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Treasury Middle Office “Target” and “Existing” Framework Gaps

Treasury Middle Office Risk Management Framework

A Treasury Middle Office group has recently been created and is in the process of developing risk policies, risk models, risk controls, risk systems, etc.
The setting up of the Treasury Middle Office function is in line with the requirements to setting up a robust risk management framework across the Bank. The Treasury Middle Office structure serving as an intermediate level function with responsibilities to manage day-to-day risks across the treasury and equity business segments. The creation of a Board level Risk Management Committee (or equivalent alternative/arrangement) at the client is now required to ensure that besides independent and effective monitoring and control over risks, Board level oversight is also provided. Ideally, the output produced by the Treasury Middle Office should be shared with the Board level Risk Management Committee on a weekly basis.

Prior to commencement of derivatives activities, a one-time approval to undertake such activity from the Board of Directors is required. This approval has not been taken.

The separation of reporting lines for Front Office, Middle Office and Back Office is already in place. Front Office reports to the President, Middle Office to the Head of Treasury Risk Management and the Back Office to CFO. However there is some room for interpretation w.r.t. to direct and conflicting lines of reporting. One such interpretation is that convergence of all three functions at the President level leads to lines that are not independent. We would recommend that clarification on this point be sought directly from Central Bank. If direct lines are required, they can be achieved by making the Treasury Risk Management Head and the CFO report directly to the Board level Risk Committee and the Board level Audit committee respectively.

Mark to Market and Interest Rate sensitivity analysis reports need to include summary statistics at the portfolio level for average Yield to Maturity, average Time to Maturity in Years, portfolio purchase price, portfolio market value, portfolio duration, portfolio convexity and portfolio interest rate sensitivity for 50, 100 and 200 basis point shifts. This information is available and calculated currently on a daily basis. Some of the above elements are also included in the report package prepared for ALCO meetings. The report could be created as a one-page summary and distributed to ALCO and the Board Risk Management Committee on a weekly basis.

On the capital market side a daily transaction summary and portfolio mark to market is prepared, summarized and distributed to senior management. Once the board risk committee is setup the report should be shared with them on a monthly basis also.

For all three markets (FX, Fixed Income and Equities), net positions, earnings, capital gains or losses and the regulatory capital charge should be calculated on a weekly basis and shared with Board Risk Management Committee.

On the liquidity gap front currently Net Interest Income at risk calculations are done using an assumed interest rate shift across the complete term structure. We suggest that two additional sets of shifts be also included in this exercise. The first shift should represent treasury’s view on expected interest rate movements while the second shift should be based on a historical average of interest rate shifts experiences over the last eighteen months. Where NII at Risk numbers look at earnings sensitivity Duration gap can help estimate Equity at Risk sensitivity. We also recommend that basic ground work for calculating Duration gap should also be completed to explore feasibility of generating this report on a regular basis.

The business operation system, i.e., sales and selling activities, internal control mechanisms and processing systems, required for engaging in derivative transactions (commensurate with projected volume of derivative business) need to be designed and submitted for review and approval of the senior management of Client Bank. Policies, procedures, organization and authorization need to be clearly set out. MIS reporting needs to be implemented and tested to reflect approved additions to the business operating system. Some of the above requirements have been documented in the Derivative Selling Manuals. Others need to be discussed and finalized

A risk management system, containing:
1. risk measurement methodology;
2. process of model validation/testing,
3. risk limits,
4. risk reporting,
5. risk adjusted performance measurement,
IT requirements for risk management, for measuring risks of the envisaged derivative business require formulation and adoption by the senior management of the bank.
Clear policies defining the pre-qualification process for the sale of a derivative instrument and related documentation required need to be specified and approved by the senior management of the bank. This would include policies for measurement of derivative credit risk (including credit enhancement procedures), suitability of counterparty, including assessment of counterparties’ understanding of the terms of contract, its obligations thereon and consistency of proposed derivative transaction with its objectives need to be formulated.

It is recommended that the legal/documentation risk; concerned with possible losses resulting from difficulties arising from the legal basis of the documentation perspective, be evaluated. In particular emphasis be placed on (i) the capacity of the counterparty to enter into the transaction; (ii) the suitability criteria, as the wording of the FDBR places a virtual fiduciary responsibility on the NMI that they have a responsibility to only offer those derivative products to their clients that are suitable for the client, i.e., ensure that the interest of the client are not adversely affected by the transaction or potential outcomes under the transaction, and (iii) enforceability with respect to the legal jurisdiction.

It is further recommended that the tax regime be examined to determine its impact on derivative transactions.

Senior Management of the bank needs to evaluate and lay down the minimum qualifications for dealers and analysts along with other persons engaged in derivatives business. An appropriate training program/schedule for relevant staff also needs to be drawn up. Staff here would include resources in Front Office, Middle Office, Back Office, Credit, FI, Internal Audit, Finance, Legal & Technology.

A review of the captioned document prepared by the bank reveals that the document sets out key elements as required by CENTRAL BANK under the ADD/NMI requirements described in earlier sections. Two exceptions have been identified and highlighted in section 3.8 above.

It is also recommended that model derivative transactions (with different combinations, if required) be developed (or alternatively, historical transactions be used) as a model/case study which may then form a basis for highlighting essential criteria for the Selling Policy Manual as well as educational material for treasury and other functions