Bank investment portfolios, a key source of income and liquidity, represent a larger percentage of bank balance sheets than ever before. PIMCO believes that with cash positions and capital levels at their highest point in history, most banks’ ability to optimize the investment portfolio’s risk/reward profile while maintaining appropriate levels of liquidity and preserving capital will play a significant role in their earnings performance over the secular time frame.
In the following interview, Jerome Schneider, head of short-term portfolio management, Paul Reisz, product manager for short-term strategies, and Justin Ayre, banking solutions specialist in PIMCO’s Advisory group, discuss the market and regulatory conditions facing banks and how PIMCO can help bank portfolios confront the challenges of today’s low-yielding environment.
Q: Have banks changed their approach to investment portfolios in response to the 2008–2009 credit crisis? Ayre: Yes, definitely. Prior to the crisis, a number of banks (and many other firms, including investment managers) invested in complex instruments where they did not fully consider the inherent structural and credit risks. Additionally, regulatory policy did not require adequate levels of capital to compensate for the risk exposures. This caused some banks to take significant mark-to-market losses and write-downs due to credit deterioration, and in some cases they were forced to sell at suboptimal levels.
Since the credit crisis, banks have increased portfolio allocations to U.S. government, agency and agency mortgage-backed securities (MBS) positions, with a particular emphasis recently on agency MBS. However, while the emphasis on government- and agency-backed securities may help limit credit risk, an unintended consequence may be a concentration in other types of risk factors and a lack of overall portfolio diversification.
Reisz: Over the past four years, banks in the U.S. have also increased their cash equivalent balances from 8% of assets to 14% of assets, a rise of approximately $1.8 trillion, according to weekly Federal Reserve bank holding data and PIMCO estimates. While partly the result of increased minimums due to deposit growth and higher liquidity cushions, much of these balances are invested in overnight and daily liquidity markets or held as excess reserves at the central bank. Based on the recent increased growth in these balances, we believe that excess amounts may be available for investments with more opportunistic risk/reward profiles than those in the interbank and daily liquidity markets.
Q: With cash assets at banks at historically high levels, are there opportunities to invest cash at rates above those earned in the interbank market?Schneider: Managing cash equivalent balances at banks, which typically include secured and unsecured liquidity investments (e.g., fed funds, deposits, etc.), is a core function of any bank’s treasury department. With U.S. interest rates on hold until at least late 2014, these cash balances will likely face near-zero yields for the foreseeable future.
In this environment, we believe banks may benefit from identifying excess cash balances and investing them in short-term and low duration instruments instead of the interbank market or certain money market strategies. It goes without saying that maintaining liquidity, preserving principal and maximizing efficient use of capital are paramount considerations for such portfolio strategies. However, bank investment officers may consider capital-efficient opportunities that offer appealing risk metrics and potential rewards without simply taking additional duration risk to generate returns.
As markets fluctuate, portfolios with intermediate liquidity needs can benefit from increased yield and capital appreciation by garnering liquidity premiums on their assets instead of purchasing assets the marketplace prices richly because they are deemed eligible for liquidity portfolios. Although such a strategy may involve taking incremental risks beyond the perceived safety of the interbank market, allocations of these excess cash balances may be invested in short-term duration bond strategies that can offer potentially higher yields, capital appreciation, and better liability matching for the banks themselves.
Q: In addition to cash and cash equivalents, where is PIMCO seeing opportunities to add value across a broader bank investment portfolio? Schneider: Expanding the opportunity set of investments, along with effective security selection and execution, can improve return and diversification potential – and both are critically important in today’s low rate and volatile environment. Certain bank-eligible asset classes may represent opportunities to enhance return without compromising overall portfolio risk by improving diversification within the investment portfolio and across the entire balance sheet. For example, high-quality non-financial corporate bonds may represent attractive risk/return opportunities with good liquidity and acceptable levels of credit risk – and offer attractive diversification from overallocations to agencies and agency MBS found in many bank portfolios currently.
Also, within individual sectors, relative value opportunities may be able to produce additional return via skilled security selection and sector expertise. For example, even in highly liquid markets such as agency MBS, an in-depth understanding of the different factors that ultimately drive performance can help the portfolio target higher risk-adjusted returns.
Across asset classes, PIMCO also seeks to offer our clients improved execution and ability to source assets in bulk, which may translate into improved returns and better diversification for certain bank portfolios. This is an important differentiating factor in selecting a portfolio manager, as execution can be a significant component of capital appreciation or preservation for any portfolio mandate.
Q: How does PIMCO approach liquidity risk management in bank portfolios, particularly in light of changing regulatory requirements?Ayre: Recent liquidity guidance proposed by bank regulators may result in a mandate for banks to hold a certain percentage of their investment portfolio in U.S. government–backed asset classes (namely, Treasuries, agencies and agency MBS). These restrictions would amplify the importance of optimizing the portfolio’s investments in those asset classes, but also put an even greater emphasis on achieving an appropriate degree of diversification with the remaining portion of the portfolio in order to optimize overall risk-adjusted returns. This could be particularly challenging for banks without the in-house capabilities to invest in a broad set of eligible asset classes.
Schneider: PIMCO’s view is that liquidity risk is fluid and ever-changing. As such, a portfolio’s investment parameters must be consistently re-evaluated and dynamically adjusted to market conditions. Most important, they should be adjusted with current and forthcoming bank regulations in mind, but not solely determined by the regulatory frameworks dictated in the marketplace. While the overarching principles of investing in high-quality “safe haven” assets are similar, we see liquidity as highly dynamic and constantly changing, requiring active surveillance of the global markets. This requires a solid, in-depth understanding of the macroeconomic variables as well as the structural landscape we are operating in – not only the historical perspective, but foresight into likely changes over the near- and longer-term horizon. In our view, liquidity characteristics do not lend themselves to a strict rules-based regime for measuring risk.
By working closely with our clients to understand their objectives and portfolio constraints, we are able to view liquidity management not only as a defensive tactic, but also as a proactive offensive strategy that may help buoy investment returns.
Q: How does PIMCO provide portfolio management services for banks? What is the process?Reisz: We’re seeing more banks using dedicated portfolio managers and risk management support to supplement their own portfolio management capabilities. To help meet this demand, PIMCO offers highly customized separate account mandates dedicated to the management of a bank’s investment portfolio (e.g., available-for-sale portfolio) that incorporate the key attributes of liquidity, capital efficiency and regulatory compliance.
Clients often ask how this portfolio management process works given the unique regulatory and operational considerations at a bank. In fact, a third-party investment manager can complement a bank’s internal processes in risk management, compliance and accounting – and can also support certain regulatory requirements related to asset-level analysis, risk management and reporting.
On a typical separate account mandate for a bank client, PIMCO works closely with management and the treasury across three broad components. First, investment strategy: We provide guidance and offer solutions on investment policies, budget and planning, asset-liability matching and asset/sector allocations. Second, portfolio management: We provide our thorough, time-tested investment processes (including due diligence and asset-level analysis), formalize portfolio constraints, sector allocations, and security selection, and conduct ongoing risk management and monitoring. Finally, operations, risk and compliance: Standardized portfolio reporting, risk analysis and customized stress testing reports at both the asset and portfolio level help support risk management and regulatory requirements.
Q: What other new regulations are likely to affect bank portfolios, and how is PIMCO responding?Ayre: We believe that many of the new bank regulations provide a natural extension for PIMCO to serve its clients in both a portfolio management and an advisory capacity.
One key example is how we have worked with banks to address new due diligence regulations: In the past, banks relied, in part, on credit ratings to assess an investment’s appropriateness for their portfolio. Then new, stricter regulations increased the burden on banks to look beyond credit ratings and understand and monitor the structural features and underlying collateral performance of the investments in both expected and stressed economic environments. In some cases, bank clients have asked PIMCO to serve as discretionary investment manager of their assets and provide the security evaluation and underlying analysis to select and monitor investments. In other cases, banks have worked with PIMCO’s Advisory team to address regulatory and risk management needs based on our security selection capabilities, risk analytics and investment insights.
For more information on PIMCO’s solutions for bank portfolios, including outsourced investment management and other customized services designed to meet the rapidly evolving needs of banks and financial institutions, please contact Advisory@pimco.com or 1(949) 720-6000.