Is the loan-to-deposit ratio still relevant?

Analysts and regulators routinely evaluate a bank's ability to repay depositors and other creditors without incurring excessive costs and while continuing to fund growth. This so-called "liquidity" of a bank is evaluated using a whole host of tools and techniques, but the traditional loan-to-deposit (LTD) ratio is a measure that often receives the most attention.

The LTD ratio—a bank's gross loans divided by total deposits—indicates the percentage of a bank's loans funded through deposits. An upswing in the LTD may indicate that a bank has less of a cushion to fund its growth and to protect itself against a sudden recall of its funding, especially a bank that relies on deposits to fund growth.

Some analysts have argued more recently that the LTD ratio does not convey as much useful information as it once did. For example, it is much more feasible for banks to sell consumer loans than it was in the past. Thus, a bank with a high LTD may have an easy time making new loans and earning fees simply by disposing of its old loans. Banks also have new sources of nondeposit funding such as those provided by the Federal Home Loan Banks. In addition, banks have a much greater array of financial techniques to allow them to better manage their exposure to their funders and maintain their growth in lending, despite having a relatively high LTD ratio.

How does to the LTD ratio measure up?

To test the integrity of the LTD ratio, we used a unique survey of agricultural bankers in the Ninth District. In each survey the banks were asked if they turned down a loan because they did not have available funds. If the LTD ratio still conveys its traditional meaning and is being interpreted correctly, those banks that turned down loans would be expected to have higher LTD ratios. If this relationship does not hold up at smaller agricultural banks, it is reasonable to believe that the LTD is even less useful for reviewing the liquidity of larger banks with access to newer financial technologies and more funding sources.

About 9 percent of the 100 banks surveyed each quarter between 1993 and 1998 refused a loan at some time because of liquidity constraints. These banks had an average LTD of 79 percent, compared with 67 percent for banks that did not refuse loans.

On the surface, then, it appears that high LTD ratios are related to loan refusals. But, to be more certain of this relationship, we needed to account for factors other than the LTD ratio that may hinder a bank's ability to meet loan demand. A more sophisticated statistical test called regression analysis controls for factors that may influence a bank's ability to fund loans. In addition to the LTD ratio, we also examined variables relating to a bank's use of insured and noninsured deposit funding, loan growth, a bank's equity level and the time period when the financial and survey variables were reported. We did not include the size of the bank or the concentration of loans to certain types of borrowers since the banks we examined were all small, agriculturally focused institutions.

The logic for including equity levels is that a bank with high levels of equity provided by stockholders may be better suited to respond to periods of high loan demand. Likewise banks which have had higher insured and uninsured deposit growth may be less likely to turn down loans. In contrast, banks experiencing rapid loan growth may be more likely to turn down additional loans.

Using regression analysis, we found that the LTD ratio was highly statistically significant and robust in explaining the likelihood that a bank would refuse a loan: The higher the LTD the more likely a bank would refuse a loan. Other of the variables were not statistically significant or did not relate to the loan refusal in the manner we expected.

Of course, this initial test is far from the last word on this topic. Because of the importance of liquidity issues to regulators in this district and throughout the country, we will continue to review which tools help identify banks that may be experiencing liquidity problems.