The investment portfolio of large commercial banks : policies and compositions
This thesis presents an analysis of the policies and compositions of the investment portfolio of large commercial banks. The thesis focuses on the portfolio structure of banks with assets over one billion dollars. Large commercial banks actively pursue their investment portfolio as a source of profit whereas smaller banks utilize this account primarily for liquidity purposes and secondarily as an earnings source. There have been many changes in the management of the portfolio in this century because of the changing policies of banks, new investment instruments available and the pervasive inflation plaguing the economy. The investment portfolio is entirely comprised of bonds because common stock is not a permissible investment. The selection and evaluation of bonds is a complex, intricate process requiring judgment and experience. Complete knowledge of the many concepts relating to interest rates, risks and maturity structures, for example, are vital to the investment manager. There are numerous elements the manager must consider in order to pursue a flexible and profitable portfolio. This thesis incorporates these elements and discusses their implications towards the selection of securities. In addition, the strategies generated to assist the manager in formulating his portfolio will be evaluated. The investment portfolio is basically composed of U.S. government securities, U.S. federal agency obligations and securities of state and political governmental units. The relative proportion is determined by the quality, marketability, maturity and yields of these securities. The timing of these purchases and sales will influence the level of profitability in this account. Other parameters that must be contemplated when constructing the portfolio include pledging requirements, tax considerations of security gains and losses and the tax liability position of the bank. Several financial models and strategies have been devised to assist the manager in selecting an optimal portfolio. This author has concluded that these financial models are neither applicable nor practical for the portfolio manager to utilize because of the unrealistic assumptions incorporated, such as predicting interest rates. There are several risks affiliated with the investment portfolio, however; the portfolio is most vulnerable because of the interest rate risk and its affect upon bond prices and yields. This thesis examines three measures of risk that can be used for a bond portfolio: duration, standard deviation and bond sensitivity risk. A computer program was designed to analyze various performance trends in two hypothetical portfolios over a ten year period. The author was unable to obtain actual yields from commercial banks; thus, monthly market rates for eight securities from 1970-1979 were utilized to construct these portfolios. The two portfolios differ in their weighted distribution of the securities, although both portfolios reflect authentic large banks' investment portfolios. The program was structured to analyze the arithmetic mean return, the geometric mean return and the standard deviation of both portfolios in each year, for all ten years and for four sub-periods within the ten years. The program determined which portfolio performed better within a risk/return framework. Management of the investment account is an activity involving constant review and decision-making regarding the purchases and sales of bonds such that a financial models is impossible to develop. Many exogenous factors such as monetary and fiscal policy, inflation rates and worldwide political stability have powerful effects on the level of interest rates and thus the portfolio. The portfolio manager can not adhere strictly to any one formula but must employ judgment within a given set of guidelines to construct his portfolio.