Middle Office Review: Sample Middle Office Assessment and review report

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Treasury Middle Office Compliance

The client primarily manages Market and Liquidity Risk through the Asset and Liability Committee (ALCO) that meets once a month. Over the last twelve months a Treasury Middle Office Function has been created that manages the risk, reporting and control functions around Treasury, Financial and Banking Middle Office activities at the Bank

Given that this Treasury Middle Office function was created in the recent past (compared to the relative history of the bank), an action Plan has been formulated and a number of Financial Risk management milestones have been hit. These include development of middle office policies, limit structures, exception reporting and management, liquidity and price gap reports as well initial value at risk profiles for capital market portfolio. Additional items and tasks are in the process of discussion and review with the senior management team. At this stage exposure limits as laid down in the Prudential Regulations issued by the Central Bank are applied and monitored on a daily basis and reported in ALCO scheduled meeting. Exceptions when raised are highlighted internally and resolved at the appropriate authorized management level. In addition a number of financial risk reports are generated and reviewed by the Middle Office. Evaluation of software/system for automated measurement, reporting and management of risk elements is also in process.

2.2 Front Office

The Treasury Front Office is manned by 5 professionals distributed between Treasury Marketing Unit, Equities, Inter Bank FX, and Money Market. The front office functions are largely focused on managing the accrual book, limited trading activities in the interbank money market, managing liquidity needs of the bank and a relatively small capital market operation. Primary exposure to FX exists due to customer accounts and activity (treasury does not engage into proprietary trading at this stage). Products and services provided by the front office include:

  • Management of assets and liabilities
  • Managing organization’s liquidity needs
  • Borrowings/placements with financial institutions
  • Trading in Government securities for accrual book
  • Trading in FX for client accounts
  • Proprietary Trading in Capital Markets

Credit evaluation and counter party line allocation for Treasury related operations (primarily credit evaluation of Financial Institutions to whom lines of credit are extended) is undertaken by the FI function staffed by 2 professionals who review about 40 lines extended to other financial institutions.

2.3 Middle Office (MO)

The functions of the MO include oversight of the Capital Market Operations (CMO), Foreign Currency Exposure, Fixed Income (Treasury) operations and other related financial risk exposures to ensure adherence to policies and procedures. This oversight is executed through a review of summary trading activity, preparation of limit overruns, review of settlement of equity trades, resolution of issues, monitoring and investigation of any discrepancies or abnormal trends, etc. Additionally, a review of balance sheet gaps (price and maturity), liquidity and other Asset & Liability management related issues is also prepared for inclusion in the ALCO report.

Reports currently generated by MO include (distribution and frequency

  1. Liquidity Gap
  2. Price Gap
  3. ALCO Summary
  4. MTM for Tbill, PIB and FIB Holdings
  5. Duration & Convexity for Fixed Income Holdings
  6. Interest Rate Shock reports – MTM based on 5, 50, 100 bps shift in the term structure.
  7. Net Open Positions – FX Summary
  8. FX Gaps
  9. FX Limit Utilization
  10. Capital Market Summary
  11. Capital Market Operations – Gain/Stop Loss Trigger Status (Daily)
  12. Capital Market Operations – Portfolio Status an dMTM
  13. Capital Market Operations – Limit Overrun Report (Daily)
  14. Liquidity/IRR Risk Management Guideline (Monthly);

Reports in the process of being generated by the MO include

  1. Value at Risk for FX position
  2. Value at Risk for Capital Market Portfolio (in development – as at end of day prices)

Additional reports that can be investigated by the MO include:

  1. Value at Risk for Money Market Portfolio
  2. Value at Risk for combined portfolio
  3. Balance Sheet Duration Gap

2.4 Back Office/Operations

The Back Office (BO) is responsible for the processing, settlement and administration of transactions. The function reports to CFO who reports to the President. Besides the settlement functions, Back Office is also responsible for accounting for MM, FX and Equity deals transacted by the Front Office, Preparation of financial statements (profit and loss account and Balance sheet for Treasury), sources and applications of funds, consolidation of daily SOP – statement of position and other statutory and in-house reports.

2.5 Risk Management System

As stated earlier, given the recent establishment of the Financial Risk Management Function, decision regarding acquisition of a risk management technology solution is at the evaluation stage. Presently, Liquidity is managed primarily at the level of ALCO and Market Risk by the Head Treasury Risk Risk Management with the Middle Office preparing/collating most reports.

The Liquidity and Market Risk Management Guidelines/Policies and Procedures document outlines the approach used by the bank to limit risk to acceptable levels.

2.6 Internal Control System

Although a detailed analysis of the internal controls mechanism was not undertaken, key elements exhibiting the existence and functionality of an internal control system appear to be in place at the bank. This is evidenced by the operation of the Front, Middle and Back Offices.

Additionally, the setup listed above is strengthened by the existence of an Internal Audit function. This department is an appraisal activity aimed at improving internal control through an examination and evaluation of the adequacy and effectiveness of data, reports, policies, and procedures.

Checklist of items and activities.

  • Pre-Audit activities.
  • Planning and executing detail audit assignments.
  • Verification of reports/returns submitted to the State Bank of Pakistan.
  • Follow up of recommendations by external auditors and State Bank of Pakistan.
  • Review of various revenue generating and support functions for the purpose of introducing checks and controls.
  • Supervising and performing the compliance function per guidelines provided by the State Bank of Pakistan
  • Reporting to the Audit Committee

2.7 Operational Risk Management

Under the new Basel II requirements a number of options are available to quantify operational risk capital requirements. Although there are no existing regulatory or statutory requirements in Pakistan for Operational Risk Capital or Operational Risk Management, Central Bank has recently asked banks to prepare a roadmap for Basel II compliance by 2007 as well as plans for disaster recovery and contingency planning. In addition Central Bank has also issued a domestic road map for Basel II implementations beginning with a parallel run from 30th June 2006. A review of Basel II operational risk requirements suggests that one of the two possible approaches may be chosen by Central Bank for operational risk requirements. The first (the basic indicator approach) would be a flat charge based on a three year average of gross income of an institution. The second is the standardized approach that breaks the capital charge down by business lines and risk factors and weights by business lines. The third approach (advance measurement approach) will require detailed estimates by business and product line of frequency and severity distributions of operational risk indicators.

2.8 Derivatives Selling Policy Manual

A Derivates Policy Manual, which largely covers elements as identified by the Central Bank FDBR is also required.