Banks - The most conservative Institutional Investor for the CFA

As part of our Institutional IPS coverage we've covered pension plans, life insurance companies, and endowments/foundations.

Banks are the last and most conservative of the institutional investors found in the CFA level 3 curriculum.

Understanding a Bank as Investor

At their core banks are intermediaries. They take in deposits, which from the bank's perspectives are their liabilities, and then they make loans from those deposits (and those loans constitute the bank's assets).

Any excess deposits that the bank receives that are not loaned out to customers can be invested. Thus a bank's investment portfolio is the surplus of deposits that are not loaned out to customers.

Clearly this surplus falls outside of a traditional bank's primary function of making loans. Treat it as a sort of residual. While it is residual, however, this surplus and investment portfolio does have an important function to play in terms of mitigating general risk.

Speaking of risk, banks are definitely investors that use ALM. Matching liabilities is absolutely critical for a bank and the reason is that they are literally investing money that you could go to the bank and demand back at a moment's notice. In other words, a bank looks to hold a basket of mostly fixed-income investments with the same duration as its liabilities. 

Banks are the most conservative of the institutional investors as they are literally investing money they are obligated to return at a moment’s notice.

That gives them a distinct below average risk tolerance. It's short-term money. It can be reclaimed at any time. Banks know this and as a result they must hold adequate reserves to insure against any immediate liquidity needs.

In addition, it means that a bank's ALM portfolio is generally invested in short-term bonds and other very liquid securities (and they'll pay a lot of attention to whether they're earning a positive net interest spread or not). If they are, then maybe they can increase the risk a little bit, similar to how any institutional investor can invest their surplus more aggressively than the rest of the portfolio.

With this overview in mind let's run through the details of bank's investment policy statement.

A bank's return objective for the CFA L3 Exam                                                                           

A bank’s return objective is to earn a positive interest rate spread above the cost of funds, but this is constrained by the bank’s ability to take risk.

Bank - Return Objective CFA

Why Bank's have below average risk tolerance

Banks have a below average risk tolerance. Their most important objective is meeting the cost and liquidity required for their liabilities (deposits) and they can’t really risk not being able to do so. That's the whole concept of bank runs right? No bank is holding enough cash to fund all those needs at once, and yet they better have it if they need it.

Bank Risk tolerance - CFA

Bank Time, Tax, Liquidity, and Legal Constraints

The time horizon is usually matched to the average duration, or maturity, of a bank’s liabilities (deposits). This usually ranges from 3-7 years. Clearly this short term time horizon is one of the reasons a bank has below average ability to take risk. 

This short term time horizon is a key difference between a bank and other types of institutions.


Banks are taxable entities and taxes must therefore be considered.


Banks face ongoing liquidity needs that are a product of withdrawals, loans, and sometimes regulatory requirements.

In other words, liquidity is definitely important.

In fact there are usually regulatory requirements (Basel I and II) mandating that banks have a certain percent of their liabilities on the books as assets. 

In addition to the percentage of liabilities they hold, banks will pay close attention to things like the leverage-adjusted duration gap, value at risk (VaR), and the net interest margin. If a bank is earning a positive net interest spread it may be able to increase the risk of its portfolio.


Banks are highly regulated. They usually have capital-reserve requirements (think Basel Accords), need collateral, and invest in short-term liquid securities.

Unique Circumstances for a Bank - Geography

The curriculum highlights one new unique factor that a bank, especially a smaller one, may face.

This is that it's book of loans may be concentrated in a single area. Think about your standard credit union whose members are all located in one region. It takes in their deposits and makes loans to them,, which concentrates its risk in that population/geography/local economy. The investment portfolio can take this into account by investing elsewhere.

Another unique factor may be an inability to divest of assets on a balance sheet. Otherwise unique constraints vary from bank to bank.

Summarizing Bank Constraints for the CFA L3 IPS Section

 Bank IPS Constraints - CFA


To see our coverage of other institutional investors:

[1] Always remember that from a bank’s perspective, the deposits are liabilities they owe to their customers.