Bank investment portfolios have become an increasingly important part of bank balance sheet management. Regulatory influences have forced bank investment portfolios into concentrated positions – significant allocations to government-backed debt such as agency mortgage-backed securities (MBS) – mostly because of favorable capital treatment and limited resources to take advantage of other high-quality, bank-eligible sectors. PIMCO thinks more can be done to improve returns and better manage risk.

Some banks have built internal investment resources to target additional fixed income opportunities and diversify investment portfolios effectively. Others look to third-party investment advisors to provide additional capabilities. In that arrangement, banks delegate investment authority to a third-party investment manager, or investment advisor, to purchase and sell securities on their behalf. Securities are held in a separate account with independent custody. Typically, these arrangements are tightly controlled discretionary or nondiscretionary arrangements. When performed with appropriate levels of vendor management controls, we believe this approach offers meaningful benefits and may better align investment portfolio activities with the “safety and soundness” objectives of the bank’s regulators.

• Potential for improved risk-adjusted returns on the investment portfolio
• Relative cost/benefit versus managing the portfolio in-house
• Well-established regulatory requirements on the use of third-party investment managers

Cost/benefit

Investment managers typically charge fixed fees for their services based on assets managed. But those fees should be evaluated within the context of the experience, resources, efficiencies and other benefits an established manager can provide. Banks should also consider that managing an investment portfolio in house has many embedded costs. These costs are less obvious, such as building out the infrastructure and team to manage the portfolio, employing rigorous risk control and complying with regulatory guidelines, not to mention potentially higher transaction costs.

Broker-dealer transaction costs can vary greatly based on the size of the transactions and access to the most liquid dealers, among other factors. While this is difficult to quantify, large investment managers typically interact with large broker-dealers and transact in blocks, which can reduce transaction costs and improve liquidity. For example, the Bid-Ask Spread Index (BASI) from MarketAxess shows that block trades on actively traded (liquid) corporate bonds currently have a 3-basis-point (bps) bid-ask spread whereas odd lots trade at 7 bps and micro trades are at 15 bps. Less liquid bonds commonly held in bank portfolios (e.g., municipals, structured credit, etc.) may have even higher transaction costs. So, access and trading capabilities with a range of large broker-dealers – which are fully developed functions of investment managers’ trading desks – may not exist for bank CFOs and treasurers who are often tasked with managing the portfolio. Well established investment managers can optimize execution for individual client portfolios using specialized sector expertise and broad access to the broker-dealer community to help minimize these costs.

As important, managers can also assess whether appropriate risk premiums are being earned, particularly in less liquid holdings where that liquidity premium is a large component of returns. Managers can also provide access to purchase bonds in new issuance markets where allocations can be scarce. They also have considerable portfolio management teams, as well as trading, compliance and risk management infrastructure, which would be hard, and prohibitively expensive, to replicate at a smaller bank.

Clearly, broker-dealers are critical to the continued functioning and liquidity in fixed income markets and they provide a valuable service to market participants including PIMCO and our clients. We simply believe that there are circumstances where banks would benefit from having an investment advisor with specialized expertise and trading scale to interact with brokers on their behalf – with specific accountability for selecting the most appropriate investments and seeking the best execution across the broker-dealer community. While broker-dealer accountability ends with the transaction execution, investment managers have an obligation to provide post-purchase risk evaluation and ongoing management of the securities in the portfolio, and the resources to do so.

Add investment expertise without significant resource drain

An outside manager can provide investment expertise in areas where a bank may not have a core competency or sufficient infrastructure. Access to additional resources may lead to better investment results. It’s no surprise that large banks have bigger investment teams with the ability to create more diverse investment portfolio allocations. Smaller banks generally do not have the resources to manage diversified portfolios and tend to concentrate portfolios on a few sectors of the fixed income market. For example, banks with assets below $1 billon concentrate in three primary sectors – U.S. government, agency MBS and municipals – which represent 95% of their investment portfolio assets. They also carry more duration risk. Larger banks, those with assets above $250 billion, have only 68% of their assets in those three sectors.

Larger institutions often adopt a core-satellite approach through which they manage “core” assets (Treasuries, agencies, etc.) and seek third-party manager assistance for satellite strategies (municipals, corporate credit, commercial mortgage-backed securities, etc.).

This does not mean that banks can simply engage a third party without understanding the investments selected by the investment manager. The manager must provide the tools to allow the bank to understand and monitor the investments consistent with the bank’s fiduciary responsibility and regulatory requirements.

Delegation of investment authority – regulatory requirements and industry practices

According to Federal Deposit Insurance Corporation (FDIC) guidance, investment authority may be delegated to a third party as long as management continues to have responsibility and oversight over the third party’s activities as well as an understanding of the investments made by the third party.

In our experience, the bank and the investment manager develop specific investment guidelines that govern the investment manager’s activities and adhere specifically to the bank’s investment policy. The bank’s investment policy is updated to prescribe the relationship with the third party and other requirements (e.g., manager registration and affiliation, performance measurement techniques, etc.) and the bank’s role in overseeing the investment manager.

The FDIC is very clear that the bank board is ultimately responsible for the bank’s investment decisions and this responsibility cannot be delegated externally. A well-defined process for interacting with the investment manager can help to ensure the bank’s management and board maintain appropriate levels of oversight and control.

Conclusion

Other industries faced similar challenges and have embraced outsourcing models for their investment portfolios. The financial crisis and continued low rates have forced the insurance industry, for example, to question the practice of managing its own investments. Increasingly, insurers are looking to third-party investment manager expertise. According to a survey by Patpatia & Associates, 55% of insurance companies outsource some or all of their general account (balance sheet) investment portfolio. We estimate the number is much lower with banks, but that trend is changing.

In our view, some banks are missing opportunities to improve yield and manage risk by concentrating portfolios in such a narrow range of sectors simply because they do not have the resources to evaluate and access broader opportunity sets in an efficient and prudent fashion.

At PIMCO, we have a dedicated team focused exclusively on managing bank investment portfolio assets. Our approach utilizes both “top-down” and “bottom-up” views generated by our time-tested investment process and our global investment team. Top down, firmwide macroeconomic analysis sets the broad investment framework, while bottom-up analysis drives our individual security selection process, helping us identify and analyze undervalued securities that offer attractive yield relative to their risk and regulatory capital requirements. Our investment management process is also flexible enough to include necessary guidelines to meet individual bank investment policy requirements. By combining PIMCO’s investment process and our experience working with banks and their regulators, we believe we can help banks achieve better investment portfolio results.