Bank Investment Management
Oleg Deev
oleg@mail.muni.cz
2
Managing the Investment Portfolio
̶ Securities activities of large and small banks are fundamentally
different.
̶ Many small banks buy securities and hold to maturity.
̶ Large banks buy securities for their own portfolios and also trade them
prior to maturity to make profits.
May also manage a trading account and have underwriting subsidiary that helps issue
securities.
̶ Historically, bank regulators have limited risk associated with
banks owning securities by:
̶ limiting debt instruments to investment grade securities
̶ prohibiting banks from purchasing common stock (for income purposes)
and mandating they effectively monitor the credit quality of individual
securities
̶ Increasingly, banks are pursuing active strategies in managing
investments in a search for higher yields.
3
Investment activities objectives
̶ When banks buy securities, they must indicate the
underlying objective for accounting purposes:
̶ Held-to-maturity securities are recorded at amortized cost on the
balance sheet with changes in value having no impact on the
income statement.
̶ Available-for-sale securities are reported at market value with
any changes in market value due to interest rate changes
recorded as unrealized in stockholders’ equity.
̶ Trading account represents securities held for resale. Listed
separately on balance sheet and marked to market with gains or
losses reported on income statement.
4
Bank Investment Trading Activities
̶ Banks perform three basic functions within their trading
activities:
̶ Offer investment advice and assistance to customers managing
their own portfolios.
̶ Maintain security inventory for possible sale to investors.
Willingness to buy and sell securities is called making a market.
̶ Traders speculate on short-term interest rate movements by taking
positions in various securities.
̶ Banks earn profits from their trading activities in several
ways:
̶ When making a market, they price securities at an expected
positive spread charging a higher price on securities sold than
price paid on securities purchased.
Bid is the price the dealer is willing to pay.
Ask is the price the dealer is willing to sell.
̶ Traders can also earn profits if they correctly anticipate interest
rate movements.
5
Objectives of the Investment Portfolio
̶ A bank’s investment portfolio differs markedly from a
trading account as investment securities are held to
meet one of six general objectives:
̶ Safety or preservation of capital
̶ Liquidity
̶ Yield
̶ Credit risk diversification
̶ Help in manage interest rate risk exposure
̶ Assistance in meeting pledging requirements
6
Objectives of the Investment Portfolio
̶ Safety or Preservation of Capital:
̶ Banks typically balance considerable loan portfolio default risk with
lower default risk in their investment portfolios.
Primary objective is to preserve capital by purchasing securities where
there is only a small risk of principal loss.
̶ Regulators encourage this policy by requiring that banks
concentrate their holdings in high quality securities.
̶ Yield:
̶ To be attractive, investment securities must pay a reasonable
return for the risks assumed.
Return may come in the form of price appreciation or interest and be
fully taxable or exempt from taxes.
7
Objectives of the Investment Portfolio
̶ Liquidity:
̶ Banks purchase debt securities to help meet liquidity
requirements.
̶ Securities with maturities < 1 year classified as liquid.
Most securities with a market value about book value can also be quickly
converted to cash, regardless of maturity, because management is willing to sell
them.
̶ Diversify Credit Risk:
̶ Diversification objective linked to safety objective and difficulties
banks have diversifying their loan portfolios.
Investment portfolios give banks the opportunity to spread credit risk outside
their geographic region and across industries.
̶ Help Manage Interest Rate Exposure:
̶ Investment securities are very flexible instruments for managing a
bank’s overall interest rate risk exposure.
Banks can select terms that meet needs without antagonizing the borrower and
can readily sell the security if their needs change
8
Objectives of the Investment Portfolio
̶ Pledging Requirements:
̶ By law, commercial banks must pledge collateral against certain
types of liabilities.
Banks that borrow via repurchase agreements essentially pledge part
of their securities portfolio against this debt.
Banks that borrow at the discount window or from the FHLB must
collateralize the loan.
Banks that accept public deposits must pledge government securities
against uninsured portions of the deposit.
̶ Banks have some discretion in choosing what to pledge.
Should pledge the least liquid acceptable asset.
9
Composition of the Investment Portfolio
̶ Money market instruments with short maturities and
durations include:
̶ Treasury bills, large negotiable CDs and Eurodollars, banker's
acceptances, commercial paper, security repurchase agreements.
̶ Capital market instruments with longer maturities and
duration include:
̶ Long-term government securities, obligations of government
agencies, municipal bonds, mortgage-backed securities backed
both by government and private guarantees, corporate bonds,
foreign bonds, and other asset-backed securities.
10
Establishing Investment Policy Guidelines
̶ Each bank’s asset and liability or risk management committee
(ALCO) is responsible for establishing investment policy
guidelines.
̶ Guidelines define parameters within which investment decisions help
meet overall return and risk objectives.
̶ Because securities are impersonal loans that are easily
bought and sold, they can be used at the margin to help
achieve a bank’s liquidity, credit risk, and earnings sensitivity
or duration gap targets.
̶ Investment guidelines identify specific goals and constraints
regarding:
̶ Return Objectives
̶ Portfolio Compositions
̶ Liquidity Considerations
̶ Credit Risk Considerations
̶ Interest Rate Risk Considerations
̶ Total Return versus Current Income
11
What Are Suitable Investment Securities?
̶ In order for an investment to be suitable, the answer to
the following questions must be YES:
̶ Does the security meet one or more of the bank’s stated
objectives?
̶ Does management understand the security’s underlying cash
flows and can changes in cash flows be reasonably forecast under
different interest rate and economic scenarios?
̶ Can the bank readily see the security at a reasonable price
because there is an active secondary market for it?
̶ Can the security be used to meet pledging requirements so that
the bank can borrow against it?
Yield Curve Strategies
Playing the yield curve - take advantage of expected movements in the shape and
level of the yield curve.
Example: purchase short-term securities when interest rate levels are low and switch to long-term
securities when rates are high. As rates subsequently fall, earn a capital gain on long-term securities.
Also, when rates were rising, capital losses are avoided.
Riding the yield curve - assumes that the yield curve will not move in the near
future.
Example: assume that the yield curve is upward sloped. Buy securities and hold them so that their
maturity decreases and (due to the shape of the yield curve) their yields decline (prices rise). Sell for a
capital gain.
Yh = Y0 + Tr(Y0 - Ym)/ Th
Example: given the original yield on a bond is 10%, time remaining to maturity on
the bond when sold is 1 year, the time lapsed between the purchase and sale of
the bond is 1 year, and the yield at the end of the holding period when the bond is
sold is 9%, we have
Yh = 0.10 + 1(0.10 - 0.09)/1 = 0.11 or 11%
13
̶ Passive Maturity Strategies
̶ The barbell maturity strategy differentiates investments between those
purchased for liquidity versus income.
Short-term securities are held for liquidity and long-term securities for income.
̶ Active Maturity Strategies
̶ Active portfolio management involves taking risks to improve total returns
by adjusting maturities, swapping securities and periodically liquidating
discount instruments.
̶ To be successful, bank must avoid trap of aggressively buying fixedincome
securities at relatively low rates when loan demand is low and
deposits are high.
̶ Riding the yield curve works best when the yield curve is upward-sloping
and rates are stable. Three basic steps:
Identify the appropriate investment horizon.
Buy a par value security with a maturity longer than the investment horizon and where the
coupon yield is higher in relationship to the overall yield curve.
Sell the security at the end of the holding period when time remains before maturity.
Active Investment Strategies
Passive Maturity Strategies
̶ Spaced-maturity approach (or ladder approach)
̶ Spread available investment funds evenly across a specified
number of periods within the bank’s investment horizon.
̶ Simple and low transactions costs, but passive with respect to
interest rate conditions and liquidity is sacrificed to some extent.
̶ Split-maturity approach (or barbell approach)
̶ Greater quantities of short-term and long-term securities are held.
̶ This strategy balances liquidity and higher income.
̶ Can adapt to front-end loaded and back-end loaded approaches.
15
16
17
LSEG Curve function
18
Strategies Underlying Security Swaps
̶ Active portfolio strategies enable banks to sell securities prior
to maturity whenever economic conditions dictate returns can
be earned without a significant increase in risk.
̶ In most cases, banks reinvest sales proceeds to improve long-term
profitability.
̶ Banks are reluctant to sell securities at a loss.
̶ Investors who hold securities to maturity may suffer an opportunity
loss by not selling security at a loss or give up substantial value by
selling at a premium to capture gain.
̶ Banks can effectively improve portfolios by:
̶ Upgrading bond credit quality by shifting into high-grade instruments
when quality yield spreads are low.
̶ Lengthening maturities when yields expected to level off or decline.
̶ Obtaining greater call protection when rates expected to fall.
̶ Improving diversification when management expects economic
conditions to deteriorate.
Bond-swapping strategies
Substitution or price swap - sell overvalued securities and buy
undervalued securities that may occur due to temporary market
disequilibrium.
Yield-pickup or coupon swap - exchange low-coupon for high-coupon
bonds, or vice versa, due to interest rate risk and tax differences
between these two types of bonds.
Spread or quality swap - exchange of two bonds with unequal risk.
Motivated by an abnormally low or high price of either or both bonds.
Portfolio shift - sell low yielding securities and replace with high yielding
securities. Deduct capital losses on low yielding securities from taxes.
Key is to compare net profits on these two bond strategies over time and
choose higher profit strategy.
20
Foreign Exchange Activities
̶ Different countries use different monetary units and traders
must be able to convert one into another.
̶ Foreign exchange markets are where monetary units are traded.
̶ Foreign exchange refers to currency other than the monetary
unit of the home country.
̶ Exchange rate is the price of one currency in terms of another
currency.
̶ Foreign Exchange Risk:
̶ Current and potential risk to earnings and stockholders’ equity arising
from changes in foreign exchange rates.
Evidenced when changing exchange rates affect cash inflows than cash outflows
associated with these currencies.
̶ Changes in values of foreign currency positions (buying and selling
foreign currencies for their own account) due to changing foreign
exchange rates indicates price risk.
21
Foreign Exchange Activities
̶ Foreign Exchange Risk:
̶ Bank’s net balance sheet exposure in currency j (NEXPj) is the
amount of assets minus the amount of liabilities denominated in
currency j:
NEXPj = Aj – Lj where: Aj = assets denominated in currency j,
Lj = liabilities denominated in currency j
̶ If NEXPj > 0, the bank is long on currency j and if NEXPj < 0, the
bank is short on currency j.
̶ Gain or loss on a position is indicated by:
NEXPj x ∆ spot exchange rate
Evaluating investment risk
̶ Security-specific risk
̶ Default risk and credit ratings by rating agencies:
Investment grade bonds (top 4 credit ratings)
Junk bonds (lower rated bonds)
Estimates of the probability of default
Bondholder losses in default not captured by credit ratings
Bond prices inversely related to default risk
Yield spreads between low- and high-quality bonds can vary with
economic conditions
̶ Price risk related to changes in interest rates:
P = -D x B x i/(1 + i)
where  = change, D = duration, B = price of bond before change in
interest rates, and i = interest rate.
Example: given a $1,000 bond with a 5-year duration and an expected
increase in interest rates from 5% to 7%, we have
P = -5 x $1,000 x (0.02/1.05) = $95
New price of this bond is $905.
Evaluating investment risk
̶ Security-specific risk
̶ Yield curve and changes in its level and shape over the business
cycle.
̶ Expectations theory of the yield curve:
(1 + 0R2)2 = (1 + 0R1) (1 + 1r2)
where 0R2 = the 2-year (spot) rate, 0R1 =the 1-year (spot) rate, and 1r2 =
the 1-year (future implicit) rate.
Example: given 0R2 = 10% and 0R1 = 9%, we have
(1 + .10)2 = (1 + .09) (1 + 1r2)
(1 + 1r2) = 1.11 such that 1r2 = 0.11 or 11%
Assumes that investors are risk-neutral and seek to maximize returns.
Empirical studies have found that implicit future rates are biased upward.
Evaluating investment risk
̶ Security-specific risk
̶ Liquidity premium theory:
Long-term interest rates contain a premium for price risk.
Need to subtract this premium from long-term rates to adjust the
expectations formula and get unbiased estimated of implicit future rates
(e.g., if the liquidity premium equals 0.5%, and 0R2 = 10%, then use
0R2 =9.5% is the formula for the expectations theory).
̶ Segmented markets theory
Money and capital markets are separate in many ways with different
supply and demand factors affecting changes in interest rates in these
markets.
̶ Preferred-habitat theory
Takes into account all three yield curve theories.
Evaluating investment risk
̶ Security-specific risk
̶ Value-at-risk (VaR)
The maximum amount that could be lost in investment activities in a
specified period of time.
Example: based on an historical distribution of interest rates, the
probability of a 50 basis point increase in interest rates in a 10-day
holding period is 5%. If a bank held $1 billion of securities with
average duration of 3 years, and interest rates are currently 6%, the
maximum possible loss in one-out-of-20 holding periods is
P = -3 x $1billion x (0.0050/1.06) = -$15.6 million
Note: Banks need to calculate VAR under alternative interest rate
conditions (or forecasts). These stress tests consider the sensitivity
of VAR to different assumptions about interest rates. Also, bank
management can use derivatives securities to hedge rate movements
and thereby better control large VARs.
Evaluating investment risk
̶ Security-specific risk
̶ Marketability risk
Selling securities quickly without capital loss.
̶ Call risk
Bonds that can be redeemed by the borrowing firm prior to maturity.
Call deferment period must expire.
Also, bond’s price must be greater than or equal to the call price.
Call risk related to reinvestment risk, as bonds are typically called during
low interest rate periods.
Call premium paid as compensation for reinvestment risk.
Evaluating investment risk
̶ Portfolio risk
̶ Diversification reduces the variability of returns on assets.
̶ Securities can reduce portfolio risk when combined with loans
(e.g., loan losses during a recession and associated low interest
rates can be partially offset with increasing capital gains on
securities as rates declined).
̶ Inflation risk
̶ Unanticipated increases in inflation can cause losses in the
securities portfolio.
̶ Historic lows in inflation rates in the 1990s and 2000s has been
cited as a factor in explaining the strong capital gains in securities
markets (especially the stock market).