When looking at bank stocks, an important metric that investors watch is the efficiency ratio, which looks at a bank's expenses expressed as a percentage of its revenue. So, if a bank has a 60% efficiency ratio, that means it is spending $0.60 to generate every $1 of revenue. The lower the efficiency ratio, the better.
Fintech and digital banks have a tougher time generating strong efficiency ratios because many are still in growth mode and spending heavily. This can begin to turn into a problem after a while as investors look for a clear path to profitability and lose patience.
The Brazilian digital bank Nu Holdings (NU -1.37%) has been an outlier among fintechs because it is making good progress on its efficiency ratio. In fact, the bank has the potential to generate industry-leading efficiency, as I'll explain below.
Rapid improvement
When you think about the efficiency ratio, there is the numerator -- expenses -- and the denominator -- revenue. The big driver for Nu has been on the revenue side, where quarterly revenue jumped from $636 million in Q4 of 2021 to $1.45 billion a year later.
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Revenue has largely grown due to rising net interest income (NII), which is the money banks make on loans and securities after funding those assets. Nu has expanded its loan portfolio by more than 71% since the end of 2021, which leads to more interest income on higher outstanding loan balances.
But Nu also increased fee income by about 81%, although it's still much lower than NII. The growth in fees is largely related to interchange fees on the company's debit and credit cards, but Nu is also expanding its offerings and selling its existing customer base more of its products.
Meanwhile, expenses only rose by less than $100 million in 2022, which is quite good when you consider the revenue growth. At the end of 2021, Nu had close to a 76% efficiency ratio, which is not a good number compared to the overall industry. At the end of 2022, the industry's average efficiency ratio had dropped to slightly over 47%, which is very strong. What's the culprit? Well, if you subtract share-based compensation, the company's efficiency ratio would have been 41%. The hope is this type of compensation will slow as the bank grows.
Nu's management team said its efficiency ratio is already comparable to that of incumbent banks in Latin America. Additionally, if you look at some of the other popular digital banks out there, it is leading the pack in terms of efficiency. The one-stop-shop financial services company SoFi Technologies had an efficiency ratio of more than 100% in its fourth quarter, while the large digital bank Ally Financial had an efficiency ratio of 57.5%.
Nu can get more efficient
While Nu has already made a lot of progress on the efficiency side of things, the management team believes it can improve further. Toward the end of last year, founder and CEO David Vélez announced that he would terminate his contingent share award that would have potentially granted him lots of stock-based compensation in the future. This move will save the company $356 million over the next seven years.
Furthermore, it expects to slow the pace of hiring moving forward and should be able to keep growing revenue as it acquires more customers and continues to cross-sell more products. It's early, but all of this could very well translate into industry-leading efficiency for Nu down the road.
