencing the liquidity risk? 2. Discuss the primary and secondary sources of liquidity? 3. Elucidate the liquidity risk management strategies. B. Multiple Choice Questions 1. The another term used to refer liquidity risk is _________ a. Funding liquidity risk b. Market risk c. Interest risk d. Credit risk 86 CU IDOL SELF LEARNING MATERIAL (SLM)

2. When assets are not readily tradable the risk that arises is termed as_________ a. Asset liquidity risk b. Interest rate risk c. Credit risk d. None of these 3.A ______________is a predetermined amount of credit that is extended to a borrower a. Cash Credit b. Short Term Credit c. Trade Credit d. Line Of Credit 4. The operational risk arises due to__________ a. Standard assets turning into non-performing assets b. Temporary problems in recovery. c. Fraud d. None of these 5. The _____________sources of liquidity are not easily converted into cash. a. Primary source b. Secondary source c. Both d. None of these Answers 1-a, 2-a, 3-d. 4-c, 5-b 5.10 REFERENCES Reference books  Chapman, C., & Ward, S. (1997): Project risk management. JOHN WILEY & Sons. 87 CU IDOL SELF LEARNING MATERIAL (SLM)

 Courtney, H., Kirkland, J., and Viguerie, P. (1997): Strategy under uncertainty. Harvard Business Review. November/ December Textbooks  Knight, F. H. (1921): Risk, Uncertainty, and Profit. Houghton Mifflin Company.  Peter Romilly, P. (2007): Business and climate change risk: a regional time series analysis. Journal of International Business Studies.  Ephraim Clark, E., Marois, B. (1996): Managing Risk in International Business. Intl Thomson Business Press.  Oetzel, J.M., Bettis, R.A. and Zenner, M. (2001): Country Risk Measures: How Risky Are They? Journal of World Business Websites  http://www.slideshare.net/sreenath.s/evolution-of-hrm  www.articlesbase.com/training-articles/evolution-of-human-resource- management- 1294285.html  http://www.oppapers.com/subjects/different-kinds-of-approaches-to-hrm- page1.html 88 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 6: TREASURY RISK MANAGEMENT STRUCTURE 6.0 Learning Objectives 6.1 Introduction 6.2 Definition and Objectives of asset liability management 6.3 Process of asset liability management 6.4 Process of asset liability management 6.5 Techniques of asset liability management 6.6 Treasury Risk Management 6.6.1 The Difference between Treasury and Liquidity Risk 6.6.2 Types of Treasury Risks 6.7 Methods to Identify Treasury Risks 6.8 Risk Management Strategies 6.9 Summary 6.10 Keywords 6.11 Learning Activity 6.12 Unit End Questions 6.13 References 6.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  know asset liability management  Define Treasury risks,  Explain about the market risks  Analyse the role of asset-liabilitymanagement 6.1 INTRODUCTION Treasury risk management gains significance for two purposes. First, the character of treasury movement is such that the every market opportunities yield to generate profits and therefore market risk is present at every step. Asset and Liability Management is the activity which assists manager to deal with its balance sheet in order to agree to substitute interest rates and 89 CU IDOL SELF LEARNING MATERIAL (SLM)

liquidity scenarios. It provides overall picture of whether company’s assets are able to meet the liabilities in the future. Figure 6.1 Asset and Liability Management I. Assets There are three categories of assets a) Based on Convertibility (fixed assets or current assets) b) Based on Physical being (tangible and intangible) c) Based on Purpose (operating assets and non-operating assets) a) Based on Convertibility Cash equivalents, stock, saleable securities and temporary deposits are some of the most widespread current assets which can be easily transformed into cash within short period and little effort. The hard assets or fixed assets like land, machinery, equipment, building, patents, trademarks, etc. cannot be easily changed into cash. b) Based on Physical existence The tangible assets are stock, land, building, office supplies, equipment, machinery and saleable securities etc., while goodwill, corporate intellectual possessions, patents, copyrights, permits, trade secrets, brand and digital assets etc., do not have a physical life and are known as intangible possessions. c) Based on Purpose Operating assets are generating cash inflows and used for daily operations of the company. Eg. cash, building, machinery, equipment, copyright, goodwill, stock, etc. while inactive assets like short-term investments, unoccupied land, revenue through fixed deposits, etc. are known as Non-operating assets. 90 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 6.2 Asset and Liability Management II. Liabilities Liability is an authorized obligation towards creditors of a company. Delayed tax liabilities, mortgage owed bonds payable capital leases and Lon-term notes due are examples of long term liabilities. The current liabilities are payable within 24 months. They are accounts owed, temporary loans, accrued expenses, bank account overdrafts, bills payable, current deposits, salaries due etc., 91 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 6.3 Asset and Liability Management There are certain liabilities to be paid on occurrence of a few events. They may or may not occur in future. These are contingent liabilities. Examples are Guarantees and counter guarantees given by a company, Product warranty, Shareholder’s guarantee etc., 6.2 DEFINITION & OBJECTIVES OF ASSET LIABILITY MANAGEMENT Definition Asset Liability Management (ALM) is the act of planning, acquiring, and directing the flow of funds through an organisation. The ultimate objective of this procedure is to produce ample/stable earning and to progressively construct an organisation equity over time while intriguing rational and calculated trade risks. Objectives An effective Asset Liability Management method aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of asset and liability as a whole so as to attain a predetermined acceptable risk/reward ratio. The intention of Asset Liability Management is  To enhance to asset quality;  To quantity risks associated with the asset and liability  To eliminate the risk involved in the business i.e. currency risk, interest rate risk and liquidity risks  To earn adequate return by establishing cash surplus more than liabilities. Figure 6.4 Asset and Liability Management 92 CU IDOL SELF LEARNING MATERIAL (SLM)

6.3 NEED FOR ASSET LIABILITY MANAGEMENT a. Interest rates deregulation Deregulation of economic structure transformed the dynamics of economic markets. Free economic setting is reflected in interest rate structure, currency supply and the overall credit position of the market, the exchange rates and price levels. For a business, which involves trading in money, rate fluctuations constantly influence the market worth of the bank and it’s Net Interest Income (NII). b.Financial Market Globalization In 1980s volatility of interest rates in US and European countries necessitated the focus on interest rate risk. The interest rate volatility will affect the bank’s assets and liabilities which in turn affect all the countries due to globalisation of financial markets. c Product Innovation/Diversification The second motive for rising significance of ALM is the speedy innovations take place in the financial commodities of the bank. Some innovations received remarkable response while others are fad. Whatever may be element of the products, most of them have an impact on the risk profile of the bank thereby enhancing the need for ALM. For example, Flexi-deposit facility. d. Regulatory Environment Bank for International settlement (BIS) gives a support for banks to deal with the market risks that may arise due to fluctuations of rate prescribed by RBI which issued structure and guidelines for bank to develop asset liability management policies. e. Management Recognition It is not just enough to have good number of deposits and less liabilities in the balance sheet. The management should realise the importance of managing the balance sheet to produce the good net worth for the company. 6.4 PROCESS OF ASSET LIABILITY MANAGEMENT 93 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 6.5 Asset and Liability Management It involves the following steps:  Re-examine the interest rate composition and weigh against the same to the interest/product pricing of both assets and liability.  Scrutinize the loan and venture portfolios in view of the foreign exchange risk and liquidity risk that might occur.  Check the credit risk and contingency risk that may begin either due to fluctuations in any of the market forces and measure the quality of assets.  Reconsider the actual performance against the estimations made and investigate the reasons for any causes.  The Asset Liability Management technique so intended to cope up various risks to stabilise the short-term profits, long-term earning and long-term substance of the bank. 6.5 TECHNIQUES OF ASSET LIABILITY MANAGEMENT 94 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 6.6 Asset and Liability Management The Asset Liability Management technique so designed to manage various risks primary aim to stabilize the short-term profits, long-term earning and long-term substance of the bank. The parameters that are selected for the purpose of stabilizing Asset Liability Management of banks are: The attributes that are selected for the purpose of stabilising Asset Liability Management are: i. Net Interest Income (NII) ii. Net interest margin (NIM) iii. Economic Equity Ratio i.Net interest income (NII) is the discrepancy between the interest proceeds a bank earns from its lending activities and the interest it pays to depositors. Net interest income = Interest earned - interest remunerated ii.Net interest margin (NIM) is a measure of the discrepancy between the interest income earned by banks or other financial institutions and the amount of interest paid out to their creditors, relative to the total of their possessions. It is comparable with the gross margin of non-financial companies. iii.Economic Equity Ratio 95 CU IDOL SELF LEARNING MATERIAL (SLM)

The shareholder equity ratio is apercentage which is calculated by dividing total shareholders' equity by the total resources of the company. The result represents the sum of the assets on which shareholders have an outstanding claim. 6.6 TREASURY RISK MANAGMENT Treasury risk management refers to the management of risks arising from changes in foreign exchange, interest rate and commodity prices. A collection of tools and monetary instruments are accessible. Some companies has formal Treasury Policy stating that how the various risk has to be identified and handled. The exposures to financial markets are recognised, calculated and mitigated even by smaller companies since they lack formal documents. 6.6.1 The Difference between Treasury and Liquidity Risk Treasury Risk is the risk linked with the management of an enterprise's holdings – ranging from money market instruments through to equities trading. Liquidity and Capital Risk is generally defined as the risk associated with an enterprise's ability to convert an asset or security into cash to prevent a loss. 6.6.2 Types of Treasury Risks There are four core types of risks faced by businesses: business risks, operational risks, compliance risks, and financial risks. Out of these, treasury risk management is exclusively concerned with financial risk. The treasury risks are further sub-categorised into the following categories:  Liquidity risk  Counterparty risk  Market/currency risk  Operational risk 6.7 METHODS TO IDENTIFY TREASURY RISKS 96 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 6.7 Types of Risks Risk is an event that may causes damage to an institution’s income and reputation. It is a state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome. The following are types of risks:  Financial Risk  Credit Risk  Liquidity Risk  Interest Rate Risk  Foreign Exchange Risk  Market Risk  Counter-Party Risk Regulatory  Legal Risk  Operational Risk  Environmental Risk  Non-Financial Risk  Business Risk  Strategic Risk The treasury risk can be identified by the company through the following ways. 1. Review of the financial statements and management accounts The values of the items such as revenue, costs, assets and liabilities are directly contributing to uncertainties such as FX rates, interest rates, commodity prices and funding costs which can be identified through periodical reviews. The scope and size of risk varies from one organisation to another. At each period end (for example, monthly), the management accounts of an organisation should be examined to see whether there are any unexpected variances caused by uncertainties that have not previously been identified. 2. Risk assessment workshops The workshops could also be a useful forum to talk about the reaction to risks, setting the suitable parameters for scenario testing, identifying potential contingency plans for stress events and for identifying rising risks. Some organisations ensure that their risk process incorporates regular workshop like discussions at all levels of the organisation including the board, regional teams, etc ., 3. Review of competitor annual reports The way the competitor manages its risks may lead to risks in one’s own organisation. It is often helpful to review the annual reports of competitors to identify risks created by the actions of competitors. 4. Discussion with stakeholder 97 CU IDOL SELF LEARNING MATERIAL (SLM)

The organisation’s management should analyse feedback provided by stakeholders such as shareholders, bond holders, loan providers, rating agencies and regulators on the critical risks of the organisation and its competitors. 5. Risk register The key risks can be recorded in a risk register along with other risks identified by the organisation’s management such as strategic, compliance, health and safety and so on. The risk register should portray the risk, including the cause of the risk, and impact on the organisational objectives. The management approach to handle each risk is very significant in managing them. 6.8 RISK MANAGEMENT STRATEGIES Figure 6.8 Risk Management strategies A.Liquidity Risk Management There are many diverse sources of liquidity and each of these comes with its own set of risks. The profession of the liquidity and risk management function is to assess and manage these risks successfully. The first step is ensuring that complete information on the amount of the amount of liquidity on hand and forecasts of how much will arise in the future is as accurate and complete as possible. This information can then be used to minimise risks, which may include tasks such as maintaining a sufficient liquidity buffer, monitoring expected cash flows and applying corrective action to fix any variation, intraday position reporting and setting up contingency plans. b.Counterparty Risk Management 98 CU IDOL SELF LEARNING MATERIAL (SLM)

All types of funding come with a few level of risk. Suppose a company has deposited funds in a bank or invested in a diverse companies and that bank or company fails, there involves a risk . Working with financial institutions and banks has inherent risk that this third party will failure to pay their debts to company. This is known as counterparty risk and the treasury department has to contend with in order to stop it from having a destructive effect on the cash flow of the business. Managing counterparty risk involves creating careful and concrete policies regarding investments and deposits. It also includes monitoring and assessing borrowing agreements and debt relationships with financial institutions and lenders. If the company uses trade financing for working capital, it will involve administration of the risks that the trade financier will fail on their obligation to pay a final invoice equilibrium. c.Currency Risk Management All businesses are engaging in cross-border transactions more frequently because the global consumer marketplace is expanding. While it gives opportunity for huge growth in sales, it also brings definite challenges i.e.Foreign Exchange risk management. The goal of FX risk management is to minimize the potential of incurring currency losses caused by exchange rate movements. Different businesses desire to manage currency risk in different ways. Some companies may wish to ignore FX risk as per customer net revenue isn’t one of their primary objectives. Others negate the risk entirely by only accepting payment in their functional currency. Some want to get from both and balance both risk and reward by monitoring exchange rate movements themselves and adapting their pricing to account for this. d.Enterprise risk management The treasury manager categorise these risks into categories since the impact of various risk brings outcome of varying range. Correlations between risks may reduce the overall risk exposures (i.e. natural hedges may exist) or augment them. Therefore, it is important that all treasury risks and non-treasury risks are re-examined periodically in order to assess whether there are any linkages between them – this is an enterprise risk management approach. 6.9 SUMMARY  Treasury risk management relates to the management of risks arising from foreign exchange, interest rate and commodity prices. A range of tools and financial instruments are available.  It should be noted that the analysis of risk relationships can be a difficult exercise for management and the board of some organisations, given the technical expertise that is required. 99 CU IDOL SELF LEARNING MATERIAL (SLM)

 It would be unusual however nowadays for an organisation of any scale not to have in-house specialist risk management expertise.  Treasury risk management activity has become increasingly important as volatility in financial markets increases.  Financial markets and institutions have responded with new vehicles for apportioning risk, reducing taxes and issuance costs, or otherwise enhancing efficiency and value.  Liquidity risk, exchange rate risks, Enterprise risk management, counter party risk are related with treasury risk which should be identified and managed in a prudent way.  An effective Asset Liability Management method aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of asset and liability as a whole so as to attain a predetermined acceptable risk/reward ratio.  The treasury risk can be identified by the company through the following ways.  Review of the financial statements and management accounts  Risk assessment workshops  Discussion with stakeholder  Risk register 6.10 KEYWORDS  Risk is an event that may causes damage to an institution’s income and reputation. It is a state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome.  Treasury Risk - the risk associated with the management of an enterprise's holdings – ranging from money market instruments through to equities trading.  Risk register – It states the risk, including the cause of the risk, and impact on the organisational objectives.  Liquidity Risk Management – It is the process of assessing and managing the risks effectively.  Counterparty risk-it is otherwise called as default risk which arises due to non- fulfilment of contractual obligations related to investment, credit and transactions. Treasury risk management relates to the management of risks arising from foreign exchange, interest rate and commodity prices. A range of tools and financial instruments are available. 6.11 LEARNING ACTIVITY 1. DefineTreasury risks 100 CU IDOL SELF LEARNING MATERIAL (SLM)