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Understanding the 4 Levels of Risk

Understanding the 4 Levels of Risk

We all know that achieving a decent return or yield is important, but risk management is also crucial.  Simply put, it’s just not something you can overlook. 

What complicates matters is that there are so many risk factors to keep in mind!  It can make your head spin as you try to stay on top of them all. 

But over the 20+ years I’ve managed portfolios for my bank and clients, I’ve found a way to make the process more manageable.  I’ve identified four levels of risk that need attention as you analyze investment ideas and consider how to position the investment portfolio.

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Risk Level 1 – The Security Level

The first level of risk to consider is the security level.  As you might expect, we’re focusing on the specific risks of an individual fixed-income investment. 

Depending on the security type, there are four security-level risks to evaluate:

Interest rate risk – Given the interest rate environment, this has gotten its share of attention in the past year!  As you’re evaluating a security, you’ll want to use its duration to gauge the sensitivity to changes in interest rates.  The higher the duration, the more price sensitivity you’ll experience. 

In addition, you’ll want to determine whether the duration can change based on other factors.  If so, ensure you’re comfortable with how the bond performs in all scenarios, not just the current ones or the most likely ones.

Also, remember that just because an investment has a short duration doesn’t necessarily mean it won’t experience price volatility.  When interest rates change, the investment’s duration and the degree of the interest rate change both play a role. 

For example, a two-year Treasury has a shorter duration than a five-year Treasury.  But if the two-year part of the yield curve experiences a bigger shift, it could create more price volatility for an investor holding the shorter maturity bond.  Just ask anyone that’s purchased or held short-term bonds in the past few months, as that part of the yield curve rose more than others.

Liquidity risk – This risk involves the ability to easily sell the security at its fair value to raise cash.  Not all fixed-income securities are easy to liquidate, and some can be downright challenging, if not near impossible, to sell!  As you evaluate an investment, consider the ease of selling it in the future. 

Many investors were surprised in the past year when they discovered that their municipal bonds, which they thought were more liquid securities, turned out to be less liquid.  This created surprises for them when the bids they received were far below what they expected. 

In addition to a security’s liquidity based on its potential sale, you’ll also want to consider how easy it may be to pledge the security.  Certain fixed-income investments may not be eligible to be pledged, including some muni bonds, some CMO tranches, corporate bonds, reverse mortgage pools, and private placement securities.  In addition to a security’s “saleability,” it’s important to consider this aspect of its liquidity.

Option risk – Option risk, or optionality, happens when a security’s cash flows change due to embedded options that are present.  Not all securities have option risk, but if you’re considering an investment in callable bonds or mortgage securities, you’ll need to evaluate the effect of optionality.

For example, how does the investment behave in different scenarios and rate environments?  Does the callable bond get redeemed early or extend to its final maturity (or somewhere in between)?  With a mortgage-backed security, what does the embedded optionality mean in terms of potential prepayment or extension risk?  These are things to analyze and consider before you pull the trigger on a purchase.

Credit risk – The last security-level risk is credit risk, which is less of a factor if your investments are only government and government agency issues.  Otherwise, you’ll want to consider the degree of potential credit risk you’re taking on, whether that’s with municipal bonds, corporate bonds, or private label issues.  The key to managing these four security-level risks is having a process to ensure you capture the pertinent information before the security trade is done.  If you’re looking for a starting point for such a process, or if you’d like to fine-tune the process you already have, check out my free fixed-income pre-purchase checklists.

Risk Level 2 – The Portfolio Level

At the portfolio level, we’re not as concerned about the individual holdings but more about the whole portfolio.  There are three primary risks to consider at this level.  We discussed two of these risks at the security level, but we’re going to take a different perspective at the portfolio level. 

Interest rate risk – As we discussed before, we want to understand the sensitivity to changes in interest rates.  But now, we’re looking at the total portfolio’s duration. 

I view managing duration as primarily a portfolio-level exercise.  While it’s important to understand how the individual securities will behave when interest rates shift, it’s the portfolio’s duration that guides a lot of the decision-making process. 

For example, you may purchase a bond that has a longer duration – but if it’s part of a diversified bond ladder, it could be less of a factor.  When working with client portfolios, managing and targeting the portfolio duration is one of the key parameters I use when developing an investment strategy.

Liquidity risk – Similar to interest rate risk, we want to look at it slightly differently than at the portfolio level.  Instead of considering the ease of selling or pledging, we want to focus on managing the portfolio to generate cash flow. 

A steady and stable principal cash flow is a source of liquidity you can use as part of your bank or credit union’s broader liquidity management efforts.  If the current cash flow from the investment portfolio is more “choppy,” with wide swings in its cash flow, this is a portfolio-level risk to consider addressing sooner rather than later. 

And the best part of this strategy is that you can receive cash from the portfolio without having to sell anything!  This is especially helpful in times like community bankers are experiencing today, where they’re hesitant to sell securities due to unrealized losses. 

Concentration risk – This refers to having a larger percentage of the portfolio in one type of investment.  Looking at this risk in the investment portfolio is just like considering concentration risk in the loan portfolio.

Concentration risk is a form of credit risk and can occur on two levels in the portfolio – the issuer level and the sector or asset class level.  Concentration risk at the issuer level becomes problematic if the issuer defaults on their outstanding obligations. 

This risk exposure is less of an issue with U. S. government and U. S. government-backed investments. But if you invest in other types of securities, it’s prudent to consider how much exposure you want to have to any single issuer.

In the same way, you’ll want to consider what level of exposure is acceptable at the sector or asset class level.  While having multiple issuers of a specific bond type provides some protection, it doesn’t necessarily mitigate the exposure to the group that the security belongs to. 

For example, it’s worth evaluating exposure levels for concentrations of muni bonds based on the state they’re in or the industry exposure for corporate bonds.  And you may also want to consider maximum exposure guidelines for private-label mortgage issues.

The best way to manage risks at the portfolio level is through any investment portfolio analytics you manage or receive from outside parties.  By keeping an eye on the metrics I mentioned in these reports – portfolio duration, cash flow trends, and concentration risk – you can understand better how things are behaving at a higher overall level.  It will also help you as you make decisions and consider course corrections to your investment strategy.

“Managing risk is like fighting one of those mythical multi-headed hydras.  It seems like a constant battle – and it is.”

Risk Level 3 – The Balance Sheet Level

We’re now going to begin evaluating what’s happening outside the investment portfolio.  Doing this allows us to factor relevant “bigger picture” conditions into the investment decision-making process.  There are four risk exposures to consider at the balance sheet level: interest rate, liquidity, credit, and capital risk. 

Your institution’s asset-liability management reports are your best resource to analyze interest rate and liquidity risk at the balance sheet level.  They will provide the overview and detail you need to understand the impact interest rates have on your institution, which allows you to make decisions within the investment portfolio to mitigate the risk.  I tend to focus on the net interest income or earnings at risk scenarios to understand what’s happening on the balance sheet.

In addition, the ALM reports provide insight into the institution’s ability to manage its liquidity.  Typically, the focus is on addressing liquidity shortfalls created by asset growth or deposit runoff. However, as we saw a few years ago, managing liquidity is also about handling excess cash balances effectively.  Liquidity cash flow scenarios and stress tests provide good information to help you determine how the institution’s liquidity risk exposures can be mitigated through the investment portfolio.

To get a handle on the institution’s credit and capital risk exposures, you’ll want to review any financial and other internal reports that contain the metrics related to these areas.  Monitoring the various credit and capital ratios and gaining perspective about what’s happening at the balance sheet level will directly shape how the investment portfolio needs to be structured and the types of investments to consider.

As I’ve said frequently, the balance sheet is the starting point for managing the investment portfolio.  By staying on top of the risks at the balance sheet level for your bank or credit union, you’ll lay the foundation for the investment decision-making process.

Risk Level 4 – The Systemic Level

What do I mean by the systemic level?  I’m referring to the financial system and capital markets.  While it’s important to ensure you’ve covered your bases for the risks facing your community financial institution, you must also remember and consider risks associated with the market itself, especially given its interconnectedness.

For the investment portfolio, the one systemic risk exposure to consider is liquidity risk.  When a major financial event or crisis occurs, market liquidity can dry up quickly as everyone pulls back. 

This makes selling almost any security more difficult, as market volatility causes everyone to become extremely conservative to protect themselves.  As someone who was around for the financial crisis in 2008, I can remember situations where even agency-backed mortgage securities were receiving poor bids. 

The one security that holds up best in situations like these is U. S. Treasuries.  As the most liquid security available, they provide some protection even in wild markets.  While there’s no guarantee that a Treasury bond wouldn’t suffer from some price pressure, it’s the least likely to be affected.

The other systemic risk factor is counterparty risk.  Like any credit risk, counterparty risk refers to the risk that one party in a financial transaction may fail to fulfill their obligations, causing financial harm to the other party involved. 

While this is generally less of an issue directly related to the investment portfolio, this risk can affect other areas in your finance day job.  For example, if you suddenly lost access to a liquidity funding source, such as a correspondent bank line or Fed funds line, because the organization got into trouble, it could create additional challenges for your institution.  Similarly, it could create a major headache if the counterparty on a derivative transaction, such as a swap, cap, or floor, could no longer meet its obligations.

How do you manage risks at the systemic level?   The best way is through planning and redundancy.  Make sure you take the time to identify and consider how financial risks outside the institution might affect the portfolio and other operations.  Then, determine the steps to create backups, just in case.  For example, you could consider allocating a portion of the investment portfolio to Treasuries as protection against systemic liquidity risk. 

Managing counterparty risk starts before the relationship begins.  Conducting thorough due diligence and risk assessments when selecting counterparties, and updating that information periodically, can help to mitigate potential risk exposures, possibly even before they happen.  You also might want to explore having more than one counterparty available for your third-party financial transactions, whether that be Fed funds lines, brokered deposits, or derivatives.

How you protect against systemic levels of risk will vary from institution to institution, so the ideas I mentioned are just that – ideas.  You’ll want to craft a response that works best for your institution based on its needs and objectives.  In addition, when evaluating any of these four levels of risk, any decisions need to be aligned with your institution’s policies and other accounting, legal, compliance, or regulatory guidelines.

When working with the investment portfolio, managing risk is like fighting one of those mythical multi-headed hydras.  It seems like a constant battle – and it is.  Risk management is always a continuous and ongoing process.  But approaching it through the four levels I’ve shared can make the job easier to understand and tackle as you work to protect the institution from potential threats and take advantage of opportunities that may arise.

The Return of Liquidity Management

The Return of Liquidity Management

Lately, I’ve been having more and more conversations with clients and community bankers about liquidity and liquidity management.  This is a topic that has been off the radar for the past couple of years. 

Actually, it’s not that the topic disappeared.  Instead, the focus was on figuring out what to do with excess liquidity due to the pandemic, the PPP program, and the considerable deposit growth that all financial institutions experienced.

Lately, however, community financial institutions have seen continued loan growth, while deposit growth has leveled off or shrunk a little.  Excess cash on the balance sheet has dried up, and they’re now beginning to borrow wholesale funding again in some cases. 

In addition, regulators are focusing more on bank and credit union liquidity and how institutions are managing it.  This is especially true given the loss in market value that investment portfolios experienced in the past few months, which has reduced the amount of liquidity available through the sale of investments if needed.

In some ways, this is one of those “back to the future” moments.  What I’ve been sharing with clients and other community bankers is that it’s time to dust off the practices and procedures we were using before the pandemic because we’re heading back to liquidity management as we once knew it.

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3 Factors to Liquidity Management Success

So given these circumstances, what should you be doing now to ensure your liquidity house is in order?  And what steps can we take with the investment portfolio to help out?  Here are three factors that are key to successful liquidity management for your institution.

Factor #1: Make sure you have multiple diversified sources of funding

The investment portfolio is one of these sources, but they also the Federal Home Loan Bank (FHLB), the Federal Reserve, brokered deposits, and other wholesale funding sources.  We’ll talk about the investment portfolio in more detail shortly, but let’s talk about the other types of funding I mentioned. 

FHLB Funding – Every financial institution has access to the FHLB system and can use its advances to help fund the balance sheet.  The source of the institution’s available borrowing capacity is based on the loans and securities pledged to them as collateral.  The more you have pledged to FHLB, the larger the borrowing capacity. 

As a result, you’ll want to be sure that you have pledged everything that’s eligible to them.  It’s worth checking with your FHLB rep to see if there are options for increasing your collateral and, therefore, the amount you can borrow from them.

Federal Reserve – The Federal Reserve is also a potential funding source through its Discount Window programs.  If you haven’t yet set up a borrower-in-custody (BIC) line with your local Fed bank, I recommend checking into it.  It takes a little time to get things in place and establish the Fed relationship, and you don’t want to wait until you absolutely need it to start the process.  You can learn more about setting up a line at your local Fed.

Brokered Deposits – Brokered deposits are another great source of funding.  There are different ways of raising funds through the brokered deposit markets that are beyond what we’re covering here.  But taking the time to establish the channels for tapping brokered deposits is time well spent.

Finally, you could also establish additional wholesale funding sources using Fed funds lines through correspondent and bankers’ banks and utilizing repurchase agreements. 

As I said, the key is having multiple and diversified sources available so that you have liquidity management options and flexibility.  Once those resources are in place, it’s a good practice to test them at least annually.

“It’s time to dust off the practices and procedures we were using before the pandemic because we’re heading back to liquidity management as we once knew it.”

Factor #2: Make sure you have sound policies, procedures, and tracking of your institution’s liquidity position

I know that everyone has a liquidity policy.  But when was the last time you really sat down and read it?  You might find that the policy needs updating or revising.  Your policy forms the foundation for your liquidity management efforts, so it’s worth checking it to be sure it’s structured the way you need it to be.

In addition, you want to be sure that you’ve established metrics and scorecards to know how your liquidity position is doing.  You don’t want to find out you have a liquidity problem after it’s already started and you’re forced into more of a reaction mode.  Establishing liquidity guidelines that show whether things are good, becoming a challenge, or have hit a critical level is essential. 

In addition, you want to be sure that you’re checking these metrics and scorecards regularly, sometimes even monthly.  You don’t need to have dozens of measurements in place, but you want to make sure you’ve covered your bases with enough monitoring that’s robust and helps you easily understand what’s happening on the liquidity front.

Factor #3: Conduct regular what-if and stress test scenarios

If you have a robust liquidity management reporting system in place, you’ll know where you are at any given moment.  But it’s also important to consider how changing conditions might affect your liquidity position.  That’s why it’s good to test the system and its underlying assumptions periodically. 

For example, what would happen if asset growth or deposit runoff is more aggressive than you thought?  What if you were to lose one or more of your wholesale funding sources?  These are all ways you can develop scenarios that push the boundaries of your liquidity management plan.  It’s not about trying to break the system; it’s about ensuring that the institution can weather more severe storms, whether they occur internally or systemically. 

In conjunction with a regular what-if scenario routine, you’ll want to make sure you’ve developed a solid liquidity contingency plan so that you’ll know what to do when the stuff hits the fan.  Again, you don’t want to wait until liquidity pressures emerge to decide on a response.  It’s also a good practice to occasionally test the contingency plan.

The Investment Portfolio as Part of Liquidity Management

Now that we’ve covered the three factors to managing liquidity successfully, let’s talk about how the investment portfolio fits into the liquidity management plan.  The investment portfolio is essential in managing a community financial institution’s liquidity.  There are two ways to utilize the portfolio for liquidity risk management.

Image of money bags and woman at desk with money falling to illustrate investment liquidity management concept

Option #1: Selling unencumbered liquid assets

Regulators usually consider selling investments the first line of defense in liquidity management.  It is the basis for the liquidity coverage ratio, which requires banks to hold sufficient amounts of high-quality liquid assets.  By raising cash through the sale of investments, a bank can produce a source of liquidity that it can use to offset changes in asset growth or liability runoff. 

With the recent sharp rise in interest rates and the related fall in market value, banks and credit unions have less available market value to liquidate to raise cash.  This is a major reason liquidity is getting more attention from regulators and bank examiners nowadays.  It’s also why investment liquidity in the portfolio becomes a more important consideration. 

What do I mean by investment liquidity?  I’m talking about the ease of selling a security in the market and converting it to cash.  Some securities, like US Treasuries, are highly liquid and can be easily sold.  Other securities are less liquid and may be harder to liquidate quickly depending on market conditions. 

Understanding the relative liquidity of investments in the portfolio is an integral part of managing the institution’s liquidity risk, especially if investment sales need to be involved.  Now, I’m not saying you need to concentrate your portfolio in highly liquid investments like Treasury securities; I’m saying that you’ll want to understand how liquid your existing holdings are.

Generating liquidity through investment sales does have two downsides right now.  First, if you had to liquidate investments today after the recent market selloff, you’d have to realize those losses.  In addition, one downside of selling investment securities for liquidity purposes is the loss of investment income.  Securities sold are earning assets that are no longer on the books.  The sale of investments raises cash immediately but comes at the expense of future interest income.

Option #2: Structuring Investments to Manage Cash Flow

This means building a portfolio that produces a steady stream of principal payments on a regular basis.  Unlike the first option, it does not require selling any assets. 

An investment portfolio with regular cash flow provides an ongoing and stable source of funds to meet liquidity needs on either side of the balance sheet.  If the funds are not needed when they’re received, they can simply be reinvested.  Simply put, managing investment cash flow is the foundation for good liquidity management. 

There are different ways to structure an institution’s investment portfolio to manage this cash flow.  If the portfolio is composed of traditional bonds, it could be structured to provide regular principal payments by building a bond ladder, which provides a series of staggered principal maturities.  Another way to create portfolio cash flow capability is to use mortgage-backed securities, which generate monthly principal payments.

The investment portfolio plays a significant role in liquidity management, whether by helping to mitigate liquidity risk on the balance sheet or as a means to manage excess liquidity.  By managing the underlying mix of investments and their cash flows, you can build an effective liquidity tool for your community financial institution.