Chapter:10

The Investment
Function in Banking

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 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.

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Functions of a Bank’s Security Portfolio….contd

f) Serve as collateral to secure government

deposits held by the banks.
g) Help hedge the bank against losses due to
changing interest rates.
h) Provide flexibility in a bank’s asset portfolio
because investment securities can be bought or
sold quickly to restructure bank assets.
i) Dress up the bank’s balance sheet & make it
look financially stronger due to the high quality
of most bank held securities.

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 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.

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 Figure: Investments – The crossroads Account
On a Bank’s Balance Sheet
Asset Liabilities
Cash Deposits

Add to Sell investments

Investments When cash is
When cash low When deposits are low use
Is excess Investments as collateral for more
borrowings
Nondeposit
Investment Borrowings
Add to investments Return investments pledged
Sell
When loan demand As collateral to the investment
Investments
Is weak. Portfolio when deposit growth
When loan
Is strong
Demand is
high
Loans

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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
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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.

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Other Investment Instruments Developed More Recently---Contd

 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

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Other Investment Instruments Developed More Recently---Contd

 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.

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Other Investment Instruments Developed More Recently---Contd

 Reasons for the popularity of Securitized Assets/Loan-

backed investment securities:
 Guarantees from government agencies or private
institutions.
 The higher average yields available on securitized
assets than on U.S. Treasury securities.
 The lack of good-quality loans & securities of other
kinds in same markets around the globe.
 The superior liquidity & marketability of securities
backed by loans compared to the loans themselves.

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Other Investment Instruments Developed More Recently---Contd

 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.

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 Factors Affecting the Choice of Investment
Securities

A. Expected Rate of Return

B. Tax Exposure
C. Interest-Rate Risk
D. Credit or Default Risk
E. Business Risk
F. Liquidity Risk
G. Call Risk
H. Prepayment Risk
I. Inflation Risk
J. Pledging Requirements

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 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.

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 How has the tax exposure of various
bank security investments changed in
recent years?
 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
when borrowing money to buy municipal securities.
 After-tax Gross Yield on Corporate Bond = Before-tax
gross yield to the bank X (1 – Bank’s marginal income
tax rate)
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What is Tax Swapping? What is Portfolio Shifting?

 Tax Swapping: A tax swap involves exchanging one type

of investment security for another when it is advantageous
to do so in reducing the bank's current or future tax
exposure. For example, the bank may sell investment
securities at a loss to offset high taxable income on loans
or to replace taxable securities with tax-exempt securities.
 Portfolio Shifting: Portfolio switching which involves
selling certain securities out of a bank's portfolio, often at a
loss, and replacing them with other securities, is usually
carried out to gain additional current income, add to future
income, or to minimize a bank's current or future tax
liability.

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 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.
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Different Types of Risk-----Contd

 Call Risk: The danger that investment securities held by a

bank will be retired early, reducing the bank’s expected
return.
 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.
 Inflation Risk: The danger that rising prices of goods &
services will result in lower bank returns or reduced values
in bank assets & equity.

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 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.

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 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

1 year 2 year 3 Year 4 year

Maturity in years & months

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 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

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 Investment Maturity Strategies----Contd

C. The Back-End Load Maturity Strategy: The back-

end loaded maturity policy calls for placing all security
holdings at the long-term end of the maturity spectrum
to maximize potential gains if interest rates fall and to
earn the highest average yields.

% 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
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 Investment Maturity Strategies----Contd

D. The Bar Bell Strategy: the bar-bell strategy places a

portion of the bank's security holdings at the short-end
of the maturity spectrum and the rest at the longest
maturities, thus providing both liquidity and maximum
income potential.

40
30
20 30%
30%
20% 20%
10

1 2 3 4 5 6 7 8 9 10 11 12 13

Maturity in years & months

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 Investment Maturity Strategies----Contd

E. The Rate Expectation Approach: the rate expectations

approach calls for shifting maturities toward the short
end if rates are expected to rise and toward the long-end
of the maturity scale if interest rates are expected to fall.
Shift towards long-term securities if interest rates are expected to fall

% of the value
of all securities
Shift towards short-term securities if interest rates are expected to rise
held

Maturity in years & months

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 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)

Time (measured in months & years)

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Maturity Management Tools----Contd

 Features of Yield Curve:

i. 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.
ii. 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.
iii. 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.

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Maturity Management Tools----Contd

2) 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.

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