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Bank Efficiency: Measure With Care

The efficiency ratio is the traditional measure for bank productivity. At its simplest, it is the cost required to generate each dollar of revenue. Its simplicity is an advantage, but the ratio always needs a business context, and consideration of the complicating factors is discussed below.

There are two basic ways to calculate the bank efficiency ratio. The most common is the cost to revenue ratio. This measures non-interest expenses as a proportion of operating revenue. Costs include salaries, technology, buildings, supplies, and administrative expenses. Revenue includes net interest income (interest revenue less interest expenses) plus fee income. Investors will also hear of the "cash efficiency ratio," which deducts the amortization of intangible assets from noninterest expenses, before calculating the efficiency ratio.

Once calculated, the next thought is how to interpret the efficiency ratio. A bank's non-interest expense level reflects its efficiency in converting inputs into revenue. A cost to revenue ratio of 50%, or below, is admired. A less efficient bank will have a higher efficiency ratio, say, 70% and above. So, all other things being equal, a low efficiency ratio is good.

Yet things are not equal. Investors need to consider other factors when interpreting efficiency ratios. For readers in a mood for mnemonics, I classify them into three "S"s.

The first "S" is strategy. Take Commerce Bancorp (NYSE: CBH  ) . Superficially, their efficiency ratio of 73% for the first nine months of 2006 is suspect. But Commerce views itself as a retailer, not a banker, and wants "fans, not customers." This high-touch service model is expensive -- hence a bad efficiency ratio -- but helps pull in low-cost deposits, which results in lower cost funding, and a higher net interest margin. In contrast, Bank of America (NYSE: BAC  ) operates at an efficiency ratio below 50%. CEO Ken Lewis does not think "there are any unique franchises in financial services," so his bank has focused on acquisitions and tight cost control.

The second "S" is shape. By shape, I mean shape of the business -- or business mix -- a big driver of the efficiency ratio. Take Bank of New York (NYSE: BK  ) . For the first half of 2006, Bank of New York had an efficiency ratio of 68%. The reason is 79% of its revenue came from fee income. This is after adjusting for the deal with JPMorgan Chase (NYSE: JPM  ) in October, swapping Bank of New York's retail and middle-market banking unit for Morgan's corporate trust business. Bank of New York's strategy is to concentrate on scale-driven processing businesses, which means high fixed costs and, on the surface, an inferior efficiency ratio.

This takes us to the third "S," scale. Bank of New York is a good example of a scale-driven business, with the planned merger with MellonFinancial (NYSE: MEL  ) as the latest evidence. However, the efficiency ratio handles scale- or fee-based businesses badly. In a scale business, banks need to recover their high fixed costs by increasing the volume of transactions processed. Maximizing volumes, not minimizing expenses, is the focus. This leads to a misleadingly high efficiency ratio, despite the highly profitable operating leverage created, which will eventually show up in higher fee income.

In summary, the efficiency ratio is a compact, easy ratio to analyze a bank's cost efficiency. However, you always need to consider a bank's strategy, business mix, and economies of scale as well.

For related reading:

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Fool contributorJohn Finneranwrites and advises on increasing the financial value of technology. He is currently ranked 220 out of 17,109 on CAPS and does not own shares of any of the companies mentioned.

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