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26

HOW MUCH PORTFOLIO

RISK IS TOO MUCH?

By Lester Murray, The Baker Group LP

E

VERYONE KNOWS THAT IF YOUWANT TO

make an omelet, you have to break a few eggs.

And, if you want to manage a bond portfolio,

you’re going to have to take a little risk. No risk,

no reward. The thorny question for many portfolio

managers, and boards of directors, is, at what point does this

inherent risk become too great? Or, a much less frequently

asked question, when is this risk not great enough?

Most banks these days have access to analytical tools that

generally do an adequate job of measuring the potential

changes in market valuations due to changing rate

environments, but this information by itself is incomplete

knowledge. The determination of the “right” amount of risk

is unique to each financial institution and to the people who

manage it. Knowing the dollar amount of potential depreciation

that might occur as a by-product of rising interest rates is not

without value, but lacking meaningful context, it may not

automatically follow that the measured amount of risk is the

appropriate amount of risk. Just as individual investors have

various degrees of risk tolerance or avoidance, so it is with

community bankers. Some investors never stop looking for

ways to roll the dice and take chances, while others never

feel safe unless they’re wearing a belt with their suspenders.

Apart from the nuances of personality and temperament, how

can community bank portfolio managers gain insight into

whether or not their portfolio’s market risk, once measured, is

appropriate?

Start with the Big Picture

The first place to look when looking to figure out just what

that right amount of risk might be is the overall risk profile

of the total balance sheet. For banks challenged by excessive

volatility in their Economic Value of Equity (EVE), it’s

important to know the degree to which negative portfolio

valuations contribute to that volatility. The mitigation of

the overall balance sheet risk may take priority over other

considerations affecting the portfolio’s exposure to market risk.

In other words, if an inordinate level of capital is already at

risk due to the combination of the valuation characteristics of

loans and liabilities, the assumption of any additional market

risk in the portfolio may not be a prudent option. In fact, such

a set of circumstances may compel a portfolio manager to

reduce overall balance sheet risk by reducing the portfolio’s

contribution to that risk. This reflects the priority of total

balance sheet risk management, and the portfolio’s role in

it, versus other factors influencing investment strategies and

tactics.

Does This Make My Risk Look Big?

If it’s determined that the comprehensive risk profile is modest

enough to not require portfolio-sourced reduction, a different

sort of contextual suitability is sought. One lens through which

risk may be viewed takes into account the potential effect that

unrealized losses might have on capital adequacy if, in fact,

those unrealized losses were to become real ones. A common

exercise involves estimating how much depreciation would

be expected to occur after a significant rate increase, and then

projecting damage to capital that would result from the actual

realization of those projected losses. If the outcome of such a

projection results in capital ratios below which management or

ownership is comfortable, that’s a good sign the portfolio has

too much market risk, and a duration alteration may be in order.

Another method for checking your risk level is based on

the presumption that the portfolio should not be allowed to

risk more than it’s pro rata share of capital in terms of price

depreciation. Or expressed another way, the percentage of total

assets represented by the bond account should not be exceeded

when potential depreciation is expressed as a percentage of

capital. If this occurs, it’s a sign that in light of the rest of the

balance sheet the portfolio’s risk characteristics might be a

bit on the excessive side in terms of price volatility. Whatever

method your bank uses to quantify market portfolio risk, don’t

forget to follow through with the next step of determining

the appropriateness of that risk. Make sure the risk you’re

tolerating is the right risk for you and your bank.

Lester F. Murray, Associate Partner of The Baker Group LP, came to the Baker

Group in 1986 following his work with the OCC as an assistant national bank

examiner. His focus is on developing community bank portfolio and interest

rate risk management strategies. Contact: 800-937-2257,

lester@GoBaker.com.