INVESTMENT OF BANK FUNDS

Introduction

Investments: A major asset in banks Why do banks invest in securities???

Safety of Capital Liquidity Yield Diversification of credit risk Managing interest rate risk exposure Meeting pledging requirements

Based on objective of investment, banks divide their security holdings into three categories:

Held to maturity (HTM) : these are securities purchased with the objective of holding till maturity. On the balance sheet, they are carried at amortised cost. The capital gain or losses at the time of maturity will be taken to the income statement. However, during the period they are held, unrealistic gains and losses due to market fluctuations have no impact on the income statement. Held for trading (HFT): these securities are purchased with the intent to sell in the near term. They are carried at market value on the balance sheet and therefore unrealistic gains or losses could impact the income statement. Available for sale (AFS): securities not classified under above two categories will be included here. They too are carried at market value on the balance sheet.

The Treasury Functions

Investment advice and assistance to customers, including other banks, to manage their investment portfolios. Most treasury products are associated with the credit and cash management needs of corporate customers. The treasury can also play an important role in structuring products to hedge the banks own capital. These products-typically derivative contracts-protect the banks capital exposure to a particular currency or to market forces such as changing interest rates and commodity prices. The treasury buys and sells securities on behalf of the customers. Treasuries willingness to buy and sell securities is also called making the market. While making the market, they also make profits on the transactions, by maintaining a positive spread between the bid and ask prices. Large banks are also market makers in options and interest rate swaps.

Banks, as traders, also speculate on short term interest rate movements. Also the treasury could borrow in short term money market and invest in commercial papers. In developed markets, the treasury departments act as risk managers for banks. By using sophisticated internal transfer pricing, the treasury buys and sells funds among the banks client-facing units, thus isolating and removing maturity and interest rate mismatches from corporate and retail business units.

Sources of Treasury Profit

Foreign exchange business

Buying and selling forex forwards, futures ,swaps involving forex Loans and advances in foreign currency

Money market products

Repos T-bills Commercial papers Certificate of deposits

Security market products

Government securities Bonds Equities

RETURNS OF INVESTMENT SECURITIES

Methods in which banks investments contribute to returns are:

Interest

income Income from reinvestment Capital gains and losses

RISKS
Interest

rate risk

Reinvestment risk

Credit

risk Liquidity risk Inflation risk

VALUE AT RISK (VaR)

VaR is defined as the maximum potential loss in the value of a portfolio due to adverse market movements, for a given probability Reduces the market risk to just one number Summarizes the predicted maximum loss over a target horizon within a given confidence level

VaR.cont.

E.g.
Assume

a bank holds Rs.100crore in medium-term investments. How much could the bank lose in a month? answer would help the bank to decide whether the returns it receives is an appropriate compensation for risk.

The

VaR PARAMETERS

Two quantitative parameters:

Horizon Confidence level

The parameters can be changed assuming portfolio returns follow a normal distribution using the formula:

VaR(n days)=n* VaR(1 day)

To convert from one confidence level to another to another, use standard normal tables

USES OF VaR
Summarizes the portfolios exposure to market risk Summarizes the probability of an adverse move Helps investors to decide their degree of comfort for a particular risk level Helps in internal capital allocation

SHORTCOMINGS OF VaR

Fails to measure event risks like market crashes

Does not readily capture liquidity difference among instruments

SUMMARY OF VaR

Using a probability of x% and a holding period of n days, an entitys VaR is the loss that is expected to be exceeded with a probability of only x% during the next nday holding period

Investment portfolio
Permanent

investment Current investment RBI stipulations

Investment category
Government sector Approved sector

Permanent
25% 25%

Current
75% 75%

Shares
Debentures/ bonds Subsidiaries / JVs Others

100% -

100%
100% 100%

Portfolio classification
Objective

of investment decided at the time of acquisition Held to maturity (HTM): intention to hold till maturity Held for trading (HFT): intention to trade by taking advantage of short term movements Available for sale (AFS): securities not falling in above categories

Held to maturity
Banks

can exceed the limit of 25% of total investment under the following : - Excess comprise only of SLR activities - Total SLR held in HTM does not exceed 25% of DTL on the last Friday of the 2nd preceding fortnight Profit on sale first to the profit/ loss and then appropriated to the capital reserve account. Loss on sale recognized in the P&L account

 Following

securities can be held under HTM

category : - SLR securities upto 25% of DTL as on last Friday of 2nd preceding fortnight - Non SLR securities included under - Fresh recapitalization bonds received from government - Fresh equity investment in subsidiaries and JVs where it holds more than 25% of equity - RIDF (Rural infrastructure development fund ) / SIDBI deposits

 Debentures/

bonds held under the HTM category must be treated as advances under following circumstances: - if issued as part of proposal for project finance and tenure is of 3 years and above - if issued as part of proposal for working capital finance and tenure is less than 1 year - if bank has a significant stake (10% or more) in the issue - if issue is part of private placement

Other categories
Profit

or loss from investments in both categories will be taken to the P&L account Investments classified under the HFT category should be sold within 90 days Bank has freedom to classify the extent of holdings under the 2 categories on the basis of: - basis of intent - trading strategies - risk management - tax planning - capital positions

Shifting categories
Banks

may shift investments to/ from HFT category once a year with the approval of board of directors Banks may shift from AFS to HFT with the approval of board of directors/ investment committee Shifting from HFT to AFS is generally not allowed, except under exceptional circumstances like inability to sell security but only with the approval of board of directors or investment committee

Valuation
HTM

- Investments carried at acquisition cost - No need of marked-to-market - Premium to be amortized over period remaining to maturity - Any diminution, other than temporary in the value of banks investment in subsidiaries or JVs should be provided for

 AVS

- Should be marked to market at most frequent intervals - Net depreciation to be provided for - Net appreciation should be ignored - No set offs across categories allowed

 HFT

- Should be marked to market at monthly or frequent intervals - Treatment of depreciation similar to AVS - Book value of securities dont change after marking to market

INVESTMENT FLUCTUATION RESERVE

To

be maintained at min. 5% of the portfolio worth Max. 10% of investment portfolio Should be calculated with reference to investments in the category of HFT & AVS Banks maintaining capital of atleast 9% of RWA for the categories HFT &AVS may transfer the balance in excess of 5% of securities to statutory reserve (part of tier 1 capital)

Market value
Quoted

securities - Market price of security available Unquoted securities - Central govt. securities: basis of proces and YTM rates published - T bills to be valued at carrying costs - State govt. securities: valued through YTM methods, marked up by 25 bps above central govt. securities of equivalent maturity - Other approved securities: valued by applying the YTM method by marking it up by 25 bps above central govt. securities of equivalent maturity

BASEL II

Three pillar approach to risk management

Pillar

1 minimum capital requirements Pillar 2 supervisory review process Pillar 3 market discipline and disclosures

Continued.
ADVANCED INTERNAL RATING BASED APPROACH
FOUNDATION INTERNAL RATING BASED APPROACH Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.
INCREASED SOPHISTICATION

Risk weights are assigned in slabs STANDARDISED according to the asset class or are based on assessment by external credit APPROACH assessment institutions
REDUCED CAPITAL REQUIREMENT

PILLAR 1- MINIMUM CAPITAL REQUIREMENT Standardised Approach Internal Rating Based (IRB) Approach Advance IRB Approach

Standardised Approach
Risk

weights are assigned in slabs of 0%, 20%, 50%, 100% & 150% on the basis of rating assigned by ECAIs. Claims on Corporates will be risk weighted in the range of 20-150% and unrated Corporates will be assigned 100% risk weight.

4-key Risk Elements of IRB

Probability of Default (PD)

It measures the likelihood that the borrower will default over a given timehorizon.

Loss Given Default (LGD) It measures the proportion of the exposure that will be lost if a default occurs.

Exposure at Default (EAD) It measures the amount of the facility that is likely to be drawn if a default occurs .

Maturity (M) It measures the remaining economic maturity of the exposure .

Minimum requirements to adopt IRB approach

Credit

risk management Rating dimensions Rating structure Assessment horizon Rating assignments PD for economic cycle Validation Use of credit risk mitigants

IRB Approach
Values for Loss given default (LGD) and exposure at default (EAD) are provided by the regulatory authority.

Advance IRB Approach

Values for Loss given default (LGD) and exposure at default (EAD) are determined by each bank through internal modeling with a data of 5-7 years.

Assessment of values of credit mitigants is done by the regulatory authority.

Banks may assess the value of its credit mitigants.

For retail exposure, there is no Advanced IRB is applicable to retail foundation IRB (only advanced IRB exposure also. where besides PD, the bank concerned will have to estimate LGD & EAD.)

PILLAR 2-SUPERVISORY REVIEW PROCESS

There are four main areas to be treated as Pillar 2:

Credit

concentration risk Interest rate risk Business cycle effects

Continued

The four key principles of supervisory review are:

Principle

1- assessing the capital adequacy to their risk profile Principle 2- monitoring and compliance with regulatory ratios Principle 3- risk characteristics of the banks

PILLAR 3- MARKET DISCIPLINE

Disclosures requirements Corporate governance Creation of confidence

Non-Performing Investments

Interest/installment is due and remains unpaid for more than 90 days. Fixed dividend on preference shares is not paid. Equity shares are valued at Re 1 per company on account of the non-availability of the latest balance sheet. The bank has invested in securities issued by a borrowing firm, credit facilities to whom is treated as an NPA

Non-Performing Investments
The investments in debentures/bonds, in the nature of advances, would also be subjected to NPI norms as applicable to investments State government guaranteed investments, where interest/principal/maturity proceeds remain unpaid for more than 90 days.

Non-Performing Investments
If interest and principal not paid no income recognition from the securities Appropriate provisions for depreciation Depreciation of NPI cannot be set off against appreciation in other securities.

Income Recognition

Accrual Basis
Securities

of corporate bodies/ public sector undertakings in respect of which the payment of interest and repayment of principal have been guaranteed by the central govt. or a state govt., provided interest is serviced regularly and as such is not in arrears. Divided on shares of corporate bodies, provided dividend on the shares has been declared by the corp. body in its AGM and the owners right to receive payment is established.

Income Recognition
Income

from govt. securities and bonds and debentures of corporate bodies, where interest rates on these instruments are predetermined and provided interest is serviced regularly and is not in arrears.

Cash basis
Income

from units of MFs

Investment Valuation
Investment Portfolio of Bank A at the end of March 2008:
Face Value (Rs.) Number of Securities Total Face Value (Rs.) Acquisition Price (Rs.) I. Govt. Securities 9.28% GOI 2014 (March) 8.51% State Govt. Loan 2016 December Sub Total 100 100 7,000 3,000 700,000 300,000 1,000,000 719,000 316,000 1,035,000

II. Approved Securities 7.55% 2011 February Sub-total III. Equity Shares: AB Financial Services Ltd. Bank G Sub-total IV. Bonds & Debentures 7% 2011 (March) (Taxable) Sub-total V. Subsidiaries AG Caps Sub-total VI. Mutual Funds Sub-total TOTALS

100

35,000

3,500,000 3,500,000

3,670,000 3,670,000

10 10

44,000 23,700

440,000 237,000 677,000

440,000 887,000 1,327,000

100

50,000

5,000,000 5,000,000

4,985,000 4,985,000

10

500,000

5,000,000 5,000,000 100,000 100,000 15,277,000

5,000,000 5,000,000 150,000 150,000 16,167,000

10

10,000

Continued

The Bank classifies the entire govt. and approved securities into current investment category. The prices of govt. securities on the RBI list for sale are:
Security 5.25% 6.10% Maturity 2012 2014 Sale Price (Rs.) 98.90 102

The shares of Bank G are traded in the market at Rs. 27. Since AB Financial Services Ltd. Is not a listed firm, the investment is valued, based on the latest audited accounts, at Rs 2.40 lakh. NAV of MF is Rs 10.75

For all other govt. securities (central and state), the following YTMs are applicable on 31 March, 08:
No. of Years YTM (%) <1 4.3 1 4.5 2 4.54 3 4.6 4 4.66 5 4.83 No. of Years YTM (%) 6 4.96 7 5.05 8 5.05 9 5.07 10 5.17

For valuation of taxable bonds, 1% above the applicable YTM rate is to be applied. Provision made during the previous year stands at Rs. 18 lakh.

Sale Price = I*n F[(0.4nr)-I] 0.6nr+I

Govt. Securities

9.28% GOI 2014 Rs. 8,53,951 8.51% state govt. loan Rs. 3,72,917

Approved Security

7.55% Feb07 Rs. 37,86,064

Equity shares

AB Financial Services Ltd no market quote Bank G 27*23,700 = Rs. 6,39,900

7% bonds Rs. 51,90,770

Investments in subsidiary permanent book value MF 10,000*10.75 = Rs. 1,07,500

Face Value (Rs.) Acquisition Value (Rs.) Market Value (Rs.) Change in Value (Rs.) I. Govt. Securities 9.28% GOI 2014 (March) 8.51% State Govt. Loan 2016 December Sub Total (I) 700,000 300,000 1,000,000 719,000 316,000 1,035,000 853,951 372,917 1,226,868 134,951 56,917 191,868

II. Approved Securities 7.55% 2011 February Sub-total (II) III. Equity Shares: AB Financial Services Ltd. Bank G Sub-total (III) IV. Bonds & Debentures 7% 2011 (March) (Taxable) Sub-total (IV) V. Subsidiaries AG Caps Sub-total (V) VI. Mutual Funds Sub-total (VI) TOTALS (III+VI)

3,500,000 3,500,000

3,670,000 3,670,000

3,786,064 3,786,064

116,064 116,064

440,000 237,000 677,000

440,000 887,000 1,327,000

240,000 639,900 879,900

-200,000 -247,100 -447,100

5,000,000 5,000,000

4,985,000 4,985,000

5,190,770 5,190,770

205,770 205,770

5,000,000 5,000,000 100,000 100,000

5,000,000 5,000,000 150,000 150,000

5,000,000 5,000,000 107,500 107,500

-42,500 -42,500 -489,600

LTCM Collapse and Link with VaR

1998 Worlds largest hedge fund failed and sent shock waves through the worlds financial system.
Federal Reserve Bank of New York facilitated a bailout. Capital base USD 3 mn, Derivatives > USD 5 tn, Assets > USD 10 bn.

Primary contributory factor to failure Poor risk management.

LTCM Collapse and Link with VaR

Combination of different VaR techniques.

VaR analysis showed:
5%

or > - 1 in 5 months 10% or > - 1 in 10 months 20% or > - 1 in 50 years 45% drop in equity value over a course of month 10 std dev - Aug 98

LTCM Collapse and Link with VaR

Aug 98 beyond predictive abilities of VaR models

Russian

crisis triggered drying up of liquidity in the global financial markets Derivative positions slacked VaR estimate daily loss < USD 50 mn Actual daily loss approx. USD 100 mn Fourth day of debacle USD 500 mn Decision to file for bankruptcy followed by bailout

LTCM Collapse and Link with VaR

Wrong basic assumption Historical trends in securities movements were an accurate predictor of future movements.
LTCM used USD 2.3 bn of equity capital and USD 1 bn excess liquidity. Lesson learnt

too many uncertainties in the future that cannot be predicted by the past. VaR has to be used judiciously.