38 JANUARY / FEBRUARY 2020 Upside-Down Thinking on Efficiency Are your priorities backward? David Carlson Senior Vice President Haberfeld dcarlson@haberfeld.com Haberfeld is an associate member of the Indiana Bankers Association. DIRECTORS / SENIOR MANAGEMENT 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. Effectively, it is 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, it is spending too much of what it makes … right? That is what the name implies (emphasis on the spending side of the equation), but this is simply a ratio of two numbers. 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 still struggles with efficiency? Saving your way to prosperity can be difficult. Many financial institutions need to also consider 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%. Its key metrics would look something like the metrics shown in Exhibit 1. Now let’s assume the FI can improve its efficiency ratio by 5% through revenue increase or expense reduction. (See Exhibit 2.) Increasing revenue provides better performance, though this approach can seem counterintuitive. 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 cannot materially improve their efficiency ratio by further reducing costs. They need to take a step back and examine some fundamental business dynamics that are often ignored in our industry. Most community financial institutions still have tremendous excess capacity, meaning they could serve significantly more customers without significantly increasing expenses. The answer to improving the efficiency ratio is to fill excess capacity with new profitable customers. How do other businesses look at the issue of excess capacity? For example, imagine a manufacturing company: • The facility is running at 50% of the capacity it was built to produce; • The factory has done everything it can to be efficient – evaluating staffing levels, implementing technology solutions, etc.; • Management’s major goals and objectives remain focused on improving profitability by further
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