The Big Idea

Funding loan growth

Tom O'Hara, CFA | September 30, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Strong loan growth and a decline in deposits are forcing many banks to re-think funding strategies. But banks fortunately can choose from several good wholesale funding alternatives. Unsecured debt, securitization and FHLBank funding all look viable for different purposes.

Banks have multiple wholesale funding alternatives

Much of the increase in wholesale funding in 2022 has come in the form of unsecured debt. Banks have been issuing all varieties of unsecured debt, out of both the bank and the holding company, fixed and floating, across a variety of maturities. While investment grade credit spreads are wider year-to-date and over longer horizons, they have not widened out as much as other asset classes such as residential mortgages (Exhibit 1). This presents an opportunity for banks to issue at relatively tight spreads, as the basis between bank debt and bank assets should eventually narrow toward some historical norm.

Exhibit 1: OAS between corporate debt and par MBS is tight

Source: Bloomberg, Amherst Pierpont Securities

Many banks look to securitization as an efficient funding alternative, particularly banks with large consumer loan origination businesses—namely credit cards and auto loans. These assets are securitized frequently and are well-understood by both the rating agencies and investors, so the capital structures and spreads result in funding costs that are generally attractive to issuers. Spreads for residential mortgages have widened significantly, making securitization less attractive. Also, while most credit card loans are floating rate and auto loans are relatively short duration, the long duration of residential mortgages has left most loans trading at a discount. To the extent a bank is seeking gain-on-sale accounting to achieve balance sheet relief, the associated loss with mortgages is likely unpalatable.

Another collateralized form of funding for banks is to fund through the Federal Home Loan Banks, or FHLBanks. Funding at the FHLBanks is generally limited to real estate related collateral such as residential and commercial mortgages. Collateral will fund with a haircut, depending upon perceived risk, and the borrowing bank will be required to invest in additional FHLBank stock, adding modestly to the effective haircut. Despite these features, the funding is usually relatively inexpensive, and FHLBank use has jumped in 2022 (Exhibit 2). FHLBank debt issued is a good proxy for the amount of collateral the FHLBank has been asked to fund for their member banks.

Exhibit 2: FHLBank YTD debt issuance through August

Source: Federal Home Loan Banks Office of Finance

For shorter-term funding of securities collateral, banks may look to the repurchase, or repo, market. Repo is likely the least expensive form of funding available to banks, with tight spreads to the index (now SOFR) and moderate haircuts. Banks need to ensure that they have the operational capability to handle daily mark-to-market. Below is an indication of funding cost and haircuts for various securities (Exhibit 3).

Exhibit 3: FHLB YTD debt issuance through August

Indicative spreads for 9/28/22 Business Day, term is to the 1moCME SOFR index
Source: Amherst Pierpont Securities

Increasing loan-to-deposit ratios

The need for alternative funding comes against the backdrop of rising loan-to-deposit ratios. At the end of 2019, loan-to-deposit ratios stood at around 89 on average for the APS tracking group. Around this level has historically been viewed as an optimal ratio, where banks have strong loan origination activity and thereby strong earnings, but also have a reasonable amount of excess liquidity. In 2020 and 2021, in response to the pandemic, the U.S. government pumped roughly $5 trillion into the economy, ballooning cash balances at banks and lowering loan-to-deposit ratios to the mid-high 60s.

In 2022, with the pandemic largely winding down and business activity generally increasing, banks started to see a corresponding increase in loan demand in Q1 and a corresponding increase in their loan-to-deposit ratios. This trend is illustrated for our tracking group banks in the chart below (Exhibit 4).

Exhibit 4: Loan-to-deposit ratios 19Q4 – 22Q1

Source: S&P Capital IQ, Amherst Pierpont Securities

Because banks were so flush with cash over this time period, they allowed many other forms of wholesale funding to expire. The table below shows the amount of senior debt outstanding, both secured and unsecured, short and long-term, for the APS tracking group (Exhibit 5). This declined by around $300 million for the group over 2020 and 2021 before starting to increase to 2022.

Exhibit 5: Senior debt outstanding, secured and unsecured, short and long-term

Source: S&P Capital IQ, Amherst Pierpont Securities

The trend of strong loan growth continued through June. Commercial and industrial loans have been leading the charge following a relatively inactive two-year period for business lending (Exhibit 6).

Exhibit 6: Commercial and industrial loans, all commercial banks, SA

Source: Federal Reserve H.8 as of 9/14/22

The impact to loan-to-deposit ratios was compounded by bank depositors seeking higher-yielding cash alternatives as the Fed embarked on an aggressive rate raising campaign to offset the impact of rising inflation (Exhibit 7).

Exhibit 7: Deposits, all commercial banks, seasonally adjusted (excludes large time deposits)

Source: Federal Reserve H.8 as of 9/14/22

For the tracking group, the YTD loan-to-deposit ratio increased by around 5 percentage points to the mid-70s on average (Exhibit 8).

Exhibit 8: Change in loan-to-deposit ratio year-to-date through 22Q2

Source: S&P Capital IQ, Amherst Pierpont Securities

As expected, with the run-off of deposits, wholesale funding is making a big comeback in 2022. The table below shows the change in senior debt outstanding, both secured and unsecured, short and long-term, through the first six months of 2022 (Exhibit 9).

Exhibit 9: Change in senior debt outstanding YTD through 22Q2, secured and unsecured, short and long-term

Source: S&P Capital IQ, Amherst Pierpont Securities

Tom O'Hara, CFA
thomas.ohara@santander.us
1 (646) 776-7955

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