Not many people would argue that banks tend to operate a little bit differently than other businesses. As a matter of fact, one of the key components of profitability and a motivation to be a potential merger target, is the proportion of loans granted which, on average, remain unused by borrowers at any given time. These loans sit on the bank’s balance sheet as deposits. Interesting accounting when looked at from a non-banking perspective. Nonetheless, it plays out that the larger the market share, the more loans and deposits it is able to create and make money from. That’s not a component that most businesses have when managing their efficiency ratios. But maybe that’s not a big deal since it seems that banks tend to focus on other ratios such as debt service coverage ratios, loan-to-value ratios and of course, the ratio of total debt to total assets, which is arguably the one that gets the most attention. A bank’s efficiency ratio seems too low on the scale of importance unless they are looking to be an attractive acquisition target.
One would think that an efficiency ratio is directly related to economies of scale and it is, but not in a very direct or easily measured way. The problem is efficiency ratios are calculated as net interest income, plus (+) noninterest income, minus (-) a provision for credit losses, divided (/) by an all non-interest expenses. And sometimes the focus on expenses just doesn’t make it to the boardroom. A bank has to be completely focused on trying to improve its overall efficiencies in every department for there to be a substantial impact. Rule of thumb has it that 50% is the maximum, but the industry average is 60%. The biggest impact on efficiency is typically employee salaries and benefits, and so it seems many times financial institutions tend to work on that problem rather than the more tedious efficiencies on a department by department basis.
That said, the more progressive banks recognize that you can only cut salaries and benefits so far before all service is negatively impacted hence, the move towards more and more Internet banking. Nonetheless, in speaking with people on both sides of some recent mergers, it seems that there has been an increase over the past three to five years for banks being willing to try and improve their efficiency ratios through the use of technology and improved workflow/processes rather than cutting payroll expenses and reducing their physical imprint – fewer branches and smaller main offices. Most of the improvement on process through technology has been on the retail side of financial institutions and so it seems there is great opportunity to make strides on the commercial and back-office areas. Even the boards of some banks are beginning to realize that it’s important to take the risk of implementing technologies that will ultimately have an impact on the bank’s efficiency ratio, even if it’s only a number of percentages of a point.
Financial institutions are rarely thought of as highly entrepreneurial in part because of regulation, and partially because of the public’s perception that they be “safe” places – the holiday movie It’s a Wonderful Life did a lot to cement that thought in people’s minds. All banks, and especially smaller banks who make up the bulk of the market, need to find a way to be safe, secure and efficient. It’s a new era. I think the market is going to continue to keep an eye on how the merger deals are put together and the impact of where efficiencies incorporate technology can play a stronger role than once thought. I’m going to keep an eye on efficiency ratios and the role they play in mergers. I’m going to watch with interest as our financial industry evolves over the next three to five years and hope that we continue to have a strong system that supports the interest and expectations of business and individuals when it comes to service. How about you? What do you see on the horizon? What would you hope to see the banking horizon look like?