Professional Documents
Culture Documents
The Investment
Function in Banking
M. Morshed 1
Why do banks and their closest competitors, the thrift
institutions, choose to devote a significant portion of their
assets to investments in securities?
M. Morshed 2
Functions of a Bank’s Security Portfolio
a) Stabilize the bank’s income, so that bank
revenues level out over the business cycle.
b) Offset credit risk exposure in the bank’s loan
portfolio.
c) Provide geographic diversification.
d) Provide a backup source of liquidity.
e) Reduce the bank' tax exposure, especially in
offsetting taxable loan revenues.
M. Morshed 3
Functions of a Bank’s Security Portfolio….contd
M. Morshed 4
Need for Written Investment Policy
The quality or degree of default risk exposure the
bank is willing to accept.
The desired to maturity range & degree of
marketability sought for all securities purchased.
The goals sought by the bank from its investment
portfolio.
The degree of portfolio diversification to reduce
risk the bank wishes to achieve with its investment
portfolio.
M. Morshed 5
Figure: Investments – The crossroads Account
On a Bank’s Balance Sheet
Asset Liabilities
Cash Deposits
M. Morshed 6
Investment Instruments Available to Banks
and Other Financial Firms
A. Popular Money Market Instruments
1. Treasury Bills
2. Short-term treasury Notes & Bonds
3. Federal Agency Securities (for USA only)
4. Certificates of Deposit
5. International Eurocurrency Deposits
6. Banker’s Acceptances
7. Commercial Paper
8. Short-term Municipal Obligations
B. Popular Capital Market Instruments
1. Long-term Treasury Notes & Bonds.
2. Municipal Notes & Bonds
3. Corporate Notes & Bonds
4. Common stock & Preferred Stock
M. Morshed 7
Other Investment Instruments Developed
More Recently
Structured Notes
Securitized Assets.
Stripped Securities
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.
M. Morshed 8
Other Investment Instruments Developed More Recently---Contd
M. Morshed 9
Other Investment Instruments Developed More Recently---Contd
M. Morshed 10
Other Investment Instruments Developed More Recently---Contd
M. Morshed 11
Other Investment Instruments Developed More Recently---Contd
M. Morshed 12
Factors Affecting the Choice of Investment
Securities
M. Morshed 13
How is the expected yield on most
bonds determined?
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.
M. Morshed 14
How has the tax exposure of various
bank security investments changed in
recent years?
when borrowing money to buy municipal securities. 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. Tax reform in the United States has also had a
major impact on the relative attractiveness of state and
local government bonds as bank investments, limiting
bankers’ ability to deduct borrowing costs for tax purposes
After-tax Yield of a Bond = Before-tax Yield (1 – T)
TEY = Yield of Tax-exempt Bond / (1 – T)
M. Morshed 15
What is Tax Swapping? What is Portfolio Shifting?
M. Morshed 16
Different Types of Risk
Interest Rate Risk: The danger that shifting market
interest rates can reduce bank net income or lower the
value of bank assets & equity.
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.
Business Risk: The danger that changes in the economy
will adversely affect the bank’s income & the quality of its
assets.
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.
M. Morshed 17
Different Types of Risk-----Contd
M. Morshed 18
Pledging Requirements
Pledging requirements are in place to safeguard the deposit
of public funds. The first $100,000 of public deposits is
covered by Government deposit insurance; the rest must be
backed up by bank holdings of. Treasury and government
agency securities valued at their par values. When a bank
borrows from the discount window of its district branches
of Central bank, it must pledge either government
securities or other collateral acceptable to the CB.
Typically, banks will use Treasury securities to meet these
collateral requirements. If the bank raises funds through
repurchase agreements (RPs), banks must pledge
securities, typically. Treasury and government agency
issues, as collateral in order to borrow at the low RP
interest rate.
M. Morshed 19
Investment Maturity Strategies
A. The Ladder or Spread-Maturity Strategy: Equally
spacing out a bank's security holdings over its preferred
maturity range to stabilize investment earnings.
% of the value
of all securities
held
30
20
25% of 25% of 25% of 25% of
10 Portfolio Portfolio Portfolio Portfolio
M. Morshed 20
Investment Maturity Strategies----Contd
B. The Front-End Load Maturity Strategy: It implies
that a bank will pile up its security holdings into the
shortest maturities to have maximum liquidity and
minimize the risk of loss due to rising interest rates.
% of the value
of all securities
held
50
40 70%
30
20 30%
10
1 year 2 year 3 year 4 year
Maturity in years & months
M. Morshed 21
Investment Maturity Strategies----Contd
% of the value
of all securities
held
30% 30%
20%
10% 10%
1 2 3 4 5 6 7 8 9 10 11 12
Maturity in years & months
M. Morshed 22
Investment Maturity Strategies----Contd
40
30
20 30%
30%
20% 20%
10
1 2 3 4 5 6 7 8 9 10 11 12 13
% of the value
of all securities
Shift towards short-term securities if interest rates are expected to rise
held
M. Morshed 24
Maturity Management Tools
1) The Yield Curve: A geographical relationship between
the maturity or term of a collection of securities & their
yield to maturity.
Yield to
Maturity
(YTM)
M. Morshed 25
Maturity Management Tools----Contd
M. Morshed 26
Maturity Management Tools----Contd