Calculate How Profitable Your Bank Is With an Efficiency Ratio
As a bank customer, you might not care how profitable your bank is—as long as they have competitive rates and provide excellent customer service. But investors and customers may want to monitor a bank’s financial strength for several reasons. A bank’s efficiency ratio is one tool you can use to determine how a bank is doing financially.
What Is a Bank Efficiency Ratio?
An efficiency ratio is a calculation that illustrates a bank’s profitability. To complete the calculation, divide a bank’s operating expenses by net revenues as shown in the formula below. A lower efficiency ratio is best because lower ratios mean lower costs to generate every dollar of income. In theory, an optimal efficiency ratio is 50 percent, but banks regularly end up with higher numbers.
Efficiency ratio formula: Efficiency ratio = Noninterest Expenses/ (Operating Income – Loan Loss Provision)
Example: Ignoring the provision for loan losses, a bank has operating income of $100 million and expenses of $65 million. To calculate the efficiency ratio, divide $65 million into $100 million ($65 million / $100 million). The result is 0.65, or 65 percent.
You can find the information needed to perform the calculation on a bank’s income statement, and we’ll break down those details below. Calculating a bank’s efficiency ratio can be as easy as copying over the numbers, but it’s best to understand what’s behind those numbers.
Banks pay a variety of operating expenses, and it’s crucial that those costs of doing business return a profit. Clearly, banks pay interest on savings accounts and certificates of deposit (CDs), but you can account for those interest costs by using net interest income in your equation. Noninterest expenses include things like:
- Personnel expenses: Salary, benefits, and recruiting for staff at all levels
- Real estate: Rent, construction, and more
Banks earn most of their revenue from interest on loans. But they have several other ways to earn income.
Net interest income: Banks take deposits (checking and savings accounts, for example), and invest that money. For example, banks offer personal loans, mortgages, credit cards, and business loans. Financial institutions may also buy investments in global financial markets. Banks typically pay low interest rates on deposits and charge higher rates on loans, earning a “spread” on the difference. When you subtract the interest paid out from the interest earned on loans, you arrive at net interest income.
Noninterest income: Banks also earn revenue through various fees. Examples include:
- Monthly maintenance charges or low balance fees on your checking account
- Swipe fee revenue when customers use bank-issued cards
- Penalty fees, such as overdraft charges or non-sufficient funds fees
- Origination fees on home loans
- Service fees for wire transfers, ATM withdrawals, and other transactions
- Fees earned through other lines of business
Loan loss provisions: Financial institutions generally include an expense category for expected losses. A subset of borrowers will default on loans, so banks need to prepare for writing off those bad debts and paying related expenses.
Why the Efficiency Ratio Matters
A bank’s efficiency ratio tells you how profitable an institution is, and it’s wise to stick with financially strong institutions.
After all, if you’re opening accounts with a bank, you probably want to be confident that your bank will continue to stay in business for many years to come, and that you won’t have to deal with inconveniences or declining customer service. Unprofitable banks are more likely to experience bank failures or mergers, and they may fail to offer competitive rates on the products you use. Profits help banks absorb loan losses and economic shocks, and they provide resources for the bank to reinvest in the business.
It’s a pain to switch banks, so stick with banks that can survive over the long-term. And if you’re fortunate enough to have more than the FDIC insures at any institution, be especially wary (or better yet, spread those funds out so that you’re adequately insured).
Different Banks, Different Ratios
A low efficiency ratio is generally best, but bank efficiency ratios don’t exist in a vacuum. When making comparisons, it’s essential to evaluate banks that have similar business models and customer bases. For example, an online-only bank is entirely different from an institution that promises high-touch in-person service in expensive real estate markets.
What’s more, efficiency ratios change as conditions change and banks make investments (or cut costs). Extreme cost-cutting can improve a bank’s efficiency ratio, but those cuts may have an impact on future profitability, customer satisfaction, regulatory compliance, and other aspects of the business. If you use the efficiency ratio to evaluate banks, be sure to study how the numbers change over time, and what a given bank does differently from competitors.