When choosing a bank, many people look at features like competitive interest rates, fees on checking accounts, or an institution's customer service. But investors—and even customers—benefit from monitoring a bank’s financial strength in several ways, including its profitability.
A bank’s efficiency ratio allows you to calculate how profitable a bank is. This provides insight into the institution's financial stability.
Learn how to calculate a bank's efficiency ratio and what that means for your bank's financial strength.
What Is a Bank Efficiency Ratio?
An efficiency ratio is a calculation that illustrates a bank’s profitability.
To calculate the efficiency ratio, divide a bank’s expenses by net revenues. The value of the net revenue is found by subtracting a bank's loan loss provision from its operating income.
Efficiency ratio = Noninterest Expenses/ (Operating Income – Loan Loss Provision)
A lower efficiency ratio is preferable: it indicates that a bank is spending less to generate every dollar of income. In theory, an optimal efficiency ratio is 50%, which would mean $1 of expenses results in $2 of revenue. However, banks regularly end up with higher ratios.
For example, if a bank has a net revenue of $100 million and expenses of $65 million, the efficiency ratio would be:
$65 million / $100 million = 0.65 = 65%
Parts of the Efficiency Ratio
You can find the information needed to calculate a bank's efficiency ratio on its income statement. Calculating a bank’s efficiency ratio can be as easy as copying over the numbers, but the resulting ratio will mean more when you 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. Noninterest expenses include operational costs like:
- Personnel: Salary, benefits, and recruiting for staff at all levels
- Marketing: Advertising, market research, and promotional materials
- Real estate: Rent, construction, and more
The interest that banks pay on savings accounts and certificates of deposit (CDs) is also an expense. However, this is accounted for in the net interest income portion of the equation, so it does not need to be included with non-interest expenses.
A bank's operating income generally comes from a variety of sources. This income can generally be divided into interest and non-interest income.
Net interest income: Banks earn interest through investing the money they hold in checking and savings accounts, as well as through loans, mortgages, credit cards, and more. Some of this interest is paid out to customers, but more is kept as income for the bank. Net interest income is the difference between earned interest and interest paid out to customers.
Non-interest income: Banks also earn significant revenues through fees. Some of these are paid by customers, such as maintenance charges, low balance fees, overdraft charges, and service fees for wire transfers or ATM withdrawals. Others may be paid by merchants, such as swipe fee revenue on bank-issued cards.
Loan Loss Provision
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, which indicates its level of financial stability. The more stable a bank or credit union is, the safer it is to trust them with your money.
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.
Comparing Efficiency Ratios Between Banks
Bank efficiency ratios don’t exist in a vacuum. Differences in banks' structure and business model can create a lot of variance in their efficiency ratios.
For example, online-only banks have lower operating costs because they don't have to pay for real estate or physical promotional materials. However, they often pay higher interest rates on checking accounts and high-yield savings accounts.
A regional bank that promises high-touch, in-person service in an expensive real estate market will have higher operating costs. They might also process more high-interest loans, which leads to greater revenue.
To compare efficiency ratios between banks, look at banks that have similar business models and customer bases. Then try to find the institution in that category with the best ratio.
Why a Bank's Efficiency Ratio Changes
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, what a given bank does differently from competitors, and how it compares to banks of a similar size and business model.