Portfolio Management -
Its Application and Impact On Commercial Banks:

The term "Portfolio Management" precisely means managing the portfolio (collection of shares, stocks or bonds) of an individual or an entity and management here refers to managing the combination of risk resulting in returns or profit. It is a profession, where a portfolio manager using his skills and knowhow guides investors where and how much to invest their limited cash resources so as to gain maximum profit. The primary job of portfolio management is to meet investors' investment goal by helping to choose the right mix of investment to held in the portfolio and by allocating investors wealth in percentage.

Objectives Of Portfolio Management:

The primary objective of Portfolio Management is identifying the assets combinations that are expected to yield highest return for wealth creation of different individual investors keeping in mind their individual risk tolerance capacity, individual goal and time horizon.

Significance Of Portfolio Management:

Investment is not child's play also the priorities of investors change with time if not frequently. As such, the investment mix (portfolio) of the investors needs to be altered with changing priorities and time. Also in the changing market scenario, it becomes tough to correctly or precisely analyse the market trend or fluctuations. So the best men suited for the job 'Portfolio Management' do the bit.

To sum up, portfolio management assesses risk and return relationships for combinations of securities in a portfolio. While the expected return of a portfolio is simply the weighted average of the expected returns of its component securities, portfolio management must also take into account the correlation of risk factors among the returns of individual securities.

Portfolio Management & Banking Profitability:

Portfolio management in commercial banks objectifies three main points:

  1. Liquidity
  2. Safety and
  3. Profitability.

1. Liquidity:

Commercial Banks need to hold a large proportion of its assets either in the form cash or with higher degree of liquidity so that it can be turned into cash with ease this is because normally its liabilities are payable on demand. This is also because the liabilities of commercial banks are large in relation to its assets because it holds a small proportion of its assets in cash. If the bank keeps liquidity the uppermost, its profit dips below on the contrary, if it compromises on liquidity and aims at earning more, it might well be disastrous for it.

Thus the portfolio management of a bank must strike a balance between the objectives of liquidity and profitability. The balance must be achieved with a relatively high degree of safety. This is because banks are subject to a number of restrictions that limit the size of earning assets they can acquire.

Commercial Banks have various types of assets at their disposal with varying degrees of liquidity. The most liquid of assets is cash. The next most liquid assets are deposits with the central bank, treasury bills and other short-term bills issues by the central and state governments and large firms, and call loans to other banks, firms, dealers and brokers in government securities. Loans extended to customers and investments in long term bonds and mortgages are less liquid. Thus the principle sources of liquidity of a bank are its borrowings from the other banks and the central bank and from the sales of the assets.

But the amount of liquidity which the bank can have depends on the availability and cost of borrowings. If it can borrow large amounts at any time without difficulty at a low interest rate, it will hold very little liquid assets. But if it is uncertain about borrowing funds or if the cost of borrowing is high, the bank will maintain more liquid assets in its portfolio with regard to the profitability of the bank.

2. Safety:

A commercial bank operates under conditions of risk and uncertainty about the amount and cost of funds it can acquire and about its future income. Moreover, it also faces couple of risks. The first is the market fluctuations which results from the decline in the prices of debt obligations when the market rate of interest rises and secondly, the risk of extended loans getting sour.

In this context, commercial banks have to maintain the safety of its assets. Again, it is to be noted that it is also prohibited by law to assume large risks because it is required to keep a proportion of its fixed liabilities to its total assets with itself and also with the central bank in the form of cash. Having said this, it is also true that if the bank follows the safety principle strictly by holding only the safest assets, it will not be able to create more credit. It will thus lose customers to other banks and its income will also gradually decline. One the other hand, if the bank takes too much risk, it may be highly harmful for it. Therefore, it becomes perquisite for commercial banks to estimate the amount of risks attached to the various types of available assets, compare the estimated risk differentials, consider both long-turn and short-run consequences, and then strike a balance.

3. Profitability:

One of the principle objectives of a bank is to earn more profit for paying interest to depositors, wage to the staff, dividend to shareholders and meeting other expenses. Also it cannot afford to hold a large amount of funds in cash for that will signify forgoing income.

But, here; what needs to be understood is that the conflict between profitability and liquidity is not very sharp. Liquidity and safety are the primary considerations for commercial banks while profitability is subsidiary for the very existence of a bank depends on the first two.

In considerations of the above three points, it can well be concluded that for a commercial bank to earn more profit, it must strike a thoughtful balance between liquidity and safety.