Pub. 6 2015 Issue 2

www.wvbankers.org 8 West Virginia Banker the assumption of any additional market risk in the portfolio may not be a prudent option. In fact, such a set of circumstances may compel a portfolio manager to reduce overall balance sheet risk by reducing the portfolio’s contribution to that risk. This reflects the priority of total balance sheet risk management, and the portfolio’s role in it, versus other factors influencing investment strategies and tactics. Does This Make My Risk Look Big? If it’s determined that the comprehen- sive risk profile is modest enough to not require portfolio-sourced reduction, a different sort of contextual suitability is sought. One lens through which risk may be viewed takes into account the potential effect that unrealized losses might have on capital adequacy if, in fact, those unreal- ized losses were to become real ones. A common exercise involves estimating how much depreciation would be expected to occur after a significant rate increase, and then projecting damage to capital that would result from the actual realization of those projected losses. If the outcome of such a projection results in capital ratios below which management or ownership is comfortable, that’s a good sign the portfolio has too much market risk, and a duration alteration may be in order. Another method for checking your risk level is based on the presumption that the portfolio should not be allowed to risk more than it’s pro rata share of capital in terms of price depreciation. Or expressed another way, the percentage of total assets represented by the bond account should not be exceeded when potential deprecia- tion is expressed as a percentage of capi- tal. If this occurs, it’s a sign that in light of the rest of the balance sheet the portfolio’s risk characteristics might be a bit on the excessive side in terms of price volatili- ty. Whatever method your bank uses to quantify market portfolio risk, don’t forget to follow through with the next step of determining the appropriateness of that risk. Make sure the risk you’re tolerating is the right risk for you and your bank. n How Much Portfolio Risk Is Too Much? Lester F. Murray, Associate Partner of The Baker Group LP, came to the Bak- er Group in 1986 following his work with the OCC as an assistant National Bank Examiner. His focus is on de- veloping community bank portfolio and interest rate risk management strategies. Contact: 800-937-2257, lester@GoBaker.com. By Lester F. Murray, The Baker Group LP E veryone knows that if you want to make an omelet, you have to break a few eggs. And, if you want to manage a bond portfolio, you’re going to have to take a little risk. No risk, no reward. The thorny question for many portfolio managers, and boards of directors, is at what point does this inherent risk become too great? Or, a much less frequently asked question, when is this risk not great enough? Most banks these days have access to ana- lytical tools that generally do an adequate job of measuring the potential changes in market valuations due to changing rate environments, but this information by itself is incomplete knowledge. The deter- mination of the “right” amount of risk is unique to each financial institution and to the people who manage it. Knowing the dollar amount of potential depreciation that might occur as a by-product of rising interest rates is not without value, but lacking meaningful context, it may not automatically follow that the measured amount of risk is the appropriate amount of risk. Just as individual investors have various degrees of risk tolerance or avoid- ance, so it is with community bankers. Some investors never stop looking for ways to roll the dice and take chances, while others never feel safe unless they’re wearing a belt with their suspenders. Apart from the nuances of personality and tem- perament, how can community bank port- folio managers gain insight into whether or not their portfolio’s market risk, once measured, is appropriate? Start with the Big Picture The first place to look when looking to fig- ure out just what that right amount of risk might be is the overall risk profile of the total balance sheet. For banks challenged by excessive volatility in their Economic Value of Equity (EVE), it’s important to know the degree to which negative portfo- lio valuations contribute to that volatility. The mitigation of the overall balance sheet risk may take priority over other consider- ations affecting the portfolio’s exposure to market risk. In other words, if an inor- dinate level of capital is already at risk due to the combination of the valuation characteristics of loans and liabilities,