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Sikkim Manipal University 4th

Semester Spring 2011

1

Alaji Mamadou Cire BAH 540910685 MF0007 SET 2

Name : Alaji Mamadou Cire BAH

Roll No. : 540910685

Subject :

Treasury Management

Subject Code : MF0007

Program : MBA Semester 4

University : Sikkim ManipalUniversity

Learning Centre : KnowledgeWorkz

Limited (02544)

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MBA SEMESTER 4

Treasury Management MF0007

SET - 2

1. Explain loanable fund theory and liquidity preference theoryAnswer: Loanable Funds Theory.Many theories have been propounded about interest from the time of classical

Economics to contemporary Economics. Investment being a function of interestrates; the stimulating impact of interest rates on the economy is very significant.

Loanable Funds theory makes an improvement on the classical theory. Money

can play a decisive role in saving and investment. In turn, the saving and

investment determine the income level. According to this theory, rate of interest

is the price that equates the demand and supply of loanable funds.

Loanable funds are defined as the sums of money supplied and demanded at

any time in the money market. Classical theory talked about money supplied as

a result of savings of the people. This theory takes into account money resulting

from savings of the people and money resulting from credit creation of the

banks. Thus, Loanable Funds Theory redefines the supply side.

Demand side is also redefined by this theory. Demand for money comprises

demand for investment (as per classical theory) and the demand arising from

need to hoard the money. Money borrowed may not be invested immediately. It

may be hoarded and invested in the near future at an opportune moment forinvestment. Classical Theory held the rate of interest as a determinant of saving

and investment. Loanable Funds Theory holds that savings, investment, credit

creation in the economy and the demand for money arising out of a need to

hoard the money determines interest.

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Liquidity Preference Theory

J.M. Keynes propounded this theory. He held that interest is a purely monetary

phenomenon in that the rate of interest is determined by demand and supply of

money. Interest is considered to be the reward for making the people to part

with liquid money i.e., cash. People prefer to hold their wealth in the form of

cash rather than in the forms of assets like bonds and securities. Demand for

money arises due to demand to hold cash. Demand to hold cash arises due to the

role of money as a medium of exchange and as a store of value. It is used as a

medium of exchange for transaction motive and as a precautionary motive.Store of value arises due to speculative motive. The demand for money is the

total of money needed for all these there motives.

The liquidity preference schedule expresses the functional relation between the

quality of money demanded for all these motives and the rate of interest. As per

the Liquidity Preference Theory, the equilibrium rate of interest is decided by

the interaction between liquidity preference function and the supply of money.

Any change in the liquidity preference alters the demand for money and thuscauses a change in the interest rate. In the same way, any change in money

supply also has its effect on the interest rate.

Prof. Hansen criticizes Keynes Theory on the same ground on which Keynes

criticized Classical Theory. The liquidity preference function depends upon

level of income. To know the level of income, we should know the rate of

interest

2. Explain the objectives of foreign exchange control and managementAnswer: Objectives of Foreign Exchange Control and Management

Generally, the central banks have the following objectives in foreign exchange

control and management.

Facilitating Economic Development: Developing the economy andcountry through providing infrastructure, strengthening the defense of the

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country and establishing basic industries require import of machinery,

equipment and technology. The foreign exchange is controlled so as to

make it available for strengthening the country basically in all its

requirements. Even during abnormal conditions as war, the country needs

to import a lot of equipment including a higher quality of import of crude

oil for the movement of troops and defense equipment. By managing the

foreign exchange, the central bank makes it available for such

unavoidable purpose.

Rationing Foreign Exchange: Developing countries generally importmore than what they export. Therefore, there is always insufficiency of

foreign exchange to meet the import demands. For that matter imports

cannot be curbed blindly. Many of the exporters import raw material,

base metals, equipments, technology and such other things in order to

manufacture and export. Therefore, the central bank intervenes in order to

control the imports without affecting the exports. This is done by way of

rationing the foreign exchange among the various segments of the

country that are in need of importing one or the other thing.

Supplementing Trade Controls of Government: Trade Control aims atthe control of foreign companies entering India. The trade control has the

objective of ensuring that foreign companies entering India are not setting

up an adverse position against the interest of the economy. While the

trade controls regulate physical transfer of goods, equipment and

technology, the central bank supervises the method of payment for

imports and repatriation of proceeds of exports through foreign exchange

control. Trade control is concerned only with imports and exports.

Exchange control is more comprehensive encompassing all exports and

imports, capital transactions and the invisibles.

Managing Excess Inflows of Foreign Funds: Excess inflows of foreignfunds pose as many problems as shortage of foreign exchange. In the year

2007, the problem for the RBI is to manage the huge inflow of foreign

exchange into the country. India is regarded as a favored destination for

investment by major investors in almost all the countries. This is causing

a huge inflow of foreign investments into the country. In addition to that,

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the remittances made by NRIs have increased so much that India is

accounting for about 20% of the total remittances taking place in the

entire world in 2006-07. When the funds are coming in, the RBI has to

release an equal amount in rupees to the recipient in India. This will result

in inflationary pressure on the economy. Moreover, the external value of

rupee may go up affecting the exports of the country adversely.

Therefore, the central bank must encourage liberal usage of foreign

exchange to meet such a situation.

Control of Hawala Transactions: Hawala market is a market forconversion of rupees into foreign currency illegally. The Hawala market

creates a distortion in the legal market. It will act as a parallel market

defeating the efforts of the central bank. Through exchange control, the

central bank attempts to curb such activities.

Curbing Activities of Terrorists Organizations: Both the World Bankand the IMF are very much concerned about the flow of the money of the

terrorist organizations through the legal channel like banks through

benami accounts. Most of the transactions involve foreign exchange for

buying the arms and ammunitions from different foreign countries. Both

the world bodies introduced the Know Your Customer concept to

prevent such transactions. With foreign exchange controls, the RBI can

do a good job in this respect.

3. Explain the role of liquidity risk management in Asset liabilitymanagement.

Answer:Role of Liquidity Risk Management in Asset LiabilityManagement (ALM)

The Asset-Liability mismatch can do any of the two things: it may make the

bank run out of cash leading to borrowing at a higher cost or selling the

investment premature at a loss, or at a loss of profit. If liquidity planning is not

proper, the banker may run out of cash very often. To meet the emergency, the

bank may liquidate its investments at a time when the market for such securities

are depressed. Alternatively, the bank may go for emergency borrowing. This

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may be a worse option, as the cost of borrowing will be very high. Such a

liquidity risk will depict itself in impairing the profitability of the bank. The

second thing is that the bank may have lent at a lower interest rate of interest,

whereas the renewal of the deposit may have to be made at a higher rate. In both

the cases, a strain is created on the profit margins. The profit margins ultimately

get reflected in the Balance Sheet in shaping up thenetworth of the bank

(capital+reserves). ALM tries to preserve the networth of the bank at as a high

level as possible. In other words, it strikes a balance between the liquidity and

profitability. It preserves the profitability and the networth of the bank without

endangering the liquidity position of the bank. Liquidity Risk Management

plays a very crucial role in ALM. For the banker, liquidity is a devilish angel. It

can enhance networth. At the same time, it can also destroy the networth

depending upon how it is managed.

Managing liquidity through its measurement as a first step is very important for

the survival of the bank. It tries to achieve sufficient cash assets at all points of

time. Through the achievement of this objective, it reduces the chances of the

bank facing a liquidity crunch in the future. It can be ensured through liquidityrisk management that enough cash is carried always without impairing

profitability so that the bank has no problem in meeting the demand of the

customers. The liquidity problem that may materialize for one bank is not

confined to that bank alone. It may spread to the whole of the banking system.

As each bank is lending to other banks or maintaining deposits with other

banks, the liquidity problem of a bank will make it to withdraw from other

banks, thus creating a problem for others also. It may also create a chain effect

in the whole of the banking system. Moreover, the depositors may undergo thetrauma of incredibility of the whole banking system for some time.

It is the duty of the management to measure and manage the liquidity not only

as a part of day- to- day management, but also for planning it for different types

of scenario in the future. The Management must imagine the various scenario of

adversity regarding liquidity and develop an action plan for each one of the

scenarios. The asset that is regarded as a liquid asset in the conventional sense

may turn out to be illiquid due to the market and participants having a uniform

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attitude or behaviour. Organised markets run on the principle of contrarian

thinking. If an investor thinks that a security is worth buying, another one thins

it is worth selling at the same point of time. That is how buying and selling

takes place. If all the investors think that it is worth selling, then no trade will

take place.

Avoiding mismatches in the cash flow, or in the maturity profile, or in the assets

and liabilities help us in carrying out liquidity risk management. The RBI has

provided guidelines to the banks to manage the liquidity risk by preparing the

Statement of Structural Liquidity (refer to Annexure 13-A-I given in unit 7). Aneffective tool can be developed through the use of the concept called, maturity

ladder. The maturity ladder can be used to measure surplus or shortage of funds

at specific maturity dates. As the statutory reserve cycle is 14 days, a time span

of 14 days is selected as relevant period for the first two legs of the maturity

profile. Each time span selected for calculating the maturity profile is called a

time bucket.

According to the RBI Guidelines and the appendices provided, the time bucketsfor preparing the maturity profile can be identified as given below:

1 to 14 days 15 to 28 days 29 days to 3 months 3 months to 6 months 6 months to 1 year

1 year to 3 years 3 years to 5 years More than 5 years

While determining the maturity buckets of specific investments, the SLR

investment, which is considerable in volume, is assumed to be not liquid. To be

classified as liquid, the securities must be included in the category, Held for

Trading. Such securities must be included in the trading book of the bank. The

holding period of such securities should not exceed 90 days. The volume of

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securities and their composition must be clearly specified. The stop-loss limit

must be stated. They should also be marked-to-market (the value of the

securities should be compared to daily or weekly market values and any

increase or decrease in the market value should be recorded as profit or loss in

the books). The defeasance period of securities should also be specified.

Defeasance period is the period required to sell the securities in the secondary

market or the time taken by the securities to mature.

mf0007-spring 2011

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