# "High loans to deposits ratio" implication for banks



## Brendan Burgess (10 Oct 2008)

In today's Irish Times Simon Carswell writes 

"Permanent tsb's high loans to deposits ratio ...leaves it vulnerable to surprises"

And I have seen this figure quoted elsewhere to as a negative indicator. 

But I would have thought it wasn't very meaningful. GE Capital and Start Mortgages have no deposits, so their loans to deposit ratios are infinity. 

Of course, if a bank has most of its assets its government gilts its loans to deposits rates would be low, so it would be very safe. 

But surely the ratio of loans to reserves is the best indicator? 

Brendan


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## JohnBoy (10 Oct 2008)

Neither GE Capital or Start Mortgages have banking licences so they cannot gather despoits.

GE Capital has the AAA backing of its parent so it can (or used to be able to) raise funds in the money markets. Start is majority owned by Investec so that is where its funding comes from.

Banks fund their lending either via despoits or borrowing. Deposits are considered to be a more stable form of funding (unless there are doubts about the solvency of the bank) and in the current environment the loan to deposit ratio is one of the key risk metrics to consider when looking at a bank.

Generally banks borrow short and lend long so they have a constant need to refinance long term assets as their short term funding expires. However, the ability to roll funding is now in doubt because of the credit crunch. This is exacerbated for any bank that has a risky profile -in this case ALL the Irish banks are considered risky because of their large exposure to a single asset class. Moreover, all Irish banks face significant funding gaps (tough Irish Life's is by far the largest).

So, if a bank has trouble funding itself then it cannot grow and, indeed, must actually shrink its balance sheet.

The ratio of loans to reserves is just a measure of how much money a bank can afford to loose before it has to raise new capital or go bust.


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## Brendan Burgess (10 Oct 2008)

Thanks JohnBoy

But I know all that already.

My question is very specific about the meaningless of the "loans to deposits ratio".  

It would be as meaningless as a loans to interbank funding ratio.

Brendan


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## Sunny (10 Oct 2008)

Brendan said:


> Thanks JohnBoy
> 
> But I know all that already.
> 
> ...


 
Why do you think they are meaningless? They are good indicators for possible liquidity problems in banks as those with high loan to deposit ratios are more dependent on having constant access to money market and capital markets than banks with who can fund their loan book through customer deposits.

As said by the other poster your use of GE and Start as examples isn't really appropriate as they are not banks. They get all their funding through their parent companies. 

Loans to equity will give us an idea about a banks leverage but it won't tell us about the banks liquidity. They are both useful ratios though. They just look at different things


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## JohnBoy (10 Oct 2008)

Brendan said:


> Thanks JohnBoy
> 
> But I know all that already.
> 
> ...


 
As a risk metric the loans/despoits ratio is vitally important. With the funding markets in effect closed it is a measure of the funding gap and it is a very real concern. For Irish Life, this gap forced it to open a €17bn ECB facility earlier this year! If it had not been for this, Irish Life might have gone the way of Northern Rock.

Are you perhaps lumping the loan/deposit ratio in with a lot of other company valuation metrics?

In what way do you think it is meaningless because banks are failing because of it.


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## Brendan Burgess (10 Oct 2008)

I must be missing something. Let's take a few simple balance sheets: 

*Example 1 *
Assets:

Loans to customers:  100
Loans to other banks   20


Liabilities 
Deposits:  50
Money Market: 40
Shareholders funds: 30

The loans to deposits ratio here is 2:1 


*Example 2*
Assets: 
Loans to customers:  100
Loans to other banks   20


Liabilities 
Deposits:  20
Money Market: 40
Shareholders funds: 60

The loans to Deposit ratio here is 5:1 so, by this measure, this bank is in a worse state than Example 1. Which is clearly not the case. 

I would have thought that the most important of a series of measures would be the Loans to reserves. 
Example 1:  100/30 - or  30% 
Example 2:  100/60  - or 60%

What exactly is meant by the "funding gap"?   In Example 2, I would have said that the funding gap is €60k - to be supplied by both deposits and the money market. 

I have left out bond issues which presumably are a longer term source of financing.  If Example 2 has a bond of 20 due in one month, then it has a liquidity problem. 



Brendan


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## JohnBoy (10 Oct 2008)

I see where you are coming from now. I think that your second example is unrealistic as no modern bank would have a balance sheet structure like that. Equity capital ratios for modern banks are more like 5%/7% so you would never see shareholder funds equivalent to 50% of outstanding loans. It would be an inefficient use of capital.

The funding gap is basically loans less despoits - it the the funding that needs to be sourced from the money markets. It is very difficult to bridge that gap wih deposits unless you are thinking in terms of years.


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## Brendan Burgess (10 Oct 2008)

Thanks for explaining the Funding Gap. 



> I think that your second example is unrealistic as no modern bank would have a balance sheet structure like that.


 
I used it to make the ratios easier to understand. 

While no bank has that at the moment, I think it's the direction which the taxpayer should force Anglo and the Irish Nationwide to go. They would end up with a very high loans to deposits ratio if they stopped new lending and started repaying their deposits. 

Brendan


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## JohnBoy (10 Oct 2008)

The funding gap is a crude measure. It is important to understand what proportion of the current non-deposit funding falls due withing the next 6/12 months as that is where the risk lies.

Lower loan/despoit ratios are just one of the factors that will be a feature of commercial banking in the near future.You need not worry about the regulators or governments forcing this though, the market has already determined what the funding profile of a low risk bank ought to look like and it is imposing its own discipline.

Unfortunately, it is not just Anglo and Nationwide that have inadequate despoit bases, AIB & BOI both have loan/deposit ratios in excess of 150%. Irish Life are even worse.


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## molesz (1 Jan 2009)

Hi, what what would you say about such a bank:
assets:
loans to customers 100
interbank deposits 20

liabilities:
customer deposits 80
interbank loans 40
in that case LDR is 125% that is quite high. 
And lets assume now that these interbank loans are 5-year loans. In that case we have high LDR 125% but substantial amount of a very stable funding at least for the next 3 years. 
Have you spotted any ideas on possible modification of LDR?


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## Spondulicks (10 Jan 2009)

All banks are contracting their loan books because they want to restore their loan deposits ratio to par. Hence credit tightness in both the retail and corporate markets.

This will increase the cost of capital and limit consumer spending. Only credit unions have the cash to lend to retail borrowers at present and the government may want to borrow that for the deficit. Watch this space. Crowding out is the technical term used to characterise government borrowing which displaces private sector fund raising.


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