What is Treasury Management in Banks | Functions, Benefits & Need?
Table of Contents
Introduction of Treasury Management
Corporate Treasury Management is the planning, organizing, and controlling of funds or cash required by a corporate entity, with the objective of optimizing liquidity and minimizing risk.
Treasury management is the planning, organizing, and control of funds required by a corporate entity. Funds come in several forms: cash, bonds, currencies, financial derivatives like futures and options, etc. Treasury management covers all these and the intricacies of choosing the right mix.
According to Teigen Lee E, “Treasury is the place of deposit reserved for storing treasures and disbursem*nt of collected funds”. Treasury management is one of the key responsibilities of the Chief Financial Officer (CFO) of a company.
Need for specialized handling of treasury
Treasury management should be practiced as a distinct domain within the Finance function of an organization for the following reasons:
• One of the most consistent demands on the CFO of a company is that money must be available when needed, and this becomes a 24/7 task.
• The cost of money raised for the business is probably the most crucial metric in a company for many of its investment and operational decisions. Hence the cost of funds has to be tracked diligently.
• Internal financial management in a multi-national corporate entity requires monitoring of several global currencies.
• Globalisation of business has thrown up an unbelievable basket of opportunities for the CFO to optimize the utilization of funds and minimize its costs. This requires expert handling.
• Globalisation has also brought in unexpected risks that are not visible to the untrained eye but can even destroy a business. Who would have thought that the crash of Lehman Brothers could impact business houses in interior India? But that was what happened in 2009.
• With increasing financial risk shareholders have become jittery about their holdings and need reassurance often. For a company, the Treasurer is probably the best spokesperson to allay the concerns of stockholders and other interested parties.
Benefits of Treasury Management
Managing treasury as an expert subject has many benefits:
• Valuable strategic inputs relating to investment and funding decisions
• Close monitoring and quick effective action on likely cash surpluses and deficits
• Systematic checks and balances that give early warning signals of likely liquidity issues
• Significant favorable impact on the bottom line for global corporations through effective management of exchange fluctuation
• Better compliance with the increasingly complicated accounting and reporting standards on cash and cash equivalents
Treasury Risk Management
In this section, we get a glimpse of the risks that are inherent in the treasury function of a corporate entity and the ways and means adopted by companies to cope with the risks.
1. Treasury exposures: The treasury function exposes an organization to a number of risks:
• Liquidity risks, arising from borrowings in the financial market and its different constituents like banks, NBFC, etc.
• Financial loss risks, arising from using a complex variety of financial instruments such as derivatives.
• Currency risks, arising from the fluctuation in the buying and selling rates of foreign currencies handled.
• Accounting risks, arising from decisions relating to accounting, reporting, and disclosure of foreign exchange transactions and translations
• Political risks, arising from changes in economic policies and decisions of governments in all countries in which the entity has business interests
2. Coping with treasury exposures: Any organization has to have in place a competent system that:
• identifies the exposures to each of the aforesaid risks (identification)
• quantifies the impact of each risk to the extent possible (quantifying)
• sets policy restrictions and systemic controls on risk-taking (policy formulation)
• has a team in place that effectively monitors the external and internal risks arising from Treasury operations
• takes care of periodic reporting to the concerned stakeholders on Treasury exposures
The treasury risk management team deals with events that impact the financial results in such a way that the impact is favorable.
Treasury Functions
What are the typical activities of the Treasury function? We first look at the traditional functions that Treasury has always handled, and then review the changes that have evolved in the Treasury function in the 21st century.
1. Traditional functions
• Funding – Planning and controlling the sourcing of both equity and debt funds for the business
• Cash management – organizing and scheduling the day-to-day movement of cash and other money market instruments
• Treasury cost control – efficient negotiation of interest rates, bank service costs, and the cost of other finances raised for the business
• Treasury administration – Dealing with banks and other financial agencies
• Treasury accounting – Complying with the relevant accounting standards on accounting and reporting of cash and cash equivalents
• Exchange management – In the case of a multinational company, managing currency fluctuation risks and deciding on actions to cope with the risk.
2. Evolving functions
• Strategic funds management – The vanilla function of funding has now given way to a strategic job of short-term and long-term sourcing and use of funds that improve financial health.
• Systematic cash management – Advanced cash management services have come up in the last 20 years that focus on effectively minimizing the ‘cash float’ i.e. the sterile money in the pipeline, which does not earn interest.
• Treasury cost management – It is no longer enough to control the bank interest and service charges, in view of treasury cost variants available now, like fixed and floating rate swaps and derivatives. As instruments multiply, with newer and more attractive features, cash management has to consider these and decide which ones to use in the attempt to reduce treasury costs.
• Treasury administration – The single-vendor concept has become outdated, and businesses are working with multiple vendors in the Finance space – banks, NBFCs, loan syndicates, and financial consultants for specific purposes. The complexity of treasury requirements has made specialization mandatory.
• Treasury accounting – Accounting and reporting standards have tightened across the globe, and after scams like Satyam, it has become crucial for companies to regularly monitor treasury reporting.
• Exchange management – Foreign exchange issues such as fluctuation, inter-currency movement, etc. have become far more important with the globalization of Indian business.
• Advanced automation of Treasury – The impact of the Internet on the contours of the treasury management function has been phenomenal. Web-based tools, online transactions, and live monitoring of interest and foreign exchange rates, etc. have given a new dimension to Treasury.
The key differences between the traditional and the modern Treasury functions are (a) the increase in complexity and (b) the recognition of the Treasury as a function that can add distinctly to the bottom line and become a profit center instead of just a cost center.
What is Money Market Instruments
Formulation of Treasury Policy
Treasury policy provides the framework for treasury operations internally as well as externally vis-à-vis related functions viz. Accounting and Finance.
The policy framework comprises management thinking, dos and don’ts, and treatment of exceptions. It helps the management keep control over the function and gives clarity to Treasury employees as regards their duties and powers.
The steps in treasury policy formulation are:
1. Spelling out management thinking on the objectives of treasury
2. Writing out the procedures to be followed in implementing the policies, the control limits, the exceptions and the escalation protocol, and the process of making policy changes when needed
3. Communicating the policies to all concerned and ensuring they understand and implement it in spirit
1. Policy aspects of treasury
While a function or an activity is largely described through a set of steps and procedures, certain aspects of the activity are also usually governed by a set of policies.
Thus, a company normally has a credit policy, which stipulates policy guidelines on credit to be given to customers; or an inventory policy, which lays down minimum and maximum inventory levels and order quantity etc. The functionary is expected to work within the framework of the policy.
In a similar manner, the Treasury function should work under policy guidelines that cover the key aspects of the Treasury. The facets of the Treasury function that require enunciation in the policies are:
• Liquidity or cash balance levels
• Risk v. return – the desired mix
• Financial ratios applicable to Treasury
• Dealings in derivatives, choice of instruments that can be used
• Defining foreign exchange fluctuation risk levels
• Statutory compliance
‘Cash’ here means liquid funds held in whatever form – bank balances, currency notes and coins, very short-period deposits, etc.
It must be noted that policies take care of normal circ*mstances and not exceptional ones. Even the exceptions specified under each policy are small and relatively low-end deviations. The major change in conditions may require a fresh set of policies.
2. Liquidity policies
Here we are concerned with
• Long-term and short-term liquidity
• Minimum and maximum idle cash
• Forms in which cash is held
• Handling of cash deficits
• Investment of cash surpluses
Policy guidelines typically answer the following questions:
• What constitutes long-term and short-term with respect to treasury decisions?
• What are the minimum and maximum cash balance levels?
• In what form or forms is liquidity to be maintained? Which forms are not to be used at all?
• In the case of a cash deficit, what actions are permissible at each managerial level? Which actions cannot be taken without Top management approval?
• How are long-term and short-term surpluses of cash to be disposed of, and with whose approval in the organization?
3. Treasury risk and return policies
Treasury risk is the danger of not having the funds when required. Treasury return is the profit earned by investing surplus funds.
In delineating treasury risk-and-return policies we are concerned with
• definition of acceptable risk level
• definition of the cost of capital or discount rate for evaluating investment
• criteria for short-term investment decisions
• matching the tenure of investment to the tenure of funding
Policy guidelines typically specify answers to the following questions:
• How is risk defined with respect to financial instruments and other treasury exposure?
• What is the acceptable risk level regarding receipt and payment of cash?
• What is the company’s weighted average cost of capital?
• What are the criteria for the decision on short-term investment options?
• What is considered an appropriate match between the relative maturity periods of the funding components and the investment portfolio?
4. Financial ratios tracking policy
Financial ratios are an integral part of a company’s analysis of its financial position and performance. Ratios measure a number of metrics related to the company’s finances, including profitability, liquidity, solvency, and market performance.
Here we are concerned with
• treasury metrics that have to be tracked and kept under control like current ratio, debt-equity ratio, and debt service coverage ratio
• specific financial ratios that have to be measured regularly
• range within which each ratio should move
• action to be taken when the ratio goes out of range
Policy guidelines typically specify answers to the following questions:
• Which parameters of treasury performance will be monitored? The most crucial parameter usually is liquidity. Other metrics are idle cash, float, returns on short-term investment, etc.
• Which ratios will be used to measure these parameters? Classic ratios of liquidity are the current ratio and acid test ratio. Many others may be used depending on the specific entity and business situations.
• What constitutes the acceptable range for each ratio?
What action is required at different managerial levels if the ratio goes out of range? For instance, if a credit purchase decision will push the acid test ratio below the minimum, the purchase may have to be cleared by a senior manager in Commercial.
5. Derivatives policy
The US Department of Treasury defines derivatives as “a wide variety of financial instruments” or “contracts whose value is derived from the performance of underlying market factors such as marketable securities or indices, interest rates, currency exchange rates, and commodity, credit, and equity prices.
Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof.”
The derivatives policy is concerned with the following:
• Different types of derivatives
• Managing risk through the use of derivatives
• Derivatives as investment options
Policy guidelines typically specify answers to the following questions:
• Should the entity handle derivative products at all?
• From the types of derivatives available which ones should be selected?
• What is the selection and implementation process?
6. Foreign exchange (Forex) policies
Foreign exchange is the conversion of one currency into another currency. For instance, the US dollar would be foreign exchange for an Indian company and will need to be converted to INR for being used in India.
The foreign exchange policies concern the following:
• Global nature of the entity
• Foreign exchange transactions in the company
• Foreign exchange conversion
• Methods of managing foreign exchange fluctuation risk
Policy guidelines typically specify answers to the following questions:
• What is the entity’s exposure to foreign exchange fluctuation risks and what is the management’s risk appetite?
• How does the management want to respond to foreign exchange risks in transactions, that is, imports and exports?
• What is the policy with respect to translation risks in financial reporting?
• Which methods are to be adopted for containing these risks and which are to be avoided?
7. Statutory compliance policies
Statutory compliance policies concern the following:
• The statutory regulations that the entity has to observe and comply with
• The approach to compliance
• Action to be taken if there are compliance issues
Policy guidelines typically specify answers to the following questions:
• What are the laws applicable to the business in general and treasury in particular?
• Would the compliance requirement related to the activity be an important consideration in deciding to take it up?
• What level of compliance reporting would be required of the officers on compliance issues, to the Board, and to shareholders?
• What would be the company’s attitude to compliance issues, for example, notice received from a government authority regarding a delayed filing?
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Conclusion:
• Corporate Treasury Management is the process of managing a business entity’s financial resources in the most efficient manner.
• The function has been recognized as a domain with distinct expertise that can benefit a company in many ways and also expose the company to a number of risks.
• Treasury management functions include funding or financing, cash management, and accounting & reporting, The focus should always be on the overall cost of the function.
• The formulation of treasury policy is a prime task before the company’s CFO and covers diverse subjects like liquidity, risk v. return, ratio analysis of key treasury performance parameters, compliance matters, and foreign exchange transactions and translations.
• The structure of a typical Treasury organization has departments for policy-making, funds & non-funded facilities, and foreign exchange.
• The company should decide whether its Treasury would be a cost center or a profit center; and whether the function is to be decentralized or centrally directed from HO. The decision would depend upon a variety of factors.
• Integrated treasury is a concept that has emerged in the last couple of decades as an effective solution for global treasury issues.
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