What is the Loan:Deposit Ratio?

The loan: deposit ratio asks: how big is a bank’s loan book relative to the size of its customer deposit base? The answer is expressed as a percentage.

Where the ratio is >100% then the bank has a loan book greater than its deposit base. Where the L:D ratio is <100% then the bank’s loan book is smaller than its customer deposit base.

The L:D ratio can present analysts with a view of the riskiness of a bank’s funding strategy. When analysts see a bank with a high loan to deposit ratio, what they’re really thinking is:

“Here is a bank that has a high ratio of loans relative to its deposit base, and if it is not taking sufficient deposits to fund all of its loan book then it must be raising a portion of its funding from places other than its customer depositors. And that portion of its funding must be coming from the wholesale markets”.

So the L:D ratio is really asking which banks are most reliant on wholesale funding - and those heavily reliant banks would be those banks with relatively higher L:D ratios.

Customer deposits really are just that. These are deposits a bank takes from their customers, which could be individual customers or commercial customers. They can come in a variety of formats but what unites them is that they are deposits left by customers.

If they are customers then they are people or entities with whom the bank has a relationship. And if a depositor has a relationship with a bank, then the theory goes that the deposit is highly likely to be supporting some kind of underlying economic activity and that underlying economic activity lends the deposit a level of “stickiness”.

This contrasts with wholesale funding which is provided by strangers, as opposed to customers, and those strangers are lending to the bank purely for their own investment purposes. And because those investors in the wholesale market are not customers and there is no underlying economic activity supporting their investment, then this funding is deemed to be less “sticky”, more transient and less reliable.

The L:D ratio is not very relevant in stable markets. Rather, the L:D ratio is primarily a risk measure, and it tries to anticipate how a bank’s funding base will react in times of stress (relating either to the specific bank’s financial condition, or stress driven by market factors). If we look back to the financial crisis of 2008 then those banks with a high loan to deposit ratio (and more reliant on wholesale funding), were more prone to coming unstuck as a result of their risky funding base, e.g Northern Rock.

The L:D ratio can be justifiably criticised as:

1. A very blunt measure, which has the potential to be misleading

It’s a very simple measure but also a blunt measure because it takes a bank’s entire funding base and divides it into two categories: on the one hand we have customer deposits which are deemed to be “good”, and on the other hand we have wholesale funding which is deemed to be “bad”. This is misguided. Within each category there is a huge diversity of real-world funding resilience, and the loan to deposit ratio makes no allowance for that.

2. Out of date

The financial crisis of 2008 revealed that funding risk was inadequately regulated and that there was no global standard to define and measure funding risk. In response, when Basel III was born after the crisis it had a substantial book of directives around funding risk in the shape of two new ratios which would set the global standard for measuring this: