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November 18, 1957




Raymond E. Hengren, Assistant Chief
Division of Research and Statistics
Federal Deposit Insurance Corporation

Conference of Examiners and Assistant Examiners
Tenth Federal Deposit Insurance District
Kansas City, Missouri
November 18, 1957


In this portion of the program which is devoted to bank
investments, with special reference to the municipal segment of the
portfolio, tiie objective will be to outline the subject matter from the
viewpoint of bank examiners and to discuss at some length the bank
investment problems characteristic of your District,

To launch this

discussion, my remarks first will furnish some background data on
developments in this part of bank asset structure since the end of World
War II,

This presentation will be followed by a brief consideration of

statistics pertaining specifically to the investment holdings of Tenth
District banks,
A review of bank investment policy as regards municipal
securities and the procedures for testing the credit quality of individual
securities will constitute the backbone of this discussion.

By following

this course, it is ay hope that we shall stimulate inquiries about subject
matter directly relevant to your work.

In the field of municipal finance

changes are now taking place rapidly.

Certainly it is time for us to take

stock of the current situation.

It may very well be that steps can be

taken both in this District and in the Washington Office that would be of
help to you in working with bank portfolios,

Growth and Shifts in Bank Investments
National and Tenth District Trends
Attention will be centered entirely on the post war period in
this discussion.

For all practical purposes the situation in the thirties

and during the war can only be of academic interest to you.

the post war

period now covers more than a decade and, so far as you are concerned, the
recent trends are the important ones.

These should be familiar to you so

that you can better Judge the position of an individual bank under
Over the post war period the notable development in bank
investments was a substantial shrinkage in holdings of United States
Government obligations and an extremely rapid increase in municipal

The total assets of the insured commercial banks increased

from approximately $150 billion to $200 billion •
Federal obligations declined from approximately

Nevertheless, holdings of


billion to



while the municipal portfolios expanded from about $4 billion to $14 billion.
Measured in terms of dollar amounts, the decline in Federal
obligations completely overshadows the growth in the municipals.

But from

the point of view of the bank examiner, the rapid Increase in municipal
holdings presents a new complication in a situation that is already

First of all, it is necessary to come to grips with the

investment policy questions that are incidental to the shift of funds from
Federal to municipal obligations.

Certainly more troublesome in terms of

work volume than policy questions are the determinations with regard to
credit quality for the great number of Individual issues of municipal
securities held by banks.

The accuracy of these determinations is

especially important in times such as the present when the economy appears
to be balanced at a high level of business activity.

- 3 Following a number of years of very rapid growth, there was
little expansion in municipal portfolios held by the insured commercial
banks during the calendar year 1956.

However, the banking statistics

tabulated for June 195? suggest that the growth trend has once again
reasserted itself,

ibis is not surprising in view of the high volume of

municipal offerings and the sharp readjustment upward In the interest
coupons of these securities.

Moreover, the prospects for growth in the

volume of municipal offerings suggests that the banks will be called upon
to absorb an increasing volume of these securities.

Accordingly, any lull

in the expansion of municipal portfolios should be viewed as an interlude
in a long-term upward trend*

From the viewpoint of the bank examiner, it

should be seized as an opportunity to encourage banks to strengthen their
municipal investment accounts.

19*4-6 the



Tenth District Insured commercial banks held

million of municipal obligations as compared with

$600 million reported for June 1957.

Municipal portfolios expanded

substantially in all of the Districts over this period but the rate of
growth here was among the most rapid for any of the Districts in the United

Belative to total assets, these banks had invested 2.9 percent in

municipals in 19*46 as compared with 7.5 percent in 1957•
Using the statistics on the growth of municipal portfolios as a
measure of work volume, the figures show clearly that examiners of State
nonmember banks have a much bigger job today than years ago in handling
this segment of bank assets*
Increased from about


percent and


Between 19**6 and 195?# these portfolios

million to

8 .*f percent,


million and the totals amounted to

respectively, of bank assets.


k -

Municipal holdings increased over the period in all of the States
comprising this District*

Kansas now stands out as & State whose banks

hold in the aggregate the largest volume of municipals.

and relative terras the expansion has been noteworthy*

Both in absolute
At the beginning of

the period the portfolios in this State amounted to approximately


billion, or




billion and

percent of total assets, as compared with recent totals

12 .1

percent, respectively.

The State-to-St&te variation in the size and growth rate of the
municipal segpaent of bank investments in this District suggests that the
problem here, as elsewhere, tends to be guite local la character.
Examiners in some areas have a sizable task when they come to the municipal
segment of the asset structure of the bank under examination.

In other

areas the Job is not large and there is little variation from year to year,
or for -that matter, even from decade to decade.

Key Questions for Portfolio and Securities Analysis
Investment Policies
Bond Portfolios
The skill with which management allocates funds to the various
segsents of the asset structure is a major factor in shaping the strength
and earning power of a bank.

To be sure, in many cases these allocations

are the result of drift rather than conscious decision.

Moreover, there are

times when management can exercise virtually no control over the

But mostly these are exceptional situations and should be

recognised as such.

- 5 When the examiner considers & bank’s holdings of securities, his
questions first should cluster about the reasonableness of the allocation
of funds to this type of commitment.

In a well managed bank there will be

recognised guides for answering the important questions that arise in
channeling funds into or away from the investment account.

Since the

ultimate objective of the examiner is to form a sound judgment concerning
the quality of management, he should be alert to evidence that a hank has
created the machinery that raises the pertinent investment questions
automatically and produces good answers.
Probably the most important questions about the investment
accounts of a bank under examination are brought to focus with inquiries
regarding the composition and size of the bond portfolio.

Owing to their

unique characteristics, the examiner first should look carefully at the
holdings of Federal obligations.

The proper selection of these issues will

build elements of strength into the asset structure of a bank that can be
achieved in no other way.

Other items in the portfolio composition,

Federal agency obligations, the securities of States and their subdivisions,
and the bonds of private enterprise, when combined in proper balance,
furnish earning power and stability to the bank’s asset structure.
Since the examiner’s approach to his work is essentially
quantitative, it is inevitable that he will ask questions such as these:
Has this bank committed a reasonable amount of its assets to the investment
portfolio? and has the total been properly distributed over the various
alternative investment opportunities?

Most commonly the size of the

portfolio is judged in relative terms, as a percentage of the total assets




invested in securities generally, or some category of bonds*

There is a

tendency to compare these ratios from bank to bank, or to compare the
ratios of en Individual bank with the averages for all others of its type,
e, g, national, State member of the Federal Beserve, or State nonmember
aggregated on a geographical basis*

To be sure, these comparisons are

helpful, but departures from the average in an individual case should be
explained before they are condemned.
Since our primary concern now is with the municipal segment of
bank investments, some attention should be given to the reasons why banks
buy these securities*

Many times an understanding of these reasons will go

a long way towards accounting for features of a portfolio that otherwise
might appear to be objectionable*

Because of local situations occasionally

banks may be obliged to depart from what otherwise would be considered
sound investment principles in managing their holding^ of municipal
To illustrates

A relatively large commitment by a bank in the

obligations of a governmental subdivision, that is, the city or county
where the bank Is situated is not usually deemed to be consistent with
sound investment practices*

Words such as “concentration of risk” and

“lack of diversification* frequently are used to high-light such departures*
nevertheless, there is an obligation on the part of the bank to serve the
credit needs of borrowers in the local community--including the
governmental units*

Sometimes these needs are sufficiently powerful to

warrant commitments that otherwise would be excessive*

- 7 What are some of the circumstances th&t mitigate the weaknesses
In an investment portfolio because of heavy commitments in local issues?
In the first place, bank management is in a good position to follow the
finances of nearby governmental units and to make certain that the units
follow sound financial policies*

Sometimes there are offsetting bank

balances that considerably reduce the exposure to possible losses*
again, the


can do much to protect itself in these circumstances by

care in choosing the selection of maturities of bonds held for investment*
The peculiarities of tax laws go a long way towards explaining
unusual situations in investment portfolios*

Municipal securities are

tax-exempt, that is, the interest coupons are not subject to Federal income
taxation and in certain States holders acquire special tax benefits.

It is

understandable that banks would act to take advantage of the favorable
treatment accorded these securities taxwise, and as a consequence the
overall portfolio may deviate from what would appear to be the precepts of
sound policy*

From the examiner*s point of view, it is clear that he

should not ignore good investment policy because management assures him
that tax advantages result from so doing*

Nevertheless, he would be

unrealistic if he did not pay attention to tax considerations.

In order to

achieve tax benefits it may be necessary for a bank to stress certain
Investment vehicles at the expense of others •

Investment Policy Statements
The Federal Deposit Insurance Corporation examination report fore
now hag a question in Section H concerning the bank*s statement of
investment policy*

The purposes of this question are twofold!

To find out

whether the bank in its Investment activities is guided by a consistent
group of principles; and secondly, whether the policy guides are adequate.
As a product of the inquiries necessary to answer the investment
policy question in the examination report, it is expected that the examiner
will direct the attention of management to elements of strength and
weakness in policy, and encourage the remedy of defects.

Questions for Discussion
1. What are the essential elements of a bank investment policy?


Is it necessary for a bank to have a definitive policy

3* Are there guides for allocating funds to the investment
k. Is there provision for appraising alternative investment
opportunities ?

Examiners * Comments and Suggestions
In the course of your work with the municipal sequent of the
investment portfolio, it seems to me that your comments can best be brought
to sharp focus on page 2 of the examination report.

This section affords

an opportunity to verbalize the result of review and analysis.

Since the

section devoted to general comments is the port of the examination report
that is most likely to be read carefully by the officers and directors of a
bank, it provides your best channel

for communication.

Much of the analytical work in the investment field tends to
become quite complicated.

Basically, however, the principles are simple

- 9 and they may readily be expressed in nontechnical language*

Care in

phrasing comments on investment policy can greatly increase the effectiveness
of the bank examination report as a tool for supervision.
fhe most effective comment, in my judgment, is one which develops
a good point completely.

As a practical matter, the examiner is limited to

a few paragraphs of comment*

He should remember that there will always be

another examination and succeeding reports will afford the opportunity to
cover other facets of the investment program.
several examinations comments on page


Thus, in the course of

may be used to inform and educate

management as well as to encourage them to improve investment policy and

Problems in Testing Bank Portfolios
Generally speaking, the tests used in assaying the quality of a
bank’s investment portfolio are the same as the ones applicable to any
other segment of its asset structure*

Bo item is appropriate for inclusion

among the earning« assets of a bank unless it measures up to high
qualitative standards*

In addition to the qualitative test, it is

essential that each earning asset possess Hie degrees of liquidity that
judgment indicates as appropriate in terms of the bank’s total situation*
In reviewing the bond portfolio of a bank under examination, the
principle objective is to form a comprehensive judgaent as regards the
quality and the liquidity of discrete items.
supported by quantitative tests.

This judgment may be

Nevertheless, the end result is a value

judgment rather than a summary of mathematical ratios •

Qualitative Standards

Both to analysts and bank examiners , the

effort t© define the

characteristics of a security deemed to be suitable for bank investment has
presented serious difficulties.

There is no simple definition, nor can the

securities be identified by mechanical tests.

The identification of

securities in this category is a judgment process and the essence of bank
quality investments is freedom from potential loss.
Only securities that measure up to high qualitative standards are
suitable for inclusion in the municipal segment of a bank’s investment

The reasons for this guide to investment selection are readily


In the first place, such securities are the only ones that

are free from the dangers inherent in default.

And the nature of bank

capitalization is such that losses stemming from defaults quickly become
Sometimes it is argued that examiners place too much stress on
potential default in ccesnenting on individual municipal issues.


the ultimate loss record on municipal securities has been quite low.
However, technical defaults even in good times are not uncommon and banks
cannot handle assets successfully if they do not behave in accordance with
the terms of the contract.

Belays in the payment of interest and forced

refunding of issues on the due date may prove to be disastrous because
banks are not designed, that is, capitalized to assunra much investment risk.

Liquidity Considerations
It is a fact that the facilities for converting the municipal
segment of a bank’s investment portfolio into cash by sale in the market

- n
place are poorly developed*


Generally speaking, dealers in municipal

securities are primarily concerned with the flotation of new issues.


is, to be sure, a secondary market over the counter for obligations of the
large and well known issuers of these securities.

Bit even trading in well

known names is complicated by the fact that the bulk of the obligations
mature serially*

As a consequence, in the event of liquidation it is

necessary for the seller to find a buyer who wants both the specific credit
and the particular maturity date on the security offered for sale.


limitations narrow the market drastically and tend to widen the spread
between bid and asked prices*

Finally, all transactions are negotiated

privately between individual buyers and sellers rather than effected by
brokers cm an organized exchange.

By fitting a selection of bank quality municipal obligations into
a desirable pattern of maturities, however, it is possible to obtain a
dependable source of cash in-flow from a municipal portfolio*


investment practice calls for a maturity pattern that is consistent with
the anticipated cash requirements.

Thus, it is possible for a bank to

avoid selling in an unorganized market.
As yet, no one has suggested a better plan for scheduling the
maturities of the items in a bank's municipal portfolio than a simple

term, such as five-to-seven years.

familiar with this arrangement.
the municipal portfolio in


All of you,

1 am confident, are

For example, if an appropriate term for

given case is five years, then one-fifth of

the investment account is committed to securities maturing in each one of the
succeeding years.

Depending upon the situation confronting the bank, the




proceeds from each year's maturities are reinvested--or used for other

This program assures Independence from the market place.


addition, it enables the bank to average its rate of return on the
municipal investments.

The return becomes the moving average of the rate

prevailing over the period covered by the investment program.
Generally speaking, the record shows that banks have not managed
their investment accounts with unusual skill.

While it is difficult to

prove, it seems to me that the mediocre record can be explained largely by
the fact that bankers endeavor to anticipate price fluctuations for

In short, there is present a disposition to speculate on

trends in the rate of interest.
of all speculations.

This is probably one of the most difficult

The logic of the situation suggests that bankers

would be better advised to accept the interest rate, whatever it may be,
and endeavor to average the rate of return by adhering to a so-called
rollover plan for managing the funds invested in the municipal portfolio.

Market Depreciation in Municipal Securities
Along with the increase in the general level of interest rates
that has characterized the past few years, there has been a sharp decline
in market prices for outstanding fixed income bearing securities*


development has been a surprise to many observers whose experience in the
financial markets was limited to the long period of stable and relatively
low interest rates prevailing from the middle of the 193®®
years of this decade.

bhe early

Since the coupon and maturity of a bond is fixed at

the time of issuance, and since securities are always priced on a basis
which is competitive with the alternative investment opportunities—

- 13 ■f.oiriwg quality and the other basic characteristics into consideration- -an
increase in market yields on bonds forces a decline in prices for
outstanding issues*
Consider the case of a community enjoying & premier credit rating
that floated at about par value a block of municipal bonds with a
maturity and a


percent coupon in


15 -year

'Today those same securities in

order to sell on a competitive basis would be priced in the market to yield
about 3^ percent, or a price approximating


percent of par*

Should the

community float a new block of bonds today, the adjustment would be In the
coupon rate and not the price*

In other words, the bonds would be offered

at par, but with a 3^ percent coupon.
Thus, the immediate effect of an increase in interest rates
following a long period when bonds have been floated with relatively small
coupons, is to introduce a substantial amount of depreciation in quotations
for the outstanding securities*

The amount of the depreciation depends, of

course, upon the difference between the coupon and the prevailing yield on
comparable investments and the due date of the bond*

The depreciation

disappears as the low coupon securities approach the due date because at
that time they are paid at par value*
According to the manual of examination policies, it is necessary
for yew to estimate the market value of all securities in the investment

Quotations for Federal obligations and corporate issues traded

actively on the organised exchanges are readily available, and this
requirement presents no problem to the examiner*

The same cannot be said

for the municipal segment of the investment portfolio*


Xh -

When reliable price quotations are not readily available, the
manual gives the examiner the option to substitute book values in his
estimate of the market value for the investment portfolio.

But that option

is limited to situations wherein the bank is not relying substantially upon
investments as a source of cash*

In any problem situation, and certainly

whenever the bank is relying on its municipals for liquidity, the examiner
has no alternative but to make the best estimate of market values.
What, then, can the examiner do to arrive at a satisfactory
market value estimate?

None of the alternatives are particularly

satisfactory, but let us consider them in order*

If the bank holds

securities that are well known in the national market, then it may be
possible to find offerings of these securities for sale at specified prices*
Publications such as the Blue List that circulate among traders of
munlelp&l bonds are a source of this information,

the quotations do not

reflect actual transactions because they are negotiated in each case.


the quotations suggest price levels in general terms*
More than likely, however, the examiner will find that some or
maybe all of the securities in the municipal portfolio are obligations of
small and little known issuers.

The degree of uncertainty in judging the

price structure for these credits is far greater than in the large, well
known issues*

Such bonds are seldom offered for sale and the Information

is unlikely to be found in public records.

As a matter of fact, the best

information on the price structure for these issues can only be obtained
from active traders*

Such individuals are in the best position to form a

judgment as to the value of the portfolio*

To do so, however, it is

necessary to obtain their opinion on a professional basis as experts, and
not as traders seeking to drive a hard bargain.
Recently, my attention has been drawn to an interesting plan for
easing the burden placed upon the examiner resulting from the requirement
that he ascertain the market value of the municipal portfolio.

In Richmond

the Federal Reserve has retained the services of a local investment house
on a professional basis to estimate the value of municipals held by banks
under examination.

These dealers are recognized as unusually well informed

on the credits in the area.

Compensation presumably is sufficient to cover

the expenses for the work, and it is hoped that the results will produce
figures that are more satisfactory than either arbitrary book values or
estimates based upon the fragmentary data in the hands of examiners.
Possibly this plan would have some application in the Tenth District.
The amount of market depreciation from book value in the
investment account for some banks has caused much concern to examiners.
Obviously market depreciation is not an element of strength in the asset
structure of a bank.

Whether it should be the cause of serious concern,

however, depends upon the likelihood that the bank will be obligated to
sell securities in a depressed market.

A sizable valuation reserve can be a source of consolation when a
bank experiences a substantial amount of depreciation in the investment

This reserve furnishes the means for absorbing losses in the

event that securities are sold at prices below book value*


The terms of

agreement among the supervisor authorities regarding the

appraisal of securities for purposes of bank examination, you will recall,

include a provision for the retention of capital gains on the sale of
securities to build up valuation reserves.

The recent experience with

¡aarket depreciation may be useful to examiners when they seek in the future
to encourage the retention of these capital gains for valuation reserve

Questions for Discussion
1* At what rate should valuation reserves be accumulated?


What is the relationship between valuation reserves and a
bank's capital accounts?

Adequate Credit Files
Examiners have always been expected to test credit files
pertaining to the bank's investment portfolios for the purpose of
determining whether an adequate amount of information is at hand.

It is

commonplace that the quality of credit files bearing on investment
securities varies tremendously from bank to bank.

Furthermore, banks often

rely on the information held by correspondent banks or others for data
pertaining to the items in the securities account.

Hot infrequently a bank

will hold the securities of small and unknown obligors without any
pertinent credit information at hand.

Questions for Discussion
1. What should the examiner do when he finds poor credit files?
2. Is an examiner Justified in classifying a security as unsuited
for bank investment when information is lacking?

Determining Credit Quality of Municipal Issues
The basic question to be answered in determining the credit
quality of a municipal issue can be phrased in simple terms s

Will the

obligor be able to service the debt according to its terms and at the same
time provide a sufficient margin of protection so that bondholders may
consider themselves well protected against the possibility of default
either as to principal or interest payments?

When the examiner sets out to

answer this question in a specific case, he is confronted with many
practical difficulties.

So that he may finish his job in a reasonable

length of time, the examiner is disposed to adopt staple mechanical tests
to determine the investment quality of Issues in the investment portfolio.
Bank examining authorities have for a good many years relied to some
extent on the adjective ratings published by investment advisory services
as indicators of credit quality.

The use of published ratings was first

recognised in the so-called 1938 agreement among Federal and State banking
authorities as regards examination practice with respect to securities.


understand the present situation, it is well to recall the occasion for the
1938 agreement.

At that time, the market quotations for municipal

securities had declined sharply.

These securities were held in substantial

amounts by the banks and the practice of valuing portfolios for purposes of
bank examination at prevailing market prices resulted in hypothetical

The margin of capital accounts in many banks suffered greatly when

these shrinkages in the book value of securities were taken into
examining authorities in


recognised that many banks

with substantial amounts of market depreciation in the investment




portfolios would not be obliged to incur actual losses because the
securities would not be sold at prices then prevailing.

Accordingly, the

terms of the 1933 agreement abandoned market values and substituted
amortized cost or book values, whichever were lower, for the valuation of
securities deemed to be suitable for bank investment purposes.


implement this agreement, however, it was necessary to develop standards
for identifying investment grade securities.

The problem was solved by so

classifying any credits in the four highest rating bands and all others of
like quality.

Since there were four investment services then publishing

ratings, the agreement contemplated that a majority opinion as to quality
would prevail.
Ratings are still used by the bank examining authorities, but it
is a fact that now the primary problem of credit quality centers in the
municipal rather than the corporate field.

Unfortunately, the investment

advisory services publish ratings only for a comparatively small portion of
all of the municipal securities outstanding.

So these ratings are not very

useful to examiners when they classify portfolios.

Furthermore, there are

only two services that publish municipal ratings in

convenient form, namely,

Moody's and Standard & Poor's.

As a consequence, the examiner is confronted

with a knotty problem when he finds that the services disagree as to
classification of a credit.

Credit Analysis Techniques
Difficult though it may be when the examiner does not have
published ratings to serve as a guide in judging credit quality, there is
no alternative but to employ the techniques of the securities analyst*

- 19 *
These techniques help him by outlining the steps to be taken in order to
arrive at a definitive judgment oaa credit quality*

But the work is time-

consuming and requires a substantial amount of information.
A starting point in the analysis of a credit is first a Judgment
concerning the strength of the

economy supporting the obligor.

This calIff

for a study of a variety of data indicative of strength or weakness.


ranges from natural resources, through growth and shift in population, to
evidences of wealth and income.
The appraisal of management is a second important feature of
credit analysis.

Whether a municipality handles its affairs generally and

its finances In particular in a workmanlike or a slipshod manner has an
important bearing on credit quality*

Management is difficult and illusive

to measure and the relevant data are not easy to find*
The structure of debt and the sources of income and expenditures
are essential facts in appraising credit quality*

To judge this feature of

a credit it is necessary, in addition to the accumulation of the pertinent
information, to have standards for comparing a given credit with others in
order to bring out elements of strength or weaknesses*

Mechanical Tests of Credit Quality
Financial ratios have proved to be valuable tools in analytical

They are indicators of sound or unsound conditions and are useful in

forming a jud&aent.

As a practical matter, however, the central fact of

credit analysis is judgment rather than the manipulation of arithmetic*


attempt to classify securities on the basis of ratios or sets of ratios is
a mistake*




Questions for Discussion
X. What are points of reference to be used in applying debt
burden measures such as the ratio of debt to assessed value
and per capita debt?


Hov can debts be related to categories of income and




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