Debunking the Efficiency Ratio Myth
How many times have you been in a meeting when the CEO proclaims, “Team, we need to improve our efficiency ratio”? After a round of discussion, everyone leaves the room to jot down ideas on how to cut expenses. And therein lies the first myth.
Myth Number 1: the Only Way to Improve the Efficiency Ratio is through Expense Reduction.
In deconstructing the formula, the efficiency ratio calculates the amount of money spent to earn one dollar in revenue and expresses the result as a percentage, i.e., a 76.05% ratio indicates that a bank spent $0.7605 to generate $1.00 in income. The basic equation is:
Non-Interest Expense / (Net Interest Income + Non-Interest Income)
Often, management’s focus and initiatives to improve the efficiency ratio are generally on the numerator — non-interest expense. Which leads to the second myth.
Myth Number 2: Having a Lower Expense Base will Drive Revenue Directly to the Bottom Line.
While there is an element of truth in Myth Number 2, there are various factors which may cause an increase in the ratio even after expense reductions, namely, swings in revenue sources which impact the denominator.
Wholesale expense reduction, re-engineering, re-organization and downsizing all have been employed to various levels of success. While gains in efficiency and reduced general and administrative (G&A) expenses will be achieved, these events can be debilitating on staff and management and can cause near- and long-term customer service issues. Employees may lose faith in management and further question the organization’s culture and wonder why these measures were necessary, potentially resulting in a drop in productivity and service quality from the staff that remains.
This is not to suggest that expense levels should not be scrutinized; management has an obligation to continue to strive for operating efficiencies to maintain competitive parity. A bloated and dysfunctional organization serves no beneficial end. However, focusing solely on the expenses is shortsighted and can inhibit opportunities for growth and sustained target efficiency ratio objectives.
Let’s return to the basic formula and presume that we have exercised measures to create a stable and scalable expense base. Mining the account base for new sources of interest and fee income can contribute as much as or more to improving the efficiency ratio — with longer term effect and less internal stress — than can a myopic expense focus.
The key to increasing value within the denominator is to drive services per household, cross sales and identify new sources of non-interest income and other fee income across the entire enterprise. This entails a thorough review and analysis of the product set — consumer and business transaction accounts; consumer, commercial and residential lending; and user and service ancillary fees — to identify gaps or variances within the competitive market. RFG clients can rely on their CEO Strategies Group reports, President’s Reports and Strategic Advisor, coupled with an organization-wide revenue enhancement program, to produce a comprehensive road-map from which management can, over time, expand both the customer base and revenue base.
Customers bank with your institution for a reason. Their reason may include your bank’s services, staff and convenience. To improve your efficiency ratio, it may be easier to leverage your customer relationships to produce more revenue, rather than cutting what attracted customers to your bank in the first place: services, staff and convenience.
We’ve debunked two myths, let’s close with a new approach to improving your efficiency ratio:
Manage the Numerator and Grow the Denominator.
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