The Traditional Banking Model Is Losing Steam In This Economy

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The bare-bones banking service of accepting customer deposits and handing out loans is admittedly not a very profitable one. After all, there is in general very little room to change the interest rates for these services in a given economic scenario – especially given the amount of competition that exists among the banks, monoline lenders and credit unions. And the prolonged low interest rate environment is also not helping with net interest margins shrinking notably for all banks over the recent quarters (see Q2 2013 Banking Round-Up: Net Interest Margin Comparisons)

But there are aspects of the plain vanilla banking service that a bank simply cannot overlook. Deposits are the cheapest source of funds that a bank has access to and the traditional banking business is a very stable revenue stream that shows little fluctuation over time. And a bulk of the income for the country’s biggest banking groups still comes from their retail banking division.

So is there a quick way in which we can compare how well the five largest U.S. banks - JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) – leverage opportunities in the retail banking industry?

We believe one such method is to compare their loan-to-deposit ratios, which summarize the proportion of deposits that a bank hands out as loans. In this article, we offer insights into the impact of the economic uncertainty that has been seen since the downturn on the retail banking operations of these banks using this metric.

See our full analysis for Bank of AmericaCitigroupJPMorganWells FargoU.S. Bancorp

The loan-to-deposit ratio, as its name suggests, is the ratio of a bank’s total outstanding loans for a period to its total deposit balance over the same period. Now one would expect this ratio to ideally be equal to 1 (i.e. 100%). In such a case, every dollar that the bank gets as deposits from customers, it lends to other customers as a loan. But this also means that the bank doesn’t have any cash on hand for any contingencies. A combination of prudence and regulatory requirements would suggest that a loan-to-deposit ratio of around 80-90% would be a good benchmark.

The table below shows how the banks actually fare in this regard. The figures have been compiled using data provided by the banks in their quarterly SEC filings, and takes the ratio of the average loans outstanding with the average total deposits for each quarter.

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013
U.S. Bancorp 96.7% 94.9% 93.9% 92.7% 92.1% 92.5% 90.7% 90.3% 90.8% 91.0%
Bank of America 91.8% 90.6% 89.6% 90.4% 88.7% 87.1% 84.7% 82.8% 84.3% 84.7%
Wells Fargo 87.6% 85.8% 82.9% 81.3% 80.9% 79.9% 78.6% 77.0% 76.7% 74.8%
Citigroup 73.8% 74.4% 74.9% 75.3% 74.4% 72.3% 71.0% 69.9% 69.9% 69.5%
JPMorgan Chase 74.0% 70.0% 66.7% 64.4% 65.1% 66.3% 65.9% 64.0% 63.4% 62.0%

The first thing that stands out from this table is the stark differences in the loan-to-deposit ratios for the five largest banks. While U.S. Bancorp loans more than 90¢ for every dollar in deposits it has, the figure for JPMorgan is just about 60¢ to a dollar. This is readily justifiable to a great extent by the fact that U.S. Bancorp has an extremely risk-averse business model that focuses almost entirely on traditional banking services, and its regional focus also supports its high loan-to-deposit ratio. On the other hand, the two banking groups that are at the bottom of the table – JPMorgan and Citigroup – have a significant custody banking service (largest in the world, actually, along with BNY Mellon and State Street) which requires them to keep more of their deposits liquid.

The explanation for the trend shown by loan-to-deposit ratio figures for Bank of America and Wells Fargo is obtained by reading this table in tandem with those we detailed as a part of our recent articles on the changes in deposit base as well as loan portfolio for these banks. Bank of America has more outstanding loans than any of its competitors and the size of its deposits has not grown much over the last 10 quarters, thanks to which it enjoys a loan-to-deposit ratio of almost 85%. On the other hand, Wells Fargo has witnessed a significantly faster growth in deposits over the period compared to loan growth, because of which its loan-to-deposit ratio has steadily fallen to roughly 75%.

But there is another important story the table has to tell. A decline in loan-to-deposit ratios over a period means that a bank’s deposit base has grown faster than its loan portfolio. And considering the fact that this trend has been observed across the banks over the period of more than two years detailed above, this just shows that people aren’t very optimistic of the economic scenario. This inference stems from the fact that the high rate of growth in deposits means that people are locking away more of their cash for use in the future instead of spending it now – indicating that they perceive the economic outlook as uncertain. The rather sluggish growth in loans also points to the same fact, as no one would take on the burden of a loan unless they are confident about the future.

This also goes a long way in explaining the steady decline in net interest margins – and hence the interest income – for banks over several quarters. As banks earn an interest income on loans and incur an interest expense on deposits, a much faster growth in deposits compared to loans would obviously mean lower incomes. The economic uncertainty is aggravating the situation created by this prolonged low interest rate environment to erode profits in the traditional banking business. And unless this trend reverses in the future, margins for retail banking operations at the banks will continue to remain under pressure.

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