VTI - Deposit Decline Slowed Lending Flat In Second Quarter: Federal Reserve

2023-07-19 00:56:13 ET

Summary

• The Federal Reserve's report on US commercial banks' assets and liabilities shows a continued decline in deposits, which could impact the sector's ability to meet loan demands.
• Despite a decrease in Treasury and agency investments, banks have managed to maintain lending activity, with the sector’s loan to deposit ratio reaching 70% at the end of Q2.
• Despite deposit declines, the banking sector has sufficient liquidity to meet outflows, with approximately $3 trillion in cash on hand; however, individual bank liquidity measures should be examined.

Last week, the Federal Reserve released its weekly report on the cumulative assets and liabilities of commercial banks in the United States. The significance of this report is that it reflected balances as of Friday, June 30 ^th , or the end of the second quarter. With big banks already reporting earnings and regional banks right around the corner, investors can benefit from understanding how the sector is performing and benchmarking those results against their banks’ earnings report.

The largest source of funding for banks is deposits. The flow of deposits is a leading indicator as to whether the banking sector will be able to meet loan demand, or if the sector will need to engage in outside borrowing to fund new loans. In the first quarter of 2023, deposits declined for the first time in the more than five decades of tracking. In the second quarter, this downward trend continued although it slowed for the quarter.

The decline in bank deposits should be examined from multiple angles. First, the decline in deposits comes after a massive increase in deposits in 2020 caused by the COVID stimulus funds. Next, deposit levels are right where they were at this time two years ago and remain $1.5 trillion or 10% above the bump they got by COVID stimulus in 2020. Deposit decline is currently acting as a function of tightening by the Federal Reserve to get excess funds out of the banking system.

Banks utilize depositor funds to lend. The sector lends to the government in the form of purchasing Treasuries and agency securities and to the private sector in the form of loans. Banks have kept pace with the decline in deposits by reducing their investments in Treasury and agency securities. Like deposits, the declines in Treasury and agency securities slowed in the second quarter. Banks are likely not selling these securities, they are just repurchasing less volume than what is maturing. The banking sector’s investment in Treasuries and agency security remains elevated compared to pre-COVID levels.

The decrease in Treasury and agency has allowed banks to not throttle the private sector on the loan side, but lending activity has slowed. Loan and lease activity inched up by 0.6% after declining slightly in the first quarter. While lending is basically flat for the first half of 2023, the surge in lending that occurred from late 2021 through 2022 has current loan balances more than $1.5 trillion higher than after the wave of PPP forgiveness.

The sector’s loan to deposit ratio continued to climb through the second quarter, topping 70% at the end of the quarter. While this is notably higher than the 63% ratio a year earlier, the sector’s loan to deposit ratio is still below pre-pandemic levels of 75 to 80%. Essentially, the growth in deposits has far outpaced the growth of lending. No lending growth in 2023 is a leading indicator that the banking sector is no longer supporting asset price inflation.

The regional banking crisis in the first quarter set off a wave of borrowing growth by the banking sector, along with a build in cash balances. Banks did not borrow more in the second quarter, but there was no significant debt reduction. Leverage moved up when the pandemic hit and remains between 9 and 9.5 to 1. Despite the increase in borrowing, the ratio of borrowings compared to both cash on hand and securities remains below pre-pandemic levels.

Should deposit declines hit the sector soon, the banking sector has enough liquidity to meet deposit outflows. The sector is sitting with approximately $3 trillion in cash on hand and due to the drop in deposits, the ratio of cash to deposits has risen. Despite the sector’s ample liquidity, investors should examine a bank’s specific liquidity measures against the sector to see where their bank adds up.

Looking ahead to the second quarter earnings release, banks that show deposit increases will certainly be “bucking the trend” of the sector. Banks with reasonable loan to deposit ratios can utilize capital to grow their lending without the need of external borrowing. While the overall picture of the sector remains healthy, outliers in the industry are still at risk for deposit runs and failure.

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