3 Main Objectives of Portfolio Management

The following points highlight the three main objectives of portfolio management by commercial banks. The objectives are: 1. Liquidity 2. Safety 3. Profitability.

Portfolio Management: Objective # 1. Liquidity:

A commercial bank needs a higher degree of liquidity in its assets. The liquidity of an assets refers to the ease and certainty with which it can be turned into cash. The liabilities of a bank are large in relation to its assets because it holds a small proportion of its assets in cash. But its liabilities are payable on demand at a short notice.

Therefore, the bank must hold a sufficiently large proportion of its assets in the form of cash and liquid assets for the purpose of profitability. If the bank keeps liquidity the uppermost, its profit win below on the other hands, if it ignores liquidity and aims at earning more, it will be disastrous for it.

Thus in managing its investment portfolio 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.

The nature of conflict between liquidity and profitability is illustrated in Figure 1 where earning assets are taken on the horizontal axis and cash on the vertical axis. CF is the investment possibility line which shows all combinations of cash and earning assets.

For instance, point A denotes a combination of OM of cash and OS of earning assets; and point B shows ON of cash and OT of earning assets. Each bank seeks to obtain its optimum point along the line CE which will be a combination of cash and earning assets so as to achieve the highest possible level of earnings consistent with its liquidity and safety.

Many types of assets are available to a commercial bank with varying degrees of liquidity. The most liquid of assets is money in 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.

The less liquid assets are the various types of loans to customers and investments in long term bonds and mortgages. 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 cost (interest rate), it willhod very little liquid assets. But if it is uncertain to borrow funds or the cost of borrowing is high, the bank will keep more liquid assets in its portfolio.

Portfolio Management: Objective # 2. Safety:

A commercial bank always operates under conditions of uncertainty and risk. It is uncertain about the amount and cost of funds it can acquire and about its income in the future. Moreover, it face two types of risks. The first is the market risk which results from the decline in the prices of debt obligations when the market rate of interest rises.

The second is the risk by default where the bank fears that the debtors are not likely to repay the principle and pay the interest in time. “This risk is largely concentrated in customer loans, where banks have a special function to perform, and bank loans to businesses and bank mortgage loans are among the high grade loans of these types.

In the light of these risks, a commercial bank has to maintain the safety of its assets. It is also prohibited by law to assume large risks because it is required to keep a high ration of its fixed liabilities to its total assets with itself and also with the central bank in the form of cash. But 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 be very low. One the other hand, if the bank takes too much risk, it may be highly harmful for it. Therefore, a commercial bank “must estimate the amount of risks attached to the various types of available assets, compare estimated risk differentials, consider both long-turn and short-run consequences, and strike a balance.”

Portfolio Management: Objective # 3. Profitability:

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

But the conflict between profitability and liquidity is not very sharp. Liquidity and safety are primary considerations while profitability is subsidiary for the very existence of a bank depends on the first two.

Conclusion:

The three conflicting objectives of portfolio management lead to the conclusion that for a bank to earn more profit, it must strike a judicious balance between liquidity and safety.