Banks
The primary function of a bank is to earn profits by taking deposits from savers and making loans to borrowers. Other functions carried out by a bank are safeguarding assets, executing transactions in securities and derivatives, and advising and investing in securities.
Most major large international banks are publicly listed, making shareholders a key external stakeholder with an interest in maximization of profits. Customers of a bank, such as depositors and borrowers, are also key external stakeholders. Other external stakeholders include creditors, credit rating agencies, regulators, and communities where the bank operates.
Internal stakeholders include the bank’s employees, managers, and directors.
Deposits constitute the majority of a bank’s liabilities. This includes demand deposits and time/term deposits.
Other liabilities include short-term wholesale funding from other financial institutions, long-term debt, and trading/securities payables and repo finance payables.
The majority of the assets of a bank are comprised of longer-term illiquid mortgage and commercial loans.
The investment horizon for a bank portfolio is influenced by the difference between the long-term illiquid assets and the short-term liquid liabilities of the bank. Although banks are perpetual organizations, the instruments held in the investment portfolio of a bank are likely to be very short in nature, such that the bank can manage the volatility of shareholder capital on a medium- to short-term basis.
With deposits as short-duration liabilities and the potential need to raise liquidity in adverse market conditions, liquidity management is a key focus for banks. Since the 2007-2009 financial crisis, regulations have been introduced that require banks to have sufficiently liquid assets to cover near-term expected cash outflows (liquidity coverage ratios, or LCRs) and to have adequate levels of capital from stable sources (net stable funding ratios, or NSFRs). This has led to the investment portfolios of banks being more liquid and banks relying less on the wholesale interbank funding markets.
Banks lending to commercial markets still tend to use wholesale funding markets more than banks lending to retail markets.
Retail banks use a higher level of retail deposits in their funding, which have lower costs and tend to be more stable than wholesale funds, giving retail banks a better liquidity position than commercial banks.
From a legal and regulatory perspective, the risks that a systemic bank failure pose to critical economic functions such as payment processing and extension of credit mean that regulators are intensely focused on capital adequacy, liquidity, and leverage levels.
The main goal of regulators is to make sure that banks have adequate capitalization to absorb losses rather than the losses having to be faced by customers, creditors, or taxpayers.
Economies of scale and the benefits of diversification encourage banks to increase their size, with the largest banks regarded by regulators as systemically important financial institutions (SIFIs). Since the global financial crisis, regulations for these SIFIs have:
- Increased capital required to absorb losses on assets.
- Placed limits on the amount of dividends and share buybacks since these payouts to shareholders effectively increase the leverage of the institution.
- Restricted the ability of subordinated debtholders and preferred shareholders to exert their claims in a bankruptcy, forcing them to bear more of the risk of the bank’s activities.
- Restricted the use of derivatives, proprietary trading, and the use of off-balance sheet liabilities and guarantees.
From an accountancy perspective, three different accounting systems apply to financial institutions:
- Standard financial reporting (GAAP or IFRS) is used to communicate results to shareholders. Due to the accruals process of accounting, this provides the smoothest reporting of income.
- Statutory accounting is utilized by regulators and is comprised of a series of adjustments to make the accounts more conservative.
- True economic accounting uses market value for all assets and liabilities. This is likely to give the most volatile measure of income.
Banks typically are fully taxable entities; hence, they must consider the after-tax returns of their investment programs.
The primary objective of a bank’s investment portfolio is to manage liquidity and reduce risk mismatches between the bank’s noninvestment assets and liabilities.
Banks establish an asset and liability management committee (ALMCo) to oversee investment activities. The ALMCo will set the IPS, monitor performance, and set risk limits regarding market, credit, liquidity, and solvency risks, with the authority to require changes on the asset and liability sides of the balance sheet. Having established these objectives, the investment team sets policy benchmarks, monitors performance, and reports to the bank’s management and board.
Insurers
Insurers can be divided into the following two broad categories:
- Life insurers. They write insurance relating to whole life or term insurance with fixed payments, variable life insurance, annuity products, health insurance, and universal life insurance.
- Property and casualty (P&C) insurers. They write insurance relating to commercial property and liability, home ownership, marine insurance, surety, and legal liabilities.
Insurers tend to be organized as either publicly listed companies or mutual companies. For publicly listed companies, key external stakeholders are shareholders who require long-term maximization of the value of their capital while simultaneously honoring obligations to policyholders.
Mutual companies are owned by their policyholders, either retaining profits as a surplus against potential losses or distributing them to policyholders through dividends or premium reductions. Other external stakeholders include derivatives counterparties, creditors, regulators, and rating agencies.
For traditional life insurance and annuity policies (including universal life), life insurers maintain a general account to fund the liabilities because the insurer bears the investment risk associated with meeting claims under these contracts. For variable life policies, the insurer operates a separate account in which assets are invested according to the investment choices of policyholders. For these policies, the policyholder bears the investment risk.
Internal stakeholders include an insurer’s employees, management, and board of directors.
Insurance companies manage their investments with a focus on asset and liability management; therefore, the nature of the liabilities is crucial to the investment horizon of the investment portfolio.
Life insurers generally face a long duration liability stream through their contract payouts, although this can vary by product line. Because of this, life insurance companies have historically set investment horizons of 20 to 40 years.
P&C insurers generally face a liability stream with a shorter duration and higher uncertainty because claims are relate to unlikely, unpredictable events with high payouts, such as natural disasters.
A key consideration for both life and P&C insurers is the frequently occurring underwriting cycle, which causes fluctuations in profitability driven by changes in the level of competition at different points of the insurance business cycle. For example, at times of intense competition and low profits from underwriting insurance contracts, insurers will be inclined to bear less underwriting risk, which may increase their appetite for investment risk, all else equal.
An insurer needs to manage both internal liquidity (cash from operations and investing activities) and external liquidity (ability to borrow in debt markets). Liquidity needs are affected by the level of interest rates.
As noted previously, P&C insurers face significant cash flow uncertainty due to the nature of their liabilities; hence, portfolios require the ample liquidity of high proportions of cash or cash equivalents and short-term fixed-income securities.
Insurers divide general account investments into two major components: the reserve portfolio and the surplus portfolio. Regulations require the insurer to maintain a reserve portfolio capable of meeting policy liabilities, and this is therefore managed conservatively. The surplus portfolio is used to generate higher returns, often by assuming liquidity risk and allocating to alternative investments.
From a legal and regulatory perspective, insurers, like banks, carry out crucial financial intermediary roles and can become large enough to be classified by regulators as SIFIs.
From an accountancy perspective, standard financial reporting, statutory reporting, and true economic accounting rules apply to insurers just as they do to banks.
Insurers typically are fully taxable entities and must run their investment programs with consideration of after-tax returns.
Similar to banks, the primary objective of an insurer’s investment portfolio is to manage liquidity and reduce risk mismatches between the institution’s assets and liabilities.
The investment oversight function of an insurer is typically carried out by a board committee that is responsible for all investment policies and procedures and reports to regulators and external stakeholders.