A bank's financial standing could affect whether or not you get a loan so learning about its loan-to-deposit ratio is important. Its ratio could also affect the deposits you put into the bank and could indicate whether or not the bank may fail, in which case the government will need to step in and allow for a takeover.
Terms like the loan-deposit ratio may sound complicated but it can be broken down into easy terms that anyone can understand.
Loan-to-deposit Ratio (LDR) is the amount of debt the bank has issued in loans versus the amount of deposits it takes in. It's similar to a debt-to-ratio percentage that individuals have when considering applying for a loan.
LDR measures a bank's liquidity. It is a percentage that indicates whether the bank has enough money to cover unexpected funding needs.
The percentage has a "sweet spot" banks like to meet because a high percentage means it doesn't have enough cash on hand for proper funding while a low percentage shows the bank isn't earning enough money off of loans.
A bank’s LDR is derived the same way your personal debt-to-ratio is calculated. It is figured by dividing the total loan amount of a bank by the total deposit amount arriving during the same period.
A bank's LDR tells you how well the institution is managed. It indicates whether a bank can cover both withdrawals made by customers as well as any loan losses. It can also indicate the success a bank has in drawing new customers.
The "sweet spot" for a bank with LDR is between 80 and 90 percent. That indicates the bank is making sufficient loans to earn money on interest while it still has enough reserves to meet all its obligations and unexpected events.
This is a number that is watched both by banking investors as well as the government. Investors like to know if the bank is successful in its fund management. While the federal government doesn't set minimums or maximum LDRs, agencies like the Federal Deposit Insurance Corporation (FDIC) monitor these numbers to ensure banks are maintaining compliance with the Riegal-Neal Interstate Banking and Branching Efficiency Act of 1994, specifically Section 109.
Others like the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency also watch these numbers. After all, it is the FDIC and the federal government that would bail out a bank that couldn't meet all its obligations as deposits are guaranteed.
An example would be if a bank had $1 million in loans and $3 million in deposits, then the LDR percentage is 33 percent.
A bank that has $4 million in loans and $3 million in deposits is going to have a 133 percent LDR. That's way too high because that bank wouldn't be able to cover all expenses if loans weren't repaid.
Those seeking to borrow from a bank should also know about the loan-to-value (LTV) ratio. This is a percentage that denotes the lending risk that banks and other lenders look at when approving loans like mortgages. While banks want their LDR number to be a bit high between 80 and 90 percent, a high LTV indicates more risk.
A loan-to-value compares the value of the property purchased by the loan to the amount of the loan. An example would be a house valued at $200,000 bought with a $120,000 loan is a positive LTV because the bank would make money if the loan failed and the property had to be sold.
Higher-risk loans put the bank at more risk. The bank offsets the risk by charging the borrower more to take out the loan with a higher interest rate. That means the borrower will pay more over the life of the loan.
Numbers like LDRs and LTV help show a financial institution's stability and management when it comes to looking at a balance sheet but numbers have limitations. One thing the LDR doesn't indicate is the loan quality nor does it show how many loans are falling behind or in default.
These numbers aren't good to use when comparing banks of different sizes or demographics. Every bank should be compared with those similar to get the best indicator of investment.
An LDR also doesn't apply well to alternative lending institutions. Private lenders aren't held the the same rules as traditional banks so these numbers aren't as helpful.
Banking LDR trends change over time. Forty years ago, it was common for a bank's LDR to range between 76 and 84 percent. That number rose steadily as more banks offered residential mortgage lending, remaining between 87 and 97 percent. Ultimately, that led to the 2008 financial crisis.
LDR dropped like a rock and remained tight in the low 70s through 2019. It declined again during the pandemic because everyone deposited their stimulus checks. It's taken some time to recover as banks to make loans again and deposits settled into a normal pattern.
Wells Fargo faced scrutiny in 2018 as the federal government initiated a growth restriction, which improved numbers for the second quarter of that year. An enforcement order mandated the bank liquidate part of its non-core deposits so it could grow. This led to a jump in its LDR with less in its loan portfolio.
Another large bank, Bank of America, had a period where its total loans amounted to $946.9 billion with deposits bringing in $1.3 million. That leaves the bank with a 68.5 percent LDR, which is a little low for profitability but otherwise stable.
The latest news about LDRs, published in the spring of 2023, indicated that the percentages are rising in part because deposits are lagging and banks are now borrowing from alternative sources to accommodate the gap.
The ratios rose throughout last year with rates around 80 percent. A continued rise would indicate possible problems with liquidity.
This means banks could be tightening guidelines on loans to reduce the number of loans issued. It also means these institutions may offer more incentives to open up accounts and maintain certain thresholds of money in those accounts.
Additionally, it's being reported that the government has initiated new rules on banks in August of 2023 to prepare them for possible failures.
One of the requirements is that certain banks issue more long-term debt to take on losses if they carry a risk of being insolvent. This happens when many feel a bank doesn't have enough cash to pay obligations.
This rule affects larger institutions with more than $100 billion in assets.
The rule's goal is to stop banks from getting the FDIC to cover deposits when they fail. The FDIC covered $31.5 billion in recent bank failures so preventing more loss is paramount. Government officials are hopeful the new rules make banks more cognizant of how they manage loans and deposits.
It shifts responsibility for loans to the bank's bondholders rather than depositors. The downside is the bank must raise interest rates to cover the responsibility and that will affect both borrowers and depositors. However, the new rule is waiting for final approval.
Anyone who has a bank account should pay attention to the bank's LDR for several reasons. First, it may indicate whether a bank may offer incentives to borrow, new loan products, or other incentives to encourage deposits and things like savings accounts.
Banks that create stricter guidelines for borrowing may be an indicator that you should look at a private lender for alternative funding for an unexpected situation. Banks that have an extremely high LDR may slow-walk the loan process or prevent many from being approved because of stricter guidelines.