Pub. 10 2015-2016 Issue 1

www.nebankers.org 24 Extraordinary Service for Extraordinary Members. E VERYONE KNOWS THAT IF YOU want 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 manag- ers, 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 poten- tial 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 mea- sured amount of risk is the appropri- ate amount of risk. Just as individual investors have various degrees of risk tolerance or avoidance, so it is with com- munity 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 trying 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 pri- ority 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 com- bination 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 bal- ance sheet risk management, and the portfolio’s role in it, versus other fac- tors influencing investment strategies and tactics. Does This Make My Risk Look Big? If it’s determined that the compre- hensive 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 howmuch deprecia- tion 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 belowwhichmanagement 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 its 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 volatil- ity. 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.  How Much Portfolio Risk Is Too Much? Lester F. Murray , The Baker Group LP 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. For more information, contact Murray at (800) 937-2257 or lester@GoBaker.com .