Lobue News: Aug 10, 2015

Keeping Score with your Efficiency Ratio

Just like professional golfers, professional bankers are measured by how low they score.  For bankers, it’s their “Efficiency Ratio” that matters.  When we look at how well bankers do in leveraging their “non-interest expense” we calculate this expense divided by revenue.  The generally accepted   ratio for well-managed banks is 55%. 

“Good Management Begets Good Efficiency Ratios”

There are a host of factors that influence bank efficiency ratios based on each bank’s focus and customer base. And when one considers banks in low labor environments, especially in emerging economies, the 55% standard is overstated due to the favorable compensation expense base in these countries.  Regardless of this variability, the efficiency ratio is the best determinant of management effectiveness over the long term, as reflected in the bank’s stock performance.

So how should management address their efficiency ratio?

First:  Educate all the employees about the importance of their efficiency ratio.  I have often asked middle-managers at major financial institutions about their efficiency ratio.  Not only do they not know what it is, they have no idea how expenses effect the ratio and thus the market value of their bank.

Second: The senior management review process should focus on the level and direction of the efficiency ratio.  Bank management should have in-depth understanding at all levels of the challenges of improving the efficiency ratio.  All investments in people, systems, facilities, etc. should be evaluated based on their long term effect on the efficiency ratio.  Every bank’s DNA must include top to bottom understanding of actions that affect the efficiency of the enterprise.

Third:  Use of creative accounting techniques should take into consideration the LONG TERM impact on the efficiency ratio.  Creative accounting (“let’s depreciate this investment so it does not affect our current earnings”….”let’s take a one-time charge to improve forward earnings”, etc.), is one efficiency ratio killer that management does not properly consider when managing earnings.  I recall a major money market bank taking a $2.0 billion charge resulting from an acquisition, followed by the sale of a valuable network two years later to compensate for the significant overstatement of the write-off.   This type of rationalization just puts institutions in play over the long-term because “figures don’t lie.”

Fourth:  The structured process of identifying efficiencies throughout the organization will be a profitable exercise for banks.

I am often amused when senior bankers tell me expense containment is not a critical factor for them. Top line growth is critical to any enterprise’s long-term success, and is often the focus of performance.  Revenue (denominator) is frequently expected to justify the existing cost base (numerator) to arrive at a competitive efficiency ratio.  In seeking improved profitability, bankers should compare the effort and investment required to gain new business versus the benefit of achieving a 5 – 10% cost reduction.

As a true commodity business, efficiency is the most important single determinant of success. 

Faced with all the non-bank threats to bank revenue streams, any bank that is not focused on improved efficiency is destined to be disenfranchised.  In addition to all of the traditional competitors—commercial paper, money market funds, private label credit cards, mortgage lenders—the industry today is coping with significantly increased regulatory pressures (AML, KYC, Dodd-Frank) as well as new challenges from a wide array of innovators. Alternative funds mobilization and transfer technologies, including crowd funding, Pay-Pal, Apple Pay, Starbucks and Bitcoin, represent a new threat to bank bottom lines. 

In light of these on-going pressures, bankers with foresight are asking “How do I get a breakthrough in my efficiency ratio from the current goal of 55% to 40%?”   While the economic recovery has produced a natural improvement in the industry’s efficiency ratios from the truly horrendous levels of the recession, driving the ratio downward requires a dedicated commitment to reviewing the organization with a renewed emphasis on performance.  Those banks which prioritize implementation of this important management tool will emerge as the market leaders of the future. 

For more information you can contact us at http://www.lobue.com/contact.

You can review more success stories at http://www.lobue.com/stories/form.