Reduce liability for losses on commercial accounts by adhering to four requirements.
The Importance of Investment Policy
During the past year, we have endured some of the worst financial conditions since the Great Depression with losses to date of more than $500 billion due to the housing crisis. There has probably never been a better time to revisit your bank’s investment policy and make sure that it is current. Consider the following:
What should our policy objectives be?
The objective of a bank’s investment policy should be to establish guidelines that maximize the return on your capital, provide liquidity, make collateral available for pledging needs, and meet or exceed regulatory requirements. The policy should provide a flexible framework for managing your bank’s bond portfolio on a daily basis.
Who is responsible for reviewing and approving our policy each year?
Your board of directors is ultimately responsible for the review and approval of this policy at least annually. Management, however, is responsible for the supervision of the portfolio on a day-to-day basis. Certain officers (or an investment committee) should be authorized by the board to purchase or sell securities, implement strategy and recommend any change in policy that may be warranted.
How broad should our security menu be?
For safety, banks generally invest the majority of their excess reserves in securities that are explicitly or implicitly guaranteed by the U.S. Government. It also makes good sense to further diversify your GSE holdings. After a credit review, funds are often invested in high-quality municipal bonds and to a lesser degree generally, commercial paper and corporate bonds. Limitations on security types should be clearly delineated in your policy.
Should we establish percentage guidelines for each type of security in which we invest?
Investing in many types of securities can dramatically reduce your risk as diversification is one of the most important rules for successful long-term investing. Your policy should set minimum and maximum percentages for each security type in your portfolio, yet remain flexible as markets change and opportunities arise.
How do we manage maturity or market risk?
Most banks establish a target average maturity for their bond portfolio that complements their bank’s risk tolerance, balance sheet structure and investment philosophy. This target generally falls between two and five years for most institutions and can be crosschecked by performing a rate shock on your balance sheet to ensure that your margin variance and economic value of equity are always within policy limits in the worst rate shock case.
Is the target maturity we select a fixed benchmark or does it change?
The target maturity should be lengthened when interest rates are high and shortened when rates are low. Your portfolio’s basis (current yield, average maturity and gain/loss position) can serve as a valuable tool for helping to determine where we are in the interest rate cycle and whether lengthening or shortening is warranted.
Should we establish quality guidelines too?
We have all learned how quickly credit quality and bond ratings can change this year and it makes sense to establish minimum quality standards for those securities that are not backed by the government. You should rely more on intrinsic quality measurements than bond insurance or ratings agencies and consider the worst case scenario before you invest.
The best investment policies require little maintenance as they are timeless with regard to their focus on quality and flexible nature. Return of principal has always been more important than return on principal.
For the past 20 years we have updated a sample investment policy for our clients to use as a template that can be customized. To receive a free copy of our 2008 Funds Management Policy, please email me.
Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.
Copyright © October 2008 BankNews Publications