Traditionally, banks make loans which bring in interest income and take deposits which cost them interest expense. Managing these assets and liabilities is crucial, otherwise a bank is going to have more expense than income and have to close down. Pretty simple, right?
Of course, in reality, the balancing act is actually pretty complicated. Otherwise, the entire banking sub-discipline of asset liability management ("ALM") wouldn't exist solely to address its difficulty.
ALM is complex for many reasons. To start, loans tend to be longer term than deposits, so there is a time management issue. Also, if deposits are short-term then they can suddenly be withdrawn and then a bank has a funding issue because, well, all that money they took in deposits is locked up in a bunch of loans. Further, because these are interest-driven products they are at the mercy of overall interest rates and when it comes to the market its hard to really know what the hell is going to happen. Oh, and interest rates are also different dynamics depending on the duration of time associated with them so just go ahead and manage that too.
Clearly a lot is going on. So, it may be helpful to try to think about just one metric that can provide some insight into the ALM of the industry.
Given all the aforementioned factors that must be managed, a simple approach to the problem could be to just have less deposits than loans, which is visualized by the chart above. Assuming the other factors were somewhat equal and unchanging, then having less deposits thans loans would ensure expense was lower than revenue. Therefore, profit!
But even this framework gets complicated because deposits are a source of funding and a pretty good one at that. They are a source of expense but they may not necessarily be as costly relative to other alternatives.
Unfortunately, ALM cannot be boiled down to one metric. There are a lot of factors to watch. Each one can tell part of the story, for example the one here has a unique feature of not directly trending with the business cycle but trends over multiple business cycles. But, for overall ALM, this is just the first of many fascinating ratios to watch.