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A loan-to-deposit ratio is a measurement used in the banking world to calculate the percentage of a bank's deposit base that it makes available in the form of loans. Laws in some nations and regions place limits on the loan-to-deposit ratio of banks and other financial institutions. In many instances, government regulators limit these ratios on a case-by-case basis.
The bulk of a bank's revenue is generated through loan production. Banks raise money by agreeing to pay interest to deposit account holders. Some of those deposited funds are then lent out to consumer and business borrowers in the form of mortgages, vehicle loans and other types of credit products. The margin between the interest rate the bank pays the depositors and interest rate it charges for loans represents the bank's profit. Therefore, the higher a bank’s loan-to-deposit ratio, the more money it can earn in terms of lending revenue.
During severe recessions, large numbers of consumer and business borrowers default on debts. Banks can offset some of these losses with revenues generated on other loans. Nevertheless, in some instances widespread defaults can leave a bank in a situation where it lacks sufficient cash to allow its depositors to withdraw their funds. Such banks are technically insolvent and may be shut down by government regulators; in this case, depositors typically lose their funds. To reduce instances of bank insolvency, regulators in many countries limit the loan-to-deposit ratio so that a bank always has a certain amount of cash on hand.
While laws in some countries limit lending ratios, laws in other countries compel banks to lend money. Banks play a critical role in a nation’s economy and if banks refuse to lend money, businesses and consumers will lack the funds to buy goods, ultimately stifling economic growth. To prevent banks from investing in income generating assets other than loans, government regulators in many countries have the powers to assess penalties against banks if loan-to-deposit ratios fall below certain levels. Therefore, banks in many countries are required to keep their loan-to-deposit ratio at a target level that exceeds the minimum required, but stays below the maximum permitted level.
Loan defaults often impact smaller institutions more severely than large ones because the fewer lending clients a bank has, the more of an impact each loan default has on the bank's balance sheet. Rather than imposing industry-wide limits on deposit ratios, regulators in many countries have the authority to assign minimum and maximum ratios on a case-by-case basis. Regulators may lower the loan-to-deposit ratio of the bank that has a already experienced a large number of defaults. Conversely, regulators may loosen lending restrictions at banks with conservative underwriting standards and minimal defaults rates.