Many financial institution executives spend considerable time thinking about strategies to improve efficiency in order to improve overall profitability. The efficiency ratio is the ratio of noninterest expenses (less amortization of intangible assets) to net interest income and noninterest income, so it is effectively a measure of what you spend compared to what you make. The very name — “efficiency ratio” — makes us think about how efficient we are with those precious income dollars. If a financial institution has a high-efficiency ratio, they are simply spending too much of what they make … right? That is exactly what the name implies (emphasis on the spending side of the equation). But this is just a ratio of two numbers, and as we all know, there are two ways to bring the ratio down — reduce costs or increase revenues. The focus across industry press and conference best practices is generally aimed at strategies to cut expenses — using technology, looking at staffing levels, increasing productivity, etc. Although this advice is sound, what happens when a financial institution has already cut what can be cut AND it is still struggling with efficiency? It is sometimes difficult to save your way to prosperity. For many financial institutions, the focus should also be on the bottom portion of the equation — increasing revenues. Let’s look at an institution that has $500 million in assets, a good return at 1% ROA and a reasonable efficiency ratio of 60%. Let’s assume the FI can improve its efficiency ratio by 5% through revenue increase or expense reduction. Financial Metric Before 5% Efficiency Ratio Improvement by Revenue Increase 5% Efficiency Ratio Improvement by Expense Increase Assets $500,000,000 $500,000,000 $500,000,000 Efficiency Ratio 60% 55% 55% Net-Interest and Non-Interest Income $12,500,000 $13,636,364 $12,500,000 Non-Interest Expense $7,500,000 $7,500,000 $6,875,000 Net Income $5,000,000 $6,136,364 $5,625,000 ROA 1.00% 1.23% 1.13% Change in Net Income $1,136,364 $625,000 $500,000 less if the better efficiency ratio is achieved by reducing expenses! It shouldn’t be surprising that increasing revenues provides better performance, even though this sometimes seems like a counterintuitive approach. Because many financial institutions need to increase investments for growth in order to significantly grow their revenues, thereby increasing the expense side of the equation, and because of their excess capacity, this will actually make them more efficient over time. Many financial institutions have cut expenses almost to the bone and can’t materially improve their efficiency ratio by further reducing costs. They 17 West Virginia Banker
RkJQdWJsaXNoZXIy MTg3NDExNQ==