laska banks employ a variety of approaches to build their own investment portfolio and maintain a healthy balance sheet. While their strategies and tactics may differ, their primary objective is the same: to diversify their investments, minimize risk, and generate income.
Historically, financial regulators limited the types of investments that banks can pursue because they are essentially investing depositors’ funds. This helps to reduce risk and minimize the chance that banks are gambling away deposits on hedge funds or other higher-risk investments. Today many banks focus on fixed-income investments like government and corporate bonds, certificates of deposit, and money market funds to earn a steady stream of revenue with less risk than stocks. However, regulatory restrictions have been loosening over the years to allow financial institutions to broaden their investments options.
For financial institutions, the investment portfolio represents an important asset for their operation. At most banks, the investment portfolio serves as a secondary source of both earnings and liquidity. And at some banks, it’s a primary generator of investment earnings.
Having the right assortment of fixed income and other investments helps banks maintain a healthy balance sheet, which is the financial statement that shows their assets, liabilities, and capital. A bank’s balance sheet differs considerably from that of a typical company. It often shows assets such as loans, securities, and a small percentage of cash, with liabilities being deposits and borrowings. However, the typical balance sheet might include assets like cash, accounts receivable, inventory, and property/equipment, with liabilities being accounts payable, accrued expenses, and loans.
The difference in balance sheets, of course, reflects how banks operate compared to businesses in other industries. A bank generates profits from managing the spread between deposits paid to consumers and the rate it receives from their loans. Banks also earn revenue from fees they charge for their products and services, which include wealth management advice, checking account fees, overdraft fees, ATM fees, interest, and fees on credit cards. On the other hand, a nonfinancial company produces income by selling goods or services to another business or other customers.
Northrim Bank has more than 400 employees, branches from Fairbanks to Southeast, and more than $1.6 billion in assets. Northrim’s balance sheet primarily lists loans and investments on the assets side and customer deposits as liabilities, according to CFO Jed Ballard. The loan portfolio has a relatively higher level of risk; therefore the bank uses its investment portfolio to mitigate and diversify that risk. “We have just under $300 million in our investment portfolio,” Ballard says. “Loans represent just over a billion dollars of assets. About 20 percent of our earning assets are investments and about 70 percent are loans.”
Northrim also consolidates the assets of its wholly-owned subsidiary, Residential Mortgage, which has provided Alaskans with more than 60,000 loans since its 1998 inception. The bank also holds cash assets to fund loans and pay depositors as well as generate interest.
Denali State Bank
Northrim has a loan-to-deposit ratio of 75 percent, which aligns well with its overall investment strategy. “If you have deposits to fund your loans, your cost of funds is lower, and it increases your ability to pay depositors, invest back into the people and infrastructure of the bank, and increase profitability,” Ballard says. “From an investment point of view, the investment portfolio is there to help with the liquidity of the bank and to diversify our balance sheet.”
The loan-to-deposit ratio, which is used to assess a bank’s liquidity, represents the total loans divided by the total deposits for the same period. For example, a loan-to-deposit ratio of 100 percent means a bank loaned $1 to customers for every $1 received in deposits. Regulators such as the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) do not set minimum or maximum loan-to-deposit ratios for banks, although they do expect them to adhere to certain standards.
The composition of Northrim’s investment portfolio is relatively short-term, with investments yielding variable interest rates. This lines up nicely with the loans on the bank’s balance sheet. “We have relatively shorter-term loans with variable interest rates,” Ballard says. “We believe that provides for a healthy balance sheet.”
Northrim’s investments are primarily in US government agency bonds and US Treasury securities. These are lower-yielding assets, but from a risk perspective they are very highly rated investments that are favored by banking regulators. Northrim also invests in corporate bonds and collateralized loan obligations, which adds some diversification in the investment portfolio and provides slightly higher yields. “The investment portfolio is a big balancing game,” Ballard says. “You want it to complement your risk from your loan portfolio and, at the same time, provide additional income to the bank without taking on too much risk.”
Denali State Bank operates five locations in interior Alaska and $295 million in assets. The bank, which is based in Fairbanks, has three main asset categories on its balance sheet: investment portfolio, loans, and properties. About 25 percent of Denali State Bank’s total assets consists of its investment portfolio, according to President and CEO Steve Lundgren. “Usually what we can’t invest in loans, we invest in our investment portfolio,” he says.
As banks are in the business of making money, they seek to invest in assets that produce higher earnings. Loans are typically higher-earning assets than the investment portfolio, Lundgren says. But rewards come with risk, and loans are generally considered higher risk. However, banks typically want to have more of their assets in their higher-earning loan portfolio.
The investment portfolio serves two purposes for Denali State Bank. It allows the bank to earn income on assets that it can’t invest in loans. It also supports the bank’s diversification strategy. “We want to have some diversification in our balance sheet of risk profiles, so the investment provides a lower-risk option,” Lundgren says.
It also provides a more liquid option, which is a regulatory requirement, according to Lundgren. “Regulators consider our investment portfolio to be liquid,” he explains. “They also will look at the bank’s line of credit as liquid. It is important for banks to demonstrate a regulatorily-accepted level of liquidity.”
In terms of its loan-to-deposit ratio, Denali State Bank is aiming for 80 percent, which Lundgren says is about average. “We will achieve that this year,” he says.
Due to regulatory guidance, Denali State Bank targets bond or fixed-income opportunities, rather than equities. “We invest in government agency bonds, mortgage-backed securities, municipal bonds, and other types of fixed income,” Lundgren says.
Diversification is a key investment strategy for Alaska’s banks. Like many financial institutions, Denali State Bank diversifies its balance sheet, even in its different portfolios. In its loan portfolio, for example, the bank has been on a course for the last few years to diversify more broadly. And it intentionally avoids credit risk in its investment portfolio. “We like to have an investment portfolio that is backed by the government [instead of corporate bonds],” Lundgren says. “We don’t know where future risk is going to be, so we try to have a diversified portfolio.”
For Northrim Bank’s investment portfolio, diversification is evident in three categories. Ballard explains: “One is the type of investments. As you move from investment types, the yield goes up because the risk level increases. Two: the duration. You don’t want all your investments to mature in two or three years. You want them to mature gradually over time in order to manage the overall liquidity of the company. Three: You want a mix between fixed and variable with your investments. So when interest rates move, you have some hedge. So it boils down to the risk tolerance, duration, and fixed/variable rates.”
In addition to diversifying, managing risk is also essential for a healthy investment portfolio. Management should set risk limits consistent with the bank’s strategic plans and overall asset/liability management objectives, according to the FDIC. Specifically, limits should be placed on market risk, credit risk, liquidity risk, asset types, and maturities.
Financial institutions apply various approaches to leverage investment opportunities and strengthen their financial position. Some rely on in-houses resources to identify and capitalize on appropriate investments. Others use the services of third-party investment advisors to expand their investing capabilities. Still other banks combine both tactics, building their investment portfolio with internal and external resources.
When it comes to managing its investment portfolio, Northrim Bank uses a somewhat mixed approach. Rather than maintain an investment professional in house, it works with an external expert to help identify suitable investments. “There are so many moving parts in the world of investing for banks,” Ballard says. “The investment advisor’s experience and expertise in the industry helps the bank make thoughtful, educated investment decisions.”
The third-party investment advisor is an invaluable resource for Northrim Bank. There are so many potential investment opportunities available, along with the intricacies involved. And the advisor has the expertise to identify opportunities and bring them to the table for further discussion. Ballard says: “There are many ways a company or bank can manage its investment portfolio, and Northrim believes that based on our profile and operations that outsourcing is the best model for our company.”
Like Northrim, Denali State Bank takes a two-pronged approach to targeting fixed income and other opportunities for its investment portfolio. It relies on external investment advisors and two professionally-trained internal investment experts. Lundgren explains: “We manage the portfolio ourselves. We make all of our investment decisions internally, but we do engage outside experts to give us information on securities we are interested in buying and our existing portfolio, so we can make buy-sell decisions on securities we already own.”
Denali State Bank uses a variety of third-party investment advisors, depending on the type of instrument involved. And most of these advisors that specialize in bank investments are located outside Alaska. For Lundgren, the key benefit of using an external investment advisor is having access to specialized knowledge. “This is their entire business,” he says. “It’s analyzing investments, so they have a real expertise in that area. We’re bankers, not investment experts. We try to outsource as much as we can to people who do whatever we need done on a full-time basis because they have more resources available to them.”
Granted, it would be less expensive to handle all of the bank’s investment activities in house—but it wouldn’t be ideal. It would be difficult if not impossible to give the bank’s internal staff members all the experience that it can obtain from external sources. “I can’t put a price on that,” Lundgren says. “I just can’t get that third-party expertise internally at a reasonable cost.”
Incidentally, banks are allowed to delegate their investment authority and have external investment advisors purchase and sell securities on their behalf. This type of arrangement is permitted as long as the bank’s management maintains responsibility for, oversight over, and understanding of the third-party advisor’s investment activities, according to the FDIC. But before delegating investment authority to a third party, “management should thoroughly evaluate the third party’s reputation, performance, creditworthiness, and regulatory background,” outlines the FDIC’s Division of Supervision and Consumer Protection Risk Management Manual of Examination Policies.
Denali State Bank is faring well with its investment portfolio, according to Lundgren. The current yields are low because interest rates have fallen significantly. “We’re fortunate our existing investment portfolio that we have on the books is yielding much more than if we were to buy an investment in today’s market,” he says. “However, the lower yields are a temporary side effect of what is happening in the markets. Nothing lasts forever in the financial world.”
Having a strong investment portfolio and balance sheet is especially important during times of uncertainty, according to Ballard. “Alaskan banks have relatively strong balance sheets with good liquidity levels and capital ratios, which is critical as our economic environment is stressed by the current uncertainty,” he says.
He adds: “Northrim is a strong financial institution. It is important for us to help our customers get through this extraordinary time and then to thrive once this is behind us.”