Company Name

Keep It Simple

By Larry Russell

One of the more perplexing fundamental challenges facing the investment portfolio manager in a community bank at this time is the ongoing administration of the portfolio in light of the changing sizes in the balances of deposits and loans. Of course, the community bank relies on core deposits, and to earn them, must be competitive in its offerings within the footprint of the institution. Likewise, the bank prospers on loan demand and, again, must offer competitive structures and pricing to retain and grow its list of borrowers.

Given the influences that competition forces in deposits, loan balances and structure, the investment portfolio is the pool of assets on the balance sheet that enables the various assets and liabilities to operate in a synchronized manner to generate satisfactory performance. With these facts in mind, consider a method to aid you in your process of appropriate asset allocation within the investment portfolio, and management of the twin goals of liquidity and income.

Step1. To begin, estimate the projected loan growth versus projected deposit growth.  Note that difference as the net amount to be funded (Net to Fund) from the investment portfolio in the case of larger relative loan growth, or to be invested into the portfolio in the case of larger relative deposit growth.  Then, add the current overnight funds position to the investment portfolio for the Total Available Funds to satisfy projected loan growth in this example.

Step 2. Establish a three-sector format (see chart) with the Core Liquidity Sector holding the shortest

bonds in the portfolio, composed of AFS issues <= 1 year, plus HTM issues <= 3 months. This total should equal 10 percent of Total Available Funds or an appropriate percentage based on your balance sheet needs.

Step 3. Establish a Variable Liquidity Sector which should equal the Net to Fund amount from Step 1. It is generally composed of bullets (AFS) <= 3 years; agency callables (AFS) <= 3 years; agency callables (HTM) <= 3 months; municipals <= 1 year; other (AFS) <= 1 year; other (HTM) <= 3 months; and MBS/CMO current face value <=1 year. The institution would anticipate using this sector to fund expected loan volumes.

Step 4. Establish a Yield Sector composed of the remaining Total Available Funds not already allocated in Steps 2 and 3. This amount will normally equal a large percentage of the investment portfolio and provides the “loan substitutes” that consistently are important in construction of high-performing portfolios. It is composed of bullets (AFS) > 3 years; bullets (HTM) > 3 months; agency callables (AFS) > 3 years; agency callables (HTM) > 3 months; municipals > 1 year; other (AFS) > 1 year; other (HTM) > 3 months; and MBS/CMO current face value > 1 year.

If the foregoing sounds complicated and not simple as the title to this article suggests, check the three sector boxes pictured and it should come into focus. In fact, there is a common sense method or rhythm in which portfolio components are allocated given that the realities of duration/interest rate risk and FASB 115 govern. In practice, fine tune weightings within the components to insure the average duration of the portfolio places interest rate risk within the parameters of bank policy.

The method outlined above should not finish the process. Now the “art” begins. The percentages of the various sectors and their components should be tailored based on the interest rate bias of you and your asset-liability committee. In other words, what is the expectation concerning the direction rates are anticipated to move over the next twelve months? How much conviction exists in that opinion? If you believe rates are moving higher as more Federal Open Market Committee-initiated increases occur, logically more weight is kept in the first two sectors. Alternatively, if belief of a lid on rate increases exists due to a fragile domestic economy and global problems, sector three may receive increased emphasis to provide additional earnings to meet budget.

Concerning your interest rate bias, there is too much to read and scan and too little time to do it. Over the past several years, the Federal Reserve has continued to say that future rate increases are and will be data dependent. A few things I would be watching as the weeks go by are the trends of global rates, employment data, regression analysis of our rates, U. S. corporate earnings, oil prices and strength of our dollar … not to mention the new administration and Congress. Of course, this is not a complete list but key indicators I will be scoping.

Seldom if ever have there been more uncertainties concerning the future direction of interest rates and the timing of their movement. Regardless, this is what we have to work with. Become comfortable with this three-sector investment portfolio concept — it may provide a clearer picture of where the portfolio stands currently in relation to the realities of the budget and goals of the bank. Practice makes perfect.


Larry Russell is senior vice president in the Capital Markets Group at Country Club Bank in Kansas City.


Print Friendly
Share This PageShare on FacebookShare on Google+Tweet about this on TwitterShare on LinkedIn
Software: Kryptronic eCommerce, Copyright 1999-2017 Kryptronic, Inc. Exec Time: 0.059377 Seconds Memory Usage: 3.783188 Megabytes
Kryptronic Internet Software Solutions