group-1-ips

Group#1

Nouman Ali (120143) Aoun Muhammad

(120145) Ahsan Khan Niazi

(120137)

BANKS AND OTHER INSTITUTIONAL

INVESTORS

Banks: Background and Investment Setting

Banks are financial intermediaries involved in taking deposits and lending money.

Nearly everywhere, however, the scope of banks’ activities has evolved and broadened over time, although distinct regional and national traditions remain same.

Background and Investment Setting

In this universal banking model, banks can provide one-stop shopping for financial services. In contrast to this model, in the twentieth century the United States and Japan evolved regulatory separations between commercial banking and investment banking (security underwriting) activities.

Pakistan is following the same thing as now in Pakistan banking industry is divided among many sectors like commercial banking, Islamic banking, corporate banking, micro finance banks and many others as well.

Background and Investment Setting

The asset side of the balance sheet consists of loan and securities portfolios as well as an variety of other asset.

Commercial banks as of the end of 2014, loans and leases represented on average 58 percent of assets. Loans may include real estate, commercial, individual, and agricultural loans.

Securities represented 19 percent of total assets; other assets (trading accounts, bank premises and fixed assets, and other real estate owned) were 14 percent; and cash and federal funds represented 5 percent and 4 percent, respectively

Background and Investment Setting

Consequently, a bank’s asset/liability risk management committee (ALCO) is generally in charge of overseeing the bank’s securities portfolio.

Bank - General

Asset Liability Management (ALM) ProcessNet Interest margin

Interest Spread

Leverage-adjusted duration Gap (LADG)DADLk = L/A (L = market value liabilities, A = market value assets)

If LADG = 0 interest rates change will NOT impact market value equity

Net Interest margin

=Interest income – Interest

expenseAverage earning assets

Interest Spread = Yield on assets - Yield on liabilities

Leverage adjusted

Duration gap= DurationAssets - k ✖

DurationLiabilities

Net interest margin

Net interest margin is a summary measure of the net interest return earned on income-producing assets such as loans and bonds.

Observing the bank’s financial performance, the ALCO can make needed changes in assets and liabilities.

Interest spread The interest spread is a measure of the bank’s ability to

invest in assets yielding more than the cost of its sources of funding.

Because both interest income and interest expense fluctuate in response to interest rate changes, net interest margin and interest spread are key indicators of a bank’s ability to profitably manage interest rate risk.

Interest rate risk

To manage overall interest rate risk of the balance sheet. In contrast to business, consumer, and mortgage loans, bank-held securities are negotiable instruments trading in generally liquid markets that can be bought and sold quickly.

Therefore, securities are the natural adjustment mechanism for interest rate risk. For example, if the duration of equity is higher than desired, a bank can shorten it by shortening the maturity of its securities portfolio.

Advances-net Advances-net

value Percentage Total value

up to 3months

78479265 25.65% 306014402

3M – 1 year 74985193 24.50% 306014402

1year-3year 70446831 23.02% 306014402

3year-5year 74497551 24.34 306014402

5year & above

7605562 2.48% 306014402

Liabilties Deposits and other account

value Percentage Total value

up to 3months

146957747 22.00% 667877615

3M – 1 year 138732436 20.77% 667877615

1year-3year 54158540 8.10% 667877615

3year-5year 826983 0.123% 667877615

5year & above

327201909 48.99% 667877615

Deferred tax liability Deferred tax value Percentage Total value

up to 3months

64416 1.77% 3622651

3M – 1 year (319408)

8.81% 3622651

1year-3year 1633568

45.6% 3622651

3year-5year 1117675

30.85% 3622651

5year & above

1126400

31.092% 3622651

Nouman Ali120143

Investment Policy

Statement

Objectives and Constraints

The purpose of the investment policy statement (IPS) is to set forth the policies and procedures that govern the administration of all the Bank’s investment activities.

Risk Objectives

Risk ObjectiveBank’s risk objectives are dominated by funding liabilitiesFocus is risk relative to liabilities rather than absolute riskIn general they have below average risk tolerance

Risk objectives Risk Objectives As already emphasized, banks’ risk

objectives are dominated by ALM considerations that focus on funding liabilities. Therefore, risk relative to liabilities, rather than absolute risk, is of primary concern.

Although banks would like to earn high interest margins, they must not assume a level of risk that exposes their ability to meet their liabilities to depositors and other entities.

Overall, banks have below-average risk tolerance as concerns the securities portfolio

Contd…

A primary objective is to preserve capital by purchasing securities when there is only a small risk of principal loss.

Regulators encourage this policy by requiring that banks concentrate their holdings in investment grade securities, those rated Baa or higher.

Because of the need to be able to satisfy depositor and other liabilities at short notice and taking account of the typical characteristics of its loan portfolio, the Bank’s tolerance for interest rate, credit, and liquidity risk in its securities portfolio is below average.

The yield on investments is secondary to liquidity To limit the risk of loss as a result of an individual issuer

default, the Bank will maintain adequate diversification in its holdings.

Diversify credit risk

The diversification objective is closely linked to the safety objective and difficulties that banks have with diversifying their loan portfolios.

Too often, particularly at small banks, loans are concentrated in one industry such as agriculture, energy, or real estate that reflects the specific economic conditions of the region.

Help manage interest rate risk exposure

Investment securities are very flexible instruments for managing a bank’s overall interest rate risk exposure.

Banks can select terms that meet their specific needs without fear of upsetting the borrower.

They can readily sell the security if their needs change.

Allied Bank of Pakistan Risk exposure

Categories of RiskThese risks are grouped under two headings: Operational and Reputational Risk. The Framework is organized with reference to these five risk categories, as detailed below:

Credit Risk This risk is defined as the possibility of loss due to unexpected default or a deterioration of credit worthiness of a business partner.

Allied Bank of Pakistan Risk exposure

Market Risk The risk of loss generated by adverse changes in the price of financial assets or contracts currently held by the Bank (this risk is also known as price risk).

Liquidity Risk The risk that the Bank is unable to meet its payment obligations when they fall due and to replace funds when they are withdrawn; the consequences of which may be the failure to meet obligations to repay depositors and fulfill commitments to lend.

Allied Bank of Pakistan Risk exposure

Operational Risk Operational Risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. The definition excludes reputational risk.

Reputational Risk The risk of failing to meet the standards of performance or behavior required or expected by stakeholders in commercial activities or the way in which business is conducted

Return Objective Positive interest spread earn positive

interest spread (difference between bank’s cost of funds & interest earned on loans & other investments)

The risk-return characteristics of investment securities

The fundamental objective of the investment portfolio is to maximize earnings while limiting risk within guidelines set by management.

Earnings come in the form of: periodic interest income reinvestment income capital gains (losses)

Managing returns involves selecting the appropriate mix of taxable and tax-exempt securities, maturities, and the timing of purchases and sales.

Accounting for investment securitiesrequires banks to divide their securities holdings into three categories: Held to Maturity: Available for Sale: Trading:

Investment portfolio Allied Bank

maturity -net

value Percentage Total value

up to 3months

66610492 15.53% 428790733

3M – 1 year 70965356 16.55% 428790733

1year-3year 177541871 41.40% 428790733

3year-5year 113673014 26.510% 428790733

5year & above

-----------------------

428790733

Ahsan Khan Niazi 120137

Constraints

Internal And External

Internal Constraints

Time HorizonDetermined by average maturity of liabilities which tends to be short termAverage age of assets tend to be short to intermediate term (<10 years)

Liquidity RequirementAssets tend to be very liquidDriven by deposit withdrawals

Unique CircumstancesLack of diversification due concentration of assets

Liquidity requirements

Liquidity Requirements A bank’s liquidity position is a key management and regulatory concern.

Liquidity requirements are determined by net outflows of deposits, if any, as well as demand for loans.

Liquidity

Commercial banks purchase debt securities to help meet liquidity requirements.

Securities with maturities under one year can be readily sold for cash near par value and are classified as liquid investments.

Liquid securities are often viewed as only those which can be sold at a gain, regardless of the remaining term to maturity, credit quality, and issue size.

Time horizon Time Horizon A bank’s time horizon for its securities

portfolio reflects its need to manage interest rate risk while earning a positive return on invested capital.

A bank’s liability structure typically reflects an overall shorter maturity than its loan portfolio, placing a risk management constraint on the time horizon length for its securities portfolio.

This time horizon generally falls in the three- to seven-year range (intermediate term)

Unique circumstances

Unique Circumstances There are no common unique circumstances to highlight relative to banks’ securities investment activities.

That situation stands in contrast to banks’ lending activities, in which banks may consider factors such as historical banking relationships and community needs, which may be viewed as unique circumstances.

Unique CircumstancesThe securities activities of large banks and small banks are fundamentally different.

Small banks generally purchase securities and hold them until maturity.

Large banks, in contrast, not only buy securities for their own portfolios, but they also frequently: manage a securities trading account manage an underwriting subsidiary that helps

municipalities issue debt in the money and capital markets

External constraints Tax

Subject to tax

Legal & Regulatory (highly regulated)Risk based capital requirements

Tax concern Tax Concerns Banks’ securities portfolios are fully taxable. Thus realized securities losses decrease reported

operating income, while securities gains increase reported operating income.

According to some observers, this accounting treatment creates an incentive not to sell securities showing unrealized losses, providing a mechanism by which earnings can be managed.

Legal and Regulatory Factors Regulations

Legal and Regulatory Factors Regulations place restrictions on banks’ holdings of common shares and below-investment-grade risk fixed-income securities.

To meet legal reserve and pledging requirements banks may need to hold substantial amounts of short-term government securities.

Risk-based capital (RBC) regulations are a major regulatory development worldwide affecting banks’ risk-taking incentives.

Pledging requirements

By law, commercial banks must pledge collateral against certain types of liabilities.

Banks that sell RPs essentially pledge part of the government’s portfolio against this debt.

Capital market investments of Allied Bank Capital market instruments consists of

instruments with original maturities greater than one year.

Banks are restricted to “investment grade” securities, those rated Baa or above; i.e., no junk bonds.