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
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
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
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.
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Fool contributor John Finneran writes 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.