18 Hoosier Banker May 2015 DIRECTORS / SENIOR MANAGEMENT Everyone knows that you can’t make an omelet without breaking eggs. And if you want to manage a bond portfolio, you’re going to have to take a little risk — no risk, no reward. For many portfolio managers and boards of directors, the thorny question is: “At what point does this inherent risk become too great?” Or a much less frequently asked question is: “When is this risk not great enough?” Most banks 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 byproduct 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. 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 their portfolios’ market risk, once measured, is appropriate? Start With the Big Picture The first place to look when trying to gauge the right amount of risk is the overall risk profile of the total balance sheet. For banks challenged by excessive volatility in the economic value of equity, it is 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 is determined that the comprehensive risk profile is modest enough to not require portfoliosourced 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 is a good sign the portfolio has too much market risk, and a duration alteration may be in order. Another method for checking 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 How Much Portfolio Risk Is Too Much? About the Author Lester F. Murray, associate partner of The Baker Group, joined the firm in 1986. He previously worked for the Office of the Comptroller of the Currency as an assistant national bank examiner and is a frequent speaker at investment conferences and educational seminars. Murray is a graduate of Oklahoma State University. The author can be reached at 800-9372257, email: lester@gobaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider.
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