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Separating Bank Loan Signal From Deposits Noise

Even though loans trail deposits, banks are seeing solid loan growth

http://www.wsj.com/articles/separating-bank-loan-signal-from-deposits-noise-1433358384

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Banks have seen a surge of deposits resulting from the Federal Reserve’s bond-buying program. Photo: CHUCK MYERS/MCT/ZUMA PRESS

By

John Carney

June 3, 2015 3:06 p.m. ET

1 COMMENTS

A common measuring stick of bank lending may be misleading some investors to overlook solid growth.
In the first quarter of 2015, loans grew 5.9% from a year earlier. That is the fastest rate of growth in over six years and above the long-term average, according to a recent Barclays report. Surprisingly, that hasn’t silenced those ringing alarm bells about credit conditions being too tight.
One reason some may be overlooking healthy loan growth is that it hasn’t been a very visible contributor to bank earnings growth. Persistently low interest rates have squeezed margins on loans, meaning banks have to lend more just to keep interest income steady.

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Plus, many have noticed that deposits have grown much faster than loans in recent years, throwing the ratio of deposits to loans far off its historical balance. The Brookings Institution, for example, recently issued a report describing the decline of loans in relation to deposits at the largest U.S. banks a “troubling” sign.
“Banks may be reluctant to lend because of continued concerns about risk, or they may be restrained from lending by regulatory pressure,” the think tank wrote. “This trend may be a cause for concern among policy makers, consumers, and industry alike if it continues.”

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While it is likely the loan-to-deposit ratio will continue to look off-kilter, this might not be a reason for great worry. Excess deposits aren’t necessarily a sign big banks are reluctant to lend. Nowadays, the loan-to-deposit ratio is more noise and less signal.

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Before the financial crisis, bank loans and deposits tended to grow in step with each other. This is because loans create deposits, so when loans are growing, deposits grow as well.
What makes the current situation so different is that banks have seen a surge of deposits that weren’t created through bank loans. They came from the Federal Reserve’s bond-buying program.
Quantitative easing swapped Treasurys and mortgage-backed securities for bank deposits, driving up the overall level of deposits more rapidly than the pace of loan growth. This inevitably led to “excess deposits” in the banking system.
The notion those deposits should lead to a flood of loans is based on an outdated view of banks as intermediaries between savers and borrowers, institutions that gather deposits to be lent out. As a recent paper from the Bank of England put it: “In the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans...The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever.”
The real determinant of lending is the difference between the return on loans and the opportunity cost of making a loan, which is based on a bank’s cost of capital and the price of reserves. The latter isn’t a function of the quantity of reserves, but the fed-funds target and the rate paid on excess reserves.
Once the distorting lens of the loan-to-deposit ratio is tossed aside, it is easier to see that lending has been relatively robust of late. And that holds out some promise of improving bank earnings as pressure comes off interest margins once the Fed begins to raise rates.
Write to John Carney at john.carney@wsj.com