Portfolio Management in a New Era

Bank balance sheets have changed significantly over the last few years, largely as a result of events surrounding the recent financial crisis. Insured deposit balances increased by $2 trillion (25.0%) in 2011, while loan balances fell slightly by $0.2 trillion (2.5%). New regulations have also introduced several complications into the investment management process. As an example, the implementation of Basel III by U.S. banks will require gains and losses from investments to be reflected in regulatory capital, thus introducing significant exposure to rising rates. In addition, the Dodd-Frank Act (DFA) directs banks to end their dependence on rating agencies on determining whether or not a security is investment grade. This will clearly require more sophisticated internal analysis.
Given the excess liquidity in the banking system, the historically low level of interest rates, and the evolving regulatory environment, it is clear the investment portfolio    management process has become a much more complicated and burdensome for financial institutions of all sizes and complexity.

Changes in the Regulatory Environment

Financial institutions should have a keen awareness of the impact of existing legislation and proposed legislation under Basel III and the DFA:

  1. The DFA stipulates banks can no longer rely exclusively on rating agencies when investing in credit related products. While banks can include the ratings as part of their review, they must also develop their own internal analysis utilizing a variety of data sources to determine the credit quality of their investment purchases. This will require significantly more time, effort and sophistication from those involved in the portfolio process. In many cases banks may need to subscribe to financial data vendor service companies (Bloomberg, IDC, Intex, etc.) at significant additional costs.
  2. U.S. regulators recently announced a joint interagency proposal altering the measurement of risk-weighted assets for regulatory capital calculations under Basel III. This applies to all U.S. banks regardless of their asset size and is scheduled to be fully implemented by January 2015. These new calculations will significantly alter the capital requirements for credit-sensitive instruments such as Non-Agency RMBS, CMBS, ABS, corporate bonds, and municipal securities. It is important to note that this is not necessarily all bad news – Angel Oak believes that these changes are creating opportunities for institutions willing to pursue new ideas. For example, the newly proposed risk-weighted asset calculations for structured financial instruments takes into account:
    • The instrument’s seniority in the capital structure
    • Historical delinquencies and cumulative losses in relation to credit support
    • Underlying collateral characteristics

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