FRM Exam Part II · The Investment Function in Financial Services Management

Investment Securities and Instruments for Institutions: Types Banks Hold

Updated 11 October 2026 · Fact-checked

Banks hold investment securities for liquidity, income and balance sheet management. Main types are government bonds, agency and mortgage-backed securities, municipal bonds and corporate bonds. To solve questions, rank them by credit risk, liquidity and prepayment or rate risk, then check the accounting category (HTM, AFS, trading) and HQLA eligibility.

Understand Investment Securities and Instruments for Institutions

A bank's investment portfolio is the part of its balance sheet that is not loans. It does three jobs: it holds a liquidity reserve, it earns a steady return on funds not lent out, and it helps manage interest rate risk.

The securities differ in credit risk and in how easily you can sell them. Government bonds (such as US Treasuries) have the lowest credit risk and the deepest markets. Agency securities are issued or guaranteed by government-sponsored or government agencies. Their credit support varies: some have an explicit government guarantee and some only an implied one. Mortgage-backed securities (MBS) pass through payments from pools of mortgages. Their special risk is prepayment risk: when rates fall, borrowers refinance, so cash comes back early and must be reinvested at lower yields (contraction and negative convexity). When rates rise, prepayments slow and the security lasts longer (extension risk).

Municipal bonds are issued by states and local authorities. Interest may be tax-exempt in some jurisdictions such as the US, which makes them attractive to taxpaying institutions. They are usually less liquid than Treasuries and carry issuer credit risk. Corporate bonds offer higher yield for more credit risk, wider bid-ask spreads and weaker liquidity, especially in stress.

Liquidity regulation sorts securities by quality. Under Basel III's Liquidity Coverage Ratio, HQLA are split into Level 1 (cash, central bank reserves, qualifying sovereign debt, zero haircut), Level 2A (15% haircut; for example certain government agency and high-rated covered or corporate bonds) and Level 2B (larger haircuts; for example lower-rated corporate bonds and certain equities, and RMBS meeting criteria). Level 2 assets are capped in the stock. Plain corporate bonds below the required rating and most MBS do not qualify.

Accounting category matters too. Under US-style classification, held-to-maturity (HTM) securities are carried at amortised cost, so price falls do not hit equity or earnings, but selling them early taints the category. Available-for-sale (AFS) securities are carried at fair value with unrealised gains and losses in other comprehensive income (OCI) rather than in profit. Trading securities are at fair value through profit. This is why rising rates can hide losses in HTM books and create a liquidity problem: you cannot sell without realising them.

Key formulas to remember

Price change from duration: ΔP ÷ P ≈ −D_mod × Δy + ½ × C × (Δy)²; Use for rate-risk questions on bonds. For MBS, effective duration and convexity (which may be negative) must reflect prepayments.
HQLA stock after haircut: Adjusted value = Market value × (1 − haircut); Level 1: 0% haircut. Level 2A: 15%. Level 2B: higher haircuts (25% for RMBS, 50% for lower-rated corporate bonds and equities).
Level 2 caps in the LCR stock: Level 2 ≤ 40% of HQLA; Level 2B ≤ 15% of HQLA; Caps are applied after haircuts, using the Basel LCR formula. Check what the question gives you.
Liquidity Coverage Ratio: LCR = Stock of HQLA ÷ Total net cash outflows over 30 days ≥ 100%; Net outflows = outflows − min(inflows, 75% of outflows).
Accounting treatment summary: HTM: amortised cost | AFS: fair value, gains/losses in OCI | Trading: fair value, gains/losses in profit; Reclassification or sale of HTM can taint the category.

How to solve Investment Securities and Instruments for Institutions questions

Use this order for any question on securities held by institutions.

1Identify the security type and who stands behind it: sovereign, agency, municipal, corporate or mortgage pool.
2List its main risks: credit, interest rate, prepayment or extension, liquidity, and tax or legal features.
3Check the rate environment in the question. Falling rates mean prepayment and contraction for MBS; rising rates mean extension and larger price falls.
4Decide the regulatory liquidity treatment: HQLA level, haircut and caps. Apply the haircut to market value, not face value.
5Identify the accounting category (HTM, AFS, trading) and where gains or losses appear.
6Do any arithmetic: price change, haircut value or LCR.
7Match the answer to the question's perspective, such as liquidity, earnings volatility or capital, and eliminate options that mix it up.

Quickest way: Rank, then classify

When to use it: Use when you have a short MCQ listing several securities and asking which is most or least liquid, riskiest, or HQLA eligible.

Rank liquidity: government > agency > municipal and high-grade corporate > MBS and lower-grade corporate.
Rank credit risk the reverse way, but remember agency MBS have little credit risk and mainly prepayment risk.
Link HQLA to the ranking: sovereign is Level 1, high-quality agency and corporate are Level 2, the rest usually fail.
For HTM versus AFS, ask whether price changes go through OCI or stay off the books.

Common mistakes in Investment Securities and Instruments for Institutions

Treating all agency MBS as having no risk because credit risk is low.
Students focus on the guarantee and forget cash flow uncertainty.
Fix: Separate credit risk from prepayment and extension risk. Agency MBS can still lose value from rate moves and negative convexity.
Saying MBS shorten in duration when rates rise.
Confusing prepayment direction.
Fix: Rates down means faster prepayments and shorter life. Rates up means slower prepayments and longer life, so losses are larger.
Applying the haircut to face value or forgetting it altogether.
Rushing through the LCR arithmetic.
Fix: Use market value × (1 − haircut). Level 1 has no haircut, but Level 2 does.
Believing HTM securities have no economic loss when rates rise.
Amortised cost hides the price fall in reported numbers.
Fix: Remember the loss exists. It becomes real if the bank must sell for liquidity, and sales can taint the category.
Putting AFS unrealised losses through profit.
Mixing AFS with trading classification.
Fix: AFS gains and losses go to OCI. Only trading securities go through profit.
Assuming all corporate bonds count as HQLA.
Equating investment-grade with eligible.
Fix: Only bonds meeting the specific rating, market depth and stability criteria qualify, and only as Level 2A or 2B with haircuts.

Worked examples

Example 1

A bank holds USD 400 million of Level 1 assets, USD 200 million (market value) of Level 2A assets and USD 100 million (market value) of Level 2B assets. Haircuts are 0%, 15% and 50%. Ignoring caps, what is the HQLA stock? If net 30-day cash outflows are USD 600 million, what is the LCR?

Show the solution

Level 1: 400 × (1 − 0) = 400.
Level 2A: 200 × (1 − 0.15) = 170.
Level 2B: 100 × (1 − 0.50) = 50.
Total HQLA = 400 + 170 + 50 = 620 million.
Check the caps: Level 2 total = 220, which is below 40% of the total as a simple check (40% of 620 = 248). Level 2B = 50, below 15% of 620 = 93. Caps are not binding.
LCR = 620 ÷ 600 = 1.0333, or about 103.3%.

Answer: HQLA = USD 620 million; LCR ≈ 103.3%, which meets the 100% minimum.

Example 2

A bank's portfolio holds agency MBS with an effective duration of 4 and a government bond with a duration of 4. Market rates fall sharply and prepayments surge. Which statement is most accurate: (A) The MBS price rises by the same amount as the bond; (B) The MBS price rises by less than the bond because of prepayment and negative convexity; (C) The MBS price falls because credit risk rises; (D) The MBS price is unchanged because of the agency guarantee?

Show the solution

Rates fall, so the government bond price rises by about duration × rate change.
For MBS, falling rates speed up prepayments. The investor receives principal back early and reinvests at lower yields.
This shortens effective duration and gives negative convexity, capping price gains.
Option A ignores prepayment. C confuses credit and rate risk. D ignores market price risk.
Option B is consistent with prepayment risk.

Answer: B: the MBS gains less than the government bond because of prepayment and negative convexity.

Exam tips

Expect short case questions that combine a rate move with MBS behaviour. Decide the prepayment direction first.
Memorise the HQLA levels and haircuts. Questions often give market values and ask for the adjusted stock.
For HTM versus AFS questions, name where the loss appears (not recognised, OCI or profit) and tie it to liquidity.
In ranking questions, separate liquidity from credit quality. A safe agency MBS can still be less liquid or more rate sensitive than a Treasury.
Read the question perspective carefully: regulatory liquidity, accounting, or economic risk can give different answers.

Practice questions from The Investment Function in Financial Services Management

Investment Securities and Instruments for Institutions in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

NISM CertificationsTypes of Securities and Financial Instruments

Investment Securities and Instruments for Institutions: frequently asked questions

What types of securities do banks hold?

Banks mainly hold government bonds, agency securities, mortgage-backed securities, municipal bonds and corporate bonds. They hold them for liquidity, income and interest rate risk management. Government and agency paper dominate the liquidity reserve.

What are examples of HQLA?

Level 1 includes cash, central bank reserves and qualifying sovereign debt with no haircut. Level 2A includes certain agency and high-rated covered or corporate bonds with a 15% haircut. Level 2B includes lower-rated corporate bonds and some other assets with larger haircuts.

Why are mortgage-backed securities risky for banks?

They carry prepayment and extension risk, which makes their cash flows and duration change with rates. They show negative convexity when rates fall. Non-agency MBS also carry credit risk and weaker liquidity.

What is the difference between held-to-maturity and available-for-sale securities?

HTM securities are carried at amortised cost and are intended to be held to maturity, so price changes do not appear in the accounts. AFS securities are carried at fair value, with unrealised gains and losses in OCI. Selling HTM securities early can taint the category.