The Investment Function in Banking

Chapter:11
The Investment
Function in Banking
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The Investment Function in Banking
The primary function of the most banks is not to buy and sell
bonds, but rather to make loans to business and individuals.
Yet buying and selling bonds has its place because not all of a
financial institution’s funds can be allocated to loans. There are
some reasons behind it-
 Many loans are illiquid, they can not easily be sold prior to
maturity.
 Loans are among the riskiest assets, generally carrying the
highest customer default rates of any form of credit.
 For small and medium size banks- the majority of loans
typically came from the local area, therefore any significant
drop in local economic activity weakens the quality of a
major portion of the lender’s loan portfolio.
The Investment Function in Banking, cont..
 Too, loan income is usually taxable for commercial banks.
For all those reasons, commercial banks have learned to devote

a significant portion of their assets portfolios, to another major
category of earning asset: investment in securities.
These instruments typically include government bonds and

notes; corporate bonds, notes, and commercial paper; assets
backed securities; domestic and Eurocurrency deposits; and
certain kind of common and preferred stock.
Functions of the investment Security Portfolio:
a) Stabilize the bank’s income, so that bank revenues level out
over the business cycle- when loan revenues fall, income
from investment securities may rise.
b) Offset credit risk exposure in the bank’s loan portfolio.
High quality securities can be purchased and held to
balance out the risk from loans.
c) Provide geographic diversification. Securities often came
from different regions than the sources of loans, helping
diversify a financial firm’s sources of income.
d) Provide a backup source of liquidity, because securities can
be sold to raise needed cash or used as collateral for
borrowing additional funds.
e) Reduce the bank' tax exposure, especially in offsetting
taxable loan revenues.
f) Serve as collateral to secure federal, state and local
government deposits held by the banks.
g) Help hedge the bank against losses due to changing
interest rates.
h) Provide flexibility in a bank’s asset portfolio because
investment securities can be bought or sold quickly to
restructure bank assets.
i) Dress up the bank’s balance sheet & make it look
financially stronger due to the high quality of most bank
held securities.
Investments also referred to as the crossroads accounts.
Investments literally stand between cash, loans and deposits.
When cash is low, some investments will be sold in order to
raise more cash. On the other hand, if cash is too high, some of
the excess cash will be placed in investment securities.
If loan demand is weak, investment will rise in order to provide
more earning assets and maintain profitability. But if loan
demand is strong, some investments will be sold to
accommodate the heavy loan demand.
When deposits are not growing fast enough, some investments
securities will be used as collateral to borrow non-deposit
funds.
Investments: Crossroads Accounts on Bank’s Balance Sheet
Asset Liabilities
Cash Deposits
Add to Sell investments

Investments When cash is
When cash low When deposits are low use
Is excess Investments as collateral
for more borrowings Non-deposit
Investment Borrowings
Return investments pledged
Sell Add to investments as collateral to the investment
Investments When loan demand Portfolio when deposit growth
When loan Is weak. is strong
Demand is
high
Loans
Investment Instruments available to Bank
The number of financial instruments are available for banks to
add to their securities portfolio. Each financial instruments has
different characteristics with regard to risk, sensitivity to
inflation, and sensitivity to shifting government policies and
economic conditions.
For better understanding of those instruments, we can divide

them into two groups:
Money Market Instruments: instruments, which has
maturities less than one year. low risk and high marketability
are two distinct characteristics.
Capital Market Instruments: instruments, which has
maturities beyond one year. Higher expected rate of return and
capital gain potentials, are two distinct characteristics.
Investment Instruments available to Bank, cont..
Popular Money Market Instruments
1. Treasury Bills
2. Short-term treasury Notes & Bonds.
3. Federal Agency Securities (for USA only)
4. Certificates of Deposit
5. International Eurocurrency Deposits.
6. Banker’s Acceptances.
7. Commercial Paper.
8. Short-term Municipal Obligations
Popular Capital Market Instruments
1. Long-term Treasury Notes & Bonds.
2. Municipal Notes & Bonds
3. Corporate Notes & Bonds
4. Common stock & Preferred Stock
Other Investment Instruments Developed 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.
Other Investment Instruments Developed Recently
Cont..
 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
Other Investment Instruments Developed Recently Cont..
 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.
 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.
 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. Claims against only
the
principal payments from a security are called PO (Principal
Only) securities, while claims against only the stream of
interest payments promised by a security are referred to as
IO (interest Only) securities. Some of these stripped payments
are highly sensitive in their value to changes in interest rates. 14
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Factors affecting choice of Investment Securities
The investments officer of a bank must consider several factors
in deciding which investments securities to buy, sell or hold.
The principal factors are-
 Expected Rate of Return (YTM)
 Tax Exposure
 Interest-Rate Risk
 Credit or Default Risk
 Business Risk
 Liquidity Risk
 Call Risk
 Prepayment Risk
 Inflation Risk
 Pledging Requirements
Factors affecting choice of Investment Securities, cont..
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.
Tax Exposure:
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.
The investments officer for a bank subject to the corporate

income tax could compare each of those potential yields using
this formula:
 After-tax Gross Yield on Corporate Bond = Before-tax
gross yield to the bank X (1 – Bank’s marginal income tax
rate)
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 risk that the security issuer may
default on the principal or interest owed on a bond or note,
specially those issued by private corporations and some local
government.
 Business Risk: The danger that changes in the economy will
adversely affect the bank’s income & the quality of its assets.
Loan would rise as borrowers struggle to generate enough
cash flow to pay the lender.
 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.
Different Types of Risk, cont..
 Call Risk: The danger that investment securities held by a

bank will be retired early, reducing the bank’s expected
return. The financial firm investing in a callable bonds and
notes runs the risk of an earnings loss because it must
reinvest its recovered funds at today’s lower interest rates.
 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.
Pledging Requirements:
Depository institutions cannot accept deposit from federal,

state, and local governments unless they post collateral
acceptable to these governmental units in order to safeguard the
deposit of public funds.
Pledging requirements also exist for selected other banks

liabilities. For example, when a bank borrows from the discount
window of the Federal Reserve bank in its district, it must
pledge either federal government securities or other collateral
acceptable to the Fed.

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Chapter:11

For all those reasons, commercial banks have learned to devote

These instruments typically include government bonds and

Add to Sell investments

For better understanding of those instruments, we can divide

 What special risks do securitized assets present to banks

Securitized assets often carry substantial interest-rate risk

 Reasons for the popularity of Securitized Assets/Loan-

How is the expected yield on most bonds determined?

The investments officer for a bank subject to the corporate

 Call Risk: The danger that investment securities held by a

Depository institutions cannot accept deposit from federal,

Pledging requirements also exist for selected other banks

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