Academic journal article ABA Banking Journal

When a Good Investment Isn't

Academic journal article ABA Banking Journal

When a Good Investment Isn't

Article excerpt

A liquidity squeeze can sink a bank as easily as a lack of capital. This issue and others discovered in the last three years have resulted in a need for Liquidity Contingency Funding Plans. These plans require an understanding of available liquidity under varying stress scenarios.

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Many ALM/IRR models provide anticipated cash flows from investment portfolios under current and varying rate scenarios. That said, it is obviously quite important to correctly measure those cash flows, which makes it critical to embed the actual deal structure and correctly measure the optionality for each holding Current and future pricing under rate shocks is also a necessary input.

The investment portfolio must complement the rest of the balance sheet and not be managed in isolation.

The cheapest bond available may be the most expensive for your bank if it doesn't solve the needs of the balance sheet, interest rate risk, income statement, and the required cash flows for liquidity. All of these should be considered when adding to, or restructuring, the investment portfolio.

As an example: A bank sees an investment at a wider spread than norreal--it's a 5-year maturity and has step-ups embedded. The greater earnings, however, may be offset by the need for shorter-term liquidity; the maturity creates a gap mismatch that negatively impacts IRR; and the step-up, though apparently attractive, may be called as rates rise, causing the bank to lose the promised yield. …

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