Increased volatility in the capital markets, similar to what we’ve experienced in recent months, can uncover both challenges and opportunities for bank investment portfolios.
Bank investment portfolios generally use high quality fixed income investments in an effort to provide a source of liquidity and income – and to balance the duration and liquidity profile of their loans and liabilities. As investment portfolios have grown from 14% of banking industry assets in 2007 to 20% of assets as of June 2013 (according to the FDIC) they have also become a more critical source of bank earnings. At the same time, regulatory challenges and low yields have pushed some banks into suboptimal investment portfolio allocations.
These portfolios include fixed income sectors that source returns primarily through maturity extension (duration) and negative convexity (mortgage-backed securities prepayment volatility). The current interest rate environment, as well as the industry’s focus on the risk of rising rates, makes these sources of return less compelling.
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