The McKinsey Quarterly: Treasury management in emerging-market banks

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Treasury management in emerging-market banks

Elevating the treasury from a support function to a bank’s primary instrument for managing market risk can have a far-reaching impact throughout the organization.

Alberto Alvarez, Hugo A. Baquerizo, and Joydeep Sengupta

The McKinsey Quarterly, Web exclusive, November 2004

Banks in emerging markets have worked hard to hone their credit-risk-management skills over the past decade, and many of them deliver credit-related services and returns on par with those of their world-class competition. Yet they lag behind their counterparts in developed markets in managing market risk and in applying this knowledge to the treasury unit.

For banks in developed markets, the treasury unit has long been a source of profit, but it remains a support function for many institutions in emerging markets. We interviewed executives at 14 banks in Latin America, the Middle East, and Southeast Asia. At 9 of them, the focus of treasury activities was short-term liquidity management: ensuring that funds are available to meet regulatory reserve requirements and the immediate needs of customers. Board members and top managers at many of these banks view certain common treasury activities—for example, trading securities and developing derivatives contracts—as forms of casino finance.

In much of the developed world, a bank's treasury, in addition to managing liquidity, is responsible for managing assets and liabilities, trading in currencies and securities, and developing new products. High-performing treasuries systematically identify, mitigate, and profit from market risk—that is, risk associated with changes in interest rates, exchange rates, and the value of securities and commodities. When board members and top executives understand market risk, they see that good treasury management is anything but a gamble. A capable treasury unit that actively manages market risk can create significant value for a bank's shareholders. To convert the treasury function into a profit center, the bank must develop a clear business plan, educate its leadership about market risk, and get treasury personnel more involved in other bank activities.

Treasury's potential

For many banks in unstable financial markets, liquidity management has evolved into a source of competitive advantage. But although these institutions can manage short-term liquidity, they fall short in other activities, such as trading, product development, and actively managing the balance sheet structure and their exposure to market risk. Without a clear understanding of market risk, managers can neither protect a bank's capital nor profit from it.¹ Several problems constrain innovation in this area: a bank's leaders may be poorly informed about the profit opportunities in treasury, local money and capital markets may be thin, and customers may not demand products available in developed markets. As a result, the treasury unit often accounts for less than 10 percent of the net profits of banks in emerging markets. For those few institutions that have turned the treasury into a profit center—primarily innovative banks in larger financial markets such as Brazil, Mexico, and Singapore, as well as local subsidiaries of global banks—its contribution tends to be much higher: from 25 to 35 percent of net profits.

Emerging-market banks with a profitable treasury function keep their strategies simple and close to home. Taiwan's Chinatrust and Venezuela's Banco Mercantil, for example, offer their large, affluent customer bases standard products such as currencies or local securities contracts, for which the treasury is responsible. These wealthy people give the banks better access to retail funds and a steady stream of income from trading, both of which allow banks to make the most of their existing customers and branch networks.

Only global players such as Citibank and HSBC have the capability to dominate all treasury segments and products. Scale advantages give these institutions superior access to markets and information, allowing them, for example, to become market makers in specific currencies. Other large banks, such as Deutsche Bank and J. P. Morgan Chase, focus on providing the full scope of treasury services to the largest corporate segments. Specialized institutions such as Goldman Sachs also serve large corporate players but aim to capture market share in specific product lines. But banks in most emerging markets, where the treasury is a support function, seldom have such explicit strategies.

Putting together a mandate

Building a treasury unit calls for an annual business plan, which includes revenue and volume targets by product line and activity—the main ones being asset and liability management, trading, and new-product development. These plans also typically include a detailed description of risk considerations, the business potential of various kinds of products, and the treasury's posture: that is, whether or not the bank should attempt to make markets and profit from price movements or simply follow market prices and fill orders from customers.

The bank's asset and liability committee should review and define the treasury's specific objectives, in what is commonly called a mandate, on a monthly basis to shape the bank's balance sheet and its exposure to market risk. This analysis examines the balance sheet with respect to target structure, short-term forecasts of interest rates, exchange rates, and the price of securities and commodities.

Managing assets and liabilities

In developed markets, treasuries act as risk managers for banks. By using internal transfers—a standard accounting practice in banks—the treasury buys and sells funds among the bank's client-facing units in order to isolate and remove maturity and interest-rate mismatches from corporate and retail business units. For the fund transfers, these banks use sophisticated pricing that allows their treasuries to account for and hedge the liquidity and interest-rate risk of each asset and liability on their balance sheets.

But most of the emerging world's banks, including 73 percent of those we surveyed, still apply a single-rate transfer price to most asset and liability contracts. By awarding the same internal transfer price to all short- and long-term funds, banks give managers no incentive to offer funds of varying maturities and repricing characteristics.² The result is an improperly structured balance sheet: since the bank can't break out the credit risk and market risk components from the net interest margin, it lacks an accurate measure of true profitability in the product or client categories.

If treasury units in emerging markets hope to compete with the local subsidiaries of global banks, it will be necessary to learn how to set transfer prices appropriately. The first step is to incorporate the maturity and interest-rate characteristics of every contract a bank holds, for both assets and liabilities.

Trading and holding positions in currencies, securities, and derivatives

Large banks in emerging markets usually generate 5 to 35 percent of their total treasury revenues from trading. The actual percentage depends largely on a bank's ability to benefit from its customer relationships. Credit-related products in foreign currencies, such as working-capital lines of credit and trade-financing letters of credit, often generate the majority of foreign-exchange trading business for corporate clients. Banks that derive a relatively high proportion of their revenues from trading rely on the treasury and their client-facing units, such as the corporate-banking group, to develop a clear understanding of their customers' needs. Product-development managers in the treasury of such a bank have developed skills in structuring contracts, and corporate-account executives know best what their clients want. Thus, when the treasury and client-facing units collaborate more closely to plan accounts and set sales strategies, it's much more likely that the bank will create attractive products for its clients and generate more revenue.

The most successful investment-driven banks in emerging markets generate up to 60 percent of the treasury's total revenue by holding inventories of, or positions in, currencies, securities, and derivatives. For maintaining profitable positions, access to information and the ability to liquidate positions are crucial. Banks in emerging markets are usually well acquainted with trading and holding positions in local and sometimes regional securities markets. Since these banks lack the experience and resources to research other markets adequately, they often delegate investing and taking positions in global securities markets to third parties. When a small or midsize bank in Dubai or Riyadh, for example, needs to purchase US Treasury bills and bonds, it may delegate the task to a large institutional investor with better market access.

Developing new products

In general, bank treasuries in the emerging world don't create and market new products themselves, since a relatively unsophisticated local customer base doesn't push them to develop a wider variety of offerings. In some markets, top corporate customers structure their own products and use the banks merely to execute transactions.

Most often, treasury products are associated with the credit and cash-management needs of corporate customers—off-balance-sheet and tax-efficient loans or project finance, for example. To sell new, more sophisticated products, banks should involve the treasury in segmenting corporate clients and in creating tailored offerings based on the needs and behavior of customers.

The treasury can also play an important role in structuring products to hedge the bank's own capital. These products—typically derivatives contracts—protect the bank's capital exposure to a particular currency or to market factors such as changing interest rates and commodity prices.

Taking the treasury seriously

To build an effective and profit-oriented treasury unit, the leadership of banks in emerging markets must develop a better understanding of and appreciation for market risk. This cultural shift must start with board members and top management and continue through the treasury organization and the rest of the bank. Implementing an effective decision-making culture means making everyone understand how the bank manages and profits from market risk.

The creation of a treasury unit that follows global best practices—with clear treasury and market-risk-management roles—is a critical step in gaining this understanding. Centralizing the treasury unit and streamlining business, support, and control processes are also vital to building a profitable treasury. For many banks in emerging markets, market risk management and activities such as liquidity management and the holding of currencies and securities are conducted in an uncoordinated way outside the treasury: It may handle foreign-exchange trading for only, say, traditional retail and corporate clients, while other business units might trade for corporate and commercial clients that demand trade finance products (import and export financing, such as letters of credit, for example). Or perhaps the treasury manages local-currency liquidity while the international-banking unit handles liquidity for foreign currencies. In such cases, it's far more difficult for the bank to monitor and manage risk, since decision making is decentralized.

Banks can better manage and profit from risk by making the treasury the lone department with access to the financial markets and the single repository for currency and securities inventories. One Latin American bank, for example, was dominant in its market but had a relatively unsophisticated and decentralized treasury unit. The bank consolidated its liquidity-management operations for all currencies under a single money-market desk and created a clear distinction between the trading and sales functions. It also adjusted its asset- and liability-management processes and tools to help the treasury take a more active role in handling market risk and in developing new products. In just 18 months, the treasury unit's contribution to the bank's bottom line increased to 25 percent, from 12 percent.

How to proceed? In our judgment, hiring experienced traders and product developers allows both frontline and top managers to build new skills in less time than would be needed if they merely watched and learned from the market itself. In addition, many banks that lack skills at the top of their treasury organizations would be wise to recruit new treasurers from global banks. For most banks in emerging markets, developing and implementing a new treasury model takes three to five years. When top management is committed to the new goals, and the bank's competitive position in the market is favorable, the transition can be completed much more quickly. Two banks in Latin America, for example, achieved significant benefits—increased profits from the treasury unit and better risk management—just 18 months after launching their transformation effort. An efficient, committed management team can increase the treasury's contribution to net profits by more than 20 percent.

The most critical aspect of the evolution of the new treasury is ensuring that the board and the top-management team are committed to it. Other key stakeholders—such as traders, account executives, and branch managers—must learn how it operates. But unless the board is well educated in the advantages of the new model and has confidence in it, all may be lost. The board must develop an understanding of market risk management in order to provide direction, while top executives must acquire a new mindset as well as the tools to implement it. The risks and rewards—increased vulnerability to the vicissitudes of the market, on the one hand, substantially higher profitability, on the other—are too large to ignore.

About the Authors

Alberto Alvarez is an associate principal in McKinsey's Caracas office, Hugo Baquerizo is a principal in the Bogota office, and Joydeep Sengupta is a principal in the Delhi office.

Notes
¹ For a broader summary of channel options, see John M. Abele, William K. Caesar, and Roland H. John, "Rechanneling sales," The McKinsey Quarterly, 2003 Number 3, pp. 64–75.
² The frequency with which a price can change, regardless of the fund's maturity date. The contract for a three-year loan, for example, might stipulate that the loan be repriced every 90 days.