1. www.AssignmentPoint.com1 Chapter:10 The Investment Function in Banking

2. 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. 2www.AssignmentPoint.com

3. 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. The Investment Function in Banking, cont.. 3www.AssignmentPoint.com

4. 4 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. The Investment Function in Banking, cont..

5. www.AssignmentPoint.com5 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. The Investment Function in Banking, cont..

6. 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. The Investment Function in Banking, cont.. 6www.AssignmentPoint.com

7. 7 Asset Cash Investment Add to Investments When cash Is excess Sell investments When cash is low Sell Investments When loan Demand is high Loans Add to investments When loan demand Is weak. When deposits are low use Investments as collateral for more borrowings Return investments pledged as collateral to the investment Portfolio when deposit growth is strong Non-deposit Borrowings Liabilities Deposits Investments: Crossroads Accounts on Bank’s Balance Sheet

8. 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 8www.AssignmentPoint.com

9. 9 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 Investment Instruments available to Bank, cont..

10. www.AssignmentPoint.com10  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

11. www.AssignmentPoint.com11 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

12. www.AssignmentPoint.com12 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. Other Investment Instruments Developed Recently Cont..

13. www.AssignmentPoint.com13  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. Other Investment Instruments Developed Recently Cont..

14. www.AssignmentPoint.com14  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. Other Investment Instruments Developed Recently Cont..

15. www.AssignmentPoint.com15 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

16. www.AssignmentPoint.com16 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. Factors affecting choice of Investment Securities, cont..

17. www.AssignmentPoint.com17 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) Factors affecting choice of Investment Securities, cont..

18. www.AssignmentPoint.com18 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.

19. www.AssignmentPoint.com19 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. Different Types of Risk, cont..

20. 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. Factors affecting choice of Investment Securities, cont.. 20www.AssignmentPoint.com