The Investment Function in Banking
Functions of a Bank’s Security Portfolio
n Stabilize the bank’s income, so that bank revenues level out over the business cycle.
n Offset credit risk exposure in the bank’s loan portfolio.
n Provide geographic diversification.
n Provide a backup source of liquidity.
n Reduce the bank’ tax exposure, especially in offsetting taxable loan revenues.
Functions of a Bank’s Security Portfolio….contd
n Serve as collateral to secure government deposits held by the banks.
n Help hedge the bank against losses due to changing interest rates.
n Provide flexibility in a bank’s asset portfolio because investment securities can be bought or sold quickly to restructure bank assets.
n Dress up the bank’s balance sheet & make it look financially stronger due to the high quality of most bank held securities.
Need for Written Investment Policy
v The quality or degree of default risk exposure the bank is willing to accept.
v The desired to maturity range & degree of marketability sought for all securities purchased.
v The goals sought by the bank from its investment portfolio.
v The degree of portfolio diversification to reduce risk the bank wishes to achieve with its investment portfolio.
Investment Instruments Available to Banks and Other Financial Firms
n Popular Money Market Instruments
n Treasury Bills
n Short-term treasury Notes & Bonds.
n Federal Agency Securities (for USA only)
n Certificates of Deposit
n International Eurocurrency Deposits.
n Banker’s Acceptances.
n Commercial Paper.
n Short-term Municipal Obligations
n Popular Capital Market Instruments
n Long-term Treasury Notes & Bonds.
n Municipal Notes & Bonds
n Corporate Notes & Bonds
n Common stock & Preferred Stock
Other Investment Instruments Developed More Recently
vStructured Notes
vSecuritized Assets.
vStripped Securities
v Structured Notes:Structured notes usually are packaged investments assembled by security dealers that offer customers flexible yields in order to protect their customers’ investments against losses due to inflation and changing interest rates. Most structured notes are based upon government or federal agency securities.
Other Investment Instruments Developed More Recently—Contd
v Securitized Assets: Securitized assets are loans that are placed in a pool and, as the loans generate interest and principal income, that income is passed on to the holders of securities representing an interest in the loan pool. These loan-backed securities are attractive to many banks because of their higher yields and frequent federal guarantees (in the case, for example, of most home-mortgage-backed securities) as well as their relatively high liquidity and marketability
Other Investment Instruments Developed More Recently—Contd
n What special risks do securitized assets present to banks and other financial institutions investing in them?
Securitized assets often carry substantial interest-rate risk and prepayment risk, which arises when certain loans in the securitized-asset pool are paid off early by the borrowers (usually because interest rates have fallen and new loans can be substituted for the old loans at cheaper
loan rates) or are defaulted. Prepayment risk can significantly decrease the values of securities backed by loans and change their effective maturities.
Other Investment Instruments Developed More Recently—Contd
Ø Reasons for the popularity of Securitized Assets/Loan-backed investment securities:
ü Guarantees from government agencies or private institutions.
ü The higher average yields available on securitized assets than on U.S. Treasury securities.
ü The lack of good-quality loans & securities of other kinds in same markets around the globe.
ü The superior liquidity & marketability of securities backed by loans compared to the loans themselves.
Other Investment Instruments Developed More Recently—Contd
v Stripped Securities: Stripped securities consist of either principal payments or interest payments from a debt security. The expected cash flow from a Treasury bond or mortgage-backed security is separated into a stream of principal payments and a stream of interest payments, each of which may be sold as a separate security maturing on the day the payment is due. Some of these stripped payments are highly sensitive in their value to changes in interest rates.
Factors Affecting the Choice of Investment Securities
n Expected Rate of Return
n Tax Exposure
n Interest-Rate Risk
n Credit or Default Risk
n Business Risk
n Liquidity Risk
n Call Risk
n Prepayment Risk
n Inflation Risk
n Pledging Requirements
How is the expected yield on most bonds determined?
n For most bonds, this requires the calculation of the yield to maturity (YTM) if the bond is to be held to maturity or the planned holding period yield (HPY) between point of purchase and point of sale. YTM is the expected rate of return on a bond held until its maturity date is reached, based on the bond’s purchase price, promised interest payments, and redemption value at maturity. HPY is a rate of discount bringing the current price of a bond in line with its stream of expected cash inflows and its expected sale price at the end of the bank’s holding period.
How has the tax exposure of various bank security investments changed in recent years?
n In recent years, the government has treated interest income and capital gains from most bank investments as ordinary income for tax purposes. In the past, only interest was treated as ordinary income and capital gains were taxed at a lower rate.
n After-tax Gross Yield on Corporate Bond = Before-tax gross yield to the bank X (1 – Bank’s marginal income tax rate)
Different Types of Risk
n Interest Rate Risk: The danger that shifting market interest rates can reduce bank net income or lower the value of bank assets & equity.
n Credit or Default Risk: The danger that a bank’s extensions of credit will not pay out as promised, reducing the bank’s profitability & threatening its survival.
n Business Risk: The danger that changes in the economy will adversely affect the bank’s income & the quality of its assets.
n Liquidity Risk: The danger that a bank will experience a cash shortage or have to borrow at high cost to meet its obligations to pay.
Different Types of Risk—–Contd
n Call Risk: The danger that investment securities held by a bank will be retired early, reducing the bank’s expected return.
n Prepayment Risk: The danger that banks holding loan-backed securities will receive a lower return because some of the loans backing the securities are paid off early.
n Inflation Risk: The danger that rising prices of goods & services will result in lower bank returns or reduced values in bank assets & equity.
Maturity Management Tools
n The Yield Curve: A geographical relationship between the maturity or term of a collection of securities & their yield to maturity.
Maturity Management Tools—-Contd
Ø Features of Yield Curve:
Ø Yield curves possibly provide a forecast of the future course of short-term rates, telling us what the current average expectation is in the market.
Ø The yield curve also provides an indication of equilibrium yields at varying maturities and, therefore, gives an indication if there are any significantly underpriced or overpriced securities.
Ø The yield curve’s shape gives the bank’s investment officer a measure of the yield trade-off – that is, how much yield will change, on average, if a security portfolio is shortened or lengthened in maturity.
Maturity Management Tools—-Contd
n Duration: Duration tells a bank about the price volatility of its earning assets and liabilities due to changes in interest rates. Higher values of duration imply greater risk to the value of assets and liabilities held by a bank. For example, a loan or security with a duration of 4 years stands to lose twice as much in terms of value for the same change in interest rates as a loan or security with a duration of 2 years.