CHAPTER 1

THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL

AN INTRODUCTION TO TREASURY MANAGEMENT Treasury Management in a financial entity is a principal determinant in the entitys financial strategy and financial policy enabling the entity to determine what businesses to invest in, organising the appropriate funding for the varying business segments, and controlling the risk in the organisation. Dependent on the inherent risks prevailing in the current environment in which the entity is operating in, treasury management seeks to create an appropriate capital structure of debt and equity in order to fund the entity, getting the optimum balance between expenses and risk. This translates into the need to ensure that at all times the entity has the liquidity and cash to meet its financial obligations as they become due, taking in funding from equity or debt capital markets activities, bank borrowings, through to day-to-day cash management and investment. The Treasury Management process is responsible for risk identification associated with the entitys varying activities and for controlling risks that could erode financial strength, using mitigation and hedging techniques and encouraging a culture of sound financial practice. In essence treasury management is all about handling the banking requirements, the funding for the entity and managing financial risk. It therefore incorporates raising and managing money, currency, commodity and interest rate risk management and dealing, and, in some entities the related areas of insurance, pensions, property and taxation.

Objective 1: Discuss the reasons for the development of treasury operations; describe the scope of treasury functions in a bank; and contrast a bank treasury and a corporate treasury.

Role of the Treasurer

The treasury department is concerned with managing the financial risks of a business. Hence, the treasurer's job is to understand the nature of these risks, the way they interact with the business, and to minimize or to offset them. He must assist and advise the board in its decision-making activity, based on his understanding of the risks. In order to do this efficiently many treasurers prefer to organise their department around treasury processes. This method is very efficient as it allows for a focus as well as links to similar functions in other geographic areas of the organisation. The treasury processes mentioned generally consist of financial planning and reporting, funding, risk management (FX and money market), credit management, and cash management.
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The most operational of these processes are risk management and cash management. Both these processes require a significant amount of attention to detail but also differ in one other aspect. Of all the processes mentioned, these two tend to be the most 'treasury independent' processes. As such the treasurer has significant leeway in both the design and implementation of the process. Given this flexibility and the operational nature of the processes it is in the best interests of the Treasurer to pay a high level of attention to the design and implementation of the processes. Not doing so results in the Treasurer getting caught up in the execution of a particular transaction, managing staff, and obtaining resources to support the function. Everything, but his actual role. Treasury plays a pivotal role in managing risks and rewards both inside and outside the organisation. As the function concerned with the provision and use of finance, Treasury typically handles collections, banking, working capital, short-term borrowing, foreign currency management, provision of capital and money market investment. In the past two decades, Treasury has become more involved in identifying unmanageable organisational risk and hedging it in open markets. Increasingly, Treasury is becoming involved in handling operational risks through insurance mechanisms and, in some leading companies, viable risk/reward management systems.

Treasury Activities comprise the following:

1. Setting corporate financial objectives strategies, policies, measurement, internal capital allocation, pricing, reporting and systems; 2. Liquidity management The treasury function has to ensure that the company has sufficient liquid funds available to ensure a smooth running of its operations and to meet short-term financial obligations as and when due. Moreover, treasury is also responsible for investing surplus funds, cash flow management, control of funds, working capital, money transmission, banking relationships and streamlining the operational flow of funds; 3. Funding management policies, procedures, types of funds and self-funding mechanisms; 4. Exposure management currency exposure, international netting/pooling, exchange dealing, international monetary economics, commodities markets and hedging; 5. Corporate finance equity capital management, taxation issues, pension funding, business acquisitions and disposals, project finance and joint ventures; 6. Corporate treasury structure information systems support, central/local procedures, cost-centre/profit-centre management, asset management, compliance, staffing, controls,
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risk attitudes, fraud prevention, business unit evaluation and Treasury performance evaluation. 7. Funding management: The treasury function has to source and secure funds for the needs of the business. 8. Debt portfolio management: The treasury function has to manage the debt portfolio which emerges from the accumulation of individual financing transactions so as to achieve an acceptable cost and risk profile for the portfolio over time. 9. Risk management: The treasury function has to advise on and implement effective hedging of treasury type risks, especially, foreign exchange, interest rate and commodity price risks, as well as liquidity, credit and counterparty risks. 10. Bank, financial counterparty and rating agency relationship management.

Objective 2: Summarise the treasury management roles of portfolio management, dealing and settlement, and proprietary trading.

Treasury Function in an International Bank

A treasury function in an international bank is concerned with three main activities: 1. Dealing, 2. Settlement 3. Control. Globalization of world markets and the complexities involved in a bank's trading operations have led to the setting up of a department specializing in the areas of funding, lending, investment and foreign exchange. Banks felt that they could operate more profitably by engaging in a function whose purpose is to minimize funding costs and to maximize returns. Further, given the need to manage the flow of transactions, a treasury function is best placed to establish and run the back-office operations - the settlement office and the control office. Within the control office, the bank has to demonstrate to the regulatory authorities and to its own senior management that the bank is operating ethically, prudently, legally and profitably. Treasury operations A dedicated treasury operation would normally be involved in the activities centering around dealing, settlement, and control. Prudent control maintains the good name of the bank while it pursues its main function as the provider of the funding for both the bank's foreign currency investments and for their international business.
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Dealing The treasury maintains and develops its dealing operations, evolving its business and controlling its operations across the broad range of instruments - for example in futures, options, cash, swaps and forward-rate agreements. It maintains and develops the investment portfolios and seeks to utilize the bank's surplus funds to best advantage for: Day-to-day funding requirements Funding investments in associated companies and subsidiaries Raising debt to meet capital requirements

Valeur Compensee (VC) Valeur Compensee (VC) relates to the aggregate of purchase and sales that mature on any one value date in the future. The principle that the deal; should be completed on the same day. Settlement The settlement office is responsible for processing payments, issuing confirmations, reconciliation of accounts, custody of securities, systems, and accounting and statutory returns. This area clears the paperwork following the purchase or sale of financial products investments, loans or trading in currency instruments. Sales have to be reconciled in the bank's back office, clients have to pay or be paid, certificates have to be exchanged and purchases and sales have to be reconciled. This is an important part of the bank's operation and requires skilled managers to ensure that there is a smooth flow of paper to support the transactions taking place. Heavy dealing in any day or over a period of time can cause serious bottlenecks which, in turn, affect the efficiency and even the reputation of the institution. Recent a dvances in electronic settlement have made the process quicker and more effective. Control The treasury function takes on the responsibility for producing a set of policies and procedures governing the way in which the bank trades in the various instruments and the levels at which it trades. Risks relating to credit limits, liquidity, cash flows, interest rates and exchange rates will also be controlled by the function using a system of checks and reviews through audits and the examination of returns required to be made by each of the dealing and settlement operations. Particular attention should be paid to the possibility of fraudulent activity, internally or by third parties, which, in the context of a bank trading in enormous amounts of money each day, could have catastrophic consequences for the very survival of the institution as demonstrated by the events that unfolded at the Bank of International Credit and Commerce and at Barings Bank.
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Even fraudulent activity on a much smaller scale can impact on the confidence the financial markets have in an institution. It undermines the perceived level of control exercised by the bank. For the purpose of maintaining the bank's capital adequacy requirements, the treasury control office will be involved in capital and loan stock issues relating to the bank's own balance sheet management, a crucial function for the very survival of the bank. All existing stock also has to be managed and this will be done through a set of guidelines, policies and procedures. Treasury functions often need to lead their organisations in understanding and managing risk and reward. Proprietary Trading This occurs when a bank trades for direct gain instead of commission dollars. Essentially, the bank has decided to profit from the market rather than from commissions from processing trades. Banks that engage in proprietary trading believe that they have a competitive advantage that will enable them to earn excess returns. Objective 3:

Differentiate between front-office, middle-office, and back-office activities from a control perspective.

The Boards Responsibility Prudential management of any bank is based on the primacy of the board, which has ultimate responsibility for the sound and prudent management of a bank. In the management of the treasury area, the board is responsible for the institutions operations and risk management and for ensuring that senior management is monitoring the effectiveness of risk controls. The board is responsible for setting the banks tolerance for risk or risk appetite, through its approval of market risk policies, limits and business strategy. Market risk policies should cover matters such as delegations, reporting, escalation, revaluations and new products. The board is expected to review policies and strategy on at least an annual basis. The board should ensure that the institutions risk controls are effective, the agreed business strategy is being followed and that the board is being regularly informed on whether risk policies are being adhered to. The board should seek active responses to limit breaches. The board should have a good general understanding of the types of treasury products and trading strategies used by their institution and to review new products. This understanding should be reinforced by board information sessions which explain the inherent risks in, for example, derivative instruments. Boards are required to be vigilant and effective in their oversight of risk. For example, it is expected that boards should understand the aggressive, competitive and at times frenzied environment in dealing rooms, and thus the crucial need to maintain clear and strong separation of

THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL

front, middle and back offices. The board is expected to be able to assess from the reports they receive whether trading is within the risk appetite it has approved and conforms to the agreed business strategy. The board should also regularly review stress tests and back testing results and should ensure, through the Board Audit Committee, that the internal models and the market risk management framework is regularly reviewed by the internal audit function. Senior Management Responsibility Senior management is responsible for ensuring that risk-taking is done within a controlled environment which is in keeping with board-approved policies, limits and strategy. It is their responsibility to ensure that people, systems and processes are up to the task. In the dealing area, senior management should have delegated trading authority from the board and should be accountable for the actions of dealers under their control. Senior management should ensure that trading desks are following the board approved business strategy. For example, if a derivatives desk is meant to be mainly client-driven, trading with interbank counterparties should predominantly be for the purpose of reducing risk rather than for taking large directional positions. Treasury dealer compensation policies should be consistent with the trading strategy and bonuses structured to encourage appropriate dealing behaviour. Leave policies should also include minimum consecutive days of leave each year, to ensure that a second set of eyes reviews dealers activities. In addition to day-to-day oversight by senior management, a senior management committee (market risk committee or Asset Liability Committee) should review trading activities on a regular basis. The committees charter should include reviews of performance and operational issues, usage of market risk capital, stress tests, back testing performance, trading strategy and the appropriateness of the risk management framework. New products and changes to limits and policies should also be agreed by the committee before being proposed to the board. Senior management of trading activities should ensure that dealers comply with policies, limits and strategy on a continuous basis. Senior management should have an open and constructive working relationship with the market risk function of the institution and ensure proper segregation of responsibilities between the front-office and middle/back office staff. Senior management is expected to guard against a dealing culture that is biased towards short-term profitability. This culture results in budget targets stretched beyond dealers competence and underinvestment in treasury risk management. Senior management should keep the board fully informed on emerging risk issues in the treasury portfolio. It should not be a crime to report bad news to the board! Such a culture is a recipe for turning small problems into big ones. Front-office Treasury dealers The front office is the first line of defence against risk in treasury operations. For this reason, banks strive for the highest level of professionalism in this area, starting with recruitment and remuneration practices. In turn, treasury dealers have responsibility for trading within their delegated mandate and for conducting their affairs, at all times, with integrity and honesty.

THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL

Treasury dealers should have appropriate systems on the desk for pricing and processing deals and for monitoring positions against limits. Front office systems should provide a secure and efficient platform for entering and pricing deals, checking credit availability pre-dealing, providing risk analytics and monitoring risk limit usage. Line management should also have access and the capability to view dealer positions and monitor dealer, desk and trading room limit usage. Integrated front office systems provide the ability to monitor limit usage on a real-time basis. Systems should be in place to ensure that dealers report their position and profit and loss on a daily basis to line managers and to finance personnel, whose task it is to reconcile dealer profit and loss estimates with independent financial accounts. Treasury dealers should have written dealing mandates that provide them with a clear understanding of their dealing authorities. A dealing mandate specifies the products, currencies, stop loss and position limits both within the day and at the end of day, as well as any other conditions such as practices when trading after hours. Limits should encompass all risks and should be set at levels where a breach clearly signals that trading has taken place outside the agreed trading strategy. The bank should ensure that breaches of limits are reported immediately by the dealer to line management. The escalation process for reporting and managing limit excesses should be clear and effective. The culture of the dealing room must be one in which dealers see risk management as a core competency, and this must be reinforced by senior management through its remuneration policies. Dealing rooms that adopt a catch-me-if-you-can approach to risk management are asking for trouble. And in the same way, a management that allows such a culture to emerge, blinded by the lure of short-term profitability, does so at its peril. Market risk management The Middle Office Market risk management the middle office is responsible for ensuring treasury dealers are complying with board-approved policies and trading within risk limits. Being independent of the dealers, the middle office provides an objective view of front office activities and ensures that limits can be monitored and risk exposures removed from the business. The market risk management system must be robust and include regular reconciliations to ensure its completeness and accuracy. An institution which calculates Value at Risk (VaR) using a model approved by the board, should regularly review the model assumptions and parameters, including stress testing scenarios. Back testing of the model should be performed regularly to ensure that the model remains valid. The middle office should have staff with sufficient skills and standing in the institution to be an effective counterbalance to the front office and to ensure the integrity of reporting and oversight of trading activities. The area must have clear reporting lines, particularly in escalating limit breaches. Ideally, the area should also have the authority to require risk positions to be reduced when dealers are in breach of limits. To be fully effective, it is essential that the middle office not be the poor cousin at budget time. The middle office should not be lagging behind the front office in terms of investment in systems, people and processes to measure and manage the risks in existing and new trading activities. Senior dealing

THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL

management should not have any disproportionate influence over the budget of market risk and support areas, weakening the effectiveness of the risk management framework. Quantitative support A number of institutions maintain a quantitative support group to develop and/or independently validate complex models used by the front office for pricing and by the middle office for risk management. The group provides an assurance that model outputs can be relied upon. Quantitative support should be actively involved in the development of new products and provide a signoff before the products are recommended to the board for approval; they might also suggest conditions to be imposed on the pricing models involved. It is important that the conditions imposed on products be monitored on a regular basis by the middle office or the quantitative support group. There should also be a periodic review of pricing models. Back office support Back office support is responsible for ensuring the integrity of deal confirmation, settlement and payment functions and may also handle financial accounting and regulatory reporting. The back office ensures that the deal information reported by the middle office is complete and accurate. The back office should be alert to large and unusual trades as well as unusual amendments to trades and/or frequent cancellation of trades, particularly around the end of day and other key financial reporting periods. Any unusual activity should be escalated to senior management. There should be strict controls around deal amendment and cancellation. For example, dealers should not be able to change standard settlement instructions (SSI) nor advise the back office of changes to SSI. Trading positions should be marked-to-market daily and revaluation rates must be provided independently of the front office. In addition, to ensure accuracy, there should be a daily validation of rates in the form of stale price checks and checks for large and unusual movements. For complex trading environments, we would expect to see a revaluation committee which continually reassesses the appropriateness of the source of revaluation rates and of assumptions and practices used. On a daily basis, the finance area should calculate profit and loss for trading activities and compare the figures with dealers estimates. Differences should be reconciled and unexplained differences highlighted to risk management and senior management, and resolved quickly. On a regular basis, source systems should be reconciled with the general ledger and internal balance sheet and profit and loss accounts should be reconciled. Where there are trading activities across multiple branches, there should also be a reconciliation of internal and inter-company balance sheets and profit and loss accounts. Though it should go without saying, both the back office and the finance function should be independent of the front office and be appropriately resourced. Internal audit Internal audit is responsible for reviewing the effectiveness of people, systems and processes which comprise the treasury risk management framework. By virtue of its independence from executive management and its direct reporting line to the Board Audit Committee, internal audit provides assurance to the board that the front office, market risk and back office support areas are functioning effectively and that senior management is active in its risk oversight. The internal audit function should be adequately resourced, or have access to external qualified resources, to be able to undertake regular reviews of
THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL

treasury operations. For internal model users, a review of the overall risk management process should take place at regular intervals.

Objective 4: Summarise the principles of risk management, and explain the importance of prudential control, risk management, and risk-management processes. RISK MANAGEMENT Management of risks has always been foremost in Treasury Management and the scope has been foremost in recent years due to the number of banks which has failed locally and internationally. Treasuries require the ability to monitor and exercise control in order to ensure that the information on which dealing decisions were based are accurate. Operational controls to ensure that the treasury function did not inadvertently threaten the rest of the organisation were a part of this control function. Risk management works most effectively when an enterprise risk management approach is used. All risks across a financial institution have to be managed together. In financial institutions, the primary risk management function is to develop, implement and communicate a consistent framework, support a process for managing risk across the financial institution. However, the objective is to help identify and take advantage of varying opportunities to optimise risk-adjusted return on capital. The financial Institution business units should have primary responsibility for and knowledge in managing risk in their own markets and products. They should manage both risk before an event and profit and loss after an event. It must be emphasized that quantifying risk alone is not sufficient. An effective risk framework must be inclusive of stress-testing capabilities. Only then will the risk management model be sufficient. Treasury Risk Treasury Risk is a subset of the overall risk profile of the institution. Treasury Risk first appears within the array of Expectation Risk elements. Most institutions forecast future interest rates, currency differentials, earnings and investment returns, price indices, and related economic factors. The results of those forecasts influence potential resources available to enable the vision of attainable goals for the enterprise. Treasury Management is also the Management of Risks. With the globalization of financial markets, financial institutions around the world are exposed to a multiplicity of risks. Movements in the rates of interests and volatility of exchange rates in an increasingly complex environment have made the process of managing risks a critical aspect of treasury management. The main types of risk associated with treasury operations are.

THE FUNCTIONS OF A BANKS TREASURY AND PRUDENTIAL CONTROL

Financial Risk Credit Risk/Counterparty - Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms; A credit risk arises where there is a commercial contract between two parties in which one party has a future obligation to repay moneys to the other with the risk that those moneys will not be repaid or a settlement is deferred or rescheduled. In each case it will result in a loss to the lender or a significant reduction in the margin on which the transaction was made. Credit risk otherwise known as bank counterparty risk, is concerned with counterparty limits between banks and focusing on acceptable exposure levels. Settlement Risk - the risk that the completion or settlement of a financial transaction will fail to take place as expected; Settlement risk includes elements of liquidity, market, operational and reputational risk as well as credit risk. The level of risk is determined by the particular arrangements for settlement. Factors in such arrangements that have a bearing on credit risk include: the timing of the exchange of value; payment/settlement finality; and the role of intermediaries and clearing houses. Market Risk; Price Risk (Interest rate risk, currency risk, equity, Maturity mis-match risk, Forced Sale risk) Curve Risk, Basis risk, Correlation risk. Option Specific risk. Liquidity Risk - Liquidity risk is the current and prospective risk to earnings or capital arising from a banks inability to meet its obligations when they come due without incurring unacceptable losses. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. Physical Risk Physical Assets; Real estate; Manufacturing process; supply chain.

Operational Risk is the risk arising from execution of a banks business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.

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Basel II regulations define Operational risk: as the risk of loss resulting from the inadequate or failed internal processes, people, and systems or from external events. Operational Risk includes legal risks but excludes reputational and strategic risks. The most important types of operational risk involve breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial losses through error, fraud, or failure to perform in a timely manner or cause the interests of the bank to be compromised in some other way, for example, by its dealers, lending officers or other staff exceeding their authority or conducting business in an unethical or risky manner. Other aspects of operational risk include major failure of information technology systems or events such as major fires or other disasters. Sales Risk Competition Risk - The ever present forces of globalization, technology, and economic liberalization are combining to make life harder than ever for established entities. Banks who are able to effectively lower their costs and possess a comparative advantage over their competitors will capture a greater market share. Elasticity risk - the ratio of the percentage change in the price of a banks product (such loans and deposits) and the percentage change in demand for that product. The relationship between movements in interest rates and service cost and the resultant impact on consumer demand. Predictive Risk Exists when banks use statistical analysis to predict future trends and behavior patterns. The core of predictive analytics relies on capturing relationships between explanatory variables and the predicted variables from past occurrences, and exploiting it to predict future outcomes. When a predicted variable behaves contrary to ones expectation it generates risk to the banks operation. Strategic Risk - Includes Regulatory Risk, Tax Risk, Catastrophe risk, Currency Policy. Political Risk Country Risk Relates to that associated with the credit afforded to the borrowers of a sovereign country. The risk arises out of the possibility that the borrowers in that sovereign country may be unwilling or unable to pay their debts.

Economic Risk - Investment risk associated with the overall health of the economy of the country or locality in which the investment is made. It includes the risk
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that a bank will not generate sufficient revenues to cover operating costs and to repay contractual obligations. This may be realized by disruptions in a strategic operation or process, emergence of a serious competitor on the market, the loss of key personnel, the change of a political regime, or natural disasters. Legal Risk Legal Risk arises from exposure that exists from being unable to enforce agreements that have been drawn up incorrectly.

Prudential Controls The prudential control refers to the regulation of deposit-taking institutions and supervision of the conduct of these institutions and set down requirements that limit their risk-taking. The aim of prudential control is to ensure the safety of depositors' funds and to ensure the stability of the financial system. A financial institutions treasury function has grown in importance, largely because of the complex nature of financial instruments traded across borders. Control is the responsibility of senior management, not the regulatory authorities. It is their duty to ensure that all types of risk are minimized and controlled, and although a slice of the work carried out by the bank's internal control functions will include the implementation of the rules laid down under statute, the issue of internal prudential control should be high on the agenda, notwithstanding the need to meet its legal requirements. The internal control function varies from one bank to another in its form and its brief, but all focus closely on the activities of the dealing operations because this is where most of the risk lies in the form of the trading exposures. Risks that exist from volatile interest rates and exchange rates, plus the credit risks associated with the ability of counterparties to meet their commitments, can be difficult to predict, but they are part and parcel of trading. The risks that can be even more difficult to detect are those related to internal or third-party fraud, whether these be at the dealing stage or at the settlement stage. Within the internal control role specification there should therefore be a framework for the monitoring of transactions in order to detect fraud at an early stage. The two ends of the extreme have so far been discussed - the standard risks involved in running the business and, at the other end of the scale, the risks associated with fraudulent activity. In between these two areas of control are the limits within which traders are allowed to operate, and the integrity they must demonstrate in order not to place the bank in an exposed position. Objective 5: Describe the functions of the board of directors, the Asset and Liabilities Committee (ALCO), and other risk committees. Board of Directors
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The principal role of the board of directors is to determine strategy. They set the terms and reference of the varying sub-committees in the institution and these committees remain responsible to the board. Asset and Liability Committee Often boards delegate the setting of the financial institution risk appetite relating to balance sheet exposure to a special formed Asset liability Management Committee (ALCO). ALCO plans, directs and controls the flow, level, mix, cost and yield of the consolidated funds of the financial institution. They are mandated to achieve the entities financial goals and controlling financial risks. ALCO set the framework for treasury activities, in line with the principles determined by the board of directors. Objective 6: Discuss the reasons for and processes of internal controls, including the internal audit function. The Internal Control Function Given that it is senior management's responsibility to prudently control the dealing operations of an international bank, one would expect to see an internal control department specifically tasked with putting controls in to place. The areas that typically form part of such a function's responsibility are: To ensure compliance with directives and policies issued by senior management To devise and put into place controls To monitor performance against these controls To ensure the security of the company's assets To ensure the dealing and settlement functions operate efficiently To satisfy management and regulators that records are accurately kept

Internal Audit Internal audit functions have important control functions. Its role is generally to monitor the appropriateness and effectiveness of a firms systems and controls. Internal Audit will demonstrate to their senior managers and to the banking authorities that they are able to exercise the appropriate level of prudence. This in itself will keep the regulators at arm's length. What the banks are unable to control voluntarily the regulators will seize upon to put their control requirements into statute, or at least into a code of practice. For example, the FSC will observe the ability of the Jamaican banks to operate within their own guidelines or within the guidelines of the central bank. If it is not then satisfied with the results of this level of intervention then statute can become a reality. At whatever stage the level of control has settled the internal control function will take responsibility for enforcement. The aim, as far as the bank is concerned, is a common approach that convinces the central banks that self-regulation is exercised at such a level as to be satisfactory for their purpose.
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The need to exercise caution and prudence in dealing operations has been around for as long as trading has existed, but the need for it has been no better demonstrated than in the late 1980s, 1990s and early 2000s when complex derivative instruments were embraced by the markets but not always fully understood across the dealing rooms and among managers. If they are not fully understood by the management then it is unlikely that awareness of the control requirements will exist either. If the Financial Services Commission (FSC) were to review the measures being undertaken by a bank to keep its own house in order it would expect to see: (a) (b) (c) Random audits, outside any regular audit cycle. Sensible targets imposed on dealers in order to ensure that they are not tempted to compromise the bank in search of their optimistic profit targets. Random checks with counterparties to confirm that deals, such as forward contracts, do in reality exist. The internal auditor would be expected to investigate unusual patterns of activity such as unusually high levels of business transacted with one particular third party.

Objective 7: Evaluate the functions of the compliance office. Basel Committee on Banking Supervision paper on Compliance and the compliance function in banks Compliance starts at the top. It will be most effective in a corporate culture that emphasises standards of honesty and integrity and in which the board of directors and senior management lead by example. It concerns everyone within the bank and should be viewed as an integral part of the banks business activities. A bank should hold itself to high standards when carrying on business, and at all times strive to observe the spirit as well as the letter of the law. Failure to consider the impact of its actions on its shareholders, customers, employees and the markets may result in significant adverse publicity and reputational damage, even if no law has been broken. The expression compliance risk is defined in this paper as the risk of legal or regulatory sanctions, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory organisation standards, and codes of conduct applicable to its banking activities (together, compliance laws, rules and standards). Compliance should be part of the culture of the organisation; it is not just the responsibility of specialist compliance staff. Nevertheless, a bank will be able to manage its compliance risk more effectively if it has a compliance function in place that is consistent with the compliance function principles in the paper. The expression compliance function is used in the paper to

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describe staff carrying out compliance responsibilities; it is not intended to prescribe a particular organisational structure. The banks compliance function should be independent. o The compliance function should have a formal status within the bank. o There should be a group compliance officer or head of compliance with overall responsibility for co-ordinating the management of the banks compliance risk. o Compliance function staff, and in particular, the head of compliance, should not be placed in a position where there is a possible conflict of interest between their compliance responsibilities and any other responsibilities they may have. o Compliance function staff should have access to the information and personnel necessary to carry out their responsibilities.

Objective 8: Evaluate the functions of financial markets, and discuss the roles of participants in these markets; namely exchanges and clearing houses, credit institutions, investment banks, brokers, market makers/dealers, and investors. A financial market is a market in which financial assets are traded. In addition to enabling exchange of previously issued financial assets, financial markets facilitate borrowing and lending by facilitating the sale by newly issued financial assets. Financial markets serve six basic functions. These functions are briefly listed below: 1. Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes. 2. Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets. 3. Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers. 4. Transformation of Risk: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments. Financial markets reduce risk through risk spreading or risk pooling. Risk pooling is undertaken by spreading any risky investment across a sufficiently large number of lenders. 5. Transformation of maturities and provision of Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets. Financial intermediaries have the ability to hold assets that are less liquid than their liabilities. 6. Transformation of transaction costs: Financial markets reduce transaction costs and information costs.

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In attempting to characterize the way financial markets operate, one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured. Major Players in Financial Markets Exchanges Credit Institutions Investment Banks Brokers Market makers/dealers Investors and issuers Objective 9: Describe the processes involved in dealing rooms or front offices, middle offices, and back offices, and discuss the rationale for, and practicalities of, the segregation of duties between trading and settlement functions. Front-office The term front-office is used for dealing activities. Dealing activities are undertaken by both market makers and dealers. The difference is that market makers will quote prices on an almost continuous basis, while dealers will only be active in the market when it suits them. Market makers are needed to ensure a market exists while dealers add additional liquidity to a market. When determining prices, dealers and market makers will take into account existing demand and supply and how they are likely to change. Developments in other markets may also affect prices and participants need to track of what market prices do to ensure that their own prices do not diverge without good reason from the market trend. A dealer may either initiate a deal or, if the dealer quotes prices, may be contacted by other market participants. Prices will be either on a bid or offer basis. A bid price is the price at which dealers are prepared to borrow or purchase. The offer price is the price at which they are prepared to lend or sell. Contact with dealers and market makers may be established via telephone or computer screen. The dealer then: 1. 2. 3. 4. 5. 6. Check that the proposed deal does not breach the internal limits. Agree to the deal as it relates to price, amounts, maturity and settlement details. Once all the relevant details are agreed the deal has been done. Details of deal input into the systems. Deal incorporated in the risk management systems of the bank. Deal included into banks accounting records

Middle-office
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Middle offices arose from the need for improved risk management. Middle office functions: 1. 2. 3. 4. 5. Produce risk management reports Check for compliance with internal limits. Liaise with back-office Filter queries from the back-offices on deals. Check valuations for inputting into integrated risk reporting.

Back-office Sometimes the activities undertaken by back-offices are collectively known as settlement activities. Middle office functions: 1. 2. 3. 4. 5. 6. Making sure that accounting entries are correct. Confirmation received Payments are authorized Accounting records for funds or securities are reconciled with actual payments/deliveries. Nostro accounts may also have to be reconciled. Margin payments may have to be made.

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