Risk Management for the Municipal Securities Portfolio

12/8/2011

By Joseph M. Press, CPA, CFE

With interest rates continuing to hover at low rates, many banks are increasingly turning to municipal securities for an investment that offers higher yields, even on a pre-tax basis. As the size of the muni portfolio grows, both as a percentage of investments and capital, the need for enhanced risk management policies and procedures are both prudent and required by banking regulators.

This topic was addressed at the recently held Subchapter S Bank Association Annual Conference. The consensus of presenters seemed to indicate that regulators would look upon a muni portfolio of 100% of capital (or greater) as a concentration meriting additional scrutiny. The following check list was offered to help banks determine that they had the appropriate policies and procedures in place when reviewing their risk exposure:

Concentration Risk Management

• Has the institution established a concentration risk management program governing significant municipal security portfolios? Are concentration measurements segmented into risk groupings that exhibit similar risk characteristics?
• Do concentration risk limits or tolerances effectively control municipal risk exposure? Do these reflect the institution's stated risk appetite and relate to the capital base?
• Is there an effective concentration reporting system identifying excessive risk exposures or noncompliance that includes courses for corrective action, if warranted?

Credit Risk Assessment

• Has the institution implemented a credit risk management framework that effectively identifies and monitors municipal risk exposure?
• Is management's ongoing credit risk assessment process commensurate with the level of risk exposure, timely, and supported by current financial information?
• Does management fully understand the structure and characteristics of all municipal holdings that are exhibiting credit deterioration, including levels of taxing authority, extent of third-party support, and local Chapter 9 Bankruptcy rules?
• For significant municipal holdings, does management's ongoing credit monitoring process rely too much on credit rating agencies for identifying changes to risk exposure and financial condition?

Pricing and Valuation Methods

• Does the institution's practice for municipal securities valuation ensure timely, independent, and accurate pricing?
• Do methods comply with current fair value accounting guidance?
• For municipal securities whose fair value drops below amortized cost, do OTTI policies ensure the timely and accurate recognition of credit- and noncredit-related impairment?

Even if a bank's muni portfolio is well under the concentration threshold, these points provide a useful tool in assessing the effectiveness of risk management procedures over the muni portfolio.