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BÛÜD POiem>LIOS— M3NICIFAL SSCUHIflSS Raymond S* Hengren, Assistant Chief Division of Research aad Statistics Federal Deposit Insurance Corporation Conference of Baak Baoaiaers sad Assistants Fourth Federal Deposit Insurance District Richmond, Virginia «hm 10, 1957 Bond Itartfolios--Municipal Securities The objectives for this portion of your program which Is devoted to hood portfolios with special reference to municipal securities are, as 1 see It, threefold* In the first place, there will be a brief discussion of the statistics concerning bank investments in municipals. In this discussion you will be furnished a frame of reference for evaluating the position of your District in the national picture* Also, the distrletwlde data will be broken down by State so that you will have ease landmarks for identifying more particularly the situation in the various areas where you may be working. Secondly, It Is ay intention to consider end discuss at some length a few specific questions concerning bank investment progrès» and the analysis of securities for the purpose of ascertaining credit quality* The purpose of this discussion will be to develop some viewpoints that may be helpful to you la the preparation of comments for page 2 of the examination report form* It is ay feeling that the effectiveness of this part of the report can be definitely increased* finally, some of you may have questions in this area that deserve detailed consideration* It is ay hope that you will present these questions for our consideration« Your participation by means of questions will help to make this part of the program practical* flflff I factual Background of Bank Investments In this discussion our attention will center entirely on the postwar period* That now covers more than a decade and for all practical purposes the situation in the 1930fs and during the war period can only be •2 o f «cateBle interest* So iter as you are concerned* the recent trends are the important com* Of these you should be familiar so that you may Judge the position of a bamir under t Over the period between 19k6 and 1956 total assets of the insured commercial banks increased from approximately $191 billion to $20k billion* As regards investments* however* the notable development in the postwar period has been the overall shrinkage in the holdings of Halted States Government bpqdf and the rise in the municipal segment of the investment portfolios* To bo sure* the magnitudes are of a very different order* The Federal portfolio declined from about $83 billion to $56 billion* whereas the municipal portfolio increased fro® about $4 billion to $13 billion* Admittedly* the dollar mount of *¡»****»0* in municipal holdings is not great as compared with the various components in i he asset structure of the banking business* Nevertheless* the rapidity of the Increase in bank holdings of these credits has presented examiners with a variety of problems that are quite perplexing* More banks now hold municipal bonds than ever before and the individual portfolios tend to be larger* Nationwide Trends in Beak Holdings of Municipals All insured commercial banks held 6.2 percent of their total assets in the form of municipals in 1956 as compared with 2.6 percent in 19^6* For banks in the Fourth district* however* the figures were $.7 percent and 1*9 percent* respectively* Thus* in both years municipal holdings by Fourth district banks ranged below the nationwide averages* Nevertheless* the 31*t percent increase in the amount of municipal holdings -3 over the decade compares with the 320 percent average increase for the nation aa a whole. Although the Insured coraaercial banks of the fourth District evidenced a rate of growth in the municipal segment of their assets that was definitely on the high side of average over the I9H6-1956 period, the fact remains that the dollar amount of municipals at the end of the period is not great* As a matter of fast, the aggregate holdings in eight of the twelve Districts exceeded the $632 million of municipals held by the fourth District beaks* Sowever, the figures show dearly that the municipal portfolios held by the bad» in the fourth District ere an important part of bank assets* The nature of the area is such that the items in this segaent of bank assets present difficulties that are somewhat harder to cope with than in other regions where the else of the investment may be greater* Trends In the fourth District When world War XX came to a close insured commercial banks in the Fourth District held shout $3*8 billion of United States Government obligations in their portfolios and obligations of States and subdivisions totaled shoot $131 million. Ten years later the holdings of Halted States Government Obligations had declined almost a billion dollars or about 26 percent* But the municipal segment of Investment portfolios bed increased almost four timss to approximately $600 million. The growth in the municipal portfolio mere then kept pace with the substantial increase of total assets from $6*9 billion to $9*5 billion over the period* •k ■m For til» Stato« vitóte the Fourth Mitriet during the 19*16*1956 period, «on» interesting developaaents have occurred with reference to the municipal holdings of the insured eoasaercial heats* Througiaoût the period the Borih Caroline hanks continued at the head of the list in terns of the relative importance of municipals in the asset structure* In 1 these teaks invested 3*9 percent of their asseti in Municipals as coopered with 8*3 percent at the close of the decade« Other States in the Matrici, however, experienced a such sore rapid Visage la the relative importance of Municipal holdings« For example, in Maryland six-tenths of 1 percent of total assets were committed to municipals la 19*rê as compared with %B percent in 1956. For liest Virginia» the corresponding percentages were 1.8 sad b«9, respectively, and for Virginia 1«9 percent and 5*3 pereaatj and for South Carolina 3*0 percent and T*0 percent. The insured commercial banks ia Borth Carolina have always been large holders of municipals. This State ied the fourth Matrici both la 19H6 and 1956« As a matter of feet, ia the latter year the municipal holdings in Berth Carolina accounted for a third of the districtwide total. However, the municipal portfolios in Maryland increased twelvefold from about (10 million ia to (131 «tilica ia 1956« Thus, within the Fourth District the figures reveal that the rate of growth ia municipal portfolios has varied substantially fro® Stats to State« Banks ia Berth Carolina continue to be large holders of these obligations« Althou# the totsl volume for the Matrici does not stand out conspicuously whan compared with other ports of the country, the fact renal,ns that the municipal holdings are large enough to demand careful review by the examiner« •5 * PART n Key Questions for Portfolio «ad aggiriti#» Analysis As bank examiners, it seems to me that your work with the municipal sequent of the investment portfolio can host ho brought to sharp focus in the comments on page 2 of the examination report. So« there is as opportunity to verbalise the results of your review and analysis» Moreover, this is the part of the report that is most likely to he studied carefully by the officers sad directors of the bank* It is a fact that the steps to he taken in analysing an investaant program and .judging the credit quality of individual securities are quite complicated. Frequently the analytical process involves sene rather detailed computations. Unless the results can he expressed in sinopie straightforward language, all of your work nay eons to nought* When it is so expressed, the page 2 consent is the appropriate channel for communicating your findings to the banka» While I do not pretend to have read a great »say examination reports prepared in the fourth District, some of them have passed through ay hands* By larga, 1 know that examinara mate a effort to use the eoamente on page 2 as an effective tool of bsnk supervision, there are times whan the paragraphs devoted to the investment program and securities are exceptionally good» However, it is my hope that acme discussion of provocative questions to he covered by these comments will enable you as individual examiners to Improve the quality of your reports» *6 * Inveetaent Policy Broadly speaking, an examinar should carry te© test« in «jad when he le eeeeeelng the condition of a bank generally or of any segment of Ite asset structure. Zn the flrst place, he should fuestioa the quality of the aseste* The only approprlate ecraaitment for the rteoureee of a bank ere aseste that aeasure up to high quailtative standard»• Such aseste próvida an slewmt of etdhlllty that vlll en&ble the bank to avoid lome* Unlike most other types of enterprlee, largs and uapredietable loases eam ot be readily absorbed by the capltallsatlon of banke* de a second Important test of a fesnk#e condition, the examinar should alvays be alert to the provielesie vith respect to liqpildlty* gvea aere than la other types of enterprlse, a bank*» positioa boconee untenable if It dees not have en asset strueture whlch aseures the eash flow neseesary to coodnct ite busInese vith a »ergio of protection that vill próvida the necessary s&feguards againat unpredictable misfortuaes. Sov vith these teste In mlnd— quality of aseste and liquídity~~let ue tura more specifically to a eonelderatlon of soma questions to be asksd by the examinar vhsn he revises the bank9s municipal portfolio. These questlone vould be efually appropriate if levelled at eay other eegment of the asset structure* Section H of the exealnatioa report nov has a question vith respect to the Inveatoent policy statemaat of the bank uader sxeminatlon. Wben the exawlner flnde that a bank doee not base a satisfactory policy, it mas to me that the eltuatlon vould cali for a rather detallad corament on pega 2 of the report* Zn thle ccsament the «nMmHvwi» eould próvida e helpfui suggestione and give soma encouragemeni for a reasdlal effort* The hoped for result of a det&iled coment m a bsnk*s investment pelicy eould be to eneoursvge some coastructive thinking by ti» bsnk#s officere and dlreetors* Ovtr ti» eouree of successive exaalnatloaas it msy ìm possible for thè exaaiiner to direct bis page 2 cowieats at variai» festures of an investment program« This aay suceeed in atlaulating ti» èsvelopaent of a vell-rounded and satisfaetosy policy. Questiona far Siscuaaion . '/ . ..>....... .. 5 ./%i;-,4-ampI ' r >t ?r :Sfi&ijfe 1. Xa a formai polle? statement esseatialt 2* What should be thè scope of thè esaminerà em am t regarding investment policyt Site «he» yoa revias' a teak1! commitmeat in snnieipal securitie#f inevitably thè question arisesi X# thè »ine of this portfolio appropriate for thè bank under examinationt Tibia la an «speciali? knotty problem beeauae It la caacerned vith a deteiadnation that eannot be quantified in sny entirely aatl«factory aaiaier« T rm tlsie to tias thè eanesnta en page a suggeat that thè baak hm eooadtted an uaduly larga portlon of ita fonda to «unicipal aeeurttlos. points of referenee are aeedsd for judging thè aiae of ti» portfolio* CmmmXy aocepted far theae «eaauremeata are perceatages representing thè average aiaount of bank asseta committed to aunlelpals for all banfce in thè Itoited States or acme subdivision sud* aa a geograpbioal «rea or type of bank* Cemparisons baaed open theae percentages are useful beeauae thay do indicate departures Anni nomai behavior pattems« In «y opinion, hocever, » 8» a coment that merely calls attention to such a departure is inadequate. Mach more detailed analysis is needed to support a jud^aent as to whether the departure is sound or unsound« Questions for Discussion 1* Is a big portfolio ipso facto good or badf 2« What is the importance of balance in the asset structure of a Me! Maturity SistributiCBi Earlier in this discussion you will recall that stress was placed upon the importance of Quality and liquidity in the asset structure of a bank, the facilities for converting the municipal segment of a bank9* investment portfolio into cash by sale in the market place are poorly developed. Banks should be reminded again and again that as a practical matter the schedule of msturitlea in the portfolio is the only dependable source of cash inflow. Sound investment practices call for a maturity pattern that is consistent with the anticipated cash requirements. Up to now no one has suggested a better plan for arranging the maturities of a municipal portfolio than the simple $-to*7*year rollover program that t m certain is fbmiliar to all of you. She proceeds f*om each year’s maturities can then be reinvested car used for other purposes, depending upon the situation confronting the bank. lot only does this rollover program provide a measure of Independence from the market pince» but it also enables the bank to achieve a rate of return on its municipal investments that reflects the averegi yields available is the market over a period of years* This mechanical arrangement prevents banks from embarking osa speculations over interest rate trends in the money market. Questions fer Discussion 1« áre tlie banks you examine customarily following a rollover program? 2. What are the characteristics of the rollover programs that cone to year attention? Concentrations In studying the municipal holdings of a bank the examiner is always confronted with the question: Do se bave here a concentration that amounts to a serious credit exposure? What criteria may be employed in identifying these concentrations? These may «seist in terms of individual Issuers of securities# geographical areas# and types of obligations. However# concentrations may also exist in other forma. Questions for Discussion 1. Is a concentration always an undesirable feature of en investment portfolio? 2. Sow can balance in the aseet structure offset the effects of certain types of concentrations? Harket Depreciation according to the m a rn i of Sxsadnaticn Policies, the examiner is expected to estimate the markst value of securities la the portfolio cf the bank under examination. Price quotations for federal obligations are always easy to obtain. This also is true for the corporate securities * 10 - traded actively on the organised exchange*« So«ever, it i* wry difficult to obtain market quotations for a great may municipal obligations« When reliable price quotations are not readily available, the examiner has the option to substitute book values in his amputation of the market value of the investment portfolio« But that option is limited to situations wherein the bank is not relying substantially upon the marketability of it« investment holdings for liquidity purposes« In such a case the »**»<«•* has no alternative but to make his best estimates of the isarket value of each itm in the investment portfolio. the Increase in the general level of interest rates has brought about sharp decline* in market price* for outstanding issue* of securities. These price declines are aot a reflection of changes in credit qaality. nevertheless, far banks that axe obliged to rely upon eecuritie* a* a source of eeyh to meet a Shrinkage of deposit* or demands fa r new loans, and that have an inappropriate maturity distribution, the decline in market value below the level of book figures can be serious* Questions for Discussion Xm Is it necessary to comment on market depreciation in every case where it is noted! 2« What constructive suggestions can the examiner incorporate in his page 2 com m it when he finds a substantial amount of market depreciation! Valuation Reserves Owing to tax considerations the valuation reserves available to protect assets have grown substantially in recent years* 9!o be sure, £ -U tbese reserves heve aceumul&ted noainally te ábsorb loases in the loan account» But a reserve, irrespective of the reason for vhich it ans established, can be used to absorb a losa wherever it oeeurs» originally Valuation reserves can be very helpful to àbsefb tha ahrinkaga in the market value of thè investment portfolio vhen a bank is obligad to liquidate securities at priées belov book values» Questions far Discussion 1* What can the examiner do te encourage the development of a valuation reserve program as a safeguard against market fluctuations for securltiesf 2» At vhat rate should valuation reserves be aceumul&ted? fuming noe frcm our considération of bank investment policías generali?, let us revise briefly a fev of the mitral questions that the examiner cibi use effectively in deteralning thè quality of spécifie crédits» Adecúate Credit files Credit files with sufficìent information to discleee the qpallty of securities in a bank's investment portfolio are alvsys recegnised ss essentiel» Rotvlthstsndliig this faet, occasionali^ an examiner vili eacounter a situation ubere the obligations of ecwparntively unkncwa issuers hâve berne acquired fer investment purposes* fhe bank vili net hâve pertinent credit informaren nor vili lt be abla te peint te the existence of such data in satisfactory feo* elseuhertj fer exemple, in the Ules of a correspondent bsnk or, for that mattar, aven in the hands ef security C . 12 dealers* be sure, the baak management amar eatertaia some beüef that it understands the crédits It bas assembled la lis investment portfolio# bat it msy net b* sble te mske s very eonvincing démonstration of this knowledge. Questions for insensate» 1, What should thè examiner do vhm he find* poca? ©redit files! 2. Is an examiner Justifie* la classifying a security es unsulted for baak investment vhen information 1s lackiag! Mechanical feste of Crédit QuaUty In deteradnlag the crédit guality of the Municipal issues, the basi© question t© be aassered ©an be phrased la very simple terne* Mlll the lesuer be able to service thè debt according te Ite terme sud at the Pi»«» time provide a suffieient sargia of protection se that bond holders aay coasider themselves meli protected agalnst thè posslbtUty of default either as to principal or latersst psymentsî Praotical dlfficultles aris© the examiner sets eut t© sasver this question la spécifie instances* la order to finish hls Job la a reasonable leagth of Urne the examiner 1s dispose* to look for some readily applicable mechanical tests to detonala© the l&vestmsnt quality of issues la the baak portfolio, fhls opens up the vhole question of the appropriateness of fiaancial ratios for Judging credit quality* Every competent student of ©redit analysis sili agréé that ¿inondai iitUs are valuable tools la work* As indicatori of sound or unsound conditions thoy «sy be helplbl in forming a Judgssat. But - 13 U mime rather clear that the beart ©f th© anatytieal proeoaa 1« the judgænt rather than the maaipulatiaa of arithmetical computations. Om eamcft m pb&slze too atroagîy that it la a Mstak© t© attenpt te classifÿ seeuritiee an the baais ©f a rati© or a set of rati©#* «her© wiU al^s be exceptions to aay tests that ©an be applied æ chanically» Question© for Piseuasion X* «hat are the points ©f referme t© be used in apptying debt barde© masures such as the ratio of debt t© aaaeeeed mine and the per eaplta debt? 2, Can the examiner use debt burden masures effeetivety in hlo page 2 camsntat fypea of Municipal Issues Xa the ©oarae ©f hia work the baak examiner la likely t© find a groving rnriety ©f municipal iaauea la the portfolioa e t banks unaer exszaination. fhe pressures for seeded public faeüities are cauaing governmentaX subdivisions t© adopt aaany oev finaaci&l plana and aehfims* Base et the noml plana are quit© Sound bat others show little promise of eurvlving hard «ma* ite©©rdiagty# the «»aœiaer «uat atuty mrefbüy the types ©f municipal eeeurltiea be finda la the portfolio. ïhia ©alla for a considération of facta that exteods beyood the identification ©f the neae of the oblige»1» What should the exaaiaer#a attitude be vith regard to the type ©f oblige«©» foaxkd in the bank's municipal porifoliof Should general obligations vhich carry the pledge ©f the full faith end ©redit ©f the Istftiar Imi given sane preferences! Ar« obligations arising out of business type activities such as sever and eater utility' revenue bonds of lover standing than general obligations floated by the sane coessunityf Hoe about these hybrid issues which combine sons of the characteristics of general obligations as well as revenue issues?
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