Portfolio Management of a Commercial Bank

Portfolio management by a commercial bank means the way it distributes its funds among the various kinds of assets it can hold — cash, near-cash items, investments and loans — so as to earn the highest possible return without endangering its ability to repay depositors. A bank's 'portfolio' is simply the whole collection of assets on the asset side of its balance sheet, and managing that portfolio is the central skill of banking.

The three competing objectives. Every banker must reconcile three goals that pull in different directions:

1. Liquidity — the ability to meet withdrawals and other obligations promptly. This calls for holding plenty of cash and easily-sold assets, which earn little or nothing.
2. Profitability — earning income for the owners. This calls for lending and investing as much as possible, because loans and investments earn far more than idle cash.
3. Safety (security) — protecting the funds from loss. This calls for lending only to sound borrowers and holding secure investments.

These three goals conflict: the most profitable assets (loans) are the least liquid and the least safe, while the most liquid and safe asset (cash) earns nothing. Good portfolio management is the art of striking the right balance between liquidity, profitability and safety.

The principle of asset distribution. A bank therefore arranges its assets in a graded structure, often pictured as a pyramid, from the most liquid at the base to the most profitable at the top:

• Cash and balances with the central bank — perfectly liquid, no earnings; held to meet withdrawals and legal reserve requirements.
• Money at call and short notice — almost as liquid, earning a little.
• Bills discounted and short-term investments — fairly liquid and earning more.
• Government and other securities — safe, steady-earning, and saleable when cash is needed.
• Loans and advances — the most profitable but least liquid and most risky. …