SLIDE 20

MANAGEMENT OF
BANKS
INVESTMENT
PORTFOLIO

OUTLINES/LEARNING
OBJECTIVES
OBJECTIVES OF BANKS
INVESTMENT PORTFOLIO
COMPOSITION OF BANKS
INVESTMENT PORTFOLIO
CLASSIFICATION OF BANKS
INVESTMENT PORTFOLIO
VALUATION OF BANKS
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 banks
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 banks success, its management at most banks is
governed by a investment policy with Boards
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 banks 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

Objectives of the
Investment Portfolio - 5
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

Objectives of the
Investment Portfolio - 6
Help Manage Interest Rate Exposure
Investment securities are very flexible
instruments for managing a banks
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

Objectives of the
Investment Portfolio - 7
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
securities/bonds

and

State

Govt.

Treasury

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
government and private guarantees
Corporate bonds
Foreign bonds

both

by

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 wellknown 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
transactions

collateralized

RBI

funds

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

investments,
the
third
one
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)

known as SLR securities/

is
known
as
Non-SLR

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 & NonSLR 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.

Commercial banks
investment portfolio
Regulation for Indian Banks 3

However, Valuation and disclosures of

investments in the balance sheet are made
under six classifications viz.,

a) Government
securities)

Securities

(incl.

b) Other approved securities

c) Shares
d) Bonds & Debentures
e) Subsidiaries / Joint Ventures
f) Units of Mutual Funds and Others

State

govt.

Commercial banks investment

portfolio

Regulation for Indian Banks - 4

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

Commercial banks investment

portfolio

Regulation for Indian Banks - 5

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 heldto-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
Investment Portfolio

Banks

Risk
Management
in
Banks,
Credit Risk Management, Interest
Rate Risk Management & AssetLiability Management (ALM)