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Bank of America Needs to Fix This Before Investors Will Get Rich

By John Maxfield - Apr 4, 2014 at 7:36AM

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Here's a shocking statistic for you: If Bank of America became merely average from an efficiency standpoint, it could nearly double its annual earnings.

Even though Bank of America (BAC -1.16%) has come a long way over the last few years, its operating expenses still consume an industry-leading 77.8% of the bank's net revenue.

In formal terms, this is known as the efficiency ratio, the purpose of which, as its name suggests, is to measure how efficiently a bank runs. The more efficient, the lower the ratio. The less efficient, the higher the ratio.

To say that Bank of America has an expense problem is an understatement. Last year, the Charlotte-based lender's net revenue added up to $88.9 billion, a full $69.2 billion of which was spent on operating expenses. After subtracting $3.6 billion for loan-loss provisions, this left only $16.2 billion in net income before taxes.

By contrast, let's assume that Bank of America was simply average, with an efficiency ratio of 61.8% -- this is the mean ratio of the nation's 10 largest traditional lenders excluding Bank of America. Holding all else equal, this would have increased the bank's annual profit last year by $14.2 billion, nearly doubling its net income before taxes.

Fortunately, Bank of America has started chipping away at the deficiency with three separate expense initiatives. The most significant is Project New BAC, which is designed to cut annual expenses by $8 billion once fully implemented. Additionally, the main source of the problem is a single department, known as "Legacy Assets & Servicing," which Bank of America is already in the process of winding down.

The takeaway for investors is straightforward: Given that Bank of America has now settled its last major legal conflict dating back to the financial crisis, its elevated expense base is the final hurdle between the bank's shareholders and major profits. Consequently, it's an area you'll want to watch closely.

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