Managing Market Risk in the Investment Portfolio

Managing Market Risk in the Investment Portfolio

DeMasi, Jim

The April edition of this column reviewed the implications of enterprise risk management for the investment portfolio. While risk factors vary by type and magnitude from bank to bank, market risk is a universal consideration for all portfolios. Given its broad relevance, this article explores the management of market risk in greater detail.

Market risk refers to the sensitivity of the portfolios market value to changes in key variables such as interest rates, volatility, and credit spreads. The level of market risk in the investment portfolio can influence several aspects of a banks financial condition. Depending on accounting classifications, market value fluctuations for securities may affect a banks earnings or equity capital balances. From an economic perspective, price changes in the portfolio may lead to volatility in a banks market value of equity calculations. On the regulatory front, market risk in the investment portfolio is incorporated into a bank's "sensitivity to market risk" rating, which is one of six components that determine a bank's overall composite rating.

For these reasons, a robust enterprise risk management program should include an effective process for addressing the market risk that arises from a banks investment activities. A centerpiece of this process should be an analytical system capable of identifying, measuring, and reporting market risk. Whether developed in-house or provided by an outside vendor, a bond analytic system should have these basic capabilities:

* Calculation of base-case risk/reward indicators, including tax-equivalent book yield, effective duration, and convexity.

* Portfolio composition analysis, where individual holdings are categorized into sectors and risk/reward indicators are provided for each sector.

* Stress tests at the bond-level and portfolio-level that reveal price sensitivity across a range of scenarios. At a minimum, the stress tests should calculate average life, effective duration, and market value in each scenario.

* "What-if " simulations that show the impact of proposed strategies on key portfolio statistics prior to impiementation.

* Detailed cash flow projections that account for potential calls and prepayments under various interest rate scenarios.

Ideally, the analytic system should be capable of performing these functions at various levels of data aggregation, offering risk insight for individual instruments, for the portfolio as a whole, and for the overall institution. The systems reporting features should provide the board and management with a summary of investment activity, the portfolio's risk exposures, and compliance with policy limits.

Due to the high cost of these systems, many community banks choose to outsource analytics to a third-party provider. While this may be a cost effective alternative, the quality of the analytics should not be compromised. The following points should be considered when selecting a third-party provider:

* Qualifications of the personnel who will be running and analyzing the portfolio.

* Quality control processes employed by the third party.

* Ability to provide results in a spreadsheet format that can be incorporated into other functions within the bank, including budgeting, management reporting, and asset/liability management.

* Commitment to client education and the ability to help management understand the results and to use the information to effectively manage the banks portfolio.

* Willingness to provide custom reports on an ad-hoc basis, which are tailored to meet the bank's specific needs.

* Access to investment professionals who can assist management with turning raw data into feasible portfolio strategies.

Regardless of whether an in-house system or third-party provider is selected, management should periodically request that analytics be prepared by an independent source. This step should be a valuable part of the banks independent review program and will help to identify bonds that have not been modeled properly and to reveal weaknesses in assumptions.

Once market risk has been accurately measured, strategies should be developed for maintaining risk levels within policy limits. Ideally, strategies should be implemented at a macro level, taking into account the net market risk exposure of the bank as a whole. Focusing on the portfolio in isolation could be counterproductive, since it ignores offsetting or balancing risk positions that may exist in other areas of the balance sheet. For example, an asset-sensitive bank may intentionally structure its investment portfolio to carry an above average duration and relatively high level of market risk. In a rising rate environment, the decline in the market value of the investment portfolio would likely be more than offset by the positive impact on the bank's current and future earnings from higher resets on floating rate loans.

For many institutions, the investment portfolio is used to balance the risk exposure that emanates from customer-driven business lines such as lending and deposit taking. In these cases, the duration and convexity of the portfolio are managed to target levels in the context of the bank's overall risk profile. Duration management strategies require careful security selection, with an emphasis on the cash flow characteristics of the portfolio. When evaluating prospective bond purchases, the potential effect of the security on the duration and price sensitivity of the portfolio are primary considerations and take precedence over yield. Portfolios constructed to manage duration tend to emphasize bonds with stable cash flow profiles across a range of scenarios.

Liability-based strategies may also be employed to manage the market risk from the investment portfolio or elsewhere on the balance sheet. Wholesale funding options, such as advances and structured repurchase agreements, allow for a high degree of customization. For example, the duration and convexity of the liability can be tailored to match the corresponding characteristics of the investment portfolio. If structured properly, the change in market value of the liability should offset the change in market value of the portfolio for a given shift in interest rates.

In addition to the more traditional asset/liability matching approaches, derivative instruments can be useful risk management tools. Interest rate swaps, where two counterparties agree to exchange interest cash flows on a predetermined notional amount, are the most common type of derivative used by community banks for hedging purposes. For example, a bank that wanted to reduce its market risk exposure to rising interest rate scenarios could enter into an interest rate swap and agree to pay a fixed interest rate in exchange for a floating rate. While derivatives possess useful hedging properties, they are subject to complex accounting rules and should only be used by banks that have a full understanding of the associated risks and with risk management systems capable of accurately monitoring and valuing the instruments.

Jim DeMasi is a pnncipai and first vice president with Stifei, Nicolaus & Company Inc.

Copyright America's Community Bankers Aug 2007
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