Squeeze More Profits Out of Your Bank's Investment Portfolio

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 are causing many banks to reevaluate portfolio management practices.

Bank investment portfolios have expanded substantially since the financial crisis. Driven by increased deposits and limited lending opportunities, 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, the average bank investment portfolio has become more concentrated in Treasury and agency securities, including agency mortgage-backed securities. These factors, combined with historically low yields, have put pressure on returns and earnings. 

All of this has some banks rethinking 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 to improve diversification and returns. Several factors are creating challenges to achieving optimal investment portfolio results:

• 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 (the figures include 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, as banks have pulled back on so-called spread products such as non- agency residential mortgage-backed securities and collateralized loan obligations which were severely impaired in the crisis. The move to higher concentrations of Treasury and agency securities has created an asset allocation that may not be well aligned with the banks’ risk/return objectives and liquidity needs.  
• The write-downs and losses that were experienced during the financial crisis, as well as uncertainty about future liquidity requirements such as Basel III’s liquidity coverage ratio have created additional hurdles as banks seek to reorient their portfolios.
• The Dodd-Frank Act will require banks to develop in-depth internal ratings methodologies to assess investment risk.  Banks without the resources to develop these internal processes may be forced to significantly limit their investment opportunity set.

Despite these challenges, banks have started to improve diversification and return potential. In addition, a growing number of banks are developing internal processes and capabilities to invest in new asset sectors.
We believe there are a number of steps banks can take to enhance the risk/return profile of their portfolios, including:

• Increase or add exposure to certain bank-eligible asset classes and sectors, such as investment-grade corporate bonds, 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.
• Skilled security selection and sector expertise can uncover relative value opportunities that can produce additional return. For example, even in highly liquid markets such as agency MBS, there may be opportunities to achieve higher risk-adjusted return potential with an in-depth understanding of different factors that drive returns, such as sensitivity to extension risk, and others.
• Recognize 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.
• Improve downside risk management and monitoring, including the due diligence that goes into security selection and ongoing risk monitoring processes.

Some banks may have the infrastructure and expertise that allows them to achieve an optimal investment portfolio risk/return profile – or appropriate resources can be brought on board within a reasonable time frame. In other cases, 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.
Regardless of the approach employed, the ability to achieve optimal investment portfolio results while keeping downside risk at appropriate levels will be an important contributor to success amid a banking environment marked by earnings pressure, increased regulatory scrutiny and capital markets volatility.

Sabrina Callin is a managing director and head of client solutions in the advisory group at Pacific Investment Management Co. Justin Ayre is a senior vice president at the firm specializing in banking advisory services.