Jonathan Arrington SEC - Functions of a Bank’s Security Portfolio

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Jonathan Arrington SEC

• Functions of a Banks Security Portfolio

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Key Topics
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• Functions of investments
• Investment securities available
• Risks in security investments
• Investment maturity strategies

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Functions of a Banks Security Portfolio
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• Stabilize the banks income
• Offset credit risk exposure
• Provide geographic diversification
• Provide backup source of liquidity
• Reduce tax exposure
• Serve as collateral
• Hedge against interest rate risk

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Functions of a Banks Security Portfolio
Liabilities
Cash
Sell investments when cash is low
Add to investments when cash is high
When deposits are low use investments as
collateral for non-deposit borrowings
Return investments as collateral to the
investment portfolio when deposit growth is high
Non-deposit borrowings
Investments
Sell investments when loan demand is high
Add to investments when loan demand is low
Loans
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Instruments Available to Financial Firms
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• Money Market Instruments
• Reach Maturity Within One Year
• Low Risk
• Ready Marketability
• Capital Market Instruments
• Maturity Beyond One Year
• Higher Expected Rate of Return
• Capital Gains Potential

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Money Market Instruments Used by a Bank
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• Treasury Bills
• Short-Term Treasury Notes and Bonds
• Federal Agency Securities
• Certificates of Deposit
• Eurocurrency Deposits
• Bankers Acceptances
• Commercial Paper
• Short-Term Municipal Obligations

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Capital Market Instruments
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• Treasury notes and bonds over one year to
  maturity
• Municipal notes and bonds
• Corporate notes and bonds
• Asset backed securities

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Dominant Investments Held By Banks in 2007
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• Obligations of the U.S. Government and Government
  Agencies
• About 60 of Banks Investments Overall
• Smaller Banks Hold a Higher Ratio Compared to
  Large Banks
• State and Local Government Obligations
• Nonmortgage-Related-Asset-Backed Securities
• Hold Relatively Few Private-Sector Securities

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Dominant Investments Held By Banks in 2007
Types of securities held Smallest banks Medium-size banks Largest banks
All U.S. government obligations 73.3 70.6 69
Securities issued by states and municipals 18.7 19.5 4.8
Asset-backed securities 0 0.3 5.3
Other domestic debt securities 2.9 4.8 12.2
Foreign debt securities 0 0.1 7.7
Equity securities 0.8 1.1 1
Total investment securities 100 100 100
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Factors Affecting the Choice of Securities
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• Liquidity Risk
• Call Risk
• Prepayment Risk
• Inflation Risk
• Pledging Requirements

• Expected Rate of Return
• Tax Exposure
• Interest Rate Risk
• Credit Risk
• Business Risk

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Interest Rate Risk
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• Rising interest rates lowers the value of
  previously issued bonds
• Longest term bonds suffer the greatest losses
• Many interest rate risk tools including futures,
  options, and swaps exist today

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Default Risk
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Business Risk
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• Risk that the economy of the market area they
  serve may turn down
• Security portfolio can offset this risk
• Securities can be purchased from outside market
  area served

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Liquidity Risk
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• Breadth and depth of secondary market
• Number of Traders on an Given Day
• Volume of Trades on Any Given Day
• Treasury securities are generally the most liquid

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Call Risk
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• Corporations and some governments reserve the
  right to retire the securities in advance of
  their maturity
• Generally called when interest rates a have
  fallen
• Investor must find new security often with a
  lower return

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Prepayment Risk
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• Specific to asset-backed securities
• Most consumer mortgages and loans can be paid off
  Early
• Caused by loan refinancing which accelerate when
  interest rates fall
• Caused by asset turnover when borrowers move or
  are not able to meet loan payments and asset is
  sold

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Inflation Risk
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• Purchasing Power from a Security or Loan May be
  Eroded by Rising Prices
• Recently Developed Inflation Risk Hedge
  Treasury Inflation Protected Securities
• Both Coupon Payments and Principal Adjusted
  Annually for Inflation Based on Consumer Price
  Index

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Pledging Requirements
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• Depository institutions cannot accept federal,
  state and local government deposits unless
  acceptable collateral is pledged
• Generally treasury securities, government agency
  securities and selected municipal securities can
  be used as collateral

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Investment Maturity Strategies
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• The Ladder or Spaced-Maturity Policy (average)
• The Front-End Load Maturity Policy (short-term)
• The Back-End Load Maturity Policy (long-term)
• The Barbell Strategy (half of short-term, half of
  long-term)
• The Rate Expectation Approach

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Thank You
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