The interest earned on the investment portfolio is often the second-largest revenue source for banks. In addition to being an important revenue source, the investment portfolio serves as a secondary reserve to help banks meet liquidity needs. Further, it is used to meet pledging requirements against governmental deposits. Investments also provide banks with a useful way to diversify their asset base.

The investment portfolio is a key revenue source and liquidity management tool for banks. When loan demand is low, banks invest excess funds in securities to earn a return until demand improves. When that occurs, banks sell the securities they purchased to make loans. Because the investment portfolio plays a critical role in a bank’s success, its management at most banks is governed by policy. The foundation for sound management and administration of the investment portfolio is the investment policy. This policy represents the board of director’s guidance and direction to management regarding the bank’s investments. With boundaries set by policy, management devises the investment strategies to meet the bank’s needs.

Depending upon the bank, the investment policy may be part of the asset and liability management policy or integrated into other polices the bank feels appropriate. It is important to note that bank policies are often integrated with one another to ensure consistent risk management throughout the bank’s operations. For example, it wouldn’t be unusual for the loan policy to do any one of the following (each of these policy items reflect the terms on which loans are available to the bank’s customers, while also addressing the bank’s market risk exposure):

• Specify a maximum term for which loans are made.
• State the type of rate (variable or fixed) that will be offered on credit extended.
• Require a prepayment penalty if a borrower repays a loan early.

Lesson Objectives

This lesson focuses on basic matters in an investment policy and the risk management role it plays. After you complete this lesson, you should be able to:

• List the purpose of the investment policy.
• Recount matters often addressed in an investment policy.

Goals of the Investment Policy

Like all other policies of the bank, the investment policy is tailored to the special needs and conditions faced by the bank. Although its primary focus is guiding investment activities, it takes into account the multiple needs of the bank, providing for such matters as asset diversification, earnings and liquidity.

At a minimum, a complete investment policy often includes:

• A statement of objectives. For example, provide earnings, liquidity, meet pledging requirements)
• A listing of investments permitted and not permitted for the bank.
• Diversification guidelines and concentration limits to avoid committing too much of the bank’s capital to a single issuer, industry group or geographical area.
• Proper reporting of securities activities, making sure investments are appropriately categorized according to generally accepted accounting principles.
• Maturity and repricing guidelines, setting out the maturity distribution of the bank’s investments, establishing interest rate terms (fixed or adjustable rate) and their appropriate use and setting out circumstances for selling specific maturities.
• Limitations on quality ratings and the agency issuing the rating. The rating grade will determine which investments the bank can buy.
• Valuation procedure and frequency—the method used to value securities and the frequency in which it must be done (monthly, quarterly, etc.). At a minimum, it most likely will be quarterly to meet financial reporting requirements to bank supervisors.
• Officer’s authority and approval process—who has what authority to conduct business for the bank and what prior approvals they must have to exercise that authority.
• Procedures covering policy exceptions—the process for handling exceptions and who approves policy exceptions. Most often it is the board that approves policy exceptions.
• New product review – setting out when a review must be done, of what it must consist and documentation required to show the review was done.
• Selection of securities dealers—listing of broker/dealers with whom the bank will do business, scrutinized for their reputation and financial standing.
• Reporting requirements—reports and the frequency of those reports to the board on the bank’s security positions including information on such things as issues held, amount of each issue held, purchase price and current market price.
• Periodic review—when the board should review the investment policy for its consistency with the board current tolerance for risk and evolving market conditions. Also, provides for the periodic independent review of the investment function for adherence to policy.

The principal control tools for managing market risk are a bank’s policies. How does your bank monitor its compliance the investment policy? Consider the Try This at Your Bank exercise: Compliance with Liquidity and Investment Policies.

Elements of an Investment Policy

At Insights Bank and Trust, the investment policy is the primary policy tool for controlling the bank’s market risk in its securities portfolio. Like other bank policies, it sets out the basic objectives to be accomplished by the policy. These objectives might be to minimize risk, provide a good return, provide ample liquidity and meet pledging requirements. It also covers basic matters relating to the bank’s investment securities, such as:

Who is responsible for the various aspects of the securities portfolio?

• For example, the board is ultimately responsible for establishing, reviewing and evaluating the investment policy. Management has responsibility for establishing policies, procedures and control systems to implement the board’s policy guidance related to the bank’s investments and for implementing systems to monitor policy adherence.

What …

• Are acceptable and unacceptable investments?
• Are unacceptable investment practices?
• Are the limits on securities holdings from a single issuer?
• Due diligence should be performed before making investments? (That is, what types of investments require analysis before purchase, what analysis is required, and what documentation is required?)
• Due diligence should be performed on a broker-dealer with whom the bank does business (reputation, financial condition, etc.)?
• Reports should be produced on the bank’s securities portfolio and its content?
• Independent review should be undertaken of the adequacy of the bank’s policies, procedures and control systems that govern the bank’s investment activities?

When…

• Are investment transactions to be reviewed by the board?
• Are the fair value of securities to be determined? (Probably at least quarterly to meet Call Report reporting requirements.)
• Should due diligence be done on the bank’s broker/dealers?
• Should the board review the investment policy to determine if it reflects the board’s current thinking Sbout appropriate securities investments?

Many banks also have broader interest rate risk policies that address the measurement, management and control of market risk inherent in the entire balance sheet. In addition to objectives and authorities, the interest rate risk policy typically addresses:

• The type of risk measurement methodology to use (for instance, the Earnings At Risk (EAR) simulation, the Economic Value of Equity (EVE) simulation, Gap analysis).
• Risk measurement metrics and explicit market risk limits.
• Exception procedures and remedies.
• Permissible hedging strategies and the use of derivatives.
• Directives regarding broker-dealers.
• Other aspects as needed.