1.

1 PURPOSE OF THE BANKING SELF-STUDY GUIDE 3

1.2 THE GOALS OF A BANK 3

1.3 RISK MANAGEMENT OVERVIEW 4

2.1 OVERVIEW OF THE FLOW OF ROUTINE TRANSACTIONS 6

2.2 THE CENTRAL POOL OF FUNDS AND MANAGING THE SPREAD 7

2.2.1 Profit Centres 7

2.2.2 Branches as Profit Centres 7

2.2.3 Deposits 7

2.2.4 Loans 7

2.2.5 Managing interest rate risks with transfer pricing and cost of funds 7

2.2.6 Funds in Foreign Currencies 8

3.1 FOREIGN EXCHANGE TRANSACTIONS 9

3.1.1 Introduction 9

3.1.2 Reasons behind foreign exchange transactions 9

3.1.3 Example 10

3.1.4 “SQUARING” the balance sheet: 11

3.1.5 Foreign exchange transactions defined 11

3.1.6 How foreign exchange profits are made 12

3.1.7 Risks involved in foreign exchange 12

3.1.8 Summary 16

4.1 TREASURY OPERATIONS 18

4.1.1 Dealing Activity 18

4.1.2 Back office 18

4.1.3 Input processing 18

4.1.4 Settlements and Nostro/Vostro accounts 19

4.1.5 Reconciliations department 19

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5.1 CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS 20

5.1.1 Cheques drawn on a domestic bank 20

5.1.2 Holding funds 20

5.1.3 Items sent on collection 20

5.1.4 International payments 20

5.1.5 International collections 20

5.1.6 Correspondent accounts and banks 21

6.1 LENDING AND CARD SERVICES 22

6.1.1 Advances repayments 22

6.1.2 Treasury department 22

6.1.3 Credit card transactions 22

6.1.4 Types of Lending Facility 23

6.1.5 Factors Governing Lending Decisions 24

6.1.6 Loan Security 25

6.1.7 Internal Control 25

6.1.8 Summary 26

7.1 TRADE FINANCE 27

7.1.1 Introduction 27

7.1.2 Documentary letters of credit 27

7.1.3 Procedure 27

7.1.4 Letter of Guarantee 28

7.1.5 Bills of exchange (Trade bills) 28

7.1.6 Performance bonds 29

7.1.7 Summary 29

8.1 INVESTMENTS 30

8.1.1 Introduction 30

8.1.2 Types of Inve stment 30

8.1.3 Generally Accepted Valuation Policies 32

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1.1 PURPOSE OF THE BANKING SELF-STUDY GUIDE

This self study guide is designed to enable engagement staff to gain a basic understanding of the
activities that a retail bank performs before they become involved in a banking engagement.

Such knowledge should enable staff who are new to the industry to grasp what a bank is trying to
achieve and why it is organised differently from other organisations. This will enable staff to add value
to the audit team and to the client more quickly and allow them to rapidly develop industry experience.

Staff who have developed basic banking knowledge and experience will then be invited to attend the
Advanced Banking course where the concepts presented here are developed and analysed in much
greater depth.

After completing this guide it you should be able to:

• Describe the routine processes that enable a bank to function and fulfil its objectives.

• Understand the practical aspect of how banks generate profit

• Understand how a typical bank is structured by department

• Understand the various departments interactions and their role in the objectives of the bank

• Understand the unique risks faced by each department and how auditors address those risks

1.2 THE GOALS OF A BANK

The basis of banking is to put capital at risk in the pursuit of earnings. A bank takes risks, transforms
risks and embeds risks in banking products/services.

Risk levels vary in every area of banking and one dollar from low risk activities is not comparable with
one dollar from high risk activities. Recognising this, banks have in recent years, moved away from the
traditional goal of profit maximisation towards a more sophisticated goals such as maximising risk
adjusted returns on capital and shareholders value added.

The goals of a bank are also driven by regulatory requirements laid down by central banks. The central
role of risk based capital in regulations focuses on the capital adequacy principle, which states that
capital should match risks. As capital is a limited and expensive resource the advancement of regulation
has contributed to the above shift in goals.

Risk management is therefore a cornerstone of the banking industry and is a rapidly advancing area.

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1.3 RISK MANAGEMENT OVERVIEW

In its core principles, the Basle Committee on Banking Supervision1 sets out eight key risks which must
be managed by banks. Banks’ organisational structure is designed to manage these risks either on a
process basis or, more commonly, by department such that the institution can meet its goals. The risks
are as follows:

Credit risk

The extension of loans is the primary activity of most banks. Lending activities require banks to make
judgements related to the creditworthiness of borrowers. These judgements do not always prove to be
accurate and the creditworthiness of a borrower may decline over time due to various factors.
Consequently, a major risk that banks face is credit risk or the failure of a counterparty to perform
according to a contractual arrangement. This risk applies not only to loans but to other on- and off-
balance sheet exposures such as guarantees, acceptances and securities investments. Serious banking
problems have arisen from the failure of banks to recognise impaired assets, to create reserves for
writing off these assets, and to suspend recognition of interest income when appropriate.

Large exposures to a single borrower, or to a group of related borrowers are a common cause of banking
problems in that they represent a credit risk concentration. Large concentrations can also arise with
respect to particular industries, economic sectors, or geographical regions or by having sets of loans
with other characteristics that make them vulnerable to the same economic factors (e.g., highly-
leveraged transactions).

Connected lending - the extension of credit to individuals or firms connected to the bank through
ownership or through the ability to exert direct or indirect control - if not properly controlled, can lead to
significant problems because determinations regarding the creditworthiness of the borrower are not
always made objectively. Connected parties include a bank’s parent organisation, major shareholders,
subsidiaries, affiliated companies, directors, and executive officers. Firms are also connected when they
are controlled by the same family or group. In these, or in similar, circumstances, the connection can
lead to preferential treatment in lending and thus greater risk of loan losses.

Country and transfer risk

In addition to the counterparty credit risk inherent in lending, international lending also includes
country risk, which refers to risks associated with the economic, social and political environments of the
borrower’s home country. Country risk may be most apparent when lending to foreign governments or
their agencies, since such lending is typically unsecured, but is important to consider when making any
foreign loan or investment, whether to public or private borrowers.

Market risk

Banks face a risk of losses in on- and off-balance sheet positions arising from movements in market
prices. Established accounting principles cause these risks to be typically most visible in a bank’s
trading activities, whether they involve debt or equity instruments, or foreign exchange or commodity
positions. One specific element of market risk is foreign exchange risk. Banks act as “market-makers” in
foreign exchange by quoting rates to their customers and by taking open positions in currencies. The
risks inherent in foreign exchange business, particularly in running open foreign exchange positions, are
increased during periods of instability in exchange rates.

1
The Basle Committee on Banking Supervision is a Committee of banking supervisory authorities which
was established by the central bank Governors of the Group of Ten countries in 1975.

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Interest rate risk

Interest rate risk refers to the exposure of a bank’s financial condition to adverse movements in interest
rates. This risk impacts both the earnings of a bank and the economic value of its assets, liabilities and
off-balance sheet instruments. Interest rate risk can arise in both the banking and trading book.
Although such risk is a normal part of banking, excessive interest rate risk can pose a significant threat
to a bank’s earnings and capital base.

Liquidity risk

Liquidity risk arises from the inability of a bank to accommodate decreases in liabilities or to fund
increases in assets. When a bank has inadequate liquidity, it cannot obtain sufficient funds, either by
increasing liabilities or by converting assets promptly, at a reasonable cost, thereby affecting
profitability. In extreme cases, insufficient liquidity can lead to the insolvency of a bank.

Operational risk

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.

Legal risk

Banks are subject to various forms of legal risk. This can include the risk that assets will turn out to be
worth less or liabilities to be greater than expected because of inadequate or incorrect legal advice or
documentation. In addition, existing laws may fail to resolve legal issues involving a bank; a court case
involving a particular bank may have wider implications for banking business and involve costs to it
and many or all other banks; and, laws affecting banks or other commercial enterprises may change.
Banks are particularly susceptible to legal risks when entering new types of transactions and when the
legal right of a counterparty to enter into a transaction is not established.

Reputational risk

Reputational risk arises from operational failures, failure to comply with relevant laws and regulations, or
other sources. Reputational risk is particularly damaging for banks since the nature of their business
requires maintaining the confidence of depositors, creditors and the general marketplace.

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2.1 OVERVIEW OF THE FLOW OF ROUTINE TRANSACTIONS

To be able to understand the client’s business a basic understanding of how banks are structured and
how the routine transactions flow is essential. What follows is an illustration of how a typical bank is
broken down into departments and the departments’ interaction with each other and banking clients.

Refer to Data Flow Diagram on routine transactions

From the diagram, you will see that a typical bank is split into profit centres and cost centres which
handle transactions as follows:

Profit Centres (proactive)

Branch Operations
Offering deposits and dealing with customer service and enquiries.

Card Services
Issuance and maintenance of credit and charge card accounts.

Credit (consumer and corporate/private)

Administration and management of the loan portfolio.

Treasury Trading
Short term purchase and sale of interest rate and foreign exchange products.

Cost Centres (reactive)

Central Treasury
The above profit centres handle a huge volume of transactions that result in an unbalanced
asset/liability position i.e. the centre is either a net user or generator of funds.
In aggregate, that net position (sometimes known as the banking book) is actively managed by the
Asset and Liability Management function within the Treasury department. The treasury department
receives the data from all the operating departments of the bank and is constantly reacting to cash flows
in the various profit centres. Treasury makes sure that foreign exchange and money flow is sufficient to
meet the needs of the bank by carrying out transactions subject to predefined limits set by the bank’s
strategic planning committees such as ALCO (Asset and Liability Committee). This function and the
mechanics of how Central Treasury ensures the bank is efficient and profitable is illustrated in more
detail in section 2.2.

Operations
This department receives and processes all transactions details and generally includes the information
technology function.

Reconciliations and Settlements

Typically part of operations these centres process transactions initiated by the retail departments and
central treasury. Settlements ensures that money is in appropriate accounts to settle deals, while the
reconciliations department ensures that the transactions with other banks were carried out as agreed.

Financial Control
Collects the data from all the subledgers of the various departments to produce the financial information
to effectively manage the bank.

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2.2 THE CENTRAL POOL OF FUNDS AND MANAGING THE SPREAD

Within banks the various departments all compete for scarce resources. For banks this resource is
funds. The activities which generate the highest returns, after discounting the return for the level of risk
assumed, will be the most attractive area to allocate funds.

Refer to Diagram on Central Pool of Funds

2.2.1 Profit Centres

All identifiable departments in banks are either profit centres or cost centres. Profit centres are those
that offer products that generate interest revenue or fee based services. Other departments such as
settlements, accounting, and reconciliations departments do not offer services outside the bank and
therefore are cost centres. In order to measure the profitability of these various lines of activity the
bank assigns a cost of funds for all banking activities. This cost of funds is the rate at which money can
be invested risk free in the money markets.

From a banker’s point of view he must make at least LIBOR on an activity to make a profit above the risk
free rate. Therefore all requests for money from the different departments are priced at LIBOR and it is
then up to the department to price its product such that an interest spread is earned which compensates
for the risk involved.

[NB. Throughout this guide the term LIBOR is used which stands for London Interbank Offer Rate.
All countries have their own interbank rate at which all banks are willing to accept deposits from
each other. For the purposes of this section all funds are considered to be borrowed and lent at
LIBOR but in practice it could be at any rate. LIBOR has been used here as a means to simplify the
concepts.]

2.2.2 Branches as Profit Centres

Each branch is responsible for generating business in the form of loans to customers and being a source
of deposits that the bank can use to issue new loans or invest in other assets.

2.2.3 Deposits

When customers choose to place their excess money with a bank the bank records this liability to the
client and either invests the money or lends it to another bank client. Banks accept many more deposits
than they can lend out so excess deposits are invested in interest earning assets such as Treasury bills
and other money market products. The branch then earns LIBOR on all of its deposits and pays
something less than LIBOR to its client leaving an interest rate spread that yields profits.

2.2.4 Loans

Loans are granted by the branch to its clients and these are assumed to be funded by borrowing money
at LIBOR and lending it to a client. The branch then charges its client interest greater than LIBOR to
generate a profit on the interest rate spread. Therefore all loans are priced with LIBOR as its basis.

2.2.5 Managing interest rate risks with transfer pricing and cost of funds

Some banks may centralise the management of interest rate risk in a unit of the bank, usually the
treasury unit, using a funds transfer pricing system. Funds transfer pricing allows the bank to transfer
the impact on earnings of changing interest rates from individual business lines to the central unit.
Profits of the bank are unaffected however, the earnings of the business lines can then be traced more
directly to the business decisions of management. Funds transfer pricing also induces line managers to
make pricing decisions that are with the interest rate risk management objectives of the treasury.

The transfer pricing system removes interest rate risk profits and losses from individual business units.
Banks can use several methods to determine the price of transferred funs. Using a “gap approach”, a

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bank can group its assets and liabilities based on the maturity and repricing characteristics of the
instruments and assign a transfer rate to each group. Alternatively, the treasury unit of a bank could
assign a cost or earnings rate to every transaction. For example, treasury assigns a cost of funds to the
commercial lending units for loans. A fixed rate, five-year loan might be assigned a cost-of-funds
equivalent to the rate paid by the bank to borrow five-year money. The treasury will assign an earnings
credit to the deposit or retail unit for the funds raised. In this way, the treasury unit acts as a middleman
between the lending and retail units.

Under a transfer pricing system, profits and losses arising from interest rate mismatches are transferred
to a central unit, generally the treasury department. The treasury, which is responsible for funding the
loans, may either match-fund the loans or maintain the repricing mismatch. If loans are matched-funded,
no interest rate risk is assumed by either the lending units or treasury. If treasury decides to maintain
the mismatch, perhaps funding a five-year fixed rate loan with a one-year deposit, the unit would earn
the difference between its actual funding costs and what it has charged the lending units. For example,
if treasury charges the lending units 10 percent for five-year funds and raises one-year money at 9
percent, treasury would earn a 1 percent spread. Obviously, the treasury unit has assumed interest rate
risk. If rates were to rise, the spread earned could decline or even become negative.

2.2.6 Funds in Foreign Currencies

All banks deal in foreign currencies so that their clients can convert money earned outside the country
into domestic currency and convert domestic currency into foreign currency when they have to make
payments outside the country. This function and the related implications are illustrated in more detail in
section 2.2.7

In terms of generating profits the bank earns money from foreign exchange by charging a premium to
sell foreign currency and a discount to purchase it. When a client deposits foreign currency at a bank
the treasury department has to make a decision whether to sell the foreign currency before the exchange
rate fluctuates or hold it with the intention of selling it when the home currency depreciates to yield a
gain.

There is a cost to holding this foreign currency because it cannot be invested to earn interest because
the dealer needs it to be able to sell it when the exchange rates are favourable. Therefore, this
speculative activity also attracts the LIBOR cost of funds. This ensures that the foreign exchange
positions are closely monitored to ensure profitability. That is, the longer the foreign currency is held
the larger the exchange movement must be to pay the cost of funds charge.

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3.1 FOREIGN EXCHANGE TRANSACTIONS

Upon completing this section, you should be able to:

• Understand the basic concept of foreign exchange and the market for foreign exchange.

• Appreciate the reasons behind foreign exchange transactions.

• Understand basic foreign exchange transactions, rates and what is meant by the term ‘position’.

• Identify the exposure to foreign exchange risks.

• Understand and identify the internal controls maintained to reduce risk exposure.

3.1.1 Introduction

Refer to Diagram on Operations in Foreign Currency

Foreign currencies in general and the process of exchanging the currency of one country for the
currency of another country are both referred to as ‘foreign exchange’. This exchanging process or the
conversion of one currency into another can take place locally, for example, when members of the public
purchase foreign currency notes and travellers cheques or internationally when the conversion involves
the receipt or payment of one currency for that of another. The market in which international
conversions take place is known as the foreign exchange market. The price at which the exchange of
currencies takes places is known as the rate of exchange.

3.1.2 Reasons behind foreign exchange transactions

The market for foreign exchange mirrors the physical trade that occurs between countries. For every
sale/purchase of goods or services, there is a corresponding monetary transaction. It also reflects
capital flows between countries. In simple terms, the market for foreign exchange enables debts
between different countries to be settled by the exchange of one currency for another. The originators
for foreign exchange funds are usually the large corporate entities. The foreign trade that they
undertake eg. Buy foreign raw materials necessitate the need for foreign funds to pay for such goods
and services. Banks may be approached if the size of funds required is huge but usually foreign
exchange brokers are used. They in turn will contact the banks and transact on their clients behalf.

Whilst, commercial traders enter into foreign exchange transactions through banks to settle liabilities or
convert assets, banks themselves trade in foreign exchange for a number of reasons. The most
important of these are:

i) To service the foreign exchange requirements of their customers at a profit.

ii) To make a profit simply by buying and selling various currencies.

iii) To hedge the foreign currency assets and liabilities of the bank against adverse exchange rate
movements.

iv) To acquire foreign currency assets in preference to the base or local currency which may be
more sensitive to rate movements.

3.1.3

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 3.1.3 Example
A bank starts operating from a position in foreign currency as follows:
USD DM
Assets

Cash 100 100

Loans 500 500

Deposits with banks

1,000 1,000
_________ _________
Total Assets 1,600 1,600
======== ========
Liabilities

Due to banks 400 500

Customer’s deposits
1,000 900

Other liabilities 200 200

_________ __________
Total Liabilities 1,600 1,600
======== =========
Daily routine transactions are as follows:

1) A client exchanges USD800 for domestic currency

2) A DM500 loan is advanced
NEW BALANCE SHEET AS FOLLOWS:
USD DM
Assets

Cash 900 100

Loans 500 1,000

Deposits with banks

1,000 1,000
_________ _________
Total Assets 2,400 2,100
======== ========
Liabilities

Due to banks 400 500

Customer’s deposits
1,000 900

Other liabilities 200 200

_________ __________
Total Liabilities 1,600 1,600
======== =========
Open position 800 500
======== =========

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Action required by treasury department

After the bank has processed these two routine transactions the treasury department is given the
information and decides what action they will take. In effect the treasury has been given 2 positions as
follows:

1) Money market position: A DM500 loan was advanced so the money market dealers must borrow
DM500 from another bank to fund the loan. The decision then becomes at what term to fund the
loan at. If interest rates are expected to decrease the money will be borrowed at short term rates
until rates decline at which time the loan term will be increased to match the maturity of the loan
granted to its customer.

2) Foreign exchange position: By purchasing the dollars the treasury must sell them or be placed at
risk of a change in the exchange rate. The DM 500 loan that was advanced must also be funded so
DM 500 must also be purchased in the foreign exchange markets. In practice the treasury will
probably sell its dollars in return for DM.

3.1.4 “SQUARING” the balance sheet:

Once the USD 100 is sold, the assets in USD will equal the liabilities and the bank is no longer exposed
to adverse changes in exchange rates. That is, the balance sheet is “squared”. Similarly once the DM
500 loan is borrowed from another bank, the liabilities in DM will equal the assets and the bank is no
longer exposed to changes in exchange rates.

3.1.5 Foreign exchange transactions defined

(a) Spot

When a sale or purchase is made spot, it means that delivery of the foreign exchange and the
corresponding base currency must be made simultaneously at a fixed date within a few days after the
sale or purchase was contracted (normally two business days for most currencies).

(b) Forward

A forward exchange transaction involves the purchase or sale of foreign currency for delivery at some
fixed future date. The rate at which the transaction is concluded is also fixed at the time of sale, but
settlement is not made until the foreign currency is delivered by the seller at the fixed future date. The
majority of forward exchange transactions are concluded for periods up to six months but can be
concluded for considerably longer maturities, particularly in the more stable currencies.

(c) Rates

The value of the world's currencies in the forward market is expressed in the forward rates which reflect
current expectations and a large variety of related market forces. If a certain foreign currency is quoted
at a higher rate ‘spot’ than ‘forward’, its forward rate is a ‘discount’. If the forward rate is higher, it is
said to be trading at a ‘premium’. Different forward rates are quoted for different periods (one, two,
three, six, or twelve months forward). It is possible that forward rates may be at a premium for one
period and at a discount for the next.

(d) Arbitrage

An arbitrage deal involves the simultaneous spot and forward transactions to take advantage of
differences in exchange rates and interest rates. The most common form of arbitrage deal is interest
arbitrage, whereby a bank attempts to take advantage of interest differentials between currencies and

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make a profit or derive funds for on-lending in currencies other than dollars at a cost which should be
offset by the additional interest obtainable by lending in those other currencies.

(e) Swaps

Swaps involve two linked exchange transactions for an identical amount of a currency with different
value dates, for example, a spot purchase and a forward sale. A swap can take place when each party
can access a particular market (either interest basis or currency) on comparatively better terms than the
other. Parties will enter the markets where they have the advantage, and will agree to exchange (swap)
payments and receipts between them which will result in better terms in their preferred market than if
they had entered it directly themselves. The most usual types of swaps are interest rate swaps and
currency swaps.

3.1.6 How foreign exchange profits are made

The two most common ways in which a bank makes a profit from the foreign exchange market are:

- From the "spread" in quoting currency prices

- From holding a currency position. (see 3.1.7 a)

The Spread

The difference between the current buying and selling rates of a particular maturity date in the market is
called the ‘spread’. For example:

The Swiss franc was quoted at $ 0.4000-0.4002, indicating that at that moment a bank would pay 40c for
a franc and would sell at 40.02c. The small spread between buying and selling rates - $0.0002 - is an
indication of the importance small fractions play in day to day trading and of the narrow margin on
which foreign exchange dealers operate to generate a profit.

Another illustration of this is seen in the forward transaction area. On a given day a trader might quote
a market rate as follows:

Spot sterling - $1.7800 - .02 (which means he is prepared to buy points discount (which means he is
prepared to buy at $1.7800 or to sell at $1.7802) six months - 453 to 448 forward at $0.0453 discount from
the spot bid price or sell forward at $.0448 discount from the spot offered price).

A customer calls to sell pounds six months forward to cover an investment in England. The trader
would bid for the sterling at $1.7347 ($1.7800 less $0.0453) for delivery in six months.

3.1.7 Risks involved in foreign exchange

The foreign exchange risks which a bank is exposed to is dependent on the type of foreign exchange
business undertaken. When only solely buying and selling foreign currency where time delay is
minimal, the exchange risk is negligible. Where large positions are frequently taken and there is time
delay in transactions being unmatured for a period, then risks undertaken are significantly higher. The
risks associated with the foreign exchange activities may arise as follows:

(a) Open positions

As explained above, a position in a currency arises when a bank is unmatched in that currency ie an
excess of assets or liabilities in that currency. If there is a long position and the value of that currency
falls in home currency terms, a loss will arise. Similarly, if there is a short position and the currency rises
in home currency terms, again the bank will experience losses.

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The bank's open position includes unmatured exchange contracts and its exchange assets and liabilities.
Where small open positions are maintained, movements in exchange rates will have little or negligible
effect. Most of the substantial foreign exchange losses suffered by banks in recent years have resulted
from a failure to manage and control large open positions properly.

To control open position risks, it is important that the bank's management and dealers should receive
prompt and regular reports showing the bank's spot and forward positions. These should be monitored
against operating spot and forward limits established by the bank.

In practice information is not updated to the treasury department on a real time basis. Rather, all
transactions processed by the bank are batched and the resulting positions are given to the treasury
department the following day. To manage the risk of having unknown open positions each individual
foreign currency transaction with customers has limits placed on it. For example, if a customer has a
large foreign currency transaction the treasury department must be contacted to be informed of the
transaction so that it can close out the open position immediately. If this did not occur the position
would be open overnight and the bank could sustain large holding losses if the rate changed by the
next day.

(b) Liquidity exposure

This is the risk that a bank may not be able to cover, on a particular day, net cash outflows which arise
from sizeable mismatched exchange positions. Examples whereby the bank may not be able to cover
such cash outflows are tight liquidity resulting from a central bank squeeze, (ie when the government
reduces the amount of money in the economy), temporary market closure, sudden concern over the
bank's credit standing or where selling new deposits and assets in adverse market conditions is
insufficient to meet these outflows. This risk could lead to a forced sale of the banks assets which may
not realise the full value of the assets. Large losses to the bank may not be avoided.

To avoid this risk, significant long and short positions maturing on any one day should be avoided by
management.

(c) Maturity mismatch

This is due to spot and forward transactions which may be matched as to amount but individual
transactions may mature on different dates. Maturity mismatch can therefore occur even though the
bank may only have small open position but significant mismatching of maturity dates.

Maturity mismatch risk should be controlled in a similar way as open position risks. The bank's spot
and forward maturity profile should be reviewed regularly by senior management. The positions should
also be regularly monitored against the limits set by the bank. Maturity mismatch can also lead to
serious liquidity exposures experienced by the bank because the bank will not be able to meet
obligations as they fall due.

(d) Credit risk

This is the risk that the counter party may be unable, or unwilling to complete his part of the transaction.
The potential loss when the bank becomes aware of the counterparty not being able to complete the
transaction is the difference between the contracted value of the transaction and the cost of completing
it with another party. Unlike credit risk in lending, the bank is not subjected to total loss in the value of
transaction. This is because, in the event of default, the bank can undertake another equivalent
transaction, albeit not at such favourable terms, and thus suffer partial loss.

(e) Settlement risk

This is where, on value date, the bank transmits and pays funds to the benefit of the counterparty but
the counterparty is unable to meet its obligations. The bank is therefore at risk of losing all the funds
transmitted. This usually results from the time gap between paying out funds in one centre (eg.
London) and the confirmation of receipt of funds in another centre (eg. New York), a 5-6 hour time zone

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difference. To minimise such risks, limits on the value of unmatured deals with individual customers
should be set and regularly monitored.

Internal control

The various risks explained above, together with high volume (number of deals per day could range
from 50-500) and often complex deals, volatile exchange rates and high cost of money, necessitate a high
level of control over foreign exchange activities. The principal internal control is clear and effective
segregation of duties between:

- initiation of the transaction

- control over the movement of funds
- maintenance of the accounting records including the valuation of open foreign
exchange positions.

Other controls that warrant mention are:

(i) Operational controls

The procedures manual normally sets out precisely the procedures required of the
foreign exchange dealers and the related settlement and accounting departments. It is
essential that:

· dealers are fully aware of the bank's foreign exchange policies

· regular meetings are held between dealers and senior management to review
policies and expected market conditions

· dealers are forbidden to trade on their own account

· dealers' remuneration is set at appropriate levels that are not excessively

based on attaining performance targets ie levels of profitability which may
encourage their taking risky positions; such targets should be set up
cautiously

· dealers remain strictly independent of counterparties

· brokers are approved by the bank

· activities of dealers are subject to the chief dealer's review, who should act in
a management capacity
· dealing outside domestic banking hours restricted to authorised personnel.

(ii) Limits

To reduce risks as explained earlier, limits should be pre-determined by senior

management. Limits should be set for:

· intra-day and overnight positions by currency

· total outstanding forward transactions

· maturity mismatch

· value of total exposure for settlement by individual counterparty

· value of deals maturing on any one day for each individual counterparty.

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 Excesses over such limits should be ‘captured’ by exception reports which should be
controlled and reviewed by senior management and authorised by them.

(iii) Recording

In order that the bank's accounting records are accurately recorded, the system of
processing an internal control should ensure that:

· a dealing slip is prepared for every foreign exchange transaction with all
necessary details correctly included

· the position sheets are promptly and accurately updated for every
transaction undertaken

· all transactions are promptly and accurately recorded

· the position sheets are reconciled daily to accounting records

· the accounting system produces regular reports including those on the

bank's positions, maturity ladders, excesses of credit limits for management.

(iv) Confirmations

The prompt despatch of outward confirmations and the prompt and accurate checking
of inward confirmations ensure that deals are recorded as transacted. The key
controls relating to confirmations are:

· all deals for which no inward confirmations have been received should be
reviewed and chased up

· all incoming confirmations should be reviewed and checked independently

of the dealing room, to deal tickets (outgoing confirmations); discrepancies
should be promptly reported, investigated and resolved

· confirmations should be despatched the same day on which the transaction

was done

· confirmations should be sequentially pre-numbered and controlled.

(v) Other controls which necessitate strict segregation of duties are:

· position account maintenance - on an individual currency basis, the

positions should be regularly monitored, controlled and checked against pre-
determined limits

· settlement of transactions - foreign exchange deals are completed by paying

one currency and receiving another on the same business day. Inward and
outward confirmations of settlement should be strictly controlled

· revaluation of positions - regular valuations, prepared independently on a

consistent basis should be carried out

· internal audit - with the foreign exchange, recording settlement and

accounting departments, internal audit inevitably plays a vital role in
ensuring that various roles are carried out in accordance to the procedures
manual. This ensures that the controls are adhered to.

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3.1.8 Summary

Foreign exchange is needed for the settlement of international trade transactions.

Features of the foreign exchange markets:

(a) Most of the dealing is directed through the Interbank Market.

(b) Participants operate from eleven major centres ie London, New York, Frankfurt, Paris, Zurich,
Bahrain, Singapore, Hong Kong, Tokyo, Chicago and Toronto.

(c) It comprises a vast network of buyers and sellers of currencies.

(d) Participants range from major banks to individuals who may only buy small amounts of foreign
currency for their holidays.

(e) A large percentage of transactions on the foreign exchange market are speculative.

Foreign exchange profits may be made through:

(i) ‘spread of rates’

(ii) speculative dealing
(iii) holding a position in the currency
(iv) arbitrage

Foreign exchange risks experienced by banks are due to:

(i) open positions

(ii) liquidity exposures
(iii) maturity mismatch
(iv) credit risk
(v) settlement risk

These risks have to be monitored in order that losses are not suffered. Limits are established and a high
degree of internal control, essentially effective segregation of duties, maintained to ensure risks are
minimised.

TEST YOURSELF QUESTIONS

1 The act of purchasing foreign currency or travellers cheques involves the conversion or
exchange of one currency for another. Does the receipt by a bank of £ 50,000 in cash for the
credit of a customers sterling current account involve conversion?

2 Can a counterparty be an individual?

3 A spot or forward transaction normally involves simultaneous (same day) receipt and payment
of currencies, therefore there is no risk involved because the exchange rate is fixed in advance.
Is this correct? Explain with reasons.

4 The only way in which banks make exchange profits is by selling foreign currencies at a higher
rate of exchange than the rate at which they bought it. Is this correct? Explain.

5 Why do banks enter into forward exchange transactions?

6 A customer enquired ‘what is dollar/dinar at today’, the bank clerk replied '.297 - .299'. If the
customer wishes to buy dollars which rate would apply?

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7 Every exchange transaction alters the overall currency or exchange position of a bank. But all
foreign currency transactions may not necessarily affect the overall position. Explain.

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4.1 TREASURY OPERATIONS

The following section will describe the routine data processes that a treasury department must carry out
in order to meet the bank’s objectives. Specifically, how situations described earlier that are created by
customer activity flow through the treasury department and how they are controlled.

Refer to Diagram on Treasury Operations

4.1.1 Dealing Activity

When a customer decides to sell dollars to a branch over a certain limit the treasury foreign exchange
desk is called. Some customers who deal in large amounts of F/X such as corporations call the desk
directly.

When a customer calls the desk a dealer completes the transaction for the customer as follows:
a) The dealer checks that deal amount is within his limits and quotes a rate that currently the market is
willing the purchase the dollars at plus a small commission.(spread)
b) He then checks counterparty limits (to ensure they are within authorised limits) and sell the dollars.
At this point the settlement date and correspondent banks brokers are also agreed between the
dealers.
c) The dealer fills out his deal ticket as the deal was agreed with the counterparty
d) A confirmation comes to the dealer either from Reuters (a secure information gathering system) or
by fax if it is with a broker not on the Reuters system.
e) The deal ticket is then agreed to the confirmation to ensure that both parties agree to the terms of
the deal.
f) Both the deal tickets and confirmations are numerically sequenced as a completeness control over
recorded deals.
g) The dealer then updates his own foreign currency position and passes a copy of the deal ticket to
the back office.

4.1.2 Back office

The back office is segregated from the dealing function and is an integral control over treasury
operations. They manage the cash flow of the bank by producing all the reports regarding the bank’s
positions as follows:

a) Once the back office gets the deal ticket it also obtains its own confirmation either from a printer
running in parallel with the dealing room or from Reuters itself. It is crucial that the confirmation
function is segregated from the dealing function.
b) The back office agrees the deal tickets to the confirmation and ensures it is within limits and with a
suitable counterparty.
c) The deal is then coded for input to the bank’s records by assigning the appropriate bank accounts
the deal will be settled from with correspondent banks. If a broker is used with accounts in common
with the bank a draft is issued to settle the deal.

4.1.3 Input processing

The processing department consists mainly of input clerks who will input the details of the deal tickets
into the computer as well as other tasks as follows:
a) Enters the approved deal ticket into the computer (ie. the date the transaction will be paid and from
what accounts)
b) Various reports will be generated such as daily deal listing, credit limits exceeded report.
c) The deals are then printed as they have been input into the computer and returned to back office
for further checking.
d) Accounting records of the bank are now updated as soon as deals are input
e) A settlements listing featuring amounts, currencies, dates and account numbers is sent to
settlements department to ensure all amounts are paid as agreed on original deal tickets.

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4.1.4 Settlements and Nostro/Vostro accounts

Once the settlements listing is obtained the settlements department actually moves the funds around
the bank. Banks have current accounts with each other in order to settle transactions. These are called
Nostro/Vostro accounts. Nostro is our account with you and Vostro is your account with us. If a bank
has to pay money to another bank it is placed in a Nostro account with them. If a bank is owed money
they collect it from its vostro account. A facility known as “SWIFT”(Society for Worldwide Interbank
Telecommunication) then simultaneously collects the funds from the Nostro account and deposits them
in the Vostro account on the value date.
a) They ensure that funds are deposited to accounts by the value dates so that SWIFT can collect the
funds.
b) If Nostro accounts go overdrawn because funds are not there according to value dates high
penalty interest is charged. Nostro accounts don’t earn interest for excess funds either.
c) Since interest is not earned on Nostro accounts it is up to Settlements department not to deposit
funds too quickly or opportunities to generate interest are lost.

4.1.5 Reconciliations department

Once the deal has been settled the reconciliations department reconciles all of the Nostro accounts daily
to ensure all deals that were intended to settle have been completed. That is, all funds have been
withdrawn by SWIFT from the Nostro accounts.
a) Reconciliations department looks at each Nostro and ensures that SWIFT has taken the specified
amount of funds from the accounts. If there are discrepancies they are investigated.
b) This is a key control to ensure that all deals have been completed as were originally agreed to.
c) If there are old outstanding items in these accounts an enquiry is raised and sent to the
counterparty to investigate the reason for the discrepancy.
d) Statements are sent by the correspondent banks detailing all the activity in the accounts to help
facilitate the reconciliations process.

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5.1 CLEARING DEPARTMENT-DOMESTIC BRANCH PAYMENTS

Refer to Diagram on Cheque Clearing

5.1.1 Cheques drawn on a domestic bank

If a customer deposits a cheque into his account the bank has to “clear” it. That is, the cheque must be
paid by the financial institution it is drawn on. In this case the process of clearing a cheque drawn on a
domestic bank will be detailed.

a) A customer deposits a cheque for USD$500 into his USD savings account. The bank then starts
paying him interest on the money but has not yet received the $500 from the bank it is drawn on.
b) At the end of the day the teller balances all cheques that were processed that day and sends them
to the clearing department of the bank.
c) The clearing department then separates all the cheques from that branch into domestic banks and
foreign banks. For each domestic bank all cheques drawn on that bank are bundled together and
that total amount of money is owed by that bank. The bundle is then taken that night to a Central
Clearing agent where all the other domestic banks have sent their cheques drawn on all other
banks.
d) The Central clearing agent then balances the two positions to reconcile which bank owes the other
more money. That is, if bank A honoured more cheques of Bank B’s then a draft is sent along with
Bank A’s cheques drawn on Bank B or vice versa.
e) Now the clearing department has inward clearing negotiated at another bank the previous day.
Therefore, all customers accounts are updated to reflect the cheque clearing their account. If there
are no funds for withdrawal the cheque “bounces back” to the bank who negotiated it. The bank
who honoured the cheque then has to try to obtain the funds back from its customer.

5.1.2 Holding funds

When a cheque that bounces is returned to a bank unpaid this places funds at risk because there is no
guarantee that the funds will be recoverable from the depositor. The bank can avoid this situation all
together by placing a hold on the cheque when it is deposited. That is, the cheque is deposited but
funds aren’t advanced on it until the danger of it being returned unpaid has lapsed. This is usually 3
days for cheques drawn on domestic banks.

5.1.3 Items sent on collection

The other alternative is for the bank to send the cheque out on collection. The bank sends the cheque
in the outward clearing again with instructions to the bank it is drawn on to hold on to it for a period of
time (usually 30 days). In this time period the bank tries to withdraw the funds from the account each
day for the next 30 days in hopes of recovering the funds. If, after 30 days the cheque can’t be paid the
cheque is sent back again and the bank must take a loss on the negotiation of the cheque or try more
vigorously to recover the funds from the depositor.

5.1.4 International payments

When a customer presents a cheque drawn on an international bank it cannot clear in the same manner
as a cheque drawn on a domestic bank. This is because the central clearing agent cannot deal with the
foreign bank to obtain the funds to pay the domestic bank.

5.1.5 International collections

When a customer presents such a cheque the teller cannot give deposit value to it or cash it. It can take
a substantial amount of time for the cheque to be paid and if it is in the customer’s account earning
interest during this time the bank cannot invest the proceeds from the cheque in the money markets.
Banks are unwilling to pay interest on funds that they cannot reinvest. Therefore, the customer obtains

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an assurance from the teller that once the funds are paid by the bank the funds will be deposited in their
account.

5.1.6 Correspondent accounts and banks

When the foreign bank receives the cheque on collection it, in effect, receives instructions from the
domestic bank to act as follows:

a) Withdraw funds from the foreign customer’s account.

b) Use those funds to purchase a draft drawn on a bank in the same country as the domestic bank
who sent the item on collection.
c) The foreign bank then interacts with its settlements department to move funds from the customer’s
account and place them in the foreign banks Nostro account with a bank in that particular country.
d) The draft is then sent back to the domestic bank who then deposit the draft drawn on a domestic
bank now and sends it through the domestic bank clearing because it is now merely a cheque
drawn on a bank in the same country.
e) The domestic bank the cheque is drawn on pays it by releasing the money from its Nostro account
where the foreign bank placed it.

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6.1 LENDING AND CARD SERVICES

At the end of this session you should be able:

• to describe how lending and card routine transactions are processed by the various departments

• to identify the various types of bank lending

• to understand the basic principles governing lending

• to recognise the various forms of security or lack thereof in the Middle East environment

• to identify the key internal control procedures within the lending framework.

Refer to Diagrams on Branch Lending and Card Services

The processes involved for card transactions processing and consumer lending are very similar and will
be described together as follows:

6.1.1 Advances repayments

a) A customer makes an instalment or pays his credit card balance at a branch.

b) The loan or card account is updated for the transaction on either the card subsystem or the loans
subsystem.

6.1.2 Treasury department

a) The acceptance or advancing of funds whether in foreign currency or domestic currency requires
action by the treasury department
b) If FC is transacted the treasury department must either buy or sell the FC as described earlier in the
foreign exchange section. The deal is then settled by the settlements department exactly as any
other F/X transaction.
c) The treasury department is also given a money market position. That is, they either have a surplus
of funds to invest or a shortfall of funds and need to borrow. Therefore, as described in the
diagram the money is borrowed in the money market to fund a loan or invested in the money market
in the case of cash surpluses.
d) The borrowing or placement is then settled by settlements department exactly as described
previously.

6.1.3 Credit card transactions

There are a few unique features to card services. These unique transactions are between the card
service provider and the card issuing bank.
a) When a customer spends money in a foreign location the merchant is reimbursed by the card
service provider, for example, Mastercard or Visa.
b) When Mastercard or VISA interact with the customer’s bank, the card account is updated in
domestic currency at the same rate the card company reimbursed the merchant at.
c) The bank’s treasury then must carry out two transactions.
d) Purchase foreign currency to reimburse Visa or Mastercard and finance the purchase of Foreign
currency by borrowing in the market. Therefore, treasury has acted on a money market position
and a foreign currency position just as in the loans example.
e) Settlements department then settles the deals with the correspondent bank of the Credit card
company.

Bank lending, by way of loans overdrafts and advances, usually represents the largest single class of
asset held by most banks and its major source of income. Due to this and also due to their nature ie.

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credit extended to corporate and personal customers, lending often carries the greatest risk to the bank,
to which much emphasis and importance is placed by us as auditors.

Loans and advances may be categorised in various ways:

1 Retail or wholesale - these terms are vaguely used to distinguish between local, often branch
based lending as opposed to the larger corporate interbank and institutional lending which is
usually head office based.

2 Personal or corporate.

3 Short term, medium term or long term.

6.1.4 Types of Lending Facility

A) Overdrafts

This is an agreed line of credit or borrowing facility (in writing) that a customer may use by drawing on a
specified current account. Originally overdrafts were regarded as temporary facilities but in the Middle
East it is far from unusual for a customer to maintain a ‘permanent’ overdraft albeit the balance
fluctuating from day to day.

Such overdrafts are nicknamed ‘evergreen’ being often the source of financing business on an on-going
basis. In recent years in some countries pressure has been exerted by the Central Banks to make the
commercial banks persuade their customers to take a term loan in place of an on-going permanent
overdraft. Legally overdrafts are repayable on demand but in practice banks rarely call in any overdrafts
where the customer keeps within agreed limits. It is also common to see accounts in excess of limits and
although accounts are reviewed from time to time, both as to facility and limit, ‘temporary’ excesses
often receive ‘temporary’ approval. Interest on overdrafts is calculated on the outstanding daily
balance at a predetermined rate.

B) Term Loans

These are made for a fixed period of time and can be repayable either in instalment or in full at the
maturity date. A short term loan is generally regarded as being a loan which is repayable within one
year from when it is granted. A medium term loan is generally regarded as being repayable after at least
one year but before the expiry of five years. A long term loan is generally regarded as one that is not
finally repayable until at least five years after it was granted. The interest rate is normally predetermined
for short term loans and is likely to be of a floating nature for medium to long term loans.

C) Syndicated Loans

A syndicated loan is one that is provided jointly by a number of banks or financial institutions who
would be individually either unwilling or unable to provide in view of the size and nature of the amount.
These banks or financial institutions are usually brought together by one or possibly more managing
banks which have organised and negotiated the whole package. The managing (or sometime it's called
lead) bank handles the negotiations with the borrower, perhaps the documentation, collects the funds
from participants and then disburses the full amount to the borrower. Subsequently the managing bank
is responsible for collecting all sums due from the borrower (both principal and interest) and for passing
their share of these sums to the participants. Apart from the managing bank, the syndicate participants
do not have any direct dealing with the borrower as all their information needs and any required action
(eg. default) is dealt with solely by the managing bank.

D) Personal (or Consumer) Loans

In addition to overdrafts banks provide a varied range of personal lending. These include:

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 1 Fixed rate loans are generally provided to finance the purchase of cars or consumer
durables. Often up to 3 year periods the documentation is simple and provides for
usually equal monthly repayments of both principal and interest. Interest is usually
fixed.

2 Mortgage loans are becoming more usual and are for longer periods usually over 5
years. Loans are specifically granted for the purchase of property and are repayable
in instalment (monthly, quarterly or half yearly). Interest is seldom of a fixed nature
but likely to be floating.

3 Credit cards are becoming more and more common and regarded as a strong marketing
tool. Please note there is a difference between a ‘charge’ card (eg. American Express,
Diners Club) and a ‘credit’ card (eg. Visa, Mastercard). Only the latter permits any
form of extension of credit and the former requires immediate settlement on issue of
the statement. Obviously in the case of the charge card there is an interest free credit
period between when the card is used and the issue of the statement. Credit cards
usually earn interest on the unpaid monthly balance at fixed monthly rates of interest
and also the bank earns commission of varying amounts based on gross sale value of
the transaction from the retailer or service company.

E) Sovereign Loans

Banks in the Middle East lend substantial sums to foreign governments, public sector organisations and
large corporations in overseas countries. These loans are usually large in amount and of a medium or
long term period. Often there is little or no security and reliance is placed on the credit worthiness of the
country and also sometimes the guarantee of the borrowing government is provided. See also c),
Syndicated Loans, which may also be part of the bank's overall sovereign risk.

F) Other

1 Bills discounted: This is a form of facility granted to a customer based on a bill of

exchange drawn on a third party and lodged with the bank as collateral. The bank
grants immediate credit to its customer for the face value of the bill until maturity at
which time it collects the face value. Often Central Bank offers a re-discount facility to
banks whereby they can sell the bill at face value less discount and charges. It is
important that as the bank relies on the bill as security, that it is satisfied as to the
credit worthiness of the third party and that there is an underlying substance to the
transaction.

2 Documentary credit: This is discussed fully in section 7.

6.1.5 Factors Governing Lending Decisions

Having now seen the various types of lending let us look briefly at the basic principles and factors
governing lending.

Firstly there is the principle of stewardship ie. the bank is using money deposited with it by members of
the public, companies and other banks and not its own and therefore this places on management a high
moral duty to exercise care and integrity. Secondly banks must make a reasonable return on their
lending. The basis here is that the higher the risk then the higher the expected rate of return. It is
however the ability to strike an acceptable or reasonable balance between these two conflicting
principles which makes banking such a fine art and is the essence of good banking.

Factors taken into account by bankers when taking lending decisions include:

a) the quality of the borrower (includes value and quality of security being offered)
b) the purpose or nature of loan

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c) the amount of loan
d) the period of loan
e) the repayment schedule proposed
f) the banks own policy limits (eg. currency of loan, country, nature of industry).

Essentially a bank will look initially at the purpose of a loan, relating this to the amount requested, and
of extreme importance, their clients demonstrated ability to repay. Under ideal conditions the loan will
be self-financing ie. that sufficient cash flow is going to be generated from the employment of the loan
proceeds to repay the loan.

6.1.6 Loan Security

A bank may lend with or without security. If the latter it is referred to as 'clean' ie. "clean" loan or
"clean" overdraft. However when a bank takes security it does not usually expect to obtain repayment
of the loan by realising that security. The security is there to reduce the risk that a loan will not be
repaid if the borrower defaults. Therefore if the risk involved is to be totally eliminated then the security
needs to be sufficient at its realisable value to repay the bank in full. It can be seen then that security
evaluation against outstanding loans is an on-going and continuing process. There are two aspects to
be considered - (a) Has the market value been maintained or has it fallen? eg. value of land or shares,
and (b) Has the outstanding loan amount been reduced within the terms of the loan agreement. Thus a
comparison of the loan outstanding amount should be regularly made against the current value of
security held.
In the Middle East a very common feature of bank lending is that it is often unsecured, or the only form
of security given is a personal guarantee, and facilities are granted on a 'name lending' basis. It is
important to realise that under these circumstances, the credit worthiness of the guarantor has to be
assessed, and the general climate of the country in which the bank is situated becomes a major factor in
the evaluation.

6.1.7 Internal Control

As mentioned earlier bank lending ie. loans and advances, usually represents the largest class of asset
as the balance sheet. It is also a bank's greatest source of exposure to loss, and this necessitates a high
degree of internal control, essentially in the following areas:

(a) Authorisation and terms of credit facilities

(b) Identification and treatment of potentially doubtful credit risks.

The controls usually implemented by banks in respect of the above are summarised below:

(a) Authorisation and terms of credit facilities

· Formal risk policy

· Independent credit/risk review department
· Setting of country/currency risk limits
· Credit review of each applicant eg. obtaining latest financial statements
· Approval of extension/excess of facility by board of directors/loan committee
· Separate credit file maintained for each customer
· Regular review of customer credit status
· Application forms/agreements signed by the customer
· Standard documentation

(b) Identification and treatment of potentially doubtful credit risks

· Regular and independent review of individual risks and credit files

· Day by day monitoring to ensure that the customer carries out his payment
obligations as per agreement terms
· Security regularly reviewed to assess it adequacy

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 · All write offs require formal authorisation and approval
· Formal policy for determining adequacy of specific and general provisions for
doubtful accounts and interest in suspense
· Regular review of problem accounts by board of directors/loan committee.

Policies and procedures operated by banks to implement the above controls should be fully explained in
internally produced Credit Policy and Accounting and Operations Manuals. These should be adhered
to at all times, and any non-compliance identified during the course of our audit brought to the bank's
attention, usually by way of inclusion in the management letter.

6.1.8 Summary

a) Lending usually represents the largest single class of asset of a bank, the most common
lending types being:

(i) overdraft
(ii) term loans
(iii) syndicated loans
(iv) personal loans
(v) sovereign loans
(vi) discounted bills
(vii) documentary credits

b) Strict internal control procedures must be maintained to enable:

(i) proper approval/authorisation of credit facilities

(ii) monitoring of performance
(iii) identification of doubtful credit risks.

TEST YOURSELF QUESTIONS

1 What is the difference between a loan and an overdraft?

2 Is a loan granted on the basis of a personal guarantee, secured or unsecured?

3 What is the single most important criterion on which a bank extends a loan to a customer?

4 Define the periods for short, medium and long term loans.

5 What is the main feature of a syndicated loan?

6 What do you understand in a sovereign risk?

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7.1 TRADE FINANCE

After studying this section, you should be able to:

• Understand why international trade finance is required.

• Identify the major types of trade finance.

7.1.1 Introduction

In international trade, where parties to a contract may operate from geographically distant areas, it is
necessary that each should be satisfied as to the ability of each to satisfy the other of their ability to
trade and pay for the goods received. Trade finance plays a very important role in ensuring that
international trade can occur by facilitating the payments for international trade. The most common
forms of trade finance includes documentary letters of credit, guarantees and performance bonds. Bills
of exchange (trade bills), forfeit and export finance insurance are used in international trade.

7.1.2 Documentary letters of credit

Where international trade occurs and each counterparty is to be satisfied as to the creditworthiness of
the other, documentary letters of credit are used. The buyer must be satisfied that the seller has the
capacity to produce, ship and deliver on time, and the seller must be satisfied that the buyer can and will
pay on time. However, the seller may have little idea of the creditworthiness of the buyer.

The commercial risks associated with international trade tend to be greater than domestic trade due to
the time lag between ordering and receipt of goods and payment for these goods by the purchaser
whose credit rating may be almost unknown to the seller. Both parties are at risk until the contract has
been fulfilled and completed.

A documentary letter of credit is a written undertaking by a bank (ie the two banks know each other)
given to a seller on the instructions of the purchaser to pay a specified amount within a stated period
against presentation of certain trade documents. Effectively the creditworthiness of the purchaser is
replaced by that of the bank. The trade documents to be presented by the seller to his bank include
invoices, bills of lading or other shipping advices, and insurance policy.

The risk to the issuing bank is the credit risk as that arising from a loan. The supplier's bank may
'confirm' the letter of credit which means that the confirming bank will pay the supplier on production of
the trade documents, irrespective of receiving the funds from the issuing bank. The confirming bank
thus has a credit risk in respect of the issuing bank. Fees will be charged for these services provided,
the level being dependent upon the assessment of the risks to which they expose themselves.
Diagrammatically:

7.1.3 Procedure

a) The buyer and seller conclude a sales contract providing for payment by way of a
Documentary Letter of Credit.

b) The buyer then approaches his own bank, "the Issuing Bank", and requests the bank to issue
a Documentary Letter of Credit in favour of the seller.

c) Assuming the Issuing Bank is satisfied with the credit standing of the buyer, it will issue the
Documentary Letter of Credit and request a bank in the seller's country to advise or confirm the credit.
However, if the Issuing Bank is dissatisfied, the buyer will have to provide guarantees in the form of
assets (money deposits and similar collateral) before the Issuing Bank is willing to issue the Letter of
Credit. If this is not possible, the deal could be rejected.

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d) The advising/confirming Bank then advises the seller that the Documentary Letter of Credit
has been issued.

e) Once the seller has received a copy of the Letter of Credit and is satisfied that he can meet its
terms and conditions he is in a position to dispatch the goods to the buyer.

f) Having dispatched the goods and accumulated the required documents, the seller then sends
the documents stipulated in the Letter of Credit to the advising/confirming Bank.

g) The advising/confirming Bank then checks the documents against the Letter of Credit.
Assuming the documents meet with the requirements of the Letter of Credit, the seller will receive
payment in accordance with the terms stated in the Letter of Credit.

h) Finally the Issuing Bank releases the documents and where these documents represent title to
the goods, the buyer on presentation of these documents to the carrier gains possession of the relevant
goods.

7.1.4 Letter of Guarantee

A guarantee is a promise by the guarantor to be liable for the debt of another person, the principal
debtor, should the principal debtor fail to perform an obligation, provided that the guarantor is notified
of that fact by the creditor. The guarantee is usually given after the bank has been suitably furnished
with collateral (eg. customer deposits, title deeds to property).

In international trade, the provision by a bank of a guarantee can enable the customer, who is perhaps
new to a country, and may be unknown to local banks and suppliers, but already has an established
credit rating in another country, to enjoy normal trading relationships. Income sources for the guarantor
bank are:

a) Commission over the period of guarantee.

b) In some cases, an interest-free or ‘cheap’ deposit as security from the customer.

The risk for the guarantor varies in accordance to the nature and value of the security required. In the
event of default the bank will exercise its right to recover losses by selling the collateral. If the collateral
proceeds are sufficient to cover the losses, the balance is returned to the customer; if not then the loss
suffered by the bank is the difference between the amount the bank paid out in the event of default and
the collateral proceeds.

7.1.5 Bills of exchange (Trade bills)

It is defined as an unconditional order in writing, addressed by one person to another, signed by the
person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or
determinable future time, a sum of money to, or to the order of, a specified person or bearer.

There are three types of bills normally encountered in banking in the Middle East:

1 Trade bills
2 Treasury bills
3 Bank bills

Trade bills are explained below. For treasury bills, see investments section of this study module.
Briefly, bank bills are bills of exchange that have been endorsed or accepted by a bank. The
endorsement by the bank basically ensures that the receiver is assured of payment because the
endorsing bank will honour the bill. Therefore it is significant that the quality of the endorsement
depends on the quality of the bank endorsing it.

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There are three parties to a trade bill

a) the drawer being the party that draws (produces) the bill. In the case of a trade bill, the drawer
will normally be the party who has provided goods or services;

b) the drawee being the party on whom the bill is drawn and who is required to make payment as
instructed by the bill;

c) the payee is the party to whom the amount shown on the bill is to be paid.

One of the main advantages of a bill of exchange is that it is usually a negotiable instrument and the
person holding it can sell it to another party for an immediate cash consideration. The proceeds
received from the purchaser is generally less than the face value of the bill because of the outstanding
period to maturity for which the purchaser must hold the bill. The amount of ‘discount’ depends mainly
on prevailing interest rates and the ‘quality’ of the bill. (Quality is dependent mainly on the financial
standing of the drawer and drawee).

7.1.6 Performance bonds

A performance bond is a form of guarantee issued normally in connection with a long-term contract
whereby the guarantor is liable for a fixed sum, due if the customer fails to complete a contract. The
performance bond has recently become an important feature in the international construction industry.

7.1.7 Summary

Trade finance helps ensure that international trade can occur by facilitating the payments for
international trade.

Common forms of trade finance:

a) Documentary letters of credit

b) Letters of guarantee

c) Bills of exchange (3 types)

(i) Trade bills

(ii) Treasury bills
(iii) Bank bills

d) Performance bonds

Banks earn commission/fees for providing these services, usually a small percentage of the actual value
involved.

TEST YOURSELF QUESTIONS

1 What is the main advantage to a buyer of using a documentary credit?

2 What is the role of an advising bank in the settlement procedure?

3 Would a credit application be required to be completed in all cases of documentary credits?

- 29 -
8.1 INVESTMENTS

This section provides a general description of the types of investments a bank may hold and discusses
the reasons why banks have investments at all.

After studying it you should be able to:

· Identify the various types of investments held by banks together with their purpose.

· Identify and understand the difference between trading investments and those held for the
long term.

8.1.1 Introduction

Securities (investments) usually represent a material, but relatively small part of the total assets of a
bank. It is not usual for banks to deal actively in securities or to be long term holders of fixed interest
stocks or other bonds. The underlying reasons why are simply because banks may find it difficult to
switch from fixed term assets such as loans to liquid assets in order to meet any unexpected demand
from its depositors. Consequently, banks hold such securities as ‘reserves’ and these not only
generate income, and possibly capital appreciation, but are also readily convertible into cash.

Banks also hold long term government stocks (which may be related to part of their free capital
resources) to provide a fixed and secure source of income. Also in this regard may be held bonds,
Eurobonds and other fixed date securities particularly where banks are involved in the secondary
markets. Banks may also if actively dealing in stocks and shares seek to take advantage of any short-
term profits offered by new issues or movements in the gilt or equity markets.

8.1.2 Types of Investment

Banks may hold security both for dealing and for longer term investment. Their characteristics are as
follows:

1 Dealing - Transactions are made frequently with the sole purpose of taking advantage of short-
term changes in market prices and yields.

2 Investment - These are held for the longer term, usually to maturity. The bank's aim is to obtain
regular interest (or dividend yield) and possibly, in the long term, capital appreciation.

It is important to realise that an exact distinction between dealing and investment securities may vary
from bank to bank but once so categorised it is vital that no transfers are made from each type to the
other. This is because the accounting treatment particularly as regards market valuation and
recognition of gains or losses is usually quite different. Consistency is of vital importance from one
accounting period to another.

Specific types of securities

Securities held by banks (whether for investment or dealing purposes) are usually described in their
financial statements as investments and include the following:

· securities issued, or guaranteed by governments, which, in the case of British Government

securities, are often described as gilt-edged and are usually dated;

· liabilities of corporate bodies, which may take the form of shares, debentures, loans stocks or
bonds.

(a) Gilt-edged securities

- 30 -
Gilt-edged securities, which are either issued or guaranteed by the UK government, are usually listed
and are considered absolutely safe in terms of interest payments and repayment at maturity. They
present the investor with less risk but a potentially lower return than an investment in equities. The
market value of gilt-edged securities is influenced by, among other factors, actual and prospective
interest rates and their value will not, therefore be necessarily more stable than other securities.
However, provided that they are dated, the total yield to maturity is guaranteed at the time of purchase.

(b) Treasury bills

These are issued weekly to fund the government's short-term borrowing requirements and to control the
money supply by absorption of surplus funds from the money market.

Treasury bills do not carry any interest and therefore, when potential buyers tender for such bills, the
tender price will be set at such a level that the difference between the offer price and the face value,
known as the discount, will represent a reasonable rate of return in exchange to prevailing market
conditions.

The risks involved in holding such bills are low. On maturity of the bills, the Treasury will repay the
bearer the face value of Treasury bill(s) it holds. Likelihood of default or non-settlement is nil because
unless the government was bankrupt, these bills will be honoured on maturity.

The discount on the bills is amortised over the period to maturity and is realised as income accordingly.

(c) Equities

Equities (or ordinary shares) that are listed on a recognised stock exchange are generally more
marketable than those that are unlisted. Although equities involve a higher degree of risk and may, in a
thin market, be difficult to realise, they offer the opportunity to participate in a company's growth in
both capital and income terms. Banks may therefore choose to hold some equities in order to provide a
means to maintaining the value of their capital base.

(d) Preference shares

Preference shares entitle holders to dividends, usually at a fixed annual rate, which are paid in priority to
dividends on ordinary shares. These dividends are often cumulative (that is to say, if a preference
dividend is passed because of an insufficiency of profits, it must be made good before any dividend can
be paid on the ordinary shares in later years). Preference shareholders normally do not have voting
rights; in the event of a liquidation, they rank before ordinary shareholders.

(e) Bonds

A Bond is a document under seal requiring the payment of principal and interest on due dates. Bearer
bonds, so called because they are payable to bearer, rather than registered in the name of a holder, are
negotiable instruments to which title can be passed on transfer for value, in good faith and without
notice of any defect.

(f) Eurobonds

A eurobond is an instrument that evidences a long-term loan, often denominated in US dollars but
which may also be in other currencies including sterling, issued by a large concern of international
standing. It may carry a fixed or variable rate of interest. There is a secondary market for dealing in
eurobonds and prices vary with the quality of the borrower and the prevailing rate of interest on
eurocurrency deposits. The market in eurobonds goes back many years, but developed significantly
after the Second World War when large amounts of US aid were given to European countries during the
reconstruction period. In recent years the market has become very large indeed because of the calls
made on banks to recycle petrodollars, the absence of regulation in the market and the levels of interest
rates prevailing internationally.

- 31 -
Finally banks may hold investments in unquoted companies. These usually represent long term
holdings in subsidiaries or associated companies and often are in similar industries including other
banks eg. consumer credit companies, investment or other financial institutions. These investments are
made usually to promote growth particularly into other geographical areas and to widen the bank's
customer base.

8.1.3 Generally Accepted Valuation Policies

Investment Accepted policies

a) Dealing/Trading The lower of cost and market value.

This valuation must be done on a line by
line basis.

This method of valuation is used to recognise the intention to hold the investments
for short term capital gain and the bank's accounts should recognise this.

b) Hold to redemption Historic cost but market value stated in

the accounts.

Provided the ‘hold’ policy is adhered to, at redemption the proceeds will be the
nominal value of the investment eg. the redemption value and the nominal value of
£10,000 Treasury Bill 7-1/8% on maturity, will be £10,000.

c) Hold for long term benefit Historic cost but provisions must be
made for permanent diminution.
Directors or market value may be stated.

Market forces acting on or profits/losses of the investee operation from year to year
may give a misleading picture as to the value of an investment held for long term
benefit. However, permanent diminution ie. continuing losses over a period of years,
deficits on reserves or loss of material part of business will necessitate provisions to
recognise a depreciation in value below cost where it is unlikely to be recouped in the
foreseeable future.

8.1.4 Summary

a) Investments are important constituents of a bank's asset portfolio, the most commonly held
investments being:

(i) Gilt-edged securities

(ii) Treasury bills
(iii) Equities
(iv) Preference shares
(v) Bonds
(vi) Eurobonds.

b) Generally accepted valuation policies:

(i) Dealing/trading investments valued at lower of cost and market value on a line by line
basis.

(ii) Investments to be held to redemption valued at historic cost but market value is
stated in the accounts.

(iii) Investments held for long term benefit are valued at historic cost but provisions must be
made for permanent diminution of value.

- 32 -
TEST YOURSELF QUESTIONS

1 What is the difference between a dealing (or trading) security and an investment security?

2 Why do banks have investments?

3 Is a bond always an investment security?

4 Is an investment in a 100% owned subsidiary a liquid asset in the balance sheet?

- 33 -
 deal negotiated to
Bank reimburses credit card
pay FC to bank of Foreign bank
Treasury company for settling with merchants
card company
Card Member Department in foreign currency

FC Purchased Bank purchases foreign currency

F/X from another counterparty
Counterparty (other banks, customers, institutions)
Advance/ Net asset and Instructions sent
Payment FC position to complete deals as
agreed
Settlements department ensures
Settlements
that Counterparty and Foreign
Department
Bank are paid as agreed
Card
Account Subsystem
Bank updated
Branch

Customer transactions in FC
updated

Merchant's
Settlement made to bank
International merchant in Foreign currency
Card
CARD SERVICES System
DATA FLOW DIAGRAM
Purchase
Merchant
Purchase details in
POS Terminal
foreign currency

Card Member
 CENTRAL POOL OF FUNDS

Central Other banks

Libor
Bank Libor
+/-
Treasury
Department

Libor Libor

Libor Profit is change

Profit is spread Profit is spread in F/X rate vs
Branches of A-B of Z F/X Dealers home currency

Card Services

A= Libor +X B= Libor - Y
Libor + change in F/X rate
at time of selling FC
Libor + Z

F/X
Loans Deposits Advances dealers
hold

Pays Interest Receives Interest Pays Interest Deposits Foreign currency

 Bank reimburses foreign bank
deal negotiated to for advancing funds through ATM
Treasury Foreign bank
pay FC to foreign bank in Foriegn currency
Department
Customer
FC Purchased
Bank purchases foreign currency
F/X
from counterparties
Net asset and Counterparties
(other banks, customers, and institutions)
FC position
Deposit/ Instructions sent
Withdraw to complete deals as
Transfer agreed
Subsystem
Settlements department ensures
Account Settlements
that counterparty and Foreign
updated Department
Bank are paid as agreed
Bank
Branch
Customer transactions in FC
updated in home currency Settlement made to foreign
bank in Foreign currency

ATM
transaction Foreign Bank
Withdrawal
carrier ATM
system Customer
OPERATIONS in FOREIGN
CURRENCY DIAGRAM
 TREASURY OPERATIONS
DATA FLOW
Client Deal Confirmed

Deal Confirmed

Deal
Ticket Settlements Reconciliations
Dealers Back Office Settlements
Listing Department

Copy
Deposit of money
Approved at Value Date Balance
Deal Ticket
reconciled

Computer input
deal details

Input Nostro
Process Accounts Balance
(2 levels) reconciled

Funds on
Accounting Records Value date
updated transferred out

Vostro of
Accounting funds on value date
SWIFT Client's
Department transferred in
Bank
 Cheques drawn on
Central Bank B
Clearing Cheques drawn on Bank B
Customer Agent other banks

Customer accounts are

Cheques accepted updated for cheques
Deposits Cheques drawn at other banks drawn negotiated at other banks
cheque on other banks on bank A

Clearing
Bank Accounts
Department
Branch updated
Bank A

Foreign Bank trades cheque drawn on

Cheque sent on collection customer account with a draft drawn
on a bank specified by Bank A
Cheque drawn on foreign
bank that Bank A does
not correspond with
Central
Foreign
Clearing
Bank
Agent
CHEQUE CLEARING
DATA FLOW DIAGRAM Bank draft in foriegn currency
drawn on a correspondent bank
 Bank agrees with a foreign bank
to borrow an equal amount of
Treasury For loans granted in Foreign bank foreign currency to match their FC
Department foreign currency
Customer loan to their customer

Loan Instructions sent

Net asset and
advance/ FC position
to complete deals as
repayment agreed
Settlements department ensures
Settlements
that Foreign Bank is
Department
paid as agreed
Loans
Subsystem
Bank Account
Branch updated

Net asset
position

The money will be borrowed

Domestic
based on the assumption that
Treasury Bank
on this banking day no funds
Department Funds borrowed
are available to advance the loan
BRANCH LENDING from another bank
to fund the loan
DATA FLOW DIAGRAM
 ROUTINE TRANSACTIONS
DATA FLOW DIAGRAM

Reconciliations
Branch Department
Transactions
Operations

Transactions
Operations Financial
Card Services Records
Department Control
Transactions

Credit Settlements
Transactions Department
Transactions

Net Asset/Liability Treasury

Positions Trading

Central
Net A/L Strategic Planning
Treasury ALCO
Position and Limit Setting
 APPENDIX A

GLOSSARY OF BANKING TERMS

ACCEPTANCE

The bankers’ acceptance is a financing involvement. Through this facility, banks are able to provide
credit, without requiring the use of their own funds, by creating a negotiable instrument.

A bankers’ acceptance is an order in the form of a draft addressed by one party (the drawer) to a bank
(the drawee) and accepted by that bank to pay a third party (the payee) a certain sum at a fixed future
date.

The bank creating an acceptance becomes liable primarily for the instrument, and all other parties are
liable secondarily for generating payment to the holder, in due course.

ANSWER BACK

The telex users reference (numbers and letters) that comes up on the telex at the discretion of the sender.
It is possible to insert answer back codes.

ARBITRAGE

1 Exchange arbitrage:

The process of taking advantage of the existence of different prices of the same currency at the
same time but in different markets.

2 Interest arbitrage:

The movement of funds out of one currency and into another for the purpose of profiting from
interest rate differentials in those currencies. The process of interest arbitrage regulates the
forward cost of foreign currencies.

BACK-TO-BACK CREDIT

This procedure arises where a customer of the bank acting as an intermediary in a trading transaction is
the beneficiary under a documentary credit opened by the foreign buyer of his goods. On the strength
and security of this credit, the customer’s bank agrees to open a credit for the benefit of the original
supplier of the goods. As the applicant for the second credit, the customer is responsible for reimbursing
the bank for payments made under it, regardless of whether or not he himself is paid under the first credit.
In this way, the customer can avoid disclosing the identity of the original supplier to the ultimate
purchaser.

It is necessary to ensure that the documents called for under the second credit will satisfy the
requirements of the first credit, in order that the seller, as beneficiary under the first credit, may be entitled
to be paid within those limits.
 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

BEARER BONDS

A bond for which the only evidence of ownership is possession.

A bearer bond passes , by its mere delivery, the full benefits conferred by the bond, so long as the
transferee takes it in good faith, for value, and without notice of any defect in the transferor’s title. If it
should appear ultimately that the transferor had stolen the bond, or his title was defective in some other
way, the transferee’s right to retain the bond would not be affected.

BILL OF EXCHANGE

An unconditional order in writing, addressed by one person to another and signed by the person giving
it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable time, a
sum certain in money, to, or to the order of, a specified person, or bearer.

BILLS UNDER LETTER OF CREDIT/BILLS NEGOTIATED UNDER CREDIT/PAYMENT AGAINST

DOCUMENTS (BLC/BNC/PAD)

In respect of sight letters of credit, the issuing bank will make payment to the beneficiary once the
documents stipulated under the documentary credits have been received and the terms and conditions
have been complied with. However, the applicant’s account is not debited until he takes delivery of the
documents, normally on arrival of the goods in port. There is, therefore, a time lag between the point at
which the issuing bank pays the beneficiary, and the point at which it is reimbursed by the applicant. In
this intervening period, the amount receivable from the applicant is said to be an amount receivable in
respect of BLC/BNC/PAD, sometimes called Advanced Against Merchandise (AAM).

BLC/BNC/PAD – PAST DUE

Once the BLC/BNC/PAD becomes due for payment by the applicant, and if such payment is not
forthcoming, some banks will transfer the amount of the BLC/BNC/PAD to a “past due BLC/BNC/PAD
account” (rather than debit the applicant’s account), which normally has a higher rate of interest.

BILL FOR COLLECTION

In this case, the bank acts merely as collecting agent. Acceptance agreement is reached between exporter
and importer on the term of acceptance. The bank will, on receipt of the documents, notify the importer,
who will sign the Bill of Exchange and collect the documents. He should then pay the amount due on the
due date, but should he fail to do so, the bank will advise the exporter but bear no risk.

BILLS DISCOUNTED

A negotiable instrument that is payable at a date later than the date upon which it is bought. The
instrument is bought at a value less than face value, the difference being the bank’s charges for interest
and commission.

BILL OF LADING

A receipt for goods received for carriage to a stated destination, signed by or on behalf of a ship owner,
undertaking to deliver the goods in the same condition as when he received them.

2
 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

BOND

A negotiable instrument evidencing indebtedness. A legal contract sold by an issuer promising to pay
the holder its face value plus amounts of interest at future dates.

CALL MONEY

Money lent by bankers and others at interest on the terms that it is repayable at call or on demand.

CASHER’S SHEET/COUNTER SHEET

A record of individual amounts paid to and by the cashier during the day, showing the opening and
closing balance of cash on hand (similar to a cash-book).

CEDEL

A clearing system for the Eurocurrency market, which clears or handles the physical exchange of
securities. Based in Luxembourg, the company is owned by several banks and operates through a
network of agents.

CENTRAL BANK

The bank in any country that is authorised by the government of that country to control the amount of
credit, supervise the operations of commercial banks, carry out the commercial business of the
government (and maintain its accounts), control note issue and the country’s reserves, and preserve the
value of the country’s currency on foreign exchanges.

CERTIFICATE OF DEPOSIT

Evidence of a deposit with a bank repayable upon a fixed date. It is a fully-negotiable bearer document
transferable by delivery. The CD normally carries an interest rate marginally lower than a market rate for
time deposits, reflecting its marketability.

CLEARING BANK

A bank that offers a full range of customer services – i.e., current, savings, and deposit accounts ; loans
and overdrafts; foreign exchange; and finance. Such banks act as the clearing agents for cheques and
credits in the banking system, the net balances of which are settled daily.

COLLATERAL

Security deposited by a third party (as opposed to primary security deposited by the borrower).

CONFIRMATION

A written advice of transaction exchanged by the parties to an agreement. “Our” confirmation is sent to
the counter-party by the bank. “Their” confirmation is the advice sent to the bank by the counter-party.

3
 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

CONFIRMED CREDIT

A credit that is opened by a bank in the importer’s country in favour of an exporter in another country is
certified to the exporter through a bank in his own country. If this bank adds its confirmation to the
certification, the exporter will enjoy the benefit of a confirmed credit. Not only has the issuing bank
undertaken to pay the exporter against these specified documents, but a bank in his own country has
also given a definite undertaking to pay, regardless of any other consideration and without recourse to
the beneficiary, provided all documents are in order and the credit requirements are met. A bank thus
confirming a credit will charge the opening banker an additional commission.

CONSOLIDATED RISK RETURN

A statement, prepared at periodic intervals, showing the total of direct and indirect risks outstanding
against the bank’s customers in each class of risk for each customer.

CONTRA ACCOUNT

Accounts where the bank’s liability to a third party is covered by a customer’s liability to the bank for the
same amount – e.g., letters of credit, guarantees, etc.

CORRESPONDENT BANK

A bank in one country that acts when so required for a bank in another country. The relationship is one
of agency.

CREDIT TRANSFER

A system through which a person is able to pay money at any branch of a bank into the account of
another person having an account at any branch of any bank.

CROSS-GUARANTEE

Security given for a loan to a parent company, or to any subsidiary in a group, that takes the form of a
guarantee from each of the other companies in the group. Cross-guarantees are particularly appropriate
where the banker is lending to more than one company. In the event of a liquidation, the banker will be
able to prove against each company the amount of its individual debt, plus the total of its guarantees on
account of all other companies.

DEALERS’ DIARY

The dealers’ working document, in which foreign exchange and money market transactions are recorded
under their respective value dates.

DEALING DATE

The date upon which a deal is arranged. It is important to check this on counter-party confirmations in
order to reveal suppressed/delayed deals.

DEMAND DEPOSIT

A deposit with a bank that can be withdrawn without prior notice.

4
 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

DEMAND DRAFT (DD)

A cheque issued by one bank, drawn on another bank, and payable to a third party for a specific amount
on demand. It is authenticated by authorised signature(s).

DEPOSIT RECEIPT

A receipt issued by bankers and others when money is lodged in a deposit account and no deposit,
pass-book, or statement is issued.

DIRECT DEBIT

A direct claim made by a creditor on the customer’s account, to be paid by the bank on each occasion.
The customer must approve this arrangement before any transfers are made.

DOCUMENTARY CREDIT

The best method of financing overseas trade is for the contracting parties to insert in the contract for the
sale of goods a provision that payments shall be made by a banker under the provisions of a
documentary credit. Under this system, a banker undertakes to pay the price of the goods, or accept a Bill
of Exchange for the invoiced amount, in return for the delivery, to him by the exporter of the invoices and
shipping documents (provided they conform with the details advised by the importer to the bank). The
nature of the undertaking varies according to whether the credit is revocable, irrevocable, or confirmed.
The issuing bank receives a percentage commission, and in most cases would expect the customer to
furnish a security. The issuing banker will either advise the exporter directly, or do so through a
correspondent banker in the exporter’s country. The letter of advice will state the conditions governing
the credit, the nature and descriptions of the goods, the date by which the goods must be shipped, and
the ports of loading and designation. The granting banker is under no obligation to honour drafts that
have not been drawn within the terms of the credit, and he will be unable to debit his customer should he
do so.

DORMANT ACCOUNT

An account that has not been used by a customer for a considerable time. The administration of dormant
accounts should be separated from that of normal accounts in order to minimise the risk of manipulation
by bank staff aware of the dormancy.

DRAW-DOWN

Disbursement of cash to a borrower under the terms of a loan agreement. Draw-down may be taken in
several branches. The failure by the borrower to draw-down the facility at the due rate given in the loan
agreement would normally involve the payment of a commitment fee (of approximately 0.5%) until actual
draw-down takes place.

EUROCLEAR

International clearing system for the settlement of transactions in securities, essentially Eurobonds. It is
based in Brussels and is provided under contract by Morgan Guaranty for the over 100 banks who own
it.

5
 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

EURO CURRENCY

A term used to describe deposits of a major world currency in a country other than that whose currency
it is – e.g., Euro dollars. Throughout this transaction, the actual dollars would remain in the US; however,
as borrowers and lenders conclude their agreement, various accounts in the US would be credited and
debited by the sum in question.

EUROPEAN CURRENCY UNIT (ECU)

A multiple currency unit linked to the currencies of the six original EEC members. The investor receives
payment in whichever currency is the strongest, but at its old parity.

FACILITY LETTER

A letter from a lending bank to a borrowing customer, confirming the terms upon which a loan has been
agreed. Such a letter specifies the total sum to be lent, the rate of interest to be charged, the terms of
repayment, and the security to be charged. It will also lay down certain conditions to be observed – e.g.,
balance sheet ratios, security margins, etc.

FACTORING

A specialist facility offered by some commercial banks, whereby the factor buys from his client, a trading
company, its invoiced debts, becoming responsible for all credit control, sales control, and credit
collection. Thus companies are able to sell their outstanding book debts for cash. A full factoring service
comprises maintenance of a company’s sales ledger, credit control over the company’s customers, full
protection against bad debts, and collection from debtors. Factoring is “disclosed” or undisclosed”
according to whether the supplier has notified his customers that payment is to be made to the factor or
not.

FIXED DEPOSIT/TIME DEPOSIT/TERM DEPOSIT

A sum of money placed by a customer with a bank for a specified period and at a specified rate of
interest.

FLOATING RATE NOTES

Notes issued by a fund-raiser. These investments are dated and have the attraction of having their
interest rate linked to current rates with a set minimum. They are not as freely negotiable as certificates of
deposit and are dealt in secondary markets.

FORWARD DEAL

A deal with a value date longer than that of a spot deal.

FORWARD EXCHANGE

Buying or selling foreign currency in advance through the foreign exchange markets: the purchase or sale
of foreign currency for delivery at a future date.

FORWARD RATE

The rate at which foreign currency can be bought or sold for delivery at a future time.

6
 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

FRONT-END FEE

A fee payable to a bank at the inception of a long-term facility (e.g., loan, guarantee). The accounting
treatment of front-end fees may have a significant effect on a bank’s income in a year in which the
number of new facilities granted suffers a major increase or decrease.

GAP

The period, in foreign exchange transactions, between the maturities for purchases and the maturities for
sales of each foreign currency.

The term can also be used with reference to loans and deposits in one currency. Gap then denotes the
difference between the maturity dates of the loan and the deposit.

GUARANTEE

An undertaking given to a bank by one person (guarantor) accepting responsibility for the debt of a
principle debtor should he default.

HEDGING

A device used to reduce losses due to market fluctuations, by counter-balancing a current sale or
purchase by another, usually future, sale or purchase. The desired result is that the profit or loss on the
current sale or purchase will be offset by the loss or profit on the future sale or purchase.

HIDDEN RESERVE/RESERVE FOR CONTINGENCIES/INNER RESERVE

A reserve not disclosed separately in the accounts. It is usually shown as part of “current, deposit, and
other accounts”.

INTER-BANK RATES

The interest and exchange rates at which banks deal with each other in the market. It is usually a tighter
market (narrower spreads) than the markets offered on commercial transactions.

INTEREST RATE DIFFERENTIAL

The difference in the rate of interest offered in two currencies for investments of identical maturities.

INTERVENTION

Government or central bank purchase or sale of foreign exchange in an effort to hold steady or change
the exchange rate in order to maintain an orderly market for the currency.

INVESTMENT BANK

A bank that provides long-term fixed capital for industry, in return for taking over shares in the borrowing
companies in order to maintain some influence or control.

7
 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

IRREVOCABLE CREDIT

A credit whose terms cannot be varied or changed without the concurrence of all parties to it. A strong
exporter would normally always insist on payment by irrevocable credit.

LEAD MANAGER

The principal house in a syndicate making a new issue, which co-ordinates and directs the efforts of the
syndicate in return for a management fee.

LEADS AND LAGS

The acceleration and delays in payment of disbursements due in a foreign currency, at a time when the
rate of exchange of a country’s currency is rising or falling.

LETTER OF CREDIT

A document issued by a banker and authorising the bank to whom it is addressed to honour the cheques
of the person named in the letter to the extent of a certain amount, charging these sums to the account of
the grantor. The letter states the period for which the credit is to remain in force, and should be endorsed
with the particulars of all drafts under the credit.

LIEN

The right to retain property belonging to another until a debt due from the owner of the debt to the
possessor the property is paid. The ownership of the property is left undisturbed – i.e., the borrower
retains ownership, but the lender has possession.

LIEN LETTER

A letter from a customer agreeing that the credit balance on a customer’s account is held as security for
his advance on another account, and that the banker may combine the accounts without notice.

LIQUIDITY RATIO

The relationship between those assets of the bank that are in money or can be very quickly turned into
cash, and the total balances that the customers of the bank have in their banking account – e.g., liquid
assets to deposits.

LIMITS

Each bank has limits within which it may deal with other banks. These limits, normally set by head office,
may cover:

• open exchange positions by currency

• amount of loans in total, by bank, country, and currency
• longest period of loans
• amount of forward exchange position by bank
• amount of spot exchange position by bank
• amount of guarantees, obligations under letters of credit, etc.

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 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

LONDON INTER-BANK OFFERED RATE (LIBOR)

The rate of interest offered on deposits with commercial banks operating in the London Eurocurrency
market.

LONG

A surplus of foreign currency assets over foreign currency liabilities. This may be in an individual
currency, or in all currencies taken together against the base currency.

MANAGERS DISCRETIONARY LIMITS

The limits to which a branch manager may commit the bank to lend without reference to higher
authorities.

MARGIN

1 The difference between the rate charged by a bank for loans and the rate allowed for deposits.

2 An amount held by the bank as security against the issuance of a letter of credit or guarantee.

3 A deposit of money, made in order to safeguard a broker against loss in commodities or securities
transactions.

4 The difference between the spot prices and the forward price of a currency, expressed as a
premium or discount.

MATCHED

A forward purchase is said to be matched when offset by a forward sale for the same or nearly the same
date (or visa versa).

MATURITY

The date upon which a given security becomes payable to the holder in full.

MONEY AT CALL AND SHORT NOTICE

This item follows cash and cheques in the course of collection in the marshalling of a bank’s liquid
resources in its balance sheet.

The bulk of the money at call and short notice comprises money market loans usually on a day-to-day
basis and at most at seven days.

MONEY MARKET

The market for the purchase and sale of short-term financial instruments. In this context, short-term is
defined usually as less than one year.

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 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

MORTGAGE

The conveyance of a legal or equitable interest in real or personal property as security for a debt or for
the discharge of an obligation.

NEGOTIABLE INSTRUMENT

Any instrument that satisfies the following tests:

1 That property in the instrument passes by mere delivery or by endorsement.

2 A transferee taking the instrument in good faith and full value without notice of defect in the title
of the transferor obtains title.

3 No notice of the transfer need be given to the person liable on the instrument.

NOSTRO ACCOUNT

A current account maintained by a home bank with the foreign bank. May be referred to as a
correspondent account.

OPEN POSITION

The difference between assets and liabilities in a particular currency. This may be measured in an
individual currency, or in all foreign currencies taken together.

OPTION CONTRACT

A forward exchange contract for which the rate is fixed, but which may be settled at any time between
two specified dates at the counter-party’s option.

OVERDRAFT

Borrowing from a bank on a current account up to a maximum agreed with the bank, interest being
calculated only on the daily balance outstanding.

OVER-BOUGHT POSITION/LONG POSITION

An over-bought position arises when the bank’s assets in a foreign currency exceeds its liabilities in that
currency.

OVER-SOLD POSITION/SHORT POSITION

An over-sold position arises when the bank’s liabilities in a foreign currency exceed its assets in that
currency.

NB: It is important to establish what position(s) are being referred to. Thus, it is quite possible to
be “long of the spot and short of the forward”.

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 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

OVER-THE-COUNTER

The purchase and sale of financial instruments not conducted on an organised exchange.

PAR

Price of 100% of a security’s face value. Principal amount at which an issuer of bonds agrees to redeem
its bonds at maturity.

PERFORMANCE BOND

A bond for due performance issued by a bank at the request of a customer who is tendering for a
contract in the building or construction industry. The bank should be satisfied that its customer is
technically capable of handling the work and financially strong enough to see it through. The bank
would normally take a counter indemnity or security to cover its own position.

PERSONAL LOAN

A bank loan to an individual, where the interest is added to the amount borrowed and the total is then
repaid by a regular monthly repayment over an agreed period.

PORTFOLIO

Collection of financial instruments on transactions denominated in various currencies.

PORTFOLIO MANAGEMENT SERVICE

Management of a customer’s quoted securities by a bank. This includes the safekeeping of the
securities, dealing with scrip and rights issues, the collection of dividends, and the preparation of
valuations. The bank may also have discretion within pre-determined limits as to the purchase and sale of
securities in the portfolio.

POSITION

A situation created through foreign exchange contracts in which changes in interest rates or exchange
rates could create profits or losses for the operator.

PREMIUM

For security issues with prices greater than par value, the amount of the difference between par and the
price.

PRINCIPAL

Par value or face amount of a security exclusive of any premium or interest; the basis for interest
computations.

PROJECT FINANCE

The arrangement from a variety of sources of the finance which will be required to appraise, set up, and
begin to operate a large capital project. Such loans would normally be made by a syndicate of lending
banks.

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 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

PROMISSORY NOTE

An unconditional promise in writing made by one person to another, signed by the maker, engaging to
pay on demand or at a fixed or determinable future time a certain sum in money to, or to the order of, a
specified person or bearer.

QUOTE

The market price of a given security.

RED CLAUSE

A clause in a documentary letter of credit designed to enable the beneficiary to draw up to 100% of the
credit amount before shipping documents are presented, and even before shipment.

RE-DISCOUNT

The act of a person who has discounted a bill of exchange in subsequently selling to another person.

REVOLVING CREDIT

A credit containing a clause for an automatic renewal of the credit on a rollover basis. Thus any part of
the credit used by the borrower and reimbursed to the banker within the term of the credit becomes
available automatically again on such reimbursements. There is , therefore, no limit to the total of
turnover, although there is a stated limit to the amount of drafts that may be outstanding at any one time.

ROLLOVER

A term indicating a continuance of existing credit. A limit on a rollover basis is renewed once it has been
exhausted.

If an interest rate is expressed to be on a rollover basis, it means that it will be negotiated at intervals –
e.g., every three or six months.

SAFE CUSTODY

In order to keep them safe, articles of value may be left in bank strong rooms by customers .

SAFE DEPOSIT

Some banks may maintain a safe deposit service, where the customer himself deposits articles of value in
a box or compartment to which he alone has the key.

SHORT

A surplus of foreign currency liabilities over foreign currency assets. This may be in an individual
currency, or in all currencies taken together against the base currency.

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 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

SHIPPING GUARANTEE

If the Bills of Lading relating to a shipment are missing, the consignees may take delivery of the
consignment by giving a written undertaking to indemnify the ship, her owners, and their agents against
any harm arising as a result of releasing the consignment without production, and surrender of the Bills
of Lading. The consignees’ bankers will guarantee the performance of such an undertaking and the
guarantee so issued is called a shipping guarantee. The guarantee is normally valid for three years or
until such time as it is released by the agents, normally upon production of the Bill of Lading, if sooner.

SINKING FUND

Repayment of debt by an issuer at stated regular intervals though purchases in the open market or
drawings by lot.

SOLVENCY RATIO

The conventional relationship between a bank’s own capital resources and its total deposit liabilities.

SPOT RATE

The price of foreign currency for delivery in two business days.

SQUARE

A position where currency inflows and outflows are matched for a given date.

STATUTORY DEPOSIT

A deposit that a bank is required by law to a place with the central bank/monetary agency of the country
in which it operates. The amount of such deposits is determined by regulations in force in that country.

SWAPS OR DOUBLE DEALS

Operations consisting of a simultaneous sale or purchase of spot currency accompanied by a purchase

or sale respectively of the same currency for forward delivery.

INVESTMENT SWAP

An investment swap is a series of linked transactions comprising a deposit, spot exchange, loan, and
forward exchange deal. The forward exchange deal is carried out as insurance against possible exchange
rate fluctuations.

SWAP COST OR GAIN

The difference between the spot and forward rates at the time of dealing. In the case of investment
swaps, it is normally quantified and apportioned over the period of the forward exchange contract.

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 Appendix A (cont’d.)
Glossary of Banking Terms (cont’d.)

TELEGRAPH TRANSFER

A payment made in international commerce by transfer of money by cable or telegraph from a bank
account in one country to a beneficiary in another. The cost of the cable is charged to the customer.

TERMS DEPOSITS

Deposits that are repayable after a pre-determined time and not on demand.

TEST OR SECURITY KEYS

The code by which a bank authenticates payment instructions to its correspondents by telex or telegraph
transfer. The code is normally comprised of the sum of such details as the date, a fixed number, and the
number of digits in the amount.

TRADE DATE

The date upon which a transaction is executed.

TRADER

An individual who buys and sells securities with the objective of making short-term gains.

TRUST RECEIPT

A document signed by a customer of a bank where goods have been pledged as security for an advance.
To repay the advance it is necessary for the customer to get the goods and sell them, but the documents
of title that would enable him to get them are in the possession of the bank. Consequently, the bank
releases the documents of title to the customer against his signature on a trust receipt, by the terms of
which the customer undertakes to deal with the goods as an agent of the bank for the purposes of
obtaining delivery of the goods and then selling or warehousing them. The trust letter protects the right
of the banker as a pledge that he would otherwise lose when he gave up the documents of title, and
protect him in the case of the customer’s bankruptcy.

UNDERWRITE

An agreement under which banks agree to each buy a certain agreed amount of securities of a new issue
on a given date and at a given price, thereby assuring the issuer of the full proceeds of a financing.

VALUE DATE

The date on which funds are actually available for use in any bank account.

VOSTRO ACCOUNT

An account maintained abroad by a bank in the currency of the country in which the account is
maintained.

WASTE SHEET/JOURNAL

A book of prime entry to which all the day’s vouchers (except cash transactions) are posted before they
are sent to the machine operator(s) for posting to ledger cards.

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