Risk Management

Big Banks Amp Up Investment Risks

Earnings pressures are causing the largest U.S. commercial banks to add riskier securities to their normally ho-hum investment portfolios, says S&s...
Vincent RyanJuly 24, 2012

Like nonfinancial companies, financial institutions have loads of liquidity on hand, but unlike nonfinancials, they are once again looking to take risks. And not the lending kind.

Much like J.P. Morgan did prior to its huge trading loss, the largest U.S. commercial banks are increasing the risk exposure in their investment portfolios as those portfolios continue to drive a greater share of earnings, according to Standard & Poor’s in a report released Tuesday. And S&P says the trend could lead to credit-rating downgrades of these banks.

Securities holdings expose banks to financial-market volatility. And S&P says banks could come to rely more heavily on returns from investment portfolios as J.P. Morgan did prior to its $5.8 billion trading loss. That could lead banks to increase their investment risks when they want to boost returns.

Investment-portfolio returns, as opposed to lending or fees-based businesses, are accounting for a larger portion of the six largest U.S. banks’ earnings compared with before the credit crisis.

Earnings from available-for-sale (AFS) portfolios at the largest banks, as a percentage of total bank earnings, are in the mid-teens on average, S&P says, and as a percentage of revenue they have risen the past five years. The aggregate size of the six largest U.S. banks AFS and held-to-maturity (HTM) securities portfolios almost doubled from December 2007 to March 2012.

Large deposit inflows and slower loan growth (outside of commercial and industrial loan books) are providing the banks with the money to invest. S&P estimates that the investable funds of the six largest U.S. banks — calculated by subtracting loan balances from a bank’s outstanding deposits — grew from a negative $199 billion to a positive $889 billion between December 2007 and March 2012.

Instead of lending that money out, the largest banks have beefed up their securities holdings. Normally, AFS and HTM portfolios consist of U.S. Treasuries and government-agency mortgage-backed securities, low-credit-risk assets that “act as a natural hedge” to some of a bank’s assets and add to a bank’s liquidity, S&P says. They are also used to offset maturity mismatches in a bank’s assets and liabilities.

But three large, complex banks (J.P. Morgan, Wells Fargo, and Citigroup) now have more than 50% of their AFS portfolio in something other than low-risk government securities. (Bank of America and U.S. Bancorp, on the other hand, have 85% and 80%, respectively, of their investments in Treasury and government-agency securities.)

Citi, Wells Fargo, JP Morgan Chase, and PNC Financial Services Group are holding significant amounts of riskier securities like foreign-government debt, nonagency mortgage-backed securities, and commercial mortgage-backed securities, says S&P.

For accounting purposes, instruments in HTM and AFS portfolios are not classified as trading securities, so unrealized losses or gains do not cause a direct hit to earnings. But big movements in the fair value of AFS securities, for example, could lead to volatility in a bank’s equity capital ratio under Basel III, S&P points out.

Another red flag on some banks’ balance sheets, according to S&P, is a higher percentage of Level 3 assets in AFS portfolios. The fair value of these illiquid securities is hard to measure and largely subjective, because it is often based on internal modeling. So these Level 3 assets’ values could have sudden, unpredictable swings. As of March 2012, Wells Fargo had the highest amount of Level 3 securities in its portfolio (14.5%), followed by PNC at 13.6%.

In its report, S&P focused on another trend brought to light by J.P. Morgan’s big trading loss: the fact that large commercial banks may be using derivative instruments as “economic hedges” for a wide variety of assets. The credit-ratings firm said unless there is more robust disclosure of how economic hedges offset a bank’s underlying securities portfolio, this kind of hedging activity “could rapidly morph into speculative trading for a variety of reasons, including the complexity of the hedge or management’s volition.” 

Because banks face an industrywide drop in earnings from the sluggish economy and weak financial markets, a bank’s management looking to make up the shortfall could use “aggressive hedging strategies identified as benign economic hedges” to boost earnings.