24 April 2011

Lower Loan-to-Deposit Ratio – A Controversial Target

In pre financial crisis period banks in several countries especially in Europe have managed to build up high loan-to-deposit ratios (LDRs). Since other funding sources than deposits proved to be rather unstable during the financial crisis, there are now clear attempts to bring this ratio down. Take for example Ireland where the current LDR is 180%, but the sustainable level for the aggregate domestic banking system that is aimed by 2013 is considered to be 122.5% (Central Bank of Ireland, 2011, The Financial Measures Programme Report). The new Basel III liquidity requirements, more specifically the required Net Stable Funding Ratio (NSFR) of at least 100%, are further urging moving towards this direction (see the Figure below). Paradoxically we shall see that lowering the loan-to-deposit ratio proves to be a controversial target.

The trick is that in the normal course of business when people just repay their loans, a change in the amount of loans is reflected in deposit side as well. In other words: if there are no additional deposits coming from external sources, deposits will decline at least in the same amount as loans are being paid back (in reality, an additional decline in deposits will come from interest payments). This is because people use their deposits to repay their loans, which technically means that equal amounts are being deleted from both the asset and the liability side of a bank. The result is that instead of a lower LDR the highly leveraged banks or financial systems will have even higher LDRs. The following Table illustrates this for the sum of four large Irish banks covered with the recent Irish bank stress testing exercise. The simple calculation reveals that if the estimated excess loans in the amount of EUR 70bn would just be paid back from the money that households and businesses have in the very same banks, then the LDR ratio would jump from nearly 180% to above 250%.

The opposite is true as well. To achieve the targeted LDR of 122.5%, Irish banks would technically only have to write an additional EUR 362.1bn to the asset side as loans and to the liability side as deposits. This of course is not the intention (the intention is still told to be a decrease in overall leverage), but rather serves as an example of the controversy of LDR target.

The only ways for achieving lower LDR in a country’s financial system combined with the aim to decrease banks’ dependence on wholesale funding include:
1) banks simply writing down parts of their existing (defaulted) loan portfolios
2) banks selling parts of their loan portfolios
3) banks not under consideration taking over the lending function while not being able or willing to keep deposits
4) attracting money that flows into the country thanks to exports exceeding imports and/or as a result of selling domestic assets to foreign investors
5) central bank “printing” new money that would replace deposits used for repaying existing debts
(1) and (2) are what usually happens first if a country doesn’t have its own monetary policy. (1) is why credit losses are and at least for some time will continue to be high in Ireland. It also explains why the losses were that high in Baltics. Note that (2) doesn’t improve the overall situation, but only transfers risks from one part of the financial system to another. The same is true for (3). (4) requires hard work. (5) is curing an hangover with another drink.

Thus, loan-to-deposit ratio without looking the absolute amounts of loans and deposits is quite a pointless target from system-wide perspective. The outlooks for balancing the banks’ balance sheets together with the aim to decrease total indebtedness however are pretty miserable by design.

1 comment:

  1. The nation’s financial regulator is considering requiring banks to downscale their loan-to-deposit ratio to 90 percent as part of efforts to defuse the problem of snowballing household debt.