Portfolio Management of a Commercial Bank: (Objectives and Theories) (2024)

Read this article to learn about the portfolio management of a commercial bank: objectives and theories:

The main aim of a commercial bank is to seek profit like any other institution. Its capacity to earn profit depends upon its investment policy. Its investment policy, in turn, depends on the manner in which it manages its investment portfolio.

Thus “commercial bank investment policy emerges from a straight forward application of the theory of portfolio management to the particular circ*mstances of commercial bank.” Portfolio management refers to the prudent management of a bank’s assets and liabilities in order to seek some optimum combination of income or profit, liquidity, and safety.

When a bank operates, it acquires and disposes of income-earning assets. These assets plus the bank’s cash make up what is known as its portfolio. A bank’s earning assets consist of (a) securities issued by the central and state governments, local bodies and government institutions, and (b) financial obligations, such as promissory notes, bills of exchange, etc. issues by firms. There earning assets constitute between one- fourth and one-third of a commercial bank’s total assets. Thus a bank’s earning assets are an important source of its income.

The manner in which banks manage their portfolios, that is acquiring and disposing of their earning assets, can have important affects on the financial markets, on the borrowing and spending practices of households and businesses, and on the economy as a whole.

We study the objective, principles and theories of portfolio management and essentials of a sound banking system.

Objectives of Portfolio Management:

There are three main objectives of portfolio management which a wise bank follows: liquidity, safety and income. The three objectives are opposed to each other. To achieve on the bank will have to sacrifice the other objectives. For example, if the banks seek high profit, it may have to sacrifice some safety and liquidity. If it seeks more safety and liquidity it may have to give up some income. We analyse these objectives one by one in relation to the other objectives.

1. Liquidity:

A commercial bank needs a higher degree of liquidity in its assets. The liquidity of assets refers to the ease and certainty with which it can be turned into cash. The liabilities of a bank are large in relation to its assets because it holds a small proportion of its assets in cash. But its liabilities are payable on demand at a short notice.

Therefore, the bank must hold a sufficiently large proportion of its assets in the form of cash and liquid assets for the purpose of profitability. If the bank keeps liquidity the uppermost, its profit will below. On the other hands, if it ignores liquidity and aims at earning more, It will be disastrous for it. Thus in managing its investment portfolio a bank must strike a balance between the objectives of liquidity and profitability. The balance must be achieved with a relatively high degree of safety. This is because banks are subject to a number of restrictions that limit the size of earning assets they can acquire.

The nature of conflict between liquidity and profitability is illustrated in earning assets are taken on the horizontal axis and cash on the vertical axis. CF is the investment possibility line which shows all combinations of cash and earning assets.

For instance, point A denotes a combination of OM of cash and OS of earning assets; and point В shows ON of cash and ОТ of earning assets. Each bank seeks to obtain its optimum point along the line CE which will be a combination of cash and earning assets so as to achieve the highest possible level of earnings consistent with its liquidity and safety.

Many types of assets are available to a commercial bank with varying degrees of liquidity. The most liquid of assets is money in cash. The next most liquid assets are deposits with the central bank, treasury bills and other short-term bills issues by the central and state governments and large firms, and call loans to other banks, firms, dealers and brokers in government securities.

The less liquid assets are the various types of loans to customers and investments in long term bonds and mortgages. Thus the principle sources of liquidity of a bank are its borrowings from the other banks and the central bank and from the sales of the assets.

But the amount of liquidity which the bank can have depends on the availability and cost of borrowings. If it can borrow large amounts at any time without difficulty at a low cost (interest rate), it willhod very little liquid assets. But if it is uncertain to borrow funds or the cost of borrowing is high, the bank will keep more liquid assets in its portfolio.

2. Safety:

A commercial bank always operates under conditions of uncertainty and risk. It is uncertain about the amount and cost of funds it can acquire and about its income in the future. Moreover, it face two types of risks. The first is the market risk which results from the decline in the prices of debt obligations when the market rate of interest rises. The second is the risk by default where the bank fears that the debtors are not likely to repay the principle and pay the interest in time. “This risk is largely concentrated in customer loans, where banks have a special function to perform, and bank loans to businesses and bank mortgage loans are among the high grade loans of these types.”

In the light of these risks, a commercial bank has to maintain the safety of its assets. It is also prohibited by law to assume large risks because it is required to keep a high ration of its fixed liabilities to its total assets with itself and also with the central bank in the form of cash. But if the bank follows the safety principle strictly by holding only the safest assets it will not be able to create more credit.

It will thus lose customers to other banks and its income will also be very low. One the other hand, if the bank takes too much risk, it may be highly harmful for it. Therefore, a commercial bank “must estimate the amount of risks attached to the various types of available assets, compare estimated risk differentials, consider both long-turn and short- run consequences, and strike a balance.”

3. Profitability:

One of the principle objectives of a bank is to earn more profit. It is essential for the purpose of paying interest to depositors, wage to the staff, dividend to shareholders and meeting other expenses. It cannot afford to hold a large amount of funds in cash for that will mean forgoing income. But the conflict between profitability and liquidity is not very sharp. Liquidity and safety are primary considerations while profitability is subsidiary for the very existence of a bank depends on the first two.

Conclusion:

The three conflicting objectives of portfolio management lead to the conclusion that for a bank to earn more profit, it must strike a judicious balance between liquidity and safety.

Theories of Portfolio Management:

There are apparent conflicts between the objectives of liquidity, safety and profitability relating to a commercial bank. Economists have tried to resolve these conflicts by laying down certain theories from time to time. These principles or theories, in fact, govern the distribution of assets keeping in views these objectives. They have also come to be known as the theories of liquidity management which are discussed as under.

1. The Real Bills Doctrine:

The real bills doctrine or the commercial loan theory states that a commercial bank should advance only short-term self-liquidating productive loans to business firms. Self-liquidating loans are those which are meant to finance the production, and movement of goods through the successive stages of production, storage, transportation, and distribution.

When such goods are ultimately sold, the loans are considered to liquidate themselves automatically. For instance, a loan give by the bank to a businessman to finance inventories would be repaid out of the receipts from the sale of those very inventories, and the loan would be automatically self-liquidated.

The theory states that when commercial banks make only short term self-liquidating productive loans, the central bank, in turn, should only land to the banks on the security of such short-term loans. This principle would ensure the proper degree of liquidity for each bank and the proper money, supply for the whole economy.

The central bank was expected to increase or diminish bank reserves by rediscounting approved loans. When business expanded and the needs of trade increased, banks were able to acquire additional reserves by rediscounting bills with the central banks. When business fell and the needs of trade declined, the volume of rediscounting of bills would fall, the supply of bank reserves and the amount of bank credit and money would also contract.

It’s Merits:

Such short-term self-liquidating productive loans possess three advantages. First, they possess liquidity that is why they liquidate themselves automatically. Second, since they mature in the short run and are for productive purposes, there is no risk of their running to bad debts. Third, being productive such loans earn income for the banks.

Its Demerits:

Despite these merits, the real bills doctrine suffers from certain defects.

First, if a bank refuses to grant a fresh loan till the old loan is repaid, the disappointed borrower will have to reduce production which will adversely affect business activity. If all the banks follow the same rule, this may lead to reduction in the money supply and price in the community. This may, in turn, make it impossible for existing debtors to repay their loans in time.

Second, the doctrine assumes that loans are self-liquidating under normal economic conditions. If there is depression, production and trade suffer and the debtor will not be able to repay the debt at maturity.

Third, this doctrine neglects the fact that the liquidity of a bank depends on the saleability of its liquid assets and not on real trade bills. If a bank possesses a variety of assets like bills and securities which can be readily should in the money and capital markets, it can ensure safety, liquidity and profitability. Then the bank need not rely on maturitis in time of trouble.

Fourth, the basic defect of the theory is that no loan is in itself automatically self-liquidating. A loan to a retailer to purchase inventor is not self-liquidating if the inventories are not sold to consumers and remain with the retailer. Thus a loan to be successful involves a third party, the consumers in this case, besides the lender and the borrower.

Fifth, this theory is based on the “needs of trade” which is no longer accepted as an adequate criterion for regulating this type of bank credit. If bank credit and money supply fluctuate on the basis of the needs of trade, the central bank cannot prevent either spiralling recession or inflation.

2. The Shiftability Theory:

The shiftability theory of bank liquidity was propounded by H.G. Moulton who asserted that if the commercial banks maintain a substantial amount of assets that can be shifted on to the other banks for cash without material loss in case of necessity, then there is no need to rely on maturities.

According to this view, an asset to be perfectly shiftable must be immediately transferable without capital loss when the need for liquidity arises. This is particularly applicable to short term market investments, such as treasury bills and bills of exchange which can be immediately sold whenever it is necessary to raise funds by banks. But in a general crisis when all banks are in need of liquidity, the shiftability theory requires that all banks should possess such assets which can be shifted on to the central bank which is the lender of the last resort.

This theory has certain elements of truth. Banks now accept sound assets which can be shifted on to other banks. Shares and debentures of large companies are accepted as liquid assets along with treasury bills and bills of exchange. This has encouraged term lending by banks.

It’s Demerits:

But it has its weaknesses. First, mere shiftability of assets does not provide liquidity to the banking system. It entirely depends upon the economic circ*mstances. Second, the shiftability theory ignores the fact that in times of acute depression, the shares and debentures cannot be shifted on to others by the banks. In such a situation, there are no buyers and all who possess them want to sell them. Third, a single bank may have shiftable assets in sufficient quantities but if it tries to sell them when there is a run on the bank, it may adversely affect the entire banking system, fourth, If all the banks simultaneously start shifting their assets, it would have disastrous effects on both the lenders and borrowers.

3. The Anticipated Income Theory:

The anticipated income theory was developed by H.V. Prochanow in 1944 on the basis of the practice of extending term loans by the US commercial banks. According to this theory, regardless of the nature and character of a borrower’s business, the bank plans the liquidation of the term-loan from the anticipated income of the borrower. A term-loan is for a period exceeding one year and extending to less than five years.

It is granted against the hypothecation of machinery, stock and even immovable property. The bank puts restrictions on the financial activities of the borrower while granting this loan. At the time of granting a loan, the bank takes into consideration not only the security but the anticipated earnings of the borrower. Thus a loan by the bank gets repaid out of the future income of the borrower in instalments, instead of in a lump sum at the maturity of the loan.

It’s Merits:

This theory is superior to the real bills doctrine and the shiftability theory because it fulfills the three objectives of liquidity, safety and profitability. Liquidity is assured to the bank when the borrower saves and repays the loan regularly in instalments. It satisfies the safety principle because the bank grants a loan not only on the basis of a good security but also on the ability of the borrower to repay the loan. The bank can utilise its excess reserves in granting term-loan and is assured of a regular income. Lastly, the term-loan is highly beneficial for the business community which gets funds for medium-terms.

Its Demerits:

The theory of anticipated income is not free from a few defects.

1. Analyses Creditworthiness:

It is not a theory but simply a method to analyse a borrower’s creditworthiness. It gives the bank criteria for evaluating the potential of a borrower to successfully repay a loan on- time.

2. Fails to Meet Emergency Cash Needs:

Repayment of loans in instalments to the bank no doubt provides a regular stream of liquidity, but they fail to meet emergency cash needs of the lender bank.

4. The Liabilities Management Theory:

This theory was developed in the 1960s. According to this theory, there is no need for banks to grant self-liquidating loans and keep liquid assets because they can borrow reserve money in the money market in case of need. A bank can acquire reserves by creating additional liabilities against itself from different sources. These sources include the issuing of time certificates of deposit, borrowing from other commercial banks, borrowing from the central banks, raising of capital funds by issuing shares, and by ploughing back of profits. We discuss these sources of bank funds briefly.

(a) Time Certificates of Deposits:

These are the principle source of reserve money for a commercial bank in the USA. Time certificates of deposits are of different maturities ranging from 90 days to less than 12 months. They are negotiable in the money market. So a bank can have access to liquidity by selling them in the money market. But there are two limitations.

First, if during a boom, the interest rate structure in the money market is higher than the ceiling rate set by the central bank, time deposit certificates cannot be sold in the market. Second, they are not a dependable source of funds for the commercial banks. Bigger commercial banks are at an advantage in selling these certificates because they have large certificates which they can afford to sell at even low interest rates. So the smaller banks are at a disadvantage in this respect.

(b) Borrowing from other Commercial Banks:

A bank may create additional liabilities by borrowing from other banks having excess reserves. But such borrowings are only for a very short duration, for a day or week at the most. The interest rate of such borrowings depends upon the prevailing rate in the money market. But borrowings from other banks are only possible during normal economic conditions. In abnormal times, no bank can afford to lend to others.

(c) Borrowing from the Central Bank:

Banks also create liabilities on themselves by borrowing from the central bank of the country. They borrow to meet their liquidity needs for short term and by discounting bills from the central bank. But such borrowings are relatively costlier than borrowings from other sources.

(d) Raising Capital Funds:

Commercial banks acquire funds by issuing fresh shares or debentures. But the availability of funds through these sources depends on the amount of dividend or interest rate which the bank is prepared to pay. Usually the banks are not in a position to pay rates higher than paid by manufacturing and trading companies. So they are not able to get sufficient funds from this sources.

(e) Ploughing Back Profits:

Another source of liquid funds for a commercial bank is the ploughing back of its profits. But how much it can get from this source will depend upon its rate of profit and its dividend policy. It is the larger banks that can depend on this source rather than the smaller banks.