A commonly calculated measure of bank productivity is the efficiency ratio: noninterest expense/(net interest income + noninterest income).

Banks routinely include the results in their quarterly and annual reports. The question is why? I believe it is done because it is an easy-to-calculate number; anybody can do it. Nobody, though, seems to have asked, "What does it tell us?" Or more accurately, "Does it tell anything important?"

I submit that it doesn't tell us very much.

A simple example will illustrate my point. Take a bank that has three major departments: retail banking, commercial banking, and a trust department. The retail bank accounts for 45% of the bank with an efficiency ratio of 58%; the commercial bank, 35%, with a 43% efficiency ratio; while the trust department represents 20% of activity, with a 70% efficiency ratio. The bank's overall ratio is, therefore, 55.15%.

Now, let the trust department double in size while improving its efficiency ratio to 65%. The bank's overall efficiency ratio has deteriorated to 55.96%. Huh? According to the efficiency ratio measure that is reported, this bank is developing a midriff bulge when, in fact, it is becoming leaner and more efficient.

The ratio is an aggregate that is a reflection of the current relative weightings of the individual departments. The operations of each department should be evaluated on their own, not blended into a puree that harms good performers and protects laggards. Further, a bank that gets out of the trust business will see a marked improvement in its ratio, while a bank that adds a trust department will experience the opposite. The ratio, though, is incapable of shedding any light on the issue of whether the addition/deletion improved the bank — that is, benefited the shareholders.

The emphasis on the efficiency ratio, clearly, is misplaced. It is part of a trend to become preoccupied with revenue-per-employee or FTE (full-time equivalents) numbers. The example shows that the conclusion obtained, less efficiency, is completely opposite to that which is actually occurring. The situations when this measure provides accurate information are so remote that it should be eliminated from any analysis of a bank's operations. In fact, the only situation where it is accurate is for an institution that hasn't opened any new branches or added new products or services in years. Further, the growth rates must be the same across each and every product, service, and delivery point. Does this describe any bank in existence?

In the branches, savings accounts require less noninterest expense than checking accounts. They look more attractive, then, than checking accounts. However, they require higher interest costs. Shareholders, ultimately, are concerned only about net income. So which is the more attractive type of funding? It depends, of course. Economics tells us that as long as marginal revenue exceeds marginal cost the activity is worth expanding. If the marginal revenue is less than marginal cost on savings accounts, then the bank should de-emphasize them. Similarly, if marginal revenue is more than marginal cost for checking accounts, the banks should work to expand the business.

Doing either of these, though, would make the efficiency ratio worse. Likewise, term lending requires less noninterest expense than revolving credit. Does this mean that a bank should load up on commercial real estate mortgages and discourage lines of credit? The efficiency ratio criterion would suggest that a bank that does so is better run. Prudent banking would suggest the opposite.

New branches or, for that matter, any new product or service will have initial phases where expenses will be high relative to income. This will damage the efficiency ratio. Further, some products by their very nature, even at maturity, have a high proportion of noninterest expense to net income; think of the trust department or insurance operations. By the efficiency ratio criterion, banks should avoid offering these products and services. Again, economics, to say nothing of common sense, tells us otherwise.

Obsessing over the efficiency ratio can cause a bank to take actions that are detrimental to its long-run profitability (the only kind that matters). Referring to the example above where the efficiency ratio worsened from 55.15% to 55.96%, a bank may believe that it needs to trim expenses. If we assume that the bank was being efficiently operated for its mix of business initially, then any cost cutting will impair its ability to deliver quality service. Cost cutting usually takes the form of letting staff go, because it is the quickest way to jettison costs.

This is a penny-wise, pound-foolish approach. Very little of the labor in banks can be considered a pure commodity. Most of the personnel have been trained in one fashion or other, most substantially: it may be external: a MBA or other academic accomplishments; or it may be bank-specific training that has helped create a culture and quality of delivery that sets the bank apart from its competitors. This human capital is the most valuable capital the bank possesses. None of these quality aspects appear in the noninterest expense amount in the efficiency calculation.

Again, what, exactly, is this efficiency ratio telling us? Is there any meaningful question — one that would cause management to alter the way in which the bank is run, and the answer to which would be the efficiency ratio? I didn't think so.

It is time to stop calculating and reporting a number that is useless at best, and malignant at worst.

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