The Investment Function in Banking

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Chapter10

• The Investment Function in Banking

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Functions of a Banks Security Portfolio

1. Stabilize the banks income, so that bank
   revenues level out over the business cycle.
2. Offset credit risk exposure in the banks loan
   portfolio.
3. Provide geographic diversification.
4. Provide a backup source of liquidity.
5. Reduce the bank' tax exposure, especially in
   offsetting taxable loan revenues.

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Functions of a Banks Security Portfolio.contd

• Serve as collateral to secure government deposits
  held by the banks.
• Help hedge the bank against losses due to
  changing interest rates.
• Provide flexibility in a banks asset portfolio
  because investment securities can be bought or
  sold quickly to restructure bank assets.
• Dress up the banks balance sheet make it look
  financially stronger due to the high quality of
  most bank held securities.

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Figure Investments On a Banks Balance Sheet
Asset Cash
Liabilities Deposits
Add to Investments When cash Is excess
Sell investments When cash is low
When deposits are low use Investments as
collateral for more borrowings
Nondeposit Borrowings
Investment
Return investments pledged As collateral to the
investment Portfolio when deposit growth Is strong
Add to investments When loan demand Is weak.
Sell Investments When loan Demand is high
Loans
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Investment Instruments Available to Banks and
Other Financial Firms

• Popular Money Market Instruments
• Treasury Bills
• Short-term treasury Notes Bonds.
• Federal Agency Securities (for USA only)
• Certificates of Deposit
• International Eurocurrency Deposits.
• Bankers Acceptances.
• Commercial Paper.
• Short-term Municipal Obligations
• Popular Capital Market Instruments
• Long-term Treasury Notes Bonds.
• Municipal Notes Bonds
• Corporate Notes Bonds
• Common stock Preferred Stock

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Other Investment Instruments Developed More
Recently

• Structured Notes
• Securitized Assets.
• Stripped Securities
• Structured NotesStructured 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

• Expected Rate of Return
• Tax Exposure
• Interest-Rate Risk
• Credit or Default Risk
• Business Risk
• Liquidity Risk
• Call Risk
• Prepayment Risk
• Inflation Risk
• 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.
• After-tax Gross Yield on Corporate Bond
  Before-tax gross yield to the bank X (1 Banks
  marginal income tax rate)

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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 banks
  extensions of credit will not pay out as
  promised, reducing the banks profitability
  threatening its survival.
• Business Risk The danger that changes in the
  economy will adversely affect the banks 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 banks 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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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
• 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.
• 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.
• 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

1. 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.