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2012 Investment Policy Update: Keep It Flexible, Consistent

By: Jeff Goble

The purpose of an investment policy is to provide consistent, long-term guidance for the management of a bank’s investment portfolio. It should be carefully and thoughtfully constructed so that it perfectly matches the overall philosophy of your stockholders/management and the liquidity and income goals of the bank.

An investment policy should also be timeless so that future generations and management teams can rely on it for steady guidance. This is especially true when the economy is struggling, loan demand is soft, there is pressure on earnings and the temptation to change the policy is elevated. Like now?
Following are some hot topics that you may wish to review and consider adding or expanding to your policy this year if they are not already included:

1) Make sure that you are rate shocking your portfolio and balance sheet to include a +/- 400 basis point shock.

Because we are facing historic lows in interest rates, the regulators are suggesting even greater shocks than the heretofore industry standard +/- 200 basis point shock. You can also ramp the changes more slowly up or down over time if you wish, but the worst case scenario preferred by regulators will always be the immediate and parallel rate shock. It is the most revealing, of course.

2) Revisit the underwriting standards and due diligence process for your municipal bonds.

While there have only been about five municipal bond bankruptcies in the last year and the largest one was a sewer revenue bond deal in Alabama that included fraud, it makes good sense to review where you stand in terms of underlying municipal bond credit quality now. There are automated systems for financial statement information available (like and many firms, including UMB, have built computer systems to make this process easier for you. The predictions of hundreds of municipal bond defaults made last year never materialized, thankfully.

3) You may wish to spotlight your efforts on any non-rated municipal bond issues you hold, as their financial statements can be difficult to obtain and non-rated bonds can be tricky to price accurately.

If financials are not available on automated systems like or Bloomberg, it may be necessary to contact the issuer directly to obtain audited statements. This is a really good time to make sure you know what you own in this asset class and drill down on any rated issues that have a B in their bond rating.

4) There is a continuing focus on pre-purchase and post-purchase due diligence for complex securities so that ongoing reviews can be conducted.

Much of this work can be automated as well but it makes sense to increase your efforts in this area to make sure you understand all the risks. In my opinion, this work is probably not necessary for Treasuries and non-callable agency (GSE) issues. If you own structured securities such as step-up bonds, non-GSE issues, corporate bonds or bonds with complex yield formulas, you may wish to enhance the pre- and post-purchase analysis. If you need to sell any of these issues, now would be a good time as bond prices are at historical highs because of historically low interest rates.

5) In the asset-liability management section of your funds management policy, make sure you can model changes to your income and capital position in a variety of interest rate environments and also with parallel and nonparallel interest rate shifts.

You may need to upgrade your ALM software to do this and there are many good options in the market that can complement the complexity of your balance sheet and size of your bank. Your policy should include defined risk limits that adjust incrementally in up and down rate shocks to 400 basis points, and your board/ALCO should review these limits monthly. These risk limits are checks and balances for managing your interest rate risk and financial ratios and this process can provide an important early warning system. You should be able to project earnings in a variety of rate environments for at least two years.

6) Add economic value of equity analysis to your interest rate risk management process if you do not perform this analysis now.

EVE attempts to measure your long-term interest rate risk in contrast to income simulation and GAP analysis, which measure the risk over shorter time horizons, like the next year. Basically, EVE subtracts the present value of your liabilities from the present value of your assets to impute the value of your bank’s capital.

7) Contingency funding issues are a red hot topic.

Given the huge increases in FDIC-insured banking deposits (also known as surge deposits) since the recession started in 2008, be prepared to have complete and thorough contingency funding plans in your policy. Model how you would fund an unexpected reversal of your growth in deposits since prerecession levels.

This is an excellent time to review and enhance your current investment and asset-liability management policies, but not make wholesale changes because of the extreme market conditions we face. Flexibility and consistency have always been the hallmarks of sound investment policy.

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)

Copyright (c) May 2012 by BankNews Media