The Investment Function in Banking and Financial Services Management

THE INVESTMENT FUNCTION IN BANKING AND
FINANCIAL SERVICES MANAGEMENT
I. Introduction: The Roles Performed by Investment Securities in Bank
Portfolios
1. Stabilize the bank’s income, so that bank revenues level out over the business cycle.
2. Offset credit risk exposure in the bank’s loan portfolio.
3. Provide geographic diversification.
4. Provide a backup source of liquidity.
5. Reduce the bank’ tax exposure, especially in offsetting taxable loan revenues.
II. Investment Instruments Available to Banks and Other Financial Firms
1. Money market instruments.
2. Capital market instruments.
III. Popular Money-Market Instruments
A. Treasury Bills: A Treasury Bill (T-Bill) is a short-term government debt obligation backed
by the Treasury Department with a maturity of one year or less.
B. Short-Term Treasury Notes and Bonds: Treasury notes are direct obligations of the U.S.
government with an original maturity of one to 10 years. Treasury bonds are direct obligations of
the U.S. government over 10 years in original maturity.
C. Federal Agency Securities: Debt instruments issued by government sponsored firms to
support their lending, secondary market trading, and loan guarantee activities.
D. Certificates of Deposit: An interest bearing receipt for the deposit of funds in a bank for a
stipulated time period.
E. Banker’s Acceptance: A bank’s commitment to pay a stipulated amount of money on a
specific future date under specified conditions.
F. Commercial Paper: A short term debt obligation normally issued by a corporation with a
high credit rating.

G. Short-Term Municipal Obligations: State and local governments—including counties,
cities, and special districts—issue a variety of short-term debt instruments to cover temporary
shortages.
IV. Popular Capital Market Instruments
A. Treasury Notes and Bonds: Treasury bonds over one years to maturity.
B. Municipal Notes and Bonds: Tax exempt state and local government long term debt
obligations.
C. Corporate Notes and Bonds: Corporate notes are medium term debt securities normally 5 to
10 year issued by corporations. Corporate bonds are the longest term debt obligations issued by
corporations.
V. Other Investment Instruments Developed More Recently
A. Structured Notes: A structured note is a debt security issued by financial institutions. The
performance of a structured note is linked to the return on an underlying asset, group of assets, or
index.
B. Securitized Assets: Asset securitization is the structured process whereby interests in loans
and other receivables are packaged, underwritten, and sold in the form of “asset- backed”
securities.
C. Stripped Securities: A stripped security is a debt obligation whose principal and coupon
payments are removed (or stripped) by investment firms or dealers and sold separately to
investors.
VI. Investment Securities Actually Held by Banks
VII. Factors Affecting the Choice of Investment Securities
A. Expected Rate of Return: The investments officer must determine the total rate of return
that can reasonably be expected from each security, including any interest payments promised
and possible capital gains or losses.
For most investments this requires the portfolio manager to calculate the yield to maturity
(YTM) if a security is to be held to maturity or the planned holding period yield (HPY) between
point of purchase and point of sale.

YTM =
HPY =
B. Tax Exposure: Banks need to pay taxes on their income. That is why, while choosing
investment banks try to find securities with more tax exemption advantages. That’s why bank
looks into following things:
1. The Tax Status of State and Local Government Bonds: Tax-exempt state and local
government (municipal) bonds and notes have been attractive from time to time.

Before-tax gross yield (1 come tax rate Firm’s marginal in After-tax gross yield
2. Bank Qualified Bonds: Bank-qualified bonds encourage banks to invest in tax-exempt bonds
from smaller, less-frequent municipal bond issuers.
3. Tax Swapping Tool: A transaction designed to reduce a bank’s tax burden and increase its
future income by selling lower yielding securities at a loss and replacing them with higher
yielding securities.
4. The Portfolio Shifting Tool: The movement out of one or more investment securities often to
get rid of lower yielding instruments or reduce taxes into another security or group of securities.
C. Interest-Rate Risk: The danger that shifting market interest rates can reduce bank net
income or lower the value of a bank assets and equity.
D. Credit or Default Risk: Default risk is the risk that a lender takes on that a borrower will be
unable to make the required payments on their debt obligation.
E. Business Risk: The danger that changes in economy will adversely affect the bank’s income
and the quality of its assets.
F. Liquidity Risk: The danger that a bank will experience a cash shortage or have to borrow at a
high cost to meet its obligations to pay.
G. Call Risk: The danger that investment securities held by a bank will be retired early, reducing
bank’s expected return.