Calculate How Profitable Your Bank Is With an Efficiency Ratio
Most people don’t care how profitable their bank is. Instead, they look for competitive rates and banks or credit unions with excellent customer service. But investors—and even customers—benefit from monitoring a bank’s financial strength in several ways.
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 indicate that it takes less cost to generate every dollar of income. In theory, an optimal efficiency ratio is 50 percent, but banks regularly end up with higher numbers. At 50 percent, $1 of expenses results in $2 of revenue.
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.
Where to obtain the numbers: 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 the numbers you use.
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 operational costs like:
- Personnel expenses: Salary, benefits, and recruiting for staff at all levels
- Marketing: Advertising, market research, and design
- 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 accept deposits from customers (through 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 significant revenues through 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 often include an expense category for expected losses. A subset of borrowers will default on their loans, and banks need to prepare for that inevitability. When customers default, banks write off those bad debts and pay expenses related to the loss.
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 stable institutions.
When you open an account at a bank, you want to be confident that your bank will continue to stay in business for many years to come. Also, it’s best to avoid inconveniences and 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. If you’re fortunate enough to have more than the FDIC insures at any single institution, be especially wary of where you keep your money—or better yet, spread those funds out so that you’re adequately protected.
Different Banks, Different Ratios
A low efficiency ratio is usually best, but bank efficiency ratios don’t exist in a vacuum. When making comparisons, it’s crucial 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.
Rising and falling ratios: What’s more, efficiency ratios change as economic conditions change. Banks may make investments or cut costs to respond to the competitive environment. 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.