Belt-tightening success may lead banks to more ... belt-tightening
A generally accepted efficiency ratio target for banks may no longer be relevant.
That is the case made by West Monroe Partners’ financial services team. They argue that, in an era of rapidly evolving digital banking and technological advances such as artificial intelligence, the general goal of having a 50% efficiency ratio — when profit roughly doubles operating costs — is outdated and should be lowered substantially.
Increased investor expectations could also push banks to aim for lower efficiency ratios.
“With all the advances we’re seeing in technology, I think 50% is obsolete,” Neil Hartman, a senior director in West Monroe’s financial services practice, said in an interview. “Small community banks can get sub-50%, and I think other banks, generally, could get to 40% — or even lower.”
Tools such as cloud computing, robotics and AI make it possible for all banks to cost-effectively bolster productivity and trim expenses by reducing the time people spend on tasks such as data collection and basic account openings. Doing so should also give bankers more time to perform high-level work such as providing financial advice and bringing in new business.
Half of all bankers that participated in a West Monroe survey conducted in April and May listed improved efficiency as their top priority this year. And 61% of the 150 respondents said technology is critical to productivity advances.
Many banks are becoming more efficient as they and their customers embrace digital products and services, industry experts said. At the same time, some observers questioned if a lower target makes sense.
While technology can help a bank become more efficient, upgrades require long-term investment in software and hardware. Revenue is also expected to come under pressure due to lower interest rates.
“Certainly, efficiency ratios should be trending down over time, but to just throw out a number and call it the new standard, I don’t think that’s the best way to look at it,” said Charles Wendel, founder and president of Financial Institutions Consulting in New York.
Still, some banks have already been able to push their efficiency ratios at or below 40%.
The $8.7 billion-asset Eagle Bancorp reported a second-quarter efficiency ratio of 38.04%. The average efficiency ratio for banks with less than $10 billion in assets was 63.63% at June 30, according to date from the Federal Deposit Insurance Corp.
Eagle is benefiting from strong revenue growth that reflects robust economic activity and commercial loan demand in the Washington area, said Charles Levingston, the Bethesda, Md., company’s chief financial officer.
The company has deepened ties to clients and has curbed increases in operating costs via online loan applications and mobile banking, Levingston said. Advances in digital banking have also allowed Eagle to operate with fewer branches that typical banks of its size.
“To the extent that more banks can shed the overhead of physical locations and the fixed costs that go with them, and take advantage of tech to reach more customers, efficiency ratio trajectories should head downward,” Levingston said.
“There’s still a lot of room for improvement almost everywhere I look,” Levingston said, adding that new technology isn’t a cure-all. Talented bankers will always be needed, and tech often breeds new forms of competition that can pressure banks.
For many banks, a key to greater efficiency is scale. With size comes increased ability to invest in the tech upgrades needed for long-term improvements, as well as to spread costs out over a broader asset base, industry observers said.
“The tech need, in particular, creates increased pressure for scale, and that in some cases leads to more M&A,” said Kevin Fitzsimmons, an analyst at D.A. Davidson.
Veritex Holdings in Dallas is a good example. The $8 billion-asset company more than doubled in size when it bought Green Bancorp in Houston earlier this year. The company lowered its operating efficiency ratio to 43.7% at June 30 from 48/67% a year earlier.
“This key metric has only gotten better with the scale and cost savings opportunities from” Green, Chief Financial Officer Terry Earley said during the company’s recent earnings call. Earley said the ratio should continue to improve as Veritex cuts more noninterest expenses.
Focusing on revenue growth is bound to prove vital in the near term, said Michael Jamesson, a principal at consulting firm Jamesson Associates in Scottsville, N.Y. With rates falling and economic uncertainty intensifying, interest income and loan demand are apt to decrease.
“So we’ll see more pressure on margins,” Jamesson said.
Successful banks will be those that can afford to invest in new digital services and products, and enter new markets, while keeping costs in check, Jamesson said. But others may even see their ratios increase due to revenue pressure.
“So long term, yes, costs will come down as machines replace people, and that will help efficiency ratios,” Jamesson said. “But near term, the combination of lower rates, competition and some uncertainty [among commercial clients] could squeeze revenue and hurt margins for many banks.”