Analysis of bank securities portfolios

First, here are some definitions. From an accounting point of view, banks and other corporations classify securities they own into one of three categories:

Trading: Securities that are bought and held principally for the purpose of selling in the near term.

Held to maturity (HTM): Debt securities that the firm has the positive intent and ability to hold until maturity.

Available for sale (AFS): A catch-all for debt and equity securities not captured by either of the above definitions. These are securities that the bank may retain for long periods but that may also be sold.

The chart below shows a breakdown of bank debt and equity securities portfolios into these three categories. The size of each portfolio is scaled by the total assets of the commercial banking system.

• ■    Heki to maturity Available for sale

• ■    Trading securities assets

• ■    T Fading bawdy for short securities positions

Percent of total assets

As the chart shows, the prominence of securities in bank balance sheets isn’t a recent phenomenon – it has been a feature of the U.S. banking system for at least the last two decades. Also evident is an increase in debt and equity securities held for trading purposes in the period after the repeal of the Glass-Steagall Act in 1999. This upward trend has partially reversed since the financial crisis: trading securities declined from 9.1% of total assets in the second quarter of 2007 to 7.2% today. Before going further, let’s step back to consider a few reasons why banking firms choose to own securities in addition to or instead of loans.

• 1.    Banks may face an imbalance between their access to deposit finance or other low-cost funding and their profitable lending opportunities. This could be the result of geographic factors, shocks to credit demand or to deposits, or other factors. In such cases, funding-rich banks may choose to invest in securities that reflect lending by other banks or by nonbank lenders (e.g., mortgage-backed securities issued by another lender), or direct debt issuance by nonfinancial firms (e.g., corporate bonds).

• 2.    Relatedly, a bank concerned about liquidity risk may be attracted to securities because of their liquidity; that is, they can be sold more easily and with lower price impact than loans, for which the secondary market is less active. Liquidity concerns may also be driven by regulation—going forward, the liquidity coverage ratio developed as part of the Basel III Capital Accord requires banks to hold enough high-quality liquid assets to meet their liquidity needs under a thirtyday liquidity stress scenario.

• 3.    From a risk management point of view, holding securities may help the bank diversify or mitigate its risk exposures. Conversely, adjusting securities holdings can provide a straightforward way for banks to ramp up their level of risk in an effort to increase expected returns. For example, recent research argues that banks respond to expansionary monetary policy by lengthening the maturity of their securities portfolios, in an effort to boost yields.

• 4.    Holding securities portfolios may help the banking firm perform other financial services . For example, broker-dealers maintain an inventory of securities to allow them to act as market makers, matching buyers and sellers in financial markets and providing liquidity to those markets.

• 5.    In some cases, holding securities instead of loans may be partially or mainly motivated by regulatory arbitrage – helping the firm reduce its capital requirements or provide other types of regulatory relief, perhaps without substantially reducing the overall risk to the firm.

Bank holdings naturally reflect the relative size of different securities markets. For example, bank ownership of non-agency MBS (mortgage bonds issued by private financial institutions rather than the GSEs) increased significantly between 2000 and 2007, alongside the rapid growth in the overall non-agency market, particularly in subprime. Non-agency residential securitization has been low since the financial crisis; correspondingly, bank holdings have shrunk, as the loans underlying old non-agency MBS have defaulted or paid down.

Finally, a notable recent market trend is the shift in bank portfolios toward

HTM securities, which although still small, have more than doubled in size as a percentage of banking system assets over the past several years. What explains this trend? A key difference between HTM and AFS is the accounting treatment of gains and losses. As noted in a number of media reports (see one article here), gains and losses in the value of HTM securities that result from movements in market prices (e.g., interest rates) aren’t recognized unless the asset is sold. For AFS securities, however, such shifts in value, while not affecting accounting income, do affect the measurement of regulatory capital adequacy for large banks under the Basel III framework (for so-called “advanced approaches” firms).

Correspondingly, increasing the fraction of securities classified as HTM has the capacity to reduce the volatility of regulatory capital ratios but will limit banks’ ability to sell those securities in the future.