The loan to deposit ratio and the trouble with US finance

 The three problems in US finance revisited

In an earlier post, I suggested there were three core problems with US finance: tendency towards dysfunction; uneven cost and access to financial services; and, waste, redundancy, and fraud. I was just browsing through blogs and saw a post at zerohedge (http://bit.ly/1so7Gd9). It is entitled ‘All that is broken with the US financial system in one chart’ and shows the loan to deposit ratio at JP Morgan from 2008 to now. The question I’m asking myself is: does JPM’s loan to deposit ratio really tell us everything wrong with US finance? Does it reveal the US tendency to undermine profitability and stability by way of incentives to misallocate credit? Does it reveal the uneven ability for consumers to access credit on good terms? Does it reveal the wastefulness of the US system, the high incidence of consumer fraud, and the high incidence of white-collar fraud?

The first thing I note is that I don’t think the 2008 to 2014 period is satisfactory for answering these questions. Furthermore, there is no comparison to other large banks, even though JPM on its own has market power and can be considered a special case worthy of analysis. I don’t post comments on that blog, but I did notice in the comments section someone asking if there was a chart for the whole financial system. The implicit criticism, I think, was that JPM is not indicative of the rest of the banking system, even though it is the largest bank in terms of deposits, or at least in the top four. I think a better starting point is asking whether or not the loan to deposit ratio can capture the problems in US finance, and then proceeding with individual banks to understand how the ratio is constructed organizationally and geographically.

I’ve attached below a chart created using FRED (http://research.stlouisfed.org/fred2/), showing the ratio of loans & leases to deposits at US commercial banks. It begins in 1973 and continues monthly to the start of October 2014.

Loan to deposit ratio, US commercial banks

It seems to me this is another important institutional relationship in US finance. Some notable features include: (1) the ratio currently stands at its lowest level since the late 1970s; (2) it peaked during the dot.com bubble, and even the mortgage lending boom could not raise the ratio to its previous peak (which suggests some interesting limits to leverage); (3) it increased rapidly starting in the mid-1990s economic boom; and, (4) it had been in decline from the panic in 2008 until earlier this year.

There are a number of different behaviors that affect the ratio. First is clearly the demand for credit, which is structured by access and cost. Demand, by this token, is affected by the organization of credit allocation, that is the specific institutions responsible for providing it (too-big-to-fail banks, savings associations, credit unions, payday lending). Second is the effect of interest rates, which affect willingness to take on risk by banks. Third is capital and other regulatory requirements.

So, does this institutional relationship reveal the problems in US finance? This question assumes that the three-problems are valid; they may not be, and this is a good exercise to work that issue out.

1. Tendency towards dysfunction

The ratio tends to drop around US recessions, but it is interesting to note that it did not drop as much during the S&L debacle. Leverage actually appears to have increased from 1985 onwards, even through 1987 when there was a sharp drop in profitability of US banks. Even during a banking crisis, leverage continued to grow. It did, however, respond dramatically to the latest recession and banking crisis, however it is hard to separate out those effects. Did leverage decline after 2008 because of demand or because of supply side factors? I don’t know. At the least, the ratio might anticipate collapses, in that periods of expansion in leverage are followed by contractions, which is to be expected based on periods of credit expansion.

2. Cost and access is uneven

In order for us to determine whether or not the ratio can reveal the problem of access, it would probably be best to disaggregate the ratio between types of organizations. First would be sector (commercial banks, savings associations, credit unions, non-regulated intermediaries); second would be size of organization; and third would be the region of operations. It would be great if there were data on the average ratio by banking markets served (which could then be related to other demographic features of those markets, such as income, population, etc), but that would be quite an undertaking. At least in general terms, the ratio suggests that there has been a significant pullback in leverage; as we cannot quantify the factors that contributed to that (it could be demand, regulation, and supply), it is difficult to know whether or not the pullback reflects lower willingness by consumers to take on debt or greater risk aversion by banks. The post at zerohedge argues that the flatlining in amount of loans outstanding indicates a conscious decision by the bank not to extend loans; I think we would need more data on the volume of loan applications as well as the rate at which applications are accepted. The Federal Reserve has survey data from banks, which speaks in a way to sentiment, but hard data would be more useful.

Another important point that comes to mind, and which returns to the issue of access and organization type, is that using commercial banks to determine lending might actually be misleading. As I’ve posted before, regulated banks are actually performing less lending. The ‘shadow’ financial sector has been encroaching on traditional lending markets for decades. It may be the case that the growth of shadow activities in financial markets has lowered the share of commercial banks in lending. To develop this line of inquiry further, one would need to explain that this pattern accelerated after 2008.

3. Waste and fraud

On the whole, the ratio really seems to be an indicator of system-wide leverage. It does not seem capable of tackling issues of consumer fraud, white-collar crime, etc.

Summary

I am weary of these reductionist articles that pop up on so many blogs and online news sites. The problems in the US financial system cannot be boiled down to any one factor. The sector is too heterogeneous for there to be even one set of factors. Clearly, there are more than three problems as well, but I’ve tried to make it so that other “sub-problems” can be filed under those categories. Again, the endeavor to determine just exactly what is wrong with US finance has to take place on a lot of levels–regional, sectoral, historical, institutional, etc. The key may be to generate case studies that are regionally and institutionally specific and see what kinds of patterns and differences can be identified. That said, I’m glad to add the ratio to the list of relevant institutions of finance.

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