Treasury Role in Liquidity and Interest-Rate Risk Management - Article

Introduction

Asset-Liability Management identifies mismatches in a bank’s:

• cash flows;

• maturity profile;

• repricing structure;

• funding sources; and

• currencies.

Someone must then convert the ALM strategy into actual market transactions.

That is where treasury becomes important.

Treasury may:

• raise short-term funds;

• invest temporary surpluses;

• use repo and money-market instruments;

• manage liquid securities and collateral;

• support intraday liquidity;

• manage foreign-currency liquidity;

• alter investment duration; and

• use permitted derivatives to hedge interest-rate exposure.

The current 2026 IIBF BFM syllabus specifically includes Liquidity Risk, Interest Rate Risk, Role of Treasury in ALM and Use of Derivatives in ALM under Module C – Treasury and Asset-Liability Management.

RBI requires banks to maintain a robust liquidity-risk framework covering cash-flow projections, diversified funding, intraday liquidity, collateral management, stress testing and contingency funding. ALCO is responsible for implementing the bank’s liquidity strategy within Board-approved risk tolerance.

Learning Objectives

After studying this topic, you should be able to:

• explain treasury’s role in liquidity management;

• distinguish temporary liquidity management from structural funding management;

• analyse how treasury responds to interest-rate mismatches;

• understand the earnings and economic-value effects of interest-rate changes;

• explain the role of securities and derivatives in ALM; and

• identify common case-study errors involving ALCO, treasury and risk limits.

ALCO Decides; Treasury Executes

Treasury should not be viewed as an independent risk-taking unit that decides the bank’s total balance-sheet risk appetite.

The broad sequence is:

Board → Risk Tolerance and Policy

↓

ALCO → Balance-Sheet and Funding Strategy

↓

ALM/Risk Function → Measurement and Monitoring

↓

Treasury → Market Execution

RBI assigns ALCO responsibilities such as deciding:

• desired maturity profile;

• asset-liability mix;

• source and mix of funding;

• fixed versus floating funding;

• wholesale versus retail funding;

• money-market versus capital-market funding; and

• domestic versus foreign-currency funding.

Treasury then implements relevant parts of that strategy.

Treasury Role in Liquidity Risk

Liquidity risk arises when a bank cannot efficiently meet expected or unexpected cash and collateral obligations when due without unacceptable cost or loss.

RBI distinguishes:

• Funding Liquidity Risk – inability to meet cash-flow and collateral needs efficiently; and

• Market Liquidity Risk – inability to sell or offset a position at prevailing market prices because the market is too thin or disrupted.

Treasury deals with both.

It manages actual cash and funding while also maintaining access to sufficiently liquid marketable assets and collateral.

Case 1: Temporary End-of-Day Liquidity Deficit

A bank expects a temporary rupee shortage at the end of the day because large customer payments are due.

The underlying balance sheet remains otherwise sound.

Treasury Response

Treasury should first determine:

• amount required;

• timing;

• expected duration of shortage;

• available collateral;

• market funding capacity; and

• approved limits.

Depending on eligibility and market conditions, treasury may use appropriate sources such as:

• call/notice money;

• repo/TREPS;

• other approved money-market borrowing; or

• eligible RBI liquidity facilities.

CAIIB Learning

A short-lived liquidity shortage should normally be addressed with an instrument suited to the size and tenor of the gap.

Borrowing long term for a one-day gap may be inefficient.

Case 2: Temporary Liquidity Surplus

Treasury expects excess funds for a few days.

Leaving the entire amount idle reduces earnings.

Treasury Response

Subject to liquidity requirements and limits, treasury may place or invest the temporary surplus through suitable short-term instruments.

However, it should first consider:

• upcoming payments;

• stressed liquidity needs;

• collateral requirements; and

• availability of funds when needed.

CAIIB Learning

Liquidity management is not simply:

“Invest every surplus.”

It is:

“Invest surplus funds without weakening the bank’s ability to meet obligations.”

Case 3: Structural Funding Gap Is Repeatedly Funded Overnight

A bank has rapidly expanded long-term loans.

Deposit growth has not kept pace.

Treasury repeatedly borrows overnight to fund the gap.

Analysis

This is no longer merely a temporary liquidity issue.

A structural funding mismatch has developed.

Repeated reliance on overnight borrowing creates:

• rollover risk;

• funding-cost volatility;

• concentration risk; and

• vulnerability during market stress.

ALCO should review the broader funding strategy.

Possible measures may include:

• obtaining more stable funding;

• lengthening liability maturity;

• altering asset growth;

• changing pricing;

• reducing funding concentration; or

• selling/restructuring appropriate assets.

RBI requires banks to maintain a funding strategy diversified by source and tenor and to monitor their capacity to raise funds from chosen markets.

CAIIB Learning

Treasury can bridge a temporary gap.

It should not hide a persistent structural ALM problem by continuously rolling short-term borrowing.

Case 4: Deposit Outflow Is Larger than Forecast

Unexpected large withdrawals create a sudden liquidity requirement.

Treasury Response

Treasury may need to:

1. assess immediately available cash;

2. estimate further expected outflows;

3. mobilise unencumbered collateral;

4. access approved market funding;

5. review liquid asset availability; and

6. escalate the position under the bank’s liquidity policy.

If the stress becomes severe, the bank’s Contingency Funding Plan (CFP) may become relevant.

RBI requires banks to maintain a formal CFP with clear strategies, responsibilities and escalation procedures for emergency liquidity shortfalls.

CAIIB Learning

Normal treasury funding and contingency funding are not the same.

The CFP is designed for stress conditions, not merely routine daily mismatch.

Case 5: Bank Has Enough Assets but Cannot Raise Cash Quickly

A bank owns substantial assets.

Management therefore concludes that liquidity risk is low.

However, many assets cannot be sold quickly except at a large discount.

Analysis

The bank may be solvent but still face liquidity difficulty.

Treasury must consider:

• market depth;

• saleability;

• haircut;

• collateral eligibility;

• encumbrance; and

• time required to monetise assets.

This is the difference between:

Asset Value

and

Usable Liquidity

CAIIB Learning

A large balance sheet does not automatically mean strong liquidity.

Case 6: Collateral Is Already Encumbered

Treasury plans to obtain secured funding using Government securities.

It later discovers that a large part of the securities is already pledged or otherwise unavailable.

Analysis

The bank’s theoretical liquid-asset stock is greater than the amount actually available for mobilisation.

RBI requires banks to manage collateral actively and distinguish between encumbered and unencumbered assets.

CAIIB Learning

For treasury:

Liquid security held ≠ automatically liquid security available

Collateral availability must be monitored continuously.

Case 7: Intraday Payment Pressure

The bank expects sufficient closing liquidity.

However, a very large payment must be made in the morning while major inflows will arrive only later in the day.

Analysis

End-of-day liquidity may be satisfactory, yet the bank can still face an intraday liquidity problem.

Treasury must manage:

• payment timing;

• settlement balances;

• incoming and outgoing flows;

• collateral;

• intraday funding sources; and

• payment-system obligations.

RBI specifically requires banks to actively manage intraday liquidity so that payment and settlement obligations can be met in normal and stressed conditions.

CAIIB Learning

Closing liquidity surplus does not guarantee adequate intraday liquidity.

Case 8: Overall Liquidity Is Positive but USD Liquidity Is Short

A bank has substantial excess INR liquidity.

It simultaneously has large USD obligations approaching maturity.

Management concludes that there is no liquidity problem because the consolidated liquidity position is positive.

Analysis

Liquidity must also be examined currency-wise.

Converting INR liquidity into USD may involve:

• market access;

• swap availability;

• pricing;

• limits;

• settlement arrangements; and

• stressed-market constraints.

RBI requires banks to monitor liquidity risk across currencies and consider limitations on transferring liquidity between currencies, entities and business lines.

CAIIB Learning

Overall liquidity surplus can coexist with a foreign-currency liquidity deficit.

Treasury Role in Interest-Rate Risk Management

Interest-rate risk arises when changes in market rates affect the bank’s:

• Net Interest Income;

• market value of interest-sensitive positions; or

• broader economic value.

For ALM purposes, interest-rate risk often arises because assets and liabilities reprice at different times.

RBI’s February 17, 2023 IRRBB framework requires specified commercial banks to measure, monitor and disclose banking-book interest-rate exposure so that excessive IRRBB does not threaten future earnings or the current capital base.

Two perspectives are especially important:

Earnings Perspective

How will changes in rates affect future income and expenses, particularly Net Interest Income (NII)?

Economic-Value Perspective

How will changes in rates affect the present economic value of assets, liabilities and off-balance-sheet positions?

These two perspectives can produce different risk signals.

Case 9: Liabilities Reprice Faster than Assets

A bank has:

• many fixed-rate or slowly repricing loans; and

• deposits or borrowings that reprice quickly.

Market interest rates rise sharply.

Effect

Funding cost may increase sooner than asset yield.

Therefore, the bank’s interest margin can come under pressure.

Treasury/ALCO Response

Possible actions may include:

• changing the fixed/floating funding mix;

• lengthening funding maturity;

• modifying investment positioning;

• using appropriate permitted interest-rate derivatives; and

• supporting revised asset/liability pricing strategy.

Treasury normally executes the market transactions, while ALCO determines the broader balance-sheet response.

CAIIB Learning

If:

Liabilities reprice upward before assets

a rate rise can hurt NII.

Case 10: Assets Reprice Faster than Liabilities

A bank has a large amount of floating-rate or quickly repricing assets funded by relatively stable fixed-rate liabilities.

Market interest rates rise.

Analysis

Asset yields may rise sooner than funding cost.

This can improve NII, other things equal.

But it does not mean the bank is automatically safe.

Management must also consider:

• customer behaviour;

• deposit repricing pressure;

• credit quality;

• basis differences; and

• economic-value effects.

CAIIB Learning

The direction of NII impact depends on the repricing structure, not simply on whether rates rise or fall.

Case 11: Falling Rates Hurt an Asset-Sensitive Bank

A bank’s earning assets reprice more quickly than its liabilities.

Interest rates decline.

Analysis

Asset income may fall faster than liability cost.

The same structure that benefited from rising rates can therefore hurt earnings when rates fall.

CAIIB Learning

Do not label:

Positive repricing sensitivity = always good

The outcome depends on the direction of rate movement.

Repricing Gap and Duration Are Different

Repricing analysis focuses mainly on:

when interest rates reset

Duration focuses mainly on:

how economic value changes when yields change

A bank may therefore appear comfortable from a short-term NII perspective but still carry large long-term economic-value sensitivity.

Case 12: Long-Duration Investment Portfolio in a Rising-Rate Market

Treasury holds a large portfolio of long-duration fixed-rate securities.

Market yields rise.

Effect

Fixed-rate bond prices fall.

The longer the duration, other things equal, the greater the price sensitivity.

Treasury Response

Depending on:

• portfolio purpose;

• accounting/regulatory treatment;

• ALCO strategy;

• liquidity requirements; and

• approved limits,

treasury may consider:

• reducing duration;

• changing future investment maturity;

• using appropriate hedging instruments; or

• accepting the exposure within approved risk appetite.

CAIIB Learning

Higher yield is not the only consideration in investment selection.

Treasury must consider the interest-rate sensitivity created for the bank.

Case 13: Treasury Sells All Long-Duration Securities to Reduce Risk

Rates are expected to rise.

Treasury proposes selling every long-duration security immediately.

Analysis

Reducing duration may reduce interest-rate exposure, but the decision cannot be based on duration alone.

The bank must also consider:

• liquidity buffer requirements;

• realised losses;

• future income;

• collateral needs;

• investment strategy; and

• applicable regulatory/accounting rules.

CAIIB Learning

Risk management means optimising exposure, not automatically eliminating every risk.

Case 14: Floating-Rate Borrowing Is Hedged with an IRS

The bank has floating-rate funding.

ALCO is concerned about rising interest rates.

Treasury enters an appropriately permitted:

Pay-Fixed / Receive-Floating Interest-Rate Swap

Effect

The floating receipt under the swap can offset the floating component of the borrowing.

The combined exposure becomes more fixed in economic terms, subject to:

• basis differences;

• credit spread;

• reset mismatch;

• counterparty risk; and

• hedge effectiveness.

CAIIB Learning

Derivatives allow treasury to change ALM exposure without necessarily replacing the original liability.

Case 15: Swap Benchmark Does Not Match the Liability

The borrowing reprices using Benchmark A.

The swap receives Benchmark B.

Management treats the hedge as perfect.

Analysis

The two benchmarks may move differently.

This creates:

Basis Risk

Therefore, the bank may still face fluctuating net interest cost.

CAIIB Learning

Correct derivative direction is not enough.

A good ALM hedge should also consider:

• benchmark;

• amount;

• tenor;

• reset frequency; and

• payment dates.

Case 16: Treasury Hedge Reduces NII Risk but Creates Counterparty Exposure

An OTC swap successfully reduces the bank’s interest-rate mismatch.

The swap later has a large positive market value.

Analysis

Interest-rate risk has fallen, but counterparty credit risk has increased.

Other risks can include:

• collateral requirements;

• liquidity risk;

• valuation risk;

• legal risk; and

• operational risk.

CAIIB Learning

ALM hedging transforms risk. It does not make risk disappear.

Case 17: Trading Book and Banking Book Are Mixed Together

Treasury has:

• a short-term proprietary bond position; and

• securities held for broader balance-sheet/liquidity purposes.

Management measures both only through one ALM repricing-gap report.

Analysis

This can be misleading.

Trading positions are primarily managed for market-price risk, while IRRBB addresses interest-rate risk arising from the banking book.

The two areas interact, but their:

• objectives;

• measurement techniques;

• limits; and

• regulatory treatment

are not identical.

RBI’s 2023 framework specifically addresses Interest Rate Risk in the Banking Book.

CAIIB Learning

Treasury location does not automatically mean every treasury position belongs to the same risk book.

Case 18: ALCO Sets Strategy but Treasury Ignores Limit

ALCO decides to reduce interest-rate exposure.

Treasury nevertheless increases a long-duration position because dealers expect rates to fall.

Analysis

Even if the dealer’s market view later proves correct, the position conflicts with approved balance-sheet strategy and limits.

Treasury should not replace ALCO’s authorised strategy with an individual market view.

CAIIB Learning

Profitability does not regularise a governance breach.

Stress Conditions Change Treasury Decisions

Normal market conditions can create a false sense of security.

During liquidity stress:

• wholesale funding may disappear;

• collateral haircuts may increase;

• asset sales may become expensive;

• deposit outflows may accelerate;

• foreign-currency funding can tighten;

• derivatives may create margin calls.

Therefore, treasury planning must consider stressed, not only normal, market access.

RBI requires regular liquidity stress tests covering institution-specific and market-wide stress, individually and in combination. Results should influence liquidity strategy, positions and contingency planning.

Treasury and the Contingency Funding Plan

Treasury generally has an important operational role when the CFP is activated.

Possible actions can include:

• mobilising available collateral;

• raising emergency market funding;

• reducing non-essential outflows;

• monetising liquid assets;

• coordinating currency liquidity;

• monitoring payment obligations; and

• providing frequent liquidity information to management.

However, the CFP should have:

• pre-defined authority;

• escalation levels;

• communication procedures; and

• approved funding options.

Treasury should not invent an emergency strategy only after a crisis begins.

Practical Banking Application

Consider a bank with:

• rapid fixed-rate loan growth;

• rising short-term deposit rates;

• a negative near-term liquidity gap;

• a long-duration investment portfolio.

If interest rates rise:

1. deposit/funding costs may rise quickly;

2. fixed-rate loan income may respond slowly;

3. NII may come under pressure;

4. bond values may fall; and

5. refinancing the liquidity gap may become more expensive.

ALCO may decide to:

• lengthen funding;

• alter fixed/floating mix;

• slow selected asset growth;

• revise pricing;

• reduce investment duration;

• strengthen liquid-asset holdings; or

• hedge selected interest-rate exposure.

Treasury then implements the market-facing actions.

This is why liquidity and interest-rate risks should not be managed in isolation.

Treasury Actions: Liquidity vs Interest-Rate Risk

CAIIB Exam Focus

ALCO sets balance-sheet strategy; treasury executes relevant market actions.

Treasury should distinguish temporary liquidity shortages from structural funding mismatches.

Repeated overnight funding of a long-term structural gap creates rollover risk.

Liquid assets must also be available and unencumbered to provide usable liquidity.

Intraday liquidity is different from end-of-day liquidity.

Liquidity should be monitored across material currencies.

RBI requires diversified funding sources and tenors, regular liquidity stress testing and contingency funding arrangements.

Interest-rate risk affects both earnings and economic value.

Liabilities repricing faster than assets can hurt NII when rates rise.

Assets repricing faster than liabilities can benefit NII when rates rise, other things equal.

The effect reverses when the direction of rates reverses.

Duration risk and repricing risk are related but not identical.

Longer-duration fixed-rate securities are generally more price-sensitive to yield changes.

Derivatives can alter ALM exposure without changing the underlying asset or liability.

A hedge may leave basis and counterparty risks.

IRRBB is banking-book interest-rate risk and should not be confused with trading-book market risk.

Common Exam Traps

Trap 1: Treasury Decides the Bank’s Risk Appetite

Incorrect.

The Board/ALCO framework determines risk tolerance and strategy. Treasury operates within it.

Trap 2: Every Liquidity Deficit Should Be Funded Overnight

Incorrect.

A structural mismatch needs a structural response.

Trap 3: A Bank with Large Assets Cannot Have Liquidity Risk

Incorrect.

Assets may be illiquid, encumbered or saleable only at a large loss.

Trap 4: Closing-Day Liquidity Surplus Means No Intraday Risk

Incorrect.

Payments can fall due before expected inflows arrive.

Trap 5: INR Surplus Automatically Solves a USD Shortage

Incorrect.

Currency-specific market access and conversion constraints matter.

Trap 6: Higher-Yielding Long Bonds Are Always Better for Treasury

Incorrect.

They may create substantially greater interest-rate sensitivity.

Trap 7: A Rate Rise Always Hurts Every Bank’s NII

Incorrect.

The effect depends on the relative repricing of assets and liabilities.

Trap 8: Positive Repricing Sensitivity Is Always Beneficial

Incorrect.

It can benefit from rising rates but hurt when rates fall.

Trap 9: Duration and Repricing Gap Mean the Same Thing

Incorrect.

Repricing analysis focuses mainly on rate-reset timing and earnings; duration focuses on economic-value sensitivity.

Trap 10: Derivative Hedge Removes All Interest-Rate Risk

Incorrect.

Basis, tenor, counterparty and other residual risks may remain.

Trap 11: Treasury Can Ignore ALCO Strategy if Its Market View Is Strong

Incorrect.

A profitable unauthorised risk position remains a governance failure.

Trap 12: Trading-Book and Banking-Book Interest-Rate Risks Are Identical

Incorrect.

They have different purposes and risk-management frameworks, even though both can respond to rate movements.

Memory Technique

Remember treasury’s ALM role as F-I-H-M:

• F – Fund liquidity gaps

• I – Invest liquidity surpluses

• H – Hedge interest-rate exposure

• M – Monitor market execution and limits

And remember the central CAIIB principle:

ALM tells the bank what liquidity and interest-rate position it should maintain; treasury uses funding, investments and hedging transactions to help achieve that position within approved limits.