Portfolio Management Unit – II Session No. 17 Topic: Managing Portfolios by Banking Unit – II Session No. 17 Topic: Managing Portfolios by Banking

Session Plan Recap the Previous Session Banking Industry ALCO Objectives in Managing Securities Portfolios Risk and Return Objectives Constraints Summarizing and Q & A

THE BANKING INDUSTRY Banks are financial intermediaries involved in taking deposits and lending money. Banks’ liabilities consist chiefly of time and demand deposits. The asset side of the balance sheet consists of loan and securities portfolios Loans may include real estate, commercial, individual, and agricultural loans. Traditionally, a bank’s portfolio of investment securities has been a residual use of funds after loan demand has been met. A key role in managing a bank’s risk and liquidity positions relative to its liabilities. * Bancassurance is the term that has developed to describe the sale of insurance by banks.

THE BANKING INDUSTRY Bank’s asset/liability risk management committee (ALCO) is generally in charge of overseeing the bank’s securities portfolio. Net interest margin - equals net interest income (interest income minus interest expense) divided by average earning assets. Interest spread - equals the average yield on earning assets minus the average percent cost of interest-bearing liabilities.

THE BANKING INDUSTRY Banks’ Objectives in Managing Securities Portfolios: 1.To manage overall interest rate risk of the balance sheet 2.To manage liquidity 3.To produce income 4.To manage credit risk.

THE BANKING INDUSTRY Risk Objectives Banks’ risk objectives are dominated by ALM considerations that focus on funding liabilities. Banks would like to earn high interest margins, they must not assume a level of risk that jeopardizes their ability to meet their liabilities to depositors and other entities. Overall, banks have below-average risk tolerance as concerns the securities portfolio.

THE BANKING INDUSTRY Return Objectives A bank’s return objectives for its securities portfolio are driven by the need to earn a positive return on invested capital. For the interest-income part of return, the portfolio manager pursues this objective by attempting to earn a positive spread over the cost of funds.

THE BANKING INDUSTRY Liquidity Requirements A bank’s liquidity position is a key management and regulatory concern. Liquidity requirements are determined by net outflows of deposits, if any, as well as demand for loans. Time Horizon A bank’s time horizon for its securities portfolio reflects its need to manage interest rate risk while earning a positive return on invested capital. A bank’s liability structure typically reflects an overall shorter maturity than its loan portfolio, placing a risk management constraint on the time horizon length for its securities portfolio. This time horizon generally falls in the three- to seven-year range (intermediate term).

THE BANKING INDUSTRY Tax Concerns Banks’ securities portfolios are fully taxable. Legal and Regulatory Factors Regulations place restrictions on banks’ holdings of common shares and below-investment-grade risk fixed-income securities. To meet legal reserve and pledging requirements banks may need to hold substantial amounts of short term government securities.

THE BANKING INDUSTRY Unique Circumstances There are no common unique circumstances to highlight relative to banks’ securities investment activities. That situation stands in contrast to banks’ lending activities, in which banks may consider factors such as historical banking relationships and community needs, which may be viewed as unique circumstances.

Summarizing What is Bancassurance? How time deposits are differing from demand deposits? How the banks used collateral to meet needs? How to implement Investment policy statement for a commercial Bank?