Security Investment: The Emergence of Security Investment

Security Investment

Security investment means investing in financial instruments that hold value in the economy, are legally backed by a financial institution or business, and can be traded between parties.

The emergence of Security Investment

This attitude of the commercial banks started changing during World War I. Because of the need for a huge quantity of war goods, accessories, and building specialized infrastructure, Governments involved in war required substantial public debt.

Self-liquidating commercial loans were the proper outlet for monetary reasons and the safest asset for practical reasons.

On the other hand, demand for usual commercial and industrial goods came down for reasons of war, leaving a conspicuous amount of surplus funds at the disposal of commercial banks.

This was how the huge need for public debt on the one side and the availability of a substantial amount of unused funds at the commercial banks level encouraged the latter to begin to buy a secure investment from the government.

Moreover, a new dimension came into the commercial banking theory towards the liquidity concept achieved by shift ability. A ‘shiftable’ asset was, in effect, a readily salable asset.

Since security was obviously more salable than loans, this concept suggested that investment in stocks and securities was considered better bank assets than other term assets that were not easily convertible.

During World War II, the same phenomenon also forced commercial Bank’s resort to public security investments for reasons of reduced need for corporate loans.

Corporate securities then almost disappeared from the commercial banking portfolio. Instead, corporate bonds came to replace those.

After World War II, commercial banks in the USA started dealing in two principal types of security, both sponsored either by the Federal Government or by the State or Local Governments.

Whatever the reasons that motivated the commercial banks to start security investments, the proportion of their total usable resources of them in the normal period was consistent with being heavier to the side of avenues other than security investments.

But some regulatory compulsions and the need for diversification of risks made almost all the commercial banks around the globe invest a proportion of their usable resources in security investments.

Approved Securities for Bank Investment

Investment is the process by which banks can increase profit and maximize the shareholder’s wealth.

As a profit-oriented organization, banks earn profit and maximize the shareholder’s wealth by investing their funds effectively and efficiently. Government and bank regulatory authorities strictly discourage investment by banks in unapproved securities.

The approved securities of banks are:

  1. Money market securities.
  2. Capital market securities.

In the USA, there are usually four main types of eligible investment. These are;

  1. Treasury obligations,
  2. Agencies,
  3. Municipals, and
  4. Corporates,

A short illustration of these security instruments is provided below:

  1. Treasury Obligations:
    1. 3-month bills
    2. 6-month bills
    3. 12-month bills, and
    4. Tax-anticipations bills
  2. Agencies:
    1. Federal Agencies
      1. Securities of the bank of Cooperatives
      2. Securities of the Federal Home Loan Banks
      3. Securities of the Federal Intermediate Credit Balance
      4. Securities of the Federal Land Bank
      5. Securities of National Mortgage Association
      6. Securities of Federal Home Loan Mortgage Corporation
      7. Securities of Student Loan Marketing Association
      8. Securities of US Postal Service
    2. Federal Agencies With Outstanding Obligations:
      1. Federal Housing Administration.
      2. Government National Mortgage Association
      3. Columbia District Armory Board
      4. The Export-Import Bank of the USA
      5. The Farmers Home Administration
      6. The General Services Administration
      7. The Maritime Administration
      8. Small Business Administration
      9. The Tennessee Valley Authority
      10. The Washington Metropolitan Area Transit Authority
      11. The Department of Housing and Urban Development
    3. International Agencies:
      1. Securities of the IBRD.
      2. Securities of the Inter-American Development Bank
      3. The Asian Development Bank
  3. Municipals:
    a. General obligation Bond, and
    b. Revenue Bonds 
    • Typical sources of repayment of these bonds include:
      • User charges on utilities.
      • Tolls, commission, and fees
      • Special taxes, and
      • Rental payments.
  4. Corporates: The usual modes of corporate securities are:
    1. Shares/Stocks
    2. Debentures
    3. Equipment Trust Certificates
    4. Certificates of Deposits
    5. Repurchase Agreements
    6. Commercial paper
    7. Bankers Acceptances
    8. Foreign Short-Term Investments

Although corporate bonds carry the top four quality ratings, eligible bank investment, the bank usually shows little interest in buying these instruments because of their considerations:

  1. yield,
  2. marketability, and
  3. maturity.

Because the after-tax yield on corporates is ordinarily below the yield on municipals of similar quality, the bank obviously prefers to invest in the latter.

In addition, corporates are sometimes difficult to liquidate in volume, especially in a declining market. Finally, because most corporate issues have long-term maturities, they involve more credit and money risk.

Advantages & Disadvantages of Approved Securities

Every security has its own advantages and disadvantages. The bank investment officer should select one or more security by considering these advantages and disadvantages.

Suppose the investment officer knows the advantages and disadvantages of each instrument while selecting the amount and maturity.

In that case, it will be easy for them to pick the appropriate security for investment with the available fund.

In the following section, we will discuss the advantages and disadvantages of approved securities:

Money Market Instruments

SecurityAdvantageDisadvantage
Treasury bill– High Quality
– Fully Secured
– Easily convertible
– Acceptable as security of the loan
– Acceptable as an alternative to cash reserve
Lower rate of earning
Short-term treasury notes and bonds– Always resealable
– Fully Secured
– Acceptable as security of the loan
– Yield is higher than T-Bills
Price risk is higher than T- bill.
Government bondModerately resalable
Fully Secured
Yield is higher than T-Bills
Less marketable compared to T- bills
Certificate of depositComparatively, CDs of smaller amounts are insured
Yield is higher than T-Bills
CDs with larger denomination is not easily marketable
Euro-dollarsLess risky
Yield is higher than CDs
Market price/interest rates are sensitive
Banker’s acceptancesLess risky with multiple certaintiesLimited supply for a specific period
Commercial securitiesLess risky for the creditworthy borrowerThe market is susceptible
Limited marketability
The short-term municipal bondTax-free interest incomeLimited marketability

Capital Market Instruments

SecurityAdvantageDisadvantage
Treasury Notes & Bonds– Fully Secured
– Easily resalable
– Accepted as security of the loan
– Accepted as an alternative to cash reserve
– Relatively less yield compared to long-term corporate securities
Local govt and municipal Bond– Tax-free interest income
– Repayability is higher
– Selected securities are easily marketable.
– The market is susceptible.
– Limited marketability of some specific securities
Notes and Bonds of govt, agencies– Before-tax interest income is higher than Govt securities.– Limited marketability
– Rigid conditions
Securities based on the mortgaged property– Before-tax interest income is higher than treasury notes.
Secured
– Highly acceptable as security of the loan
– Highly resalable
– Relatively less marketable than T-notes
– Price is more unstable than T-notes
– Maturity is uncertain

Mathematical Approaches to Security Selection

Many researchers, however, are trying to develop investment selection techniques that will make this aspect of a bank work on mathematical models to solve portfolio construction problems.

The models developed to this time are of two basic types: those using estimates of future return and risk measures (variance in past income) to produce an efficient portfolio and those using a linear programming approach. The efficient portfolio approach is based largely on the work of Markowitz.

Using linear programming techniques, the alternative approach is perhaps more difficult to conceptualize but is ultimately more promising. The linear programming models provide exciting results.

They provide a recommended optimal portfolio and can also be used to indicate the value to the bank of any additional deposits that might be attracted (or the profits foregone by not attracting additional deposits).

Such an analysis might be highly relevant to a bank considering the use of CDs for the first time. A major weakness of this type of model in its presence is its failure to consider the individual bank’s willingness to accept risk in return for higher earnings.

Nevertheless, this type of mathematical approach is certain to increase in importance, particularly since the mechanics of the technique are highly suitable for the solution on electronic computer equipment.

This is one more aspect in which the bank executive should be familiar with the current and proposed development.

Grading / Rating Of Investable Securities

Government/Bank regulatory authority instructs to make investments in high-standard securities. The more the profitability, the more the liquidity of invested funds will be.

We have mentioned earlier that there are two private organizations in the USA that rate security for the convenience of investors. They are:

  1. Standard and Poor’s Corporation
  2. Moody’s Investors Services

It is admissible that defining the grading of investible securities is a very tough task because investment activities are not established based on unalterable scientific information.

There remains the huge possibility of uncertainty, the inadequacy of information, and speculation. The grading of the investable securities may change due to the change in the issuer’s financial position and issuance amount.

Investor banks prefer securities regularly traded in the market or easily liquidated when necessary, with minimal loss. The grading of security changes from time to time based on demand and supply.

So. bunking specialist Mr. Edward. W Reed opined, “Quality is to a great extent relative.”

It should be mentioned here that the individual and institutional investors of the USA keep faith in the valuation and grading performed by the two above-mentioned companies.

Even bank regulatory authorities and government also have faith in the security analysis carried out by them. It should be remembered that banks with a grading below the first four levels are not considered investible.