The solution to Q9B stated : Winthrop Bank should have more leeway to invest in BELOW-INVESTMENT-QUALITY DEBT in its bond portfolio as a result. Why the bank have to invest in BELOW-INVESTMENT-QUALITY DEBT ? I don’t get it !
Just remember that the Securities portfolio serves to counter the loan portfolio High duration loan portfolio? —> Low duration securities portfolio High risk Loan Port? --------> Low risk securities port You get the idea. What throws me off, is the final question … where there are “more options to expand net interest margin through low risk loans” … and the answer is to “take less risk” in the securities portfolio. Seems very counter to what they imply elsewhere.
So, the concepts indicated in B and D are contrary ?
I feel they are contrary. I posted about this and got very few responses. The ONLY logical way for me to make sense of D, is that if you are able to get great low risk NIM expanding opportunities in loans, perhaps you would want highly liquid securities portfolio so you can move out of securities and into those loans on demand. Higher liquidity typically implies lower risk. But it certainly seems to contrast with their other “lessons” of balancing the loan portfolio characteristics with the security portfolio. You will find that in the text securities are always the counterbalance, with the exception of part D.)
Anyone else can help ?
I think the loans in that question are Assets to the bank. The bank usually takes risk to invest in Securities portfolio, and takes risk to make loans. I totally forgot Net Interest Margins, and have to look it up from VitalSource.
This type of questions can show up in the exams. We could make mistakes on them when mentally tired or exhausted.
elcfa - thats great and all, but it still doesn’t address 9-D, which seems to completely go against the counter-balancing concept, unless I am missing something.
What is not clear? I wrote earlier: " think the investment portfolio as a counterweight/support/complement to the bank’s loan portfolio (to its customers), so for a FIXED OVERALL target for both, changes in loan portfolio necessitate opposite change in the investment portfolio D.More return in loan --> less return requirement from investment --> less need to take risk in investment" Say the bank’s overall return requirement is 6%. This return comes from either the loan portfolio or the bank equity investment. Previously, it is met by 3% (loan) *.5 + 9%(equity investment)*.5 = 6%. Here I assume the bank has 50% of its portfolio in customer loan and 50% in equity. Now, if there are opportunities to get 4% from the loan portfolio (with low risk) then the required return of the equity is now 4% (loan) *.5 + 8%(equity investment)*.5 = 6% --> req return has gone down from 9% to 8% --> less need to take risk (to meet the 8% as compared to the 9%). Let me know if it is still not clear.
Re: Reading 20-Institutional Posted by: elcfa (IP Logged) Date: April 11, 2010 02:38PM B. Loan risk standard higher --> Loan risk lower --> investment can take higher risk. C. Less capital binding (more liquid) in loan portfolio --> Less need to provide liquidity from investment --> less liquid investment. D.More return in loan --> less return requirement from investment --> less need to take risk in investment. — Again, if CFAI is indeed monitoring AF, it should take elcfa’s answers seriously – update the books, please.
In return stance, you are correct… however what about in terms of risk? If you are low risk in the loans, you can afford to take high risk, and seek higher returns, in securities. To me there is not a clear “right” answer.
Man, have you not learned anything in the IPS setting process? The goal is to meet the required return with lowest possible risk, not to maximize return while meeting a predetermined risk level. This applies for (most) private IPS and institutions (apart from investment companies) not only banks. For banks, ALM is even more critical than others (say foundations), so risk/mismatch mgnt is even more important. Beside, the text says low, not LOWER risk.
D. More opportunities exist for expanding net interest margins with low risk in Winthrop’s loan portfolio than in its securities portfolio. (Level III Vol2, p. 436). It seems that the bank will need to take more risk to expand the net interest margins. In general, it’s not easy to get a higher return and lower risk at the same time. The “low risk” may mean keeping risk low, not “lower”.
B.) the ALCO decides to increase Winthrop Bank’s credit standards for loans although Winthrop Bank’s overall risk tolerance is unchanged. Answer: Winthrop should have more leeway to invest in below investment quality debt. So if this question implies that having low risk assets on the books in terms of loans means you should counter by having higher risk assets in securities, how does that not correlate with part D? To your point about meeting the return, yah thats great, but if you don’t know what return you need, and aren’t given more information, you can’t make a generalization that risk needs to be kept at a certain level. If the point of the securities portfolio (according to CFAI) is to balance the loan portfolio, characteristics should offset eachother. Just because I get “expanding NIM” through loans, should not mean that i have to seek low yielding assets from the securities portfolio. “Expanding NIM”, could mean by 20 basis points for all we know.
>Answer: Winthrop should have more leeway to invest in below investment quality debt. It means increased risk-taking ability. It does not change the return objective. >So if this question implies that having low risk assets on the books in terms of loans means > you should counter by having higher risk assets in securities. No, it does not say SHOULD (or even MUST as you imply), it says CAN. >To your point about meeting the return, yah thats great, but if you don’t know what >return you need, and aren’t given more information, you can’t make a generalization that >risk needs to be kept at a certain level. The point here is RELATIVE change, so one can assume that the ALCO has done its job previously so that the current portfolio (loan and investment) meets req return with minimal risk (and within acceptable risk level). The question is what if you change the conditions somewhat, what relative changes you can afford. Again, you MUST meet req return. If there are many choices that meet this required return, you SHOULD choose the one with least risk. > Just because I get “expanding NIM” through loans, should not mean that i have to seek >low yielding assets from the securities portfolio. “Expanding NIM”, could mean by 20 >basis points for all we know. It does not matter. Higher NIM on loan can afford the bank to take less risk since required return for securities is now lower, so if NIM goes up by 20 bps, req return of securities will go down certain bps --> less risk in some proportion of the portfolio. Hope it is clearer.
I just got to this question this evening. I think people are missing the key phrase “assuming overall risk tolerance remains unchanged.” If the risk in the loan portfolio decreases, the risk in the investment portfolio has to increase in order for the overall risk tolerance to remain unchanged.
I think it is the other way, in this case: If the risk in the loan portfolio decreases, the risk in the investment portfolio CAN increase (if needed to meet the req return). However, if the risk in the loan portfolio increases, the risk in the investment portfolio MUST decrease to meet the constant overall risk tolerance (assuming that the previous portfolio combination matches the overall risk tolerance). Again, it is assumed that doing so, the bank still can meet the overall req return. bpdulog Wrote: ------------------------------------------------------- > I just got to this question this evening. I think > people are missing the key phrase “assuming > overall risk tolerance remains unchanged.” > > If the risk in the loan portfolio decreases, the > risk in the investment portfolio has to increase > in order for the overall risk tolerance to remain > unchanged.