The turmoil in capital markets and changes in the regulatory environment over the past several years have sparked significant changes in bank investment portfolios – and caused many banks to reevaluate portfolio management practices.
Bank investment portfolios have expanded substantially since the financial crisis. Driven primarily by increased deposits and limited lending opportunities, the vast majority of bank investment portfolios now account for a greater share of total assets and potential profitability than just a few years ago. At the same time, bank investment portfolios have become more concentrated in Treasury and agency securities, including agency mortgage-backed securities. These factors, combined with historically low yields, result in a lower expected return and put pressure on earnings at a time when the banking industry already faces significant headwinds.
This has prompted some banks to rethink the best way to achieve the primary objectives of the investment portfolio; providing balance sheet liquidity and generating income. In some cases, banks are expanding their investment portfolio into additional asset classes and sectors in an effort to improve diversification and risk-adjusted returns. The complexity of this new global environment has also encouraged some banks to outsource, relying on outside investment specialists to complement their in-house capabilities.
Investment portfolio challenges
The investment portfolio has become increasingly important to bank balance sheets – and, at the same time, hurdles to achieving optimal investment results have increased. Let’s look at these key challenges more closely:
- Bank investment portfolios have increased in size relative to total assets, and thus importance to bank profitability. Bank investment portfolios grew by $900 billion to 21% of total assets at the end of 2011 from 15% four years earlier, according to data from U.S. bank holding companies (includes available-for-sale and held-to-maturity securities).
- Although there are signs this trend may be reversing, credit risk has declined on average across bank securities portfolios from pre-crisis levels, as reflected in portfolios with higher concentrations in Treasury and agency securities. Specifically, the share of the investment portfolio dedicated to credit (e.g., “spread”) investments declined to 37% at the end of 2011 from 41% at the end of 2007 (See Figure 1). The end result may be a highly conservative asset allocation that may not be well aligned with the bank’s risk/return objectives and liquidity needs.
- The write-downs and losses that were experienced during the financial crisis, as well as uncertainty with respect to future liquidity requirements, have created additional hurdles with respect to re-orienting the investment portfolio toward optimal risk-adjusted returns.
The history behind this disconnect between risk exposure and return objectives is well documented: As was the case with other investors, many banks experienced significant impairments during 2007-2009 as a result of their positions in certain spread investments such as non-agency residential mortgage-backed securities (RMBS), collateralized loan obligations (CLOs), etc. As a result, a number of banks revised their investment policies to further restrict credit risk, designating certain spread investments as “non-core” holdings and issuing mandates to liquidate associated asset portfolios as well as prohibiting new purchases. These actions were clearly prudent in cases where individual banks did not have the resources to evaluate the nuances inherent in certain asset structures and to properly assess the associated credit and liquidity risks. However, there may be unintended consequences from these actions that restrict banks’ ability to improve profitability, diversify risk and build capital.
In addition, forthcoming regulations such as Basel III’s Liquidity Coverage Ratio (LCR) suggest a significant portion of the investment portfolio (potentially as high as 60%) may need to be held in highly liquid (and lower yielding) securities for a large portion of the portfolio, making it that much more important for banks to obtain optimal results from the remainder of the portfolio.
Similarly, Dodd-Frank legislation may require banks to develop in-depth internal ratings methodologies to assess investment risk. As a result, regulators and boards will likely have higher expectations for the investment due diligence processes banks and their external service providers have in place. Banks without the resources to develop these internal processes may be forced to significantly limit their investment opportunity set, possibly limiting earnings and diversification potential in the securities portfolio.
Demand for increased investment portfolio return
Despite internal and external hurdles, and in contrast to the general trend over the past few years, banks appear to be taking active steps to improve diversification and return potential in recent quarters. In addition, a growing number of banks are developing internal processes and capabilities to invest in new asset sectors, and in some cases, instruments that were deemed non-core and in “run-off” mode as recently as two years ago.
Throughout 2011, the portion of the securities portfolio classified as credit or spread investments increased at the top 50 U.S. banks (see Figure 2).
As shown in Figure 3, this trend was particularly apparent in the fourth quarter, led by a $45.5 billion increase in credit portfolio assets, while liquidity portfolio asset exposures increased by only $3.3 billion. The increase in credit/spread positions was composed of foreign debt ($23.5 billion), municipals ($9.7 billion), commercial mortgage-backed securities ($8.6 billion), structured products/asset-backed securities ($8.4 billion) and non-agency RMBS ($6.6 billion).
Overall industry dynamics may put continued pressure on banks to generate incremental revenues across the balance sheet, leading to a further broadening of investment portfolio risk exposures. Of course, increased risk does not necessarily translate into higher returns, and has the potential to produce exactly the opposite result if the downside is not well understood or properly managed. The ability to effectively manage risk, meet new regulatory requirements and achieve investment goals will depend on a bank’s ability to access the appropriate investment and risk- management expertise.
Bottom line: The investment portfolio may represent an opportunity to improve bank revenues and risk-adjusted performance by expanding into investments with improved return and diversification potential. But doing so in a prudent manner may require banks to rethink internal capabilities and also to consider potential strategic investment advisory partnership arrangements.
Improving the risk/return profile
Banks can potentially improve the risk/return profile of their portfolios in a number of ways, including:
- Increasing or adding exposure to certain bank-eligible asset classes and sectors in an effort to enhance returns without compromising (and possibly even reducing) overall portfolio risk. This approach can improve diversification within the investment portfolio and across the entire balance sheet.
- Using skilled security selection and sector expertise to uncover relative value opportunities that can produce additional return. For example, even in highly liquid markets such as agency MBS, opportunities may exist to achieve higher risk-adjusted return potential based on an in-depth understanding of different factors that drive returns (e.g., sensitivity to extension risk, etc.).
- Recognizing attractive investment opportunities that arise out of a rapidly changing market environment and associated increases in risk premiums and volatility. This may be especially effective when coupled with an investment process that matches a robust and dynamic macroeconomic forecasting process with bottom-up asset evaluation expertise.
- Improving downside risk management and monitoring. As a case in point, many of the low-risk (i.e., low volatility and highly rated) portfolios from the pre-crisis era experienced significant losses, possibly due to limited resources and insufficient due diligence that went into the security selection and ongoing risk monitoring process.
Some banks may have the infrastructure and expertise that allows them to achieve an optimal investment portfolio risk/return profile. In other cases, appropriate resources can be brought on board within a reasonable time frame. Or, it may make sense to consider outsourcing a portion of the investment portfolio to quickly access attractive investment opportunities that provide valuable diversification and return potential. Even in cases where existing internal resources are sufficient, outsourcing may add fresh insights to the bank’s investment process (e.g., tactical asset allocation perspectives or performance measurement benchmarks) and provide an important source of manager diversification.
Regardless of the approach employed, the ability to achieve optimal investment portfolio results while keeping downside risk at appropriate levels may be an important contributor to success amid a banking environment marked by earnings pressure, increased regulatory scrutiny and capital markets volatility.