Slide-20-Management of Bank's Investment Portfolio

MANAGEMENT OF BANK’SINVESTMENT PORTFOLIO

SLIDE – 20

OUTLINES/LEARNING OBJECTIVES

• OBJECTIVES OF BANK’S INVESTMENT PORTFOLIO

• COMPOSITION OF BANK’S INVESTMENT PORTFOLIO

• CLASSIFICATION OF BANK’S INVESTMENT PORTFOLIO

• VALUATION OF BANK’S INVESTMENT PORTFOLIO

KEY WORDS/TERMINOLOGIES/GLOSSARY - 1

• SLR Investment & Non-SLR Investment, Govt. & Govt. Approved Securities, Held to maturity (HTM), Held for Trading (HFT) & Available for Sale (AFS), Asset Liability Committee (ALCO)/Investment Committee, Marking to Market (MTM).

The Investment Portfolio• Most banks concentrate their asset

management efforts on loans. The second largest asset on a bank’s balance sheet is security investments

– Managing investment securities is typically a secondary role, especially at smaller banks

• Historically, small banks have purchased securities and held them to maturity

The Investment Portfolio

• Large banks, in contrast, not only buy securities for their own portfolios to earn interest income, but they also trade them more actively prior to maturity in an effort to make a profit in the form of capital gains due to interest rate movements :

– Manage a securities trading account

The Investment Portfolio• Historically, bank regulators have limited the risk associated

with banks owning securities by generally:

– Prohibiting banks from purchasing common stock (for income purposes)

– Limiting debt instruments to investment grade securities

• Increasingly, banks are pursuing active strategies in managing investments in the search for higher yields

• To provide greater liquidity, many banks keep securities maturities or durations short term because of the lower price volatility

Commercial banks’ investment portfolio

• The interest earned on the investment portfolio is often the second-largest revenue source for banks after loans and advances.

• In addition, the investment portfolio serves as a secondary reserve/second line of defense to help banks manage liquidity needs.

• During recessionary periods when demand for commercial credit and other loans is relatively low (i.e. Credit to Deposit ratio (CDR) is low), banks invest excess funds in securities (i.e., Investment to Deposit Ratio (IDR) is high) to earn a return (which provide good alternative source of income) until demand improves.

• As economic recovery proceeds and loan demand increases, banks sell the maturing securities they purchased to make loans or shorter term securities can be sold to fund higher earning loans. During this period CDR will rise and IDR will fall.

Commercial banks’ investment portfolio – (2)

• Because the investment portfolio plays a critical role in a bank’s success, its management at most banks is governed by a investment policy with Board’s approval. The foundation for sound management and administration of the investment portfolio is the investment policy

• So that managers can make decisions that are consistent with the overall goals of the organisation

• In general, investment policy seeks to maximise the return per unit risk on the investment portfolio of securities, although regulatory requirements, lending needs, tax laws, liquidity sources and other factors can limit return/risk performance

• Bank policy should have sufficient flexibility to enable it to shift investment goals in response to changes in financial and economic conditions and competition from rival institutions

Objectives of the Investment Portfolio

• A bank’s investment portfolio differs markedly from a trading account

– Objectives of the Investment Portfolio

• Safety or preservation of capital

• Liquidity

• Yield

• Credit risk diversification

• Help in managing interest rate risk exposure

• Assist in meeting pledging requirements

Objectives of the Investment Portfolio – 2

• Safety or Preservation of Capital– Banks assume substantial credit or default risk in their loan

portfolios. Banks typically balance this by accepting much lower default risk in their investment portfolio. Thus, a primary objective of the investment portfolio is to preserve capital by purchasing securities when there is only a small risk of principal loss.

– Regulators encourage this policy by requiring that banks concentrate their holdings in investment grade securities, those rated Baa (BBB) or higher.

Objectives of the Investment Portfolio -3

• Liquidity– Banks need adequate liquidity to pay off unanticipated

demands from depositors and other liability holders as ell as meet loan demands. Commercial banks purchase debt securities to help meet liquidity requirements

– Securities with maturities under one year can be readily sold for cash near par value and are classified as liquid investments

• In reality, most securities selling at a premium can also be quickly converted to cash, regardless of maturity, because management is willing to sell them

Objectives of the Investment Portfolio - 4

• Yield– To be attractive, investment securities must pay a reasonable

return for the risks assumed

– The return may come in the form of price appreciation/capital gains, periodic coupon interest, and interest-on-interest

– The return may be fully taxable or exempt from taxes

– Higher returns flow investments with higher risk. Portfolio managers, therefore, have to look at risk return trade offs while building the investment portfolio of the bank


• Diversify Credit Risk– The diversification objective is closely linked to the safety

objective and difficulties that banks have with diversifying their loan portfolios

– Too often loans are concentrated in one industry that reflects the specific economic conditions of the region. Over time, banks develop expertise in lending to a specific sector or industry and find it difficult to diversify their loan portfolios

– Investment portfolios give banks the opportunity to spread credit risk outside their geographic region and across different 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 or duration of their investment portfolio that meet their specific needs without fear of antagonizing the borrower

– They can readily sell the security if their needs change


• Pledging Requirements

– By law, commercial banks must pledge collateral against certain types of liabilities.

• Banks that borrow via repurchase agreements (REPO) essentially pledge part of their government securities portfolio against this debt

Composition of the Investment Portfolio

• Money market instruments with short maturities and durations include:

– Treasury bills

– Large negotiable CDs

– Bankers acceptances

– Commercial paper

– Repurchase agreements

Composition of the Investment Portfolio - 2

• Capital market instruments with longer maturities and duration include:

– Long-term GOI and State Govt. Treasury securities/bonds

– Obligations of government agencies and Public Financial Institutions classified as approved securities by RBI for SLR purposes

– Obligations of state and local governments and their political subdivisions labeled municipals

– Mortgage-backed securities backed both by government and private guarantees

– Corporate bonds

– Foreign bonds

Characteristics of Money Market Securities

• Money Market Investments

– Highly liquid instruments which mature within one year that are issued by governments and large corporations

– Very low risk as they are issued by well-known borrowers and a active secondary market exists

– Banks purchase money market instruments in order to meet liquidity and pledging requirements and earn a reasonable return

Characteristics of Capital Market Securities

• Capital Market Investments

– Consists of instruments with original maturities greater than one year

– Banks are restricted to “investment grade” securities, those rated Baa (BBB) or above; i.e., no junk bonds

– If banks purchase non-rated securities, they must perform a credit analysis to validate that they are of sufficient quality relative to the promised yield .

Money Market Investments

• Repurchase Agreements (Repos)

– A loan between two parties, with one typically either a securities dealer or commercial bank

– The lender or investor buys securities from the borrower and simultaneously agrees to sell the securities back at a later date at an agreed-upon price plus interest

– Essentially are collateralized RBI funds transactions

Money Market Investments - 2• Repurchase Agreements (Repos)

– The minimum denomination is generally Rs. 1 million, with maturities ranging from one day to one year

– The rate on one-day repos is referred to as the overnight repo rate and is quoted on an add-on basis assuming a 360-day year

• Rupee Interest = Par Value x Repo Rate x Days/360

• Longer-term transactions are referred to as term repos and the associated rate the term repo rate

Money Market Investments - 3• Treasury Bills– Marketable obligations of the Govt. of India that

carry original maturities of one year or less

– They exist only in book-entry form, with the investor simply holding a dated receipt

Commercial banks’ investment portfolio – Regulations for Indian Banks

• Commercial banks’ investments are of three types : (a) Government of India (GOI) securities (b) Other approved securities like State Govt. securities and securities issued by specified PSUs and Public Financial Institutions (PFIs) and (c) Non-approved securities, inter alia, Corporate/PSU equity shares and Corporate/PSU Bonds, CPs, CDs, Mutual Funds & Bank FDs etc.

• While the first two types are known as SLR securities/ investments, the third one is known as Non-SLR securities/investments

• Commercial banks in India invest a negligible part of their resources in Corporate shares and bonds, partly because of regulatory restrictions and partly due to lack of skills and orientations of the Operating Managers and Top Management Personnel.

• At present banks are allowed to invest 40% of their Net worth as on 31st March of the previous year in corporate shares, convertible debentures/bonds and units of equity-oriented Mutual funds and other direct and indirect exposures to capital market (both fund based and non-fund based)

Commercial banks’ investment portfolio – Regulation for Indian Banks - 2

• When banks purchase securities, they must indicate the underlying objective of investment for accounting purposes

RBI stipulates that banks classify their entire investment portfolio (including SLR & Non-SLR securities) into three categories :(a) Held-to-Maturity (HTM)

(b) Held-for-Trading (HFT)

(c) Available-for-Sale (AFS)

– Banks should decide the category of the investment at the time of acquisition and the decision should be recorded on the investment proposals.


• However, Valuation and disclosures of investments in the balance sheet are made under six classifications viz.,

a) Government Securities (incl. State govt. securities)

b) Other approved securities

c) Shares

d) Bonds & Debentures

e) Subsidiaries / Joint Ventures

f) Units of Mutual Funds and Others


• Held to Maturity (HTM) – Securities purchased with the intent and ability to hold up to final

maturity

– Carried at historical/acquisition/(amortized) cost on the balance sheet. The excess/premium, if any, of the acquisition cost over the face value of each security is amortized over the remaining period of maturity. Thus HTM investments need not be Marked-to-Market (MTM)

– Profit/Loss on sale of investments is taken to the Profit & Loss A/C. In case of Profit, an equivalent amount is appropriated to the “Capital Reserve Account”

– Unrealized gains and losses due to market fluctuations, during the period they are held, have no impact on the income statement

– Currently Banks in India are normally allowed to include investments under HTM category up to 25% of their total investments


• Held-for-Trading (HFT) :

– Securities purchased with the intent to trade/sell them in the near term by taking advantage of the short-term price/interest rate movements

– These securities are to be sold within 90 days

– Individual scrips are held at Original Cost on the balance sheet

– However, individual scrips will be marked to market (MTM) at monthly or at more frequent intervals

– Hence unrealized gains and losses impact the income statement. In respect of each classification under this category depreciation/ appreciation should be aggregated. Net depreciation, if any, shall be provided for/charged to revenue. Net appreciation, if any, is ignored. Net depreciation required to be provided for in any one classification should not be reduced on account of net appreciation in any other classification.

– The book value of the individual securities would not undergo any change after the marking to market

– Profit or loss on sale of investments will be taken to the Profit & Loss Account

Commercial banks’ investment portfolio– Regulation for Indian Banks - 6

• Available-for-Sale (AFS) :

– Securities that are not classified as either held-to-maturity securities or trading securities

– Individual securities are marked to market

(MTM) at Quarterly or at more frequent intervals

– Carried at market value on the balance sheet with unrealized gains and losses impact the income statement

– All other things are the same as HFT category

KEY WORDS/TERMINOLOGIES/GLOSSARY - 1

• SLR Investment & Non-SLR Investment, Govt. & Govt. Approved Securities, Held to maturity (HTM), Held for Trading (HFT) & Available for Sale (AFS), Asset Liability Committee (ALCO)/Investment Committee, Marking to Market (MTM).

Topics for Next Class – All of you Should get prepared before coming to the class

• Management of Bank’s Investment Portfolio

• Risk Management in Banks, Credit Risk Management, Interest Rate Risk Management & Asset-Liability Management (ALM)

Documents

Slide-20-Management of Bank's Investment Portfolio