The Concept of Treasury

Origin and Applications
Professor Dr.hc Heinz Riehl

Treasury Departments, which combine the key financial activities of a company under one manager, always have been a part of the organizational structure of non-financial institutions. The purchase of raw materials, the manufacturing of goods and their sales usually are the main operations of a company. Any activity that has anything to do with finance is the job of the Treasurer, including the borrowing or investing of local or foreign currencies to satisfy the company’s liquidity needs and the purchase of foreign currency to pay for imports or the sale of foreign currency resulting from exports.

Until 1960, financial institutions and banks did not have Treasury departments. Instead, the key treasury functions were separated, and each one was headed by a powerful, important and independent manager.

In this article I will describe how I developed the first centralized Treasury in 1960 at Citibank’s first German branch in Frankfurt, and the advantages flowing from the applications of this concept.


The centralized organization of “Treasury” in a bank combines under one manager, the Treasurer, the supervision of trading in the:

  • Local Currency Money Market
  • Foreign Currency Money Market
  • Foreign Exchange Market

Local Currency Money Market

The manager who is focused on the local currency money market and the Central Bank has a very important role in any bank. A well capitalized bank might have 10% equity capital and 90% deposits, which are liabilities. Most of those deposits have relatively short tenors and mature within six months, but the bank’s business is to lend a large percentage of that money for much longer periods, often for several years. Against that background, it is clear that the Funding Liquidity of a bank is critical. This is one of the most important jobs in a bank and the manager who is responsible for this activity must make sure that money is available whenever obligations are contractually due, and must try to do this at the lowest possible cost.

Foreign Currency Money Market

The manager of this department is responsible for what one could almost call a separate part of the balance sheet. Many customers wish to have their borrowings denominated in foreign currencies. This means the bank must find deposits denominated in those currencies so that deposits and loans are matched by currency. Likewise some of the bank’s customers wish to make deposits denominated in foreign currencies. The bank has to pay interest on those deposits and invest them to earn back the interest plus a profit. In addition to matching all those different currencies, the maturities of those foreign currency assets and liabilities must be matched or consciously managed so there is adequate Funding Liquidity on the bank’s foreign currency book.

While this part of the balance sheet is usually smaller than local currency, it is nevertheless complicated by the different currencies involved. The manager of this department often is more globally oriented and maintains relationships with many banks around the world.

Foreign Exchange (FX)

The FX Manager is responsible for maintaining working balances in accounts with correspondent banks around the world. The accounts are denominated in the local currencies of the respective foreign countries, i.e. Swiss franks in Switzerland, yen in Japan, euros in the Euro-Zone, US dollars in the United States, etc. Those accounts are used to handle a bank’s incoming and outgoing payments in the respective currencies. The Foreign Exchange trader must keep the balances in those accounts at a level commensurate with the daily turnover in the accounts. In addition, the FX trader services the bank’s clientele, buying foreign currencies from exporters and selling foreign currencies to importers. Finally the FX trader often performs proprietary trading for the bank’s own account and frequently is an important profit center.

Foreign Exchange contracts are closed for spot value dates and various forward value dates. Value spot means that the currencies sold and purchased are delivered and received two business days later than the contract date, i.e. the date on which the transaction is made. Forward value dates are usually for a number of months into the future. This means that the exchange of currencies purchased and sold might take place 1, 2 3, 6 or 12 months later than the contract date.

The FX business is sometimes not fully understood by other people in a bank. This perceived mystery combined with the obvious internationalism puts the FX Manager often into a powerful and important position.

Now that you have reviewed the trading responsibilities of a bank’s Treasury, I would like to share with you how I was instrumental in bringing these separate departments together under one manager, the Treasurer.

Foreign Exchange Trader For Local Bank

In the 1950s the European financial markets slowly emerged from the ashes of the war. Until the end of 1958
the industrialized European countries were members of the European Payment Union. The currencies of all member nations were not freely convertible against US dollars, but could be traded against each other. In short, people were trading junk against junk. The entire market consisted of maybe 25 active trading banks in all of Europe. The individual standard transaction amount between banks was the equivalent of 25,000 English Pounds.

In 1953, at age 17, I joined a small German bank and began to trade foreign currencies. My bank had no customers, but understood very well the technicalities of foreign exchange trading, including forward foreign exchange rates. In particular, I understood that the premiums and discounts of forward exchange rates are equal to the interest rate differential between the two currencies involved. Let’s illustrate this point with an example.

Assume the following:

  • Spot FX rate for the dollar is 7.00 local currency.
  • One year interest rates are 5% for dollars and 3% for local currency.

The interest rate differential is 2%.
As a result, the one year forward FX rate for dollars against local currency must be 2% lower than 7.00 or 6.86 local currency (LCY) per US dollar.*

Spot rate:   7.00
less 2% of 7.00  =  0.14  swap rate
6.86 forward FX rate for dollars against local currency.
* All interest rates are ‘per annum’ rates. The annual flat swap rate of 0.14 will be different for shorter or longer periods, such as 0.07 flat for six months or 0.28 flat for two years.

A holder of dollars could swap dollars into LCY at a 2% discount income and invest the resultant LCY at 3% for a total return of 5%, which is equal to the 5% he could have earned on his dollars on a direct dollar investment. Likewise a holder of LCY could swap LCY into dollars at a discount cost of 2% and invest the resultant dollars at 5% for a net return of 3%, which is equal to the 3% she could have earned on her LCY on a direct LCY investment.

Co-Founder of Citibank, Frankfurt, Germany

In 1960, I became a co-founder of Citibank’s new Frankfurt Branch in Germany. To open the new branch, Citibank brought three experienced Americans to Germany and hired 14 young Germans. As one of those 14 people, I was hired to be the Foreign Exchange Trader with responsibilities as described above. I traded spot and forward FX, strictly speculating for the Bank’s own account. There were no customers yet.

The general telephone switchboard for the branch was located in the same small room where I worked.  There also was one telex machine behind me which I could easily reach by turning around on my swivel chair. This telex served the branch as a whole. It also served me to communicate with international banks for FX trading, which was sometimes faster than the phone. In addition to trading FX, it was my responsibility to answer the general phone number of the branch at the switchboard and to send / receive general telex messages for the branch that had nothing to do with trading.

Trader in the Local Currency Money Market

The export-driven German economy was booming. The German Central Bank was accumulating huge foreign exchange reserves and the German mark had become a candidate for revaluation. Citibank’s many branches in South America and Asia had all opened accounts with our new German branch. In a modest way, they were all speculating on a revaluation of the German mark and, because of that, maintained slightly higher balances in their mark accounts with the Frankfurt Citibank branch. It was customary at that time to send messages to correspondent banks when one was remitting money into the accounts. As a result, every morning I saw messages from some of our branches that they were sending German marks for credit to their account with my branch. I processed those messages and carried them to my friend Bernie Nix who was the head of the bookkeeping department.

After a few weeks Mr. Nix and I met for a drink after work and, after exchanging the jokes of the day, we naturally talked about the business. I asked him what we were doing with all those marks which we were receiving from all over the world. He did not know the answer. The next day he told me that we had accumulated more than 200 million marks (US$50 million) in our non-interest bearing checking account with Deutsche Bank, an account that our Representative Office had used to pay salaries, rent and utility bills prior to the opening of the branch.

I knew that there was an inter-bank money market in Germany and recommended to the Branch Manager that I invest those marks in that market. The Manager was skeptical and worried about our liquidity, because the balances in the overseas branches’ accounts were demand balances and could be withdrawn without notice.
I told him about the overnight money market in which I could invest funds as call money, which I could get back at any time. He approved an investment of ten million marks. After three days he walked into my office and asked me to call the money back from the market. Of course there was no problem. I got the money back and the Branch Manager was convinced. He appointed me the local currency money market trader for the branch on that same morning. Interest rates for German marks were around 3%, so that investing the 200 million marks netted us a nice profit.

Trader in the Foreign Currency Money Market

One Monday morning Peter, a trader from a savings bank, called and asked whether I could sell to him 500,000 dollars for value the next day, Tuesday. As it was Monday, the standard spot value date was Wednesday, two business days later. I told him ‘no’ because I did not have any dollars for value Tuesday. Peter told me that I had many dollars at Citibank headquarters in New York. He explained that I could sell dollars to him value Tuesday and buy them back in the spot market for value Wednesday. This would leave me with cash positions short or overdrawn in dollars from Tuesday until Wednesday, and long or excess cash in marks for the same period.

It became clear to me that the FX rate at which I would sell dollars to Peter value Tuesday (tomorrow) could be the same as the standard offered  rate at which I would sell dollars to him value Wednesday, provided that the interest rate for dollars and marks for the Tuesday – Wednesday period was the same.

If the interest rate for marks was higher than the interest rate for dollars, I would earn that differential, because I could invest the marks at a higher rate than the rate at which I would borrow the dollars from New York. Then I could offer the dollars for value Tuesday at a slightly lower FX rate than the standard offered rate for value Wednesday.

If the interest rate for marks was lower than the interest rate for dollars, that differential would be a cost to me, because I would have to invest the marks at a lower rate than the rate at which I would borrow the dollars from New York. In that case I would have to charge a slightly higher FX rate for the dollars value Tuesday than the standard offered rate for value Wednesday.

I sold the dollars to Peter value Tuesday at an exchange rate that was based on the standard offered rate for value Wednesday, adjusted for the interest rate differential between dollars and marks, plus a profit margin for my branch. I did not borrow the dollars from my New York Headquarters at what would have been a penalty rate. Instead, I borrowed from another bank in the slowly emerging offshore US dollar money market, i.e. the Euro dollar market. I was also grateful to Peter, because the entire episode had taught me how to become a trader in the foreign currency money market.

First Treasurer in a Bank

At this point I had command over all three legs of the business of Treasury: Foreign Exchange, local currency money market and foreign currency money market operations. This was especially attractive because all other banks were not organized that way. They were still decentralized, as described above in this article.

In addition, few if any FX traders understood the interrelationship between interest rate differentials on one side and premiums and discounts in the forward FX market on the other side. Instead, they thought that those premiums or discounts were indicators for the expected trend of the respective spot rates: When the spot exchange rate of a currency is expected to move lower, then the forward exchange rate is already at a discount. And likewise, when the spot exchange rate of a currency is expected to move higher, then the forward exchange rate is already at a premium. Their thinking appeared to be quite logical, but was of course completely wrong.

This misconception presented wonderful opportunities for those of us who did correctly understand forward exchange rates and had access to the local and foreign money markets

In addition to the misconception about forward exchange rates, at other banks the three managers heading the local and foreign money market departments as well as the foreign exchange department did not cooperate much with each other. Because their businesses were so closely  related, they always felt that the other managers were infringing on their territory. This lack of cooperation between those three departments in other banks made life for those of us who had the organizational structure of Treasury even easier and more profitable. A good example for this problem is that even in Citibank, where I invented Treasury, the Treasury concept was introduced last at Headquarters in New York because we had to wait until the very powerful head of the local currency money market department retired.

Expansion of the Treasury Concept

In the mid 1960s, Citibank opened new branches in many other European countries. All of them sent people to Frankfurt. They studied the Treasury concept, and adopted the Treasury organizational structure right from the beginning. The concept had two major advantages. First, it was immensely profitable, because it allowed the Treasurer to take advantage of imperfections and disparities in the international market place. Second, the ability to create fully hedged local currency by swapping dollars and other foreign currencies into those miscellaneous local currencies augmented the local currency deposit base in all those countries. This increased Citibank’s ability to make local currency loans to customers, which often sparked new expanded banking relationships.

In 1970 soon after I moved from Germany to Citibank’s headquarters in New York, Citibank asked me to systematically go around the world and implement the Treasury concept in all Citibank branches. This was a self-liquidating job. After two years all countries had been converted. At that time, Regional Treasurers were appointed to assure the ongoing maintenance and successful implementation of the Treasury. In 1975, I became the first Regional Treasurer for Asia and lived for several years in Manila and Hong Kong.

Gradually the global market recognized the advantages of the Treasury organizational structure and the concept became industry standard.

Applications of the Treasury Concept

Below Market Rate Local Currency Funding

Because the German mark (DM) was a revaluation prone currency the US dollar (US$) was always under downward pressure to move lower. As a result the discount quoted in the market for forward US$ against DM was larger than it should have been based on the interest rate differential. Earlier in this article, I used a set of market rates, in which the spot FX rate was 7.00  and the interest rates for dollar and LCY were 5% and 3% respectively. In that situation the discount of the dollar is 2%, the swap rate is 0.14 and the one year forward FX rate is 6.86

Imagine that a bank in Germany was quoting a discount of 0.20 for a one year swap, i.e. offering one year forward dollars at 6.80, which is equal to a discount of 2.86%. In that case

  • I would have borrowed dollars  for one year at 5.00%
  • minus the discount or swap gain of 2.86% (0.20 as % of the FX rate of 7.00 per $)
  • and create fully hedged LCY for one year at 2.14% or 0.86% lower than the 3% market rate

A slightly different but basically similar technique involved the commercial FX business with customers. Instead of entering into a natural swap with a bank (spot and forward contract performed with the same counterparty) I would quote very competitive forward outright bid rates to exporters who wished to sell forward dollars in order to hedge their dollar denominated export receivables. After buying the forward dollars outright from the customer I would sell spot dollars in the inter-bank market and create the same cash flows as if I had done a natural swap with another bank. I called this an engineered (pieced together) swap, because forward purchase from a customer and spot sale of dollars against LCY to another bank was done with two different counterparties. The result was the same: Creation of below-market-rate local currency funding. Using this approach, I did more customer FX business, bolstered the relationship with a customer and did not touch the FX forward inter-bank market, in which constant demand for forward dollars might have narrowed the discount for dollars.

Bolstering Funding Liquidity at a Rate Equal to the Market Rate

Frankfurt was the third branch to be opened by Citibank in Europe. The other two branches were in London and Paris and had been opened many years before. It turned out that the Paris branch had substantial local currency loan demand in French franks but could not lend because they did not have the local currency deposits. However, the same branch had received from customers substantial dollar deposits, which the branch kept on deposit with other banks in the Euro dollar market. The solution was easy: Swap those dollars into French franks, and use those French franks to satisfy the local currency loan demand of our customers in France.

Broad Global Application in the International Financial Market

In retrospect, one can say that the forward exchange contract was the first financial derivative contract.
Together with derivatives for interest rates, equities and credit, it allowed sophisticated borrowers and investors to increase liquidity and lower borrowing costs on the borrowing side, and increase investment yields on the investment side.

Borrowers do not borrow at the type of interest rate and in the currency which they really ultimately want.
Instead they offer debt instruments at interest rates and in currencies that are popular with investors. Once borrowers have the money, they will use the aforementioned derivatives to create the kind of currency at the type of interest rate (fixed or floating) they really want.

Likewise, investors will not invest at the type of interest rate and in the currency in which they really wish to invest. Instead they invest in instruments and currencies and at types of interest rates that are popular with borrowers. Once the investment has been made, the investors will use the aforementioned derivatives to turn their investment into the type of currency and interest rate (fixed or floating) which they originally wanted.

The World Bank was one of the first financial institutions to apply this philosophy. In the early 1980s, they regularly came to the market and borrowed US dollars at a fixed rate. However, even though they were a AAA borrower, the world gradually got tired of investing in that type of paper. The dollar’s value began to go down, and the world’s Central Banks held reserves not only in dollars but also in Yen, Marks and Swiss franks. The World Bank realized that and began to issue it’s debt in various different currencies and at floating as well as fixed interest rates.

Those modified debt instruments were more popular with investors. The World Bank debt was easier to place and their liquidity was improved. The problem was that the borrowed money was in the wrong currencies and at the wrong interest rates. Therefore the World Bank used miscellaneous derivatives to turn the proceeds of their borrowings into fixed interest rate dollars, which is what they wanted in the first place. Their effort and their willingness to cater to their customer needs were rewarded with improved liquidity and a borrowing cost that was below prevailing market rates.

Risks in Trading and Financial Engineering

Borrowing and investing, including the use of derivatives, is only limited by the imagination of market participants, which is why I often refer to it as “Financial Imagineering, ” i.e. financial engineering with imagination. As we have seen in the most recent past, this can lead to quite complex operations and instruments which sometimes even the participants themselves can no longer understand. In 1990 Alan Greenspan, then Chairman of the Federal Reserve Board warned:

“We must all guard against a situation, in which the designers of financial strategies (traders)
lack the experience to evaluate the attendant risks, and their experienced senior managers are
too embarrassed to admit that they do not understand these new strategies.”

Exactly what Greenspan wanted to avoid has happened almost continuously over the last 25 years. It is therefore imperative for participants in this market to focus on treasury related operations and internal controls as much as on the business itself.

In the late 1980s, I became a member of Citibank’s Credit Policy Committee and soon thereafter also a founding member of the Bank’s Market Risk Policy Committee. At that time I pioneered volatility-based techniques for controlling risks associated with financial trading. These techniques include the concept of ‘Value-at-Risk’ (VAR) for the control of price risk and ‘Loan Equivalents’ for the control of pre-settlement counterparty credit risk in trading. These two concepts allowed a meaningful “risk versus return” analysis for the first time. One of my favorite slogans is “Just making money is not good enough anymore!” Profits must be judged in conjunction with how much price risk (VAR) was assumed and how many Risk Assets were put on the balance sheet. In other words, how much equity capital was tied up in order to earn those profits and what were those profits expressed as a percentage of this tied up equity (Return on Equity or ROE)

I am in the process of using the “Value-at-Risk” concept to create a real risk-versus-return ratio (Riehl Risk Ratio – pun intended!) for Hedge Funds as a complement to the Sharp Ratio, which measures performance   against the volatility of past earnings.

McGraw-Hill in New York published my book “Managing Risk in the Foreign Exchange, Money, and Derivative Markets,” which has been translated into Chinese (ISBN 978-7-81138-034-7). This book describes all the business-related risks mentioned above, including the concepts of Value-at-Risk and Loan Equivalents. The book also has a large section on Internal Controls which are still “state of the art.”  These controls include segregation of responsibilities, Product Programs (which ex-ray new products for any kind of risk – a similar concept to the testing of new pharmaceutical products by the government before releasing them to consumers), customer suitability and appropriateness, risk versus return analysis as well as the importance of the audit function. Had these control mechanisms been observed, most of the mishaps during the 2007 – 2008 period including the sub-prime mortgage crisis would not have happened.