Metric of the Month -- Efficiency Ratio

January 20, 2017 | Dr. Stephen Timme

Metric of the Month -- Efficiency RatioWhat time is it?? It’s metric time!! This month we’re talking about Efficiency Ratio. If you have clients in the banking industry, you no doubt hear this term repeatedly – but how is it really measured and why is it meaningful? Read on….

This Month’s Metric – Efficiency Ratio

Who uses it? Primarily banks, including commercial banks, savings institutions, and credit unions. The efficiency ratio is also commonly referred to as the cost to income ratio.

How is it measured? The efficiency ratio is simply the total of all non-interest expenses measured as a percentage of total income, or what’s also called revenue; this excludes interest expenses and the provision for loan losses. The simplest way to think of it is that it’s the operating cost required to produce each dollar of revenue.

What’s in it? You can think of total non-interest expenses as the operating expenses that a bank incurs to keep the doors open and the lights on – these include salaries & benefits paid to employees; technology & communications expenses; occupancy costs like rent & utilities; advertising & marketing expenses; legal costs; and amounts paid to third parties for professional services.

Why is it important? Non-interest operating expenses can consume a significant portion of total income – typically anywhere from 50% to 70% - the efficiency ratio measures how effective a bank is at turning its investment in its resources into revenue, or income.

What drives it? One of the key drivers of the efficiency ratio is the bank’s service mix – services such as credit cards don’t require an investment in a storefront presence like traditional retail banking, this means that banks that generate a sizable portion of their revenue from servicing credit cards may have a lower (better) efficiency ratio than a traditional brick-and mortar bank that doesn’t offer its own card services. Or a bank that derives a significant part of its revenue from wealth management may have a higher (worse) efficiency ratio simply because the education, skill, and know-how required of employees to provide good wealth management advice means the bank has to pay those employees more. But, all of that investment may pay off in terms of higher revenue. Another key driver is business model or strategy – a no-frills, low cost provider will likely have a different efficiency ratio than a bank that invests heavily in customer service to drive revenue or one who capitalizes on technology to drive revenue through multiple channels.

What is the Goal? Usually, the lower the efficiency ratio, the better. This can be through better management of sales & marketing, customer service, mid- and back office processing, information technology, or any number of other factors. It’s important, however, that decisions made to improve the efficiency ratio don’t ultimately adversely impact other areas like total income growth and hurt overall financial performance.

So HOW do you translate this into conversation about value with your clients? We’ll follow this up on Thursday with The KPI Connection, connecting this month’s metric to key business processes and ultimately measurable impact on your clients’ business, so check back for that.

For a deeper discussion on Financial Metrics, Operational KPIs and how they drive sales, see our previous blog post at www.finlistics.com/blog/introducing-a-new-series/

This blog was originally posted on January 21, 2014. 

Posted in Executive Industry Insights, KPI, Metric of the Month, Key Performance Indicator

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