Business — Banking — Management — Marketing & Sales

Investment Portfolio Management

Category: Corporate Governance

Banks own investment securities and money market assets in order to manage asset and liability positions, diversify their earning assets base, maintain a liquidity cushion, and meet pledging requirements. For most banks, the investment portfolio constitutes a significant earning asset. The increasing complexity of the securities available in the marketplace has heightened the need for effective management of the portfolio.

Oversight of investment portfolio activities is an important part of managing the bank’s overall interest rate, liquidity, and credit risk profiles. Members of Supervisory Council play a key role in overseeing the bank’s investment activities. They establish strategic direction and risk tolerance limits; review the portfolio’s activity, risk profile, and performance; and monitor compliance with authorized risk limits.

1.Selection of Securities Dealers

Some banks may rely on securities sales representatives, investment bankers, and brokers to recommend proposed investments, investment strategies, and the timing and pricing of securities transactions. Members of Supervisory Council should review and approve a list of securities firms with whom the bank is authorized to do business. They should also ensure that dealers used by the bank are financially stable, reputable, and knowledgeable.

As part of the process of managing a bank’s relationship with securities dealers, the Supervisory Council may also want to consider prohibiting employees who are directly involved in purchasing and selling securities for the bank from engaging in personal securities transactions with the same securities firm the bank uses for its transactions without specific Council approval and periodic review.

2.Categorization of Securities

When a bank purchases a security, it must decide under current accounting rules whether it intends to hold the security to maturity. If it does, the security may be classified as held-to-maturity and accounted for at amortized cost. Held-to-maturity securities may be sold prior to maturity only if credit quality deteriorates or if other rare situations occur. The bank must classify other securities as available-for-sale and carry them at fair value (essentially market value). For accounting purposes, changes in fair value are reflected in the bank’s capital or directly in income statement.

Members of Supervisory Council should ensure that bank management’s original classification decisions are reasonable and are adhered to. Improper sales of held-to-maturity securities may require some or all of the bank’s other held-to-maturity securities to be marked to fair value. If so and if the value of these securities has declined, the bank ‘s capital could be greatly diminished.

Members of Supervisory Council are ultimately responsible for supervising a bank’s investment portfolio. A bank’s Council may delegate investment decision-making authority for all or a portion of their investment securities portfolio to a nonaffiliated firm or to an individual who is not an employee of the institution or one of its affiliates. Such a delegation of authority is intended to obtain a higher total return on the portfolio than the institution would realize if it managed the portfolio itself. Because bank management would no longer control the portfolio, held-to-maturity securities would no longer qualify as such under IFRS, and they would have to be marked to market. Sales of these securities would be recorded as available-for-sale transactions on ledgers independent of the decision-maker’s control.

3. Investment Reports

Directors find the following reports helpful in assessing the overall quality, liquidity, and performance of the investment portfolio:

Maturity breakdown and average maturity —shows each sector of the investment portfolio (Treasury bonds, municipal bonds, etc.) and the portfolio as a whole.

Distribution of credit ratings (if available) for all municipal and corporate securities — shows the percent of the portfolio in each rating category. This report provides useful information on the overall credit quality of the portfolio.

Adjusted cost for each security relative to its current market value — shows held-to-maturity securities’ appreciation or depreciation not recorded on the books. For depreciated available-for-sale securities, it shows the amount recorded as an unrealized loss or gain against capital for accounting purposes.

Purchases and sales — indicates the type of security, its par value, maturity date, rate, yield, cost and sales prices, as well as any profit or loss.

Sensitivity analysis of the value of the portfolio in different interest rate environments — compares the value in each interest rate scenario with the current portfolio value, illustrating the amount of portfolio risk. This report also provides a means of assuring that management has complied with the board ‘s tolerance for risk.

Summary of investments by obligor, industry, related obligor, geographic area, etc — shows concentrations of investments that Supervisory Council should review.

Investment Portfolio Red Flags:

Purchase of individual securities that do not meet Supervisory Council guidelines on risk, quality, or quantity.

Securities purchased without pre-purchase analysis.

Securities purchased from only one securities dealer.

Significant changes in the type, quality, or maturity distribution of the portfolio.

Sale of securities previously designated held-to-maturity, or transfer of securities from the held-to-maturity account to the available-for-sale account.

High volume of purchases and sales.

Purchase of securities based only on yield.

Investment purchases from securities dealers not approved by the Council.

Investment returns that are well above or below the market or peer group average.

Significant depreciation in the market value of investments.

The classification of high-risk securities as held-to-maturity, and low-risk, short-term securities as available-for-sale.

Purchase of securities in excess of concentration limits.

Significant amounts of securities pledged for repurchase agreements.

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