Chapter:10
The Investment
Function in Banking
1
Functions of a Bank’s Security Portfolio
a)
b)
c)
d)
e)
Stabilize the bank’s income, so that bank
revenues level out over the business cycle.
Offset credit risk exposure in the bank’s loan
portfolio.
Provide geographic diversification.
Provide a backup source of liquidity.
Reduce the bank' tax exposure, especially in
offsetting taxable loan revenues.
2
Functions of a Bank’s Security Portfolio….contd
f)
g)
h)
i)
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 bank’s asset portfolio
because investment securities can be bought or
sold quickly to restructure bank assets.
Dress up the bank’s balance sheet & make it
look financially stronger due to the high quality
of most bank held securities.
3
Asset
Cash
Figure: Investments –
On a Bank’s Balance Sheet
Liabilities
Deposits
Add to
Investments
When cash
Is excess
Sell investments
When cash is
When deposits are low use
low
Investments as collateral for more
borrowings
Nondeposit
Investment
Borrowings
Add to investments
When loan demand
Is weak.
Sell
Investments
When loan
Demand is
high
Return investments pledged
As collateral to the investment
Portfolio when deposit growth
Is strong
Loans
4
Investment Instruments Available to Banks
and Other Financial Firms
A.
Popular Money Market Instruments
1.
2.
3.
4.
5.
6.
7.
8.
B.
Treasury Bills
Short-term treasury Notes & Bonds.
Federal Agency Securities (for USA only)
Certificates of Deposit
International Eurocurrency Deposits.
Banker’s Acceptances.
Commercial Paper.
Short-term Municipal Obligations
Popular Capital Market Instruments
1.
2.
3.
4.
Long-term Treasury Notes & Bonds.
Municipal Notes & Bonds
Corporate Notes & Bonds
Common stock & Preferred Stock
5
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.
6
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-mortgagebacked securities) as well as their relatively high
liquidity and marketability
7
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.
8
Other Investment Instruments Developed More Recently---Contd

Reasons for the popularity of Securitized Assets/Loanbacked 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.
9
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.
10
Factors Affecting the Choice of Investment
Securities
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
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
11
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.
12
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
– Bank’s marginal income tax rate)
13
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.
14
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 loanbacked 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.
15
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)
16
Maturity Management Tools----Contd

i.
ii.
iii.
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.
17
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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