Chapter-7: Investment Management of Commercial Banks

Investment: Investment is the use of money for the purpose of making more money to gain
income, profit or increase in capital or both. The term investment is also used to include those
funds both public and private, for relatively long period of time with the objective of earning
income. Investment is mainly made for the purpose of generation income. To meet up the
liquidity requirement is one of the major purposes of investment. So, bank’s investment means
the part of bank’s loanable funds which are employed in money market or capital market by
purchasing securities for the purpose of earning profit.

Characteristics of Bank Investment

Loan and investment are two major profit making activities for banks. But bank investments
have different aspects in comparison to loans. Some distinguishing and important features bank
investments are as follows:
 Nature of fund
 Third line of defense
 Creditor status of bank
 Initiative of transactions
 Volume of investment relative to the size of bank
 Personal vs. impersonal transactions
 Secondary reserve asset vs. investment asset
 Fluctuation of market price
 Negotiation
 Knowledge of use of fund by the provider of funds
 Termination

Nature of Fund:  Banks make investment with residual funds after meeting the reserve and loan
requirements. Banks have instance to utilize funds only for loan purpose without making any
investment. But there are no instances of using the excess funds to make only investment and
giving no loans. So bank investment means utilization of residual funds profitability after
meeting loan requirement.
Third Line of Defense:  Bank loan is called illiquid asset. Based on liquidity, primary reserve
and secondary reserves act as the first and second line of defense respectively. Bank loan is such
asset of a bank, which cannot be used in the time of liquidity crisis. In that sanitation, bank’s
investment in securities can be used as the third line of defenses.
Creditor Status of Bank:  In case of loan or investment, bank the position of creditors. In case
of loan bank is one of the few big creditors of the borrowers. But in case of investment, bank is
one of many creditors to the issuers of investment
Initiatives of Transactions:  In case of loan, the initiative of loan transactions comes from borrowers. But in
case of investment, the initiative comes from the part of the bank.
Volume of Investment Relative to the Size of Bank: Banks provide loan to creditworthy borrowers
and make profit. On the other hand, small banks make investment of different maturities through
financial market for the purpose of meeting liquidity and profitability. It indicates that the small
banks make investment by one-thirds of fund available for the purpose of making profit. But
large size bank make investment by not more than of 20% of their funds.
Personal vs. Impersonal Transaction: In case of bank’s loan activities, there is a personal
transaction between the bankers and the borrowers. But in case of investment, there are no direct
transactions between the main issuers of securities and the banks.
Secondary Reserve Asset vs. Investment Asset: Short – securities are used as secondary
reserve asset and investment assets. But in case of investment, medium and long term financial
instruments should be used.
Fluctuation of market Price:  Financial instruments are affected by fluctuation of market price.
But, loan amount is accumulated and increased by nonpayment of loan installments.
Negotiation: Borrowers may bargain with the banks about loan amount, installment, security
and interest rate. But there is no such provision for debentures purchasing banks as condition are
pre-fixed.
Knowledge of Use of Fund by the providers of Funds: Banks know what the borrowers will
do with the loan amount. But in case of investment fund, they have no knowledge about what the
issuers of financial securities are going to do with that fund.
Termination: Incase of loan, successful termination depends on the willingness and the ability
of the borrowers rather than the bank. But the holders of debt instruments may terminate the same at their will
Investment management : Investment management (or financial management) is the
professional asset management of various securities (shares, bonds, and other securities) and
other assets (e.g., real estate) in order to meet specified investment goals for ensuring the benefit
or earnings .

Principles of sound investment policy of Commercial Bank

1. Safety of principal: A banker deals in borrowed funds and therefore his main consideration is
safety of principal invested in securities. The banker has to ensure that the principal invested in
securities. The banker has to ensure that the principal amount invested by him remain safe. The
safety of investments depends on the solvency and ability of the issuing authorities to honour
their commitment made to the investors. The government and semi-government securities are the
safest securities because they are guaranteed by the government.
2. Price stability: The price of security selected by the banker should remain stable. The safety
of investments depends on the stability in the prices of securities. Banker is not a speculator and
hence his object of buying security should not be to gain by a possible rise in the price of
securities which are liable to wide fluctuations in their prices and should prefer those securities
whose prices remain fairly stable over a period of time. The Prices of government securities
remain stable and do not fluctuate.
3. Marketability or liquidity: The primary objective of buying securities by the banker is to
earn income and at the same time maintain his liquidity position. Thus, the banker should see
that the security in which he invests his funds possesses a ready market i.e. they can be sold in
the market without loss of time and money. Marketability of securities ensure liquidity of
investments. Government and semi-government securities are highly liquid as they have a ready
market.
4. Profitability of yield: After ensuring the safety of the principal money invested in securities,
the banker should consider the returns from the investments. In other words, the banker should
not give undue importance to higher yields at the cost of safety. The banker should not expect
windfall profit, because high profit may bear the germ of loss.
5. Diversification of Investment: The banker should diversify the risk involved in investment
by investing in wide variety of securities issued by wide variety of business enterprises
belonging to different trade and industry.
6. Refinance: To ensure the liquidity of his investments the banker has to see that the security is
eligible to obtain refinance from the Central Bank and other refinancing institutions.
7. Duration: In addition to the above factor, a banker also considers the duration and
denomination of security and its future earnings prospects.

Principles roles played by a commercial bank’s investment portfolio:

The vital issues of bank assets portfolio are providing income, liquidity, diversification to reduce
the risk and sheltering of at least some portion of bank earnings from taxation. Investments also
tend to stabilize bank earnings, providing supplementary income when other sources of revenue
(especially interest on loan) decline.
 Stabilize the bank’s income so that bank revenues level out over the business cycle –
when loan revenue fall, income from securities may rise.
 Offset the credit risk exposure in the bank’s loan portfolio. High-quality securities can be
purchased and held to balance out the risk from bank loans.
 Provide geographic diversification: Securities often come from different regions than the
sources of a bank’s loans helping a bank diversify its earning.
 Provide a backup source of liquidity, because securities can be sold to raise needed cash
or used as collateral for bank borrowings of additional funds.
  Reduce bank’s tax exposure especially in offsetting taxable loan revenue
 Serve as collateral to secure government deposits held by the bank.
 Help hedge the bank against losses due to changing interest rate.
 Provide flexibility in a bank’s portfolio because investment securities unlike most loans
can be brought or sold quickly to restructure bank assets.
 Dress up the bank balance sheet and make it look financially stronger due to the high
quality of most bank held securities.

Investment Tools or Instruments of Commercial Banks

Investments vehicles open to banks are divided into two broad categories such as money market
instruments and capital market instruments.
Money market instruments: Any loan or securities having original maturity of one year or less
and are noted for their low risk and ready marketability are known as money market securities.
Money market instruments are briefly discussed below:
 Treasury bills: One of the most popular of all short-term investments is the Treasury
bill, a debt obligation of government that by law must be mature within one year from
date of issue. It is attractive to banks because of their high degree of safety. Market prices
of T-bill are relatively stable and are readily marketable. Moreover T-bill serves as
collateral for attracting loans from other institutions through repurchase agreements and
other borrowing instruments. Bills are issued & traded at discount from their par value
without promised interest rate. Thus the investors return consists of price appreciation as
the bill approach maturity.
 Certificates of deposits: A certificate of deposits is simply an interest-bearing receipt for
the deposits of funds in a bank or non bank thrift institutions. The primary role of CDs is
to provide banks with an additional source of funds. However, banks often buy the CDs
issued by other depository institutions, regarding them as an attractive, lower- risk
investment. CDs carry a fixed maturity term and there is imposed penalty for early
withdrawal.
 Bankers Acceptance: A bank’s commitment to pay a stipulated amount of money on a
specific future date under specific conditions. It is provided by a commercial bank to
worthy customers in return for a fee. Another bank or many market investors attracted to
 Bankers acceptance due to its safety and active resell market. If a bank sells the
acceptance it holds, this does not erase the issuing bank’s obligation to pay off its
outstanding acceptances at maturity. The Bankers acceptance is a discount instruments
and therefore always sold at a price below par before its reach maturity.
 Commercial paper: A short debt obligations normally issued by a corporation with high
credit rating. Most commercial papers are issued at a discount from par, like T-bill and
acceptances through some paper bearing a promised rate of return.
 Repurchase agreements: Short-term loans—normally for less than one week and
frequently for one day—arranged by selling securities to an investor with an agreement to
repurchase them at a fixed price on a fixed date.
Capital market instruments: Any loan or securities whose original maturity exceeds one year
and are noted for their higher expected rate of return and capital gains potential.
Common stock or equity securities (shares): Equity securities are financial assets that
represent shares of a corporation. The most prevalent type of equity security is the common
stock. And the characteristic that most defines an equity security, differentiating it from most
other types of securities, is “ownership.”
Corporate bond:
A corporate bond is debt issued by a company in order for it to raise capital.
An investor who buys a corporate bond is effectively lending money to the company in
return for a series of interest payments, but these bonds may also actively trade on the
secondary market.
Corporate bonds are typically seen as somewhat riskier than government bonds, so they
usually have higher interest rates to compensate for this additional risk.

Debenture:
 A debenture is a type of debt instrument that is not backed by any collateral and usually
has a term greater than 10 years.
 Debentures are backed only by the creditworthiness and reputation of the issuer.
 Both corporations and governments frequently issue debentures to raise capital or funds.
 Some debentures can convert to equity shares while others cannot.
Other investment instruments:

 Securitized assets: In recent year hybrid securities based upon pools of loans have been
one of the most rapidly growing bank investments. These securitized assets are back by
selected loans of uniform type and quality. The most popular securitized assets that banks
buy as investment today are based upon mortgage loans.
 Stripped securities: A financial instruments that is broken down into multiple financial
instruments each representing one of the original instrument’s expected payments.

Factors affecting bank’s investment portfolio:

 Expected rate of return
 Tax exposure
 Interest rate risk
 Credit risk
 Business risk
 Liquidity risk
 Call risk
 Prepayment risk
 Inflation risk
 Pledging requirements