Tutorial 3

Managing the security portfolio

1. The security portfolio is treasury s most important component of the balance sheet Discuss Banks buy investments to generate income, but also to better manage their risk exposure. When banks buy securities they must indicate the underlying objective for accounting purpose. Objectives of the investment portfolio A banks investment portfolio differs markedly from a trading account as investment securities are held to meet one of six general objectives: 1. Safety or preservation of capital 2. Liquidity 3. Yield 4. Credit risk diversification 5. Help in manage interest rate risk exposure 6. Assist in meeting pledging requirements Safety or preservation of capital A primary objective 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 or higher. Liquidity 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. Yield To be attractive, investment securities must pay a reasonable return for the risks assumed.
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 The return may come in the form of price appreciation or periodic

coupon interest. (Augment earnings) 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, particularly at small banks, loans are concentrated in one industry such as agriculture, energy, or real estate that reflects the specific economic conditions of the region. Help manage interest rate risk exposure Investment securities are very flexible instruments for managing a banks overall interest rate risk exposure. Banks can select terms 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 sell RPs essentially pledge part of the governments portfolio against this debt. Improve quality of balance sheet Riskless securities add to overall rating Reduces overall risk of asset portfolio

1. Koch &MacDonald Chapter 13: questions 1,2, 3& 8

1. A bank makes a profit when it sells securities for a higher price than it pays for the securities. This is why a dealers ask price exceeds the bid price at any point in time.

3. Zero coupon securities pay no coupon interest and have longer durations than comparable maturity securities. They are thus less liquid, holding other factors constant 8. Objectives: 1) safety and preservation of capital: low credit risk in securities 2) liquidity: most securities owned by banks can be readily sold in well-established secondary markets; thus, securities can be used to meet liquidity needs 3) yield: securities provide income in the form of coupon interest, reinvestment income, and capital gains 4) credit risk diversification: loans incorporate considerable credit risk; banks that limit securities holdings to investment grade instruments largely limit credit risk 5) managing interest rate risk: securities are bought and sold in well-established primary and secondary markets. They can be used to adjust a banks GAP/duration gap and earnings sensitivity or MVE sensitivity profile easily and quickly without harming any customer relationship 6) pledging requirements: banks must post collateral against certain liabilities, such as public deposits, borrowing from the Federal Home Loan Bank and Federal Reserve, and Repos. Securities are the best form of collateral. 16.Large banks do not normally hold securities to meet liquidity needs. They simply buy liquidity by issuing new liabilities. These are not offsetting risk positions, but instead demonstrate the role of securities at a large bank. Large banks choose to do this because they can readily access liquid funds from borrowing. Securities play a balancing role in asset and liability management, and generate income from trading activity as well as the direct returns from the instruments.
17. The laddered maturity strategy involves buying securities such that

a constant proportion matures each year. As such, the investor must only decide what the maximum holding period is and which securities to buy with that maturity each year. Securities are held until maturity to earn the fixed returns
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The barbell strategy involves buying short-term securities for liquidity purposes and longer-term securities for yield. Differentiates investments between those purchased for liquidity and those for income. When the longer-term securities approach maturity, the bank sells them, hopefully for a gain. Short term securities are held for liquidity while long term securities for income. The barbell strategy should outperform because the yield curve is generally upsloping such that long-term yields exceed short-term yields. Laddered maturity strategies are passive because they require little analysis or expertise. They produce yields that represent average interest rates over the investment horizon. The barbell strategy requires that investors concentrate their security holdings either shortterm for liquidity purposes or longerterm for yield. In most cases, the barbell strategy produces higher average yields than the laddered strategy.

Percent of Portfolio M aturing 10

Laddered M aturity Strategy

8 9 10 M aturity in Years

Percent of Portfolio Maturing 40 30 20 10 1 2 3

Barbell Maturity Strategy

...

...

10

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12 13 14 15 Maturity in Years

In a total return framework, the investor earns greater coupon interest, higher reinvestment income, and can sell the long-term securities for a gain if rates remain stable or decline. In a rising rate environment, an investor would have to sell the long-term securities for a loss, which reduces the total return, or would have to hold them until maturity. A laddered strategy might dominate if the investor can continue to reinvest in successively higher yielding instruments each year. The Treasury yield curve is normally upsloping. The yield curve is inverted at the peak of activity when the Fed tightens the money supply to control credit growth. As spending collapses from the peak, the economy slows, borrowing declines, and banks are flush with liquidity.
18.

In the U.S. the yield curve has typically inverted just prior to a recession, which follows an average of 12-14 months after the first date of inversion (since World War II). The Treasury yield curve inverted in 1998 when Treasury Secretary Larry Summers announced a buyback of outstanding long-term Treasuries as part of a budget surplus management program. A recession did not follow then. The yield curve last inverted in December 1999 with the most recent U.S. recession during the last nine months of 2001. From 2002 2005 the yield curve exhibited a positive slope. 20. With a contracyclical investment strategy, banks will generally buy longerduration security purchases when interest rates are relatively high. This means buying longterm instruments when the yield curve inverts. Many banks follow this strategy and have systematically earned more than competitors who do not. In light of the contracyclical investment strategy, a portfolio manager should lengthen maturities of securities purchased when the yield curve inverts. The key factors include whether the bank can ration credit from commercial and consumer
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borrowers, and whether interest rates are expected to fall below forward rates calculated from the term structure.

Question 3: Discuss the major sources of risk facing the securities portfolio manager of a bank. General risk characteristics Credit Risk variability in returns resulting from not making promised payments Purchasing Power Risk unanticipated changes in inflation Interest Rate Risk interest rate changes affect returns in two ways: price risk and reinvestment rate risk Liquidity Risk risk of not being easily traded prior to maturity. liquidity risk is also affected by pledging requirements that limit the pool of securities that banks can sell to obtain cash

Liquidity risk for a financial institution

1. Liquidity risk management requires the most attention within the treasury operation to ensure the viability of a financial institution. Discuss. What is liquidity risk? The risk that a bank lacks sufficient funds to meet financial obligations such as: Depositors withdrawal demands- Meet cash demand for deposit withdrawals as banks have legal responsibility/obligation to deposits contractual liquidity needs. Maturing debts Prior loan commitments- Meet cash demands for loans Meet RBA liquidity managements i.e. PAR & NCD requirements. Why does liquidity risk arise? Liquidity risk arises because of the variability of loan demands, and variability of deposit or liability flows. Without uncertainties there would be no issues of liquidity risk. What is liquidity risk management? Liquidity management is a day to day responsibility to ensure demands (or unexpected demands) is met by the bank and maintains public confidence of the banks financial position.

How? Historically, liquidity management focused on assets and was closely tied to lending policies. Under the commercial loan theory prior to 1930, banks were encouraged to make only short-term, self-liquidating loans. In particular, a bank could satisfy its liquidity requirements if it held loans and securities that could be sold in the secondary market prior to maturing. Around 1950 the focus shifted to the anticipated income theory. Banks were still encouraged to invest in marketable instruments but now structured loans so that the timing of principal and interest payments matched the borrowers ability to repay from income. More recently, banks have focused on liabilities. When they need immediately available funds, they can simply borrow via federal funds purchased, jumbo CDs, commercial paper, and Eurodollars. Banks now use both asset and liabilities to meet liquidity needs Available liquidity sources are identified and compared to expected needs by a banks asset and liability management committee Problem? Liquidity vs Profitability There is a short run trade off between liquidity and profitability. The more liquid a bank is the lower its return on equity and return on assets, all other things being equal Therefore. To answer the question..does it require the most attention?
1. Koch & MacDonald (Chapter 8: Questions 22, 26, 30).

22. a. Not discretionary, but predictable. b. Not discretionary, but predictable. c. Not discretionary, but predictable. d. Not discretionary and unpredictable. e. Not discretionary, but predictable. f. Not discretionary, but predictable. g. Not discretionary and unpredictable. h. Discretionary 26. Banks that assume large amounts of credit or interest rate risk accept greater volatility in profits. If losses arise, depositors
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may move their funds creating a liquidity crisis, especially when there is a chance of bank failure. 30. The bank needs to replace $150 million of the $180 million liquidity need (expected cash outflow) with the projected funding sources identified, plus obtain an additional $30 million in financing. Management needs to identify contingency sources, such as federal funds, reverse RPs, CDs, FHLB advances, Eurodollars, and other lines with correspondents. It may also choose to shorten asset maturities if it might need securities to sell, with the best decisions dependent on economic conditions. 2. Are decisions regarding liquidity made in isolation to other functions of the treasury environment? What other functions does it affect? Why? Liquidity decisions are made in consultation with other departments of a bank. Other functions may be affected: Credit function. Current account and deposit unit. Strategic planning/Business Development unit. Refer to the flow diagram

If bank is unable to meet customer demands, this would lead to believe that bank is experiencing big problem. Anxious to recover their funds, customers would rush to withdraw their deposits, causing a run on the bank.
Liquidity Crisis
Mere rumour Spread from other fin institution

Credi t risk

Capital risk

Int rate risk

Othe r risks

Imprudent bank mgt

Loss of confidence

Liquidity crisis

Bankrupt

Survived

merged

3. Describe the liquidity index and explain how it operates. Why do assets and liabilities with a longer maturity have a higher weighting? Explain. What are the difficulties associated with calculating nominal maturity? Liquidity index = Weighted Value of total liabilities Weighted Value of total assets To work out the weighted value, we need to assign weight to each maturity period and then multiply by the $ amount. Higher maturity period will have a higher weight. Why to reflect maturity gap i.e. whether the financing of assets is with liabilities of shorter or longer average maturity. Difficulties in calculating nominal maturity: Deposits without maturity/on demand Classified short term or long term? Liability items fall between 3 and 6 months maturity periods Classified 3 months or 6 months? Loans with rollover Classified short term or long term? 4. The balance sheet of XYZ Bank is as follows:
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a)
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Estimate the liquidity requires of the Bank. [-$1,193]

Assets $ 100 Liabilities Cash % Liquid 10 3 5 $ Liquid $ 10 $ 60 $ 45 Deposits $ 400 Other Equity $1,600 $1,000 % Volatile $ Volatile 7 $ 80 0 $

Loans $2,000 $1,280 Other $ 900 0 Totals $3,000

$1,308

$115

Liquidity need = 115 1308 = -1193 b) What would happen if loan demand resulted in loans having a 3% liquidity? Recalculate the new liquidity requirements of the bank. [-$1,313] If loans have 3% liquidity, total liquid assets = -5 Liquidity need = -5 1308 = -1313 c) What would the bank do with regard to this liquidity situation? The bank should restructure the assets portfolio i.e. invest more in liquid assets. 1. The following data relates to XYZ Bank:
Assets Loans Investments Other Liquidity Needs ($M) -16,200 -24,200 2,200 -38,200 Liabilities Demand deposits Fixed deposits CDs Capital Net funding requirement

-1,300 5,400 33,100 1,000 38,200

a) Calculate the liquidity ratio for XYZ bank. [28.23%] Liquidity ratio = Net funding requirement

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Total interest sensitive funds required 38,200 = 135,300 = 28.3%

b) What does this figure mean? That means the bank must borrow/purchase funds equal to 28.3% of the total interest sensitive funds. c) Is it a good figure? Depending on the position and size of the bank.

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