Previously I discussed Loan Management. Now, in this article, you are going to know everything about investment management.
Introduction of Investment Management
Introduction: Investment Management: Commercial Banks are traditionally known as lending institutions. Making loans to business houses and industrial enterprises has been their popular activity. But recently, banks have departed considerably from their popular activity by making finances to speculators & dealers in securities, to consumers, to real estate businesses and so on.
As such, in general, the dealing in bonds & securities are not looked upon as a primary banking function but is rather relied mainly on to fill in gaps of the use of resources left by a slackening demand for loans. Even when customers’ demands for loans are strong, most commercial banks, in the interest of safety, hold to the standard that their total.lending should not exceed 50-60% of the number of their total deposits.
As stated earlier, investment in securities is a residual commitment, funded after the bank has met its reserve and loan demands. But its use of residual funds is largely dependent on the cyclical nature of the economy characterized by the purchase & sale of security instruments. During the recessionary periods when demand for commercial credit is relatively low, security investments are a good alternative source of income. When economic recovery proceeds, loan demand increases, maturing security investment can be rolled over into loans or shorter-term securities may be sold to enhance the volume of the funds for higher-earning loans or investments.
Experiences show that banks prefer most interest-bearing rather than dividend-yielding instruments. It is, therefore, logical that security investments of commercial banks are most likely to be significantly influenced by the different phases of the interest rate cycle. This may be seen from the following figure:
The figure provided above states that –
- When interest rates are at the lowest label, demand for loans is weak, and the monetary policy is expansionary.
- When demand for loans picks up, the monetary policy usually turns less expansionary.
- But when demand for loans is highest/greatest, monetary policy is probably contractionary and interest rates are high, and
- When demand for loans weakens, monetary policy becomes more expansionary.
Emergency of Security Investment
The emergency of Security Investment: Self-liquidating commercial loans were believed to be the proper outlet for monetary reasons and the safest asset for practical reasons. This attitude of commercial banks started changing during World War I. Because of the need for a huge quantity of war goods, accessories and building specialized infrastructure. Governments involved in war required a substantial amount of public debt. On the other hand, for reasons of war, demand for usual commercial and industrial goods came down leaving the conspicuous amounts of surplus funds at the disposal of commercial banks. This was how for the huge need for public debt on the one side and the availability of a substantial amount of unused funds at the commercial banks level. encouraged the latter to begin to buy security investment of the government.
Moreover, a new dimension came in the theory of commercial banking towards the concept of liquidity achieved by shift ability. A ‘shiftable’ asset was, in effect, a readily salable asset. Since security was obviously more salable than loans. This concept suggested that investment in stocks and securities. We considered better bank assets compared to other term assets not easily convertible.
During World War II, the same phenomenon also forced the commercial Bank’s report to public security investments for reasons of reduced need for corporate loans. Corporate securities then almost disappeared from the commercial banking portfolio. Instead, corporate bonds came to replace those.
Commercial banks in the USA after World War II started dealing in two principal types of security both sponsored either by the Federal Government or by the State or Local Governments. Whatever were the reasons that motivated the commercial banks to start security investments, the proportion of the total usable resources of then in the normal period was consistently seen to be heavier to the side of avenues other than security investments. But some regulatory compulsions and the need for diversification of risks made almost all the commercial banks around the globe invest a proportion of their usable resources in security investments.
“An investment company is deLight, if its portfilio selection is right”.
– Helen Fisher
What is meant by Bank Investment?
Investment and loan are the two strategies of the utilization of bank funds. I have already discussed loan vs Investment. Although the main purpose of these two strategies is to earn a profit, but they have many dissimilarities also. Let’s now observe some definitions provided by some specialists:
"Investment is the use monry for the pupose of making more money to gain income or increase in capital or both."
– Dictionary of Banking and Finance
"The term investment is used to include those funds both public and private, for relatively long period of time with the objective of earning income."
– E. W. Reed
So, by bank investment, we mean that part of a bank’s loanable funds is employed in the money market or capital market by purchasing more securities for the purpose of earning profit.
That investment could be an earning source that was almost unknown before the Second World War. Now, the question is what is the rationale of using loanable funds in non-loun investment activities?
Rationale of Using Bank Funds in Non-Loan Investment
The rationale of Using Bank Funds in Non-Loan Investment; There are some logic of utilizing bank funds on non-loan investments. These logics are as follows:
- Illiquidity of loan: Generally, the loan is very difficult to convert into cash before the maturity.
- Risk of loan: There are very few examples of 100% recovery of the bank loans. That is the late payment of the loan, along with, the possibility of bad debt is a very common phenomenon.
- Adverse local economic condition: Generically loans can be considered as local transactions. Any unexpected adverse event in the locality under the purview of the bank may cause an economic downturn of that particular locality as well as the banks. Therefore, the demand for a loan will be reduced as well as the risk of non-recovery of loans will be increased.
- Taxability of Bank Loan Income: It is an important consideration that income from are fully taxable, so the amount of tax payable often becomes higher.
To eliminate the above-mentioned limitations of loans and to earn more profit, investment activity has emerged. The above 4 limitations of loan can be avoided by investing in short term and long term securities. That is, debt instruments can be converted into cash with little risk of loss of principal value. Because unlike loan defaulters, the issuer of debt instruments are not unable or unwilling to make payments to holders of debt instruments.
On the other hand, it is not so difficult to sell the instruments in the money market and capital market with little loss of principal value rather than presenting them to the issuer of those instruments. The risk related to the recovery of invested funds in securities is less than the risk of the loan. Bank loan activities are affected by unexpected local conditions. But investment in securities is less affected by local economic condition rather it is affected by the impact of the national economic condition on the money market and capital market. Income from security tax-free, eligible to get tax rebate and in some cases, eligible to enjoy concessionary tax rate.
For these reasons, banks make investments in the money market and/or capital market instruments such as share, bond, debenture and other financial instruments of well-known companies for the purpose of making profits and ensure the best use of their non-loan investment funds.
Administrative Structure of Investment Activities
Administrative Structure of Investment Activities; Banks have separate departments/sections to perform their investment activities. Formulating investment policy is the responsibility of the Board of Directors. Legally, the Board of Directors is responsible for the management of the investment portfolio. In actual practice, the Board, usually, delegates this responsibility to a committee known as DC i.e. Investment Committee works through a department viz. Investment Department. The Investment Department of a commercial bank normally performs the functions as under:
- To carry out regular studies of trends of security markets.
- To select securities for long term investment purposes.
- To undertake to trade and switching functions.
- To undertake security issues.
- To undertake an evaluation of securities in order to determine credit and money rate risks associated with them.
- To keep in safety vault all the security instrument.
- To maintain proper records of all the securities held by the banks.
The chief of the investment department is known as a chief investment officer. We have already known that the activities of the investment department are monitored and controlled by the board of directors through a permanent investment committee. Investment policies and strategies are approved by the permanent investment committee including directors. Investment policies and strategies once approved are translated into reality by the chief investment officer.
Characteristics of Bank Investment
Characteristics of Bank Investment; We have discussed previously that loan and investment are the two major profit-making activities for banks. Bank investment has different aspects in comparison to loam. Let us discuss some important features of the bank investment:
- Nature of Fund: Banks make investments with the residual fund after meeting the reserve and loan requirements. Banks have instances to utilize funds only for loan purposes without making any investment. But there are no instances of using the excess funds to make only investments and giving no loans. So, bank investment means the utilization of residual funds profitably after meeting loan requirements.
- Third Line of Defense: Bank loan is called illiquid assets. Based on liquidity, primary reserve and secondary reserve act as the first and second line of defense respectively. A bank loan is such an asset of a bank, which cannot be used in the time of liquidity crisis. In that situation, the bank’s investment in securities can be used as the third line of defense.
- Creditor Status of Bank: In case of loan or investment, the bank takes the position of the creditor. In case of a loan, the bank is one of the few big creditors of the borrower. But in case of investment, the bank is one of many credito6 to the issuer/seller of the instrument.
- Initiative of Transaction: In case of a loan, the initiative of the transaction comes from the borrower. But in case of investment, the initiative of the transaction comes from the part of the bank.
- Volume of Investment Relative to the Size of Bank: Banks provide loans to creditworthy browsers and make a profit. On the other hand, relatively small banks make investments of different maturities through the financial market for the purpose of meeting liquidity and profitability. From the analysis of the usage of bank funds, it is found that small banks make investments by one-third of funds available for the purpose of making a profit. But large-sized banks make an investment by not more than 20% of their funds.
- Personal Vs. Impersonal Transaction: In the case of banks’ loan activities, there is a personal transaction between the bankers and the borrowers. But in case of investment, there is no direct transaction between the mam issuers of securities and the banks.
- Secondary Reserve Assets vs. Investment Assets: Short-term securities are used as secondary reserve assets and investment assets. But in case of investment, medium and long-term financial instruments should be used.
- Fluctuations of Market Price: Financial instruments are affected by the fluctuation of the market price. But the loan amount is accumulated and increased by non-payment of loan installments.
- Negotiation: Borrowers can bargain with the bank about loan amount, installment, security, and interest i.e. borrower and bank can enter into the discussion. But there is no such provision for debenture purchasing banks as conditions are pre-fixed.
- Knowledge of Use of Fund by the provider of Funds: Banks know what the borrower will do with the loaned amount. That is, in case of a loan, banks know the purpose. But when banks invest funds they have no knowledge about what the issuer of financial security is going to do with that fund. That is, as the provider of funds, banks don’t have any knowledge regarding the purpose of the loan.
- Termination: In case of a 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.
Objectives of Bank Investment
Objectives of Bank Investment; Loan activities are the traditional technique of profit earning of banks. There are some purposes, which recently gained popularity for non-loan bank investment. These are as follows:
- Maximization of the Wealth of Shareholders: The main purpose of each activity of the bank is to maximize the wealth of the shareholders by earning appropriate profit. Credit risks are barriers to maximizing shareholders’ wealth. So, banks make an investment by part of their loanable funds to earn profit and maximize the wealth of shareholders with minimal risk.
- Diversification of Risk: Banks should not use the fund to provide the loan only. Banks also invest in the debt instruments issued by well-known companies to reduce the risk of the use of funds.
- Supporting income: Interest receipts, commissions, charges, fees are the main sources of bank income. On the other hand, dividend/income from purchasing securities, bonus share, and capital appreciation are considered as supporting income received from an investment, which, along with the conventional incomes, contributes a lot to strengthen the financial position of a bank.
- Source of supplementary liquidity: Primary reserve and secondary reserve are the conventional sources of banks’ liquidity. But if the primary and secondary reserve is not enough to meet the liquidity requirement, the liquidity crisis may occur. In this case, as the third source of liquidity, investments by banks can be used as the supplementary asset.
- Reducing tax liability: Bank’s earnings from loans are always taxable. The rate of tax varies with varying levels of income. In this situation, banks can invest in different types of shares, bonds and debentures that are tax-free or tax exempted and thereby banks can enjoy a reduced amount of tax.