Analysis of Investment Securities and Liquidity Management in Banking

This report provides a comprehensive overview of the investment function within the banking and financial services sector. It delves into the roles investment securities play in bank portfolios, including stabilizing income, offsetting credit risk, providing diversification, ensuring liquidity, and reducing tax exposure. The report explores various investment instruments available to banks, categorizing them into money market and capital market instruments, and detailing popular instruments such as Treasury Bills, bonds, certificates of deposit, and corporate notes. Furthermore, it examines factors influencing the choice of investment securities, including expected rates of return, tax exposure, interest-rate risk, credit risk, business risk, liquidity risk, and other risks. It also discusses investment maturity strategies such as ladder, front-end load, back-end load, barbell, and rate expectations approaches, along with maturity management tools like the yield curve and duration. Finally, the report addresses liquidity and reserve management strategies, including asset, liability, and balanced approaches, and the significance of legal reserves and money-position management. The analysis includes the sources and uses of funds, factors influencing the money position, and the role of central bank reserve requirements.

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.

H. 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.
I. Inflation Risk: The danger that rising prices of goods and services will result in lower bank
returns or reduced values in bank assets and equity.
J. Pledging Requirements: The collaterlisation of government deposits held in a bank by setting
aside selected securities to protect those deposit from loss.
VIII. Investment Maturity Strategies
A. The Ladder or Spaced-Maturity Policy: In a bond ladder, the bonds' maturity dates are
evenly spaced across several months or several years so that the proceeds are reinvested at
regular intervals as the bonds mature.

B. The Front-End Load Maturity Policy: All security investments are short-term.
C. The Back-End Load Maturity Policy: All security investments are long-term.
D. The Barbell Strategy: Security holdings are divided between short-term and long-term.

E. The Rate Expectations Approach: Change the mix of investment maturities as the interest-
rate outlook changes.
VII. Maturity Management Tools
A. The Yield Curve: A graphical relationship between the maturity or term of collection of
securities and their yield to maturity.
B. Duration: A value weighted measure of maturity or term of financial instrument which
considers the present value and timing of all its expected cash flows.

LIQUIDITY AND RESERVE MANAGEMENT: STRATEGIES
AND POLICIES
I. Introduction: Meaning of Liquidity
The availability of cash in the amount and at the time needed at a reasonable cost.
II. The Demand for and Supply of Liquidity
A. Sources of Liquidity Demands
1. Customer deposit withdrawals.
2. Credit requests from quality loan customers.
3. Repayment of nondeposit borrowings.
4. Operating expenses and taxes.
5. Payment of stockholder cash dividends.
B. Sources of Liquidity Supplies
1. Incoming customers’ deposits.
2. Revenues from the sale of nondeposit services.
3. Customer loan repayments.
4. Sales of bank assets.
5. Borrowing from the money market.
C. Net Liquidity Position and Liquidity Surpluses and Deficits: The difference between the
total supply of liquidity flowing into a bank and the demands made upon the bank for liquidity.
Net Liquidity Position = Supplies of liquidity – Demands for liquidity

Ill. Why Financial Firms Often Face Significant Liquidity Problems
A. Maturity Mismatches
B. Sensitivity to Changing Interest Rates
C. Liquidity and Public Confidence

IV. Strategies for Liquidity Managers
A. Asset Liquidity Management (or Asset Conversion) Strategies
B. Borrowed Liquidity (Liability) Management Strategies
C. Balanced (Asset and Liability) Liquidity Management Strategies
D. Guidelines for Bank Liquidity Managers
V. Estimating Liquidity Needs
A. The Sources-and-Uses-of-Funds Approach: A method for estimating a bank’s liquidity
requirements by focusing primarily on expected changes in deposits and loans.
B. The Structure-of-Funds Approach: A method for estimating a bank’s liquidity needs by
dividing its borrowed funds into categories based upon their probability of withdrawal.
C. Liquidity Indicator Approach: Ratios or other measures of changes in a bank’s liquidity
postion.

D. The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace
1. Public Confidence
2. Stock Price Behavior
3. Risk Premiums on CDs and Other Borrowings
4. Loss Sales of Assets
5. Meeting Commitments to Credit Customers
6. Borrowings from the Federal Reserve Banks
VI. Legal Reserves and Money-Position Management
A. The Money Position Manager: The bank official primarily responsible for a bank’s cash
position and for meeting its legal reserve requirements.