For Mutuals, Cutting Costs Is Best Way to Improve Returns

As regulators steadily raise the ante by redefining capital adequacy, generating new capital has become the name of the game for many thrifts.

That can be a major challenge at a time when higher deposit insurance premiums and regulatory costs cut deeply into operating profits.

Mutual thrifts would be well-advised to concentrate on cutting operating expense. This is a good strategy regardless of whether a thrift's focus is on building capital internally or on attracting investors in preparation for conversion to stock company form.

Data from thrifts reporting to the Federal Deposit Insurance Corp. show that reduction of operating expense is the single best way to improve return on equity.

The Human Factor

Personnel is the biggest expense in this labor-intensive business.

For superior-ranked mutual thrifts, personnel costs average 8.34% of operating revenue. Surprisingly, these outstanding mutuals performed slightly better in controlling personnel costs than their stock counterparts -- even though mutuals, which cannot offer stock options to managers, must provide all incentives out of payroll.

The best mutuals did better on personnel costs even though mutuals' assets average only $140 million, compared with $520 million for superior-ranked stock thrifts.

This calls conventional wisdom about operating economies of scale into question.

Where Expenses Rise

The good news for mutuals ends there. At mutual thrifts of lower quality (mostly because of much higher delinquencies), personnel expense ratios were higher. This was not the case for lower-rated stock companies.

The below-average group of mutuals averaged 11 1/2% in this category, compared with 9% for below-average stock companies.

Unlike their higher-ranked colleagues, the below-average mutuals had more employees per $1 million in revenues -- 1.4 more, to be precise -- than stock companies with the same ranking. Personnel expenses as a percentage of revenues averaged 11.57% for the lower-ranking mutuals, 8.06% for the below-average stock companies.

Running the Office

Office expense ratios followed the same pattern:

* The higher-ranked the mutuals, the more they outperformed like-ranked stock thrifts.

* Among below-average thrifts, mutuals spent 5.03% of their revenues in this category, compared to 4.42% for stock companies.

Other operating-expense ratios likewise rose as the quality of institutions declined. Mutuals that were ranked below-average spent 6.04% of their revenues in this category -- the highest figure for any of the groups.

The Payoff

Out of adversity comes opportunity. There's obviously a lot of room for trimming fat at many mutual institutions.

If you're a typical mutual thrift, you can add about 35 basis points to your pretax return on earning assets by reducing your overall operating expenses as little as three percentage points -- for instance, from 21% to 18%. After taxes, that translates into a rise of 25 basis points.

For a modestly leveraged (10 times) mutual rated "superior" or "excellent" by my company, such a reduction in expenses would add 250 basis points to return on equity. The improvement would be 300 basis points at a mutual leveraged twelvefold.

Such increases would bring many healthy institutions a return on equity exceeding the estimated cost of equity capital.

If you intended to remain a mutual, this would enable you to add substantially to internal growth of equity capital. If you were contemplating going public, you would raise your profitability to a level that justifies a higher stock price.

Mr. Rickmeier is chief executive officer of Hartland, Wis.-based IDC Financial Publishing Inc., which rates U.S. financial institutions.

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