I've long argued that the efficiency ratio is the single most important variable investors should examine before buying a bank stock. The main reason is counterintuitive, but it's important to appreciate if you don't want to lose money.
On a superficial level, the significance of the efficiency ratio should be obvious. It measures the amount of a bank's net revenue consumed by its operating expenses. As such, it shows how much money is left over to cover bad loans, pay dividends, repurchase stock, or boost book value by allowing the excess income to accumulate in retained earnings.
These direct effects are important -- indeed, vitally so -- but they're less important compared to the indirect effect that the efficiency ratio has on a bank's underwriting discipline. Take a look at the following chart, which I've shared before. It shows a strong relationship between the efficiency ratios at the nation's 16 biggest banks and their non-performing loan ratios over the past decade.
There are two reasons banks with low efficiency ratios also tend to underwrite better loans. The first is that both require discipline. If a bank has the discipline to keep expenses low -- which, based on my research, is rare -- then it seems natural that it would also have the discipline to manage credit risk shrewdly.
The second reason, which is a corollary of the first, is that inefficient banks appear to compensate for their inefficiency by taking on higher-yielding assets, which, not coincidentally, are also riskier. This allows them to generate profitability ratios in the short run that are comparable to their more efficient peers. But the downside to this approach is that, over the long run, it subjects the offending banks to potential failure when the credit cycle exacts its revenge.
Professor Charles Calomiris alludes to this in Fragile by Design: The Political Origins of Banking Crises & Scare Credit: "Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind."
Furthermore, even if an inefficient bank wanted to maintain superior credit discipline, there's reason to believe that it wouldn't be able to do so. That's because its more efficient rivals can afford to compete more aggressively on loan terms and screen potential borrowers more thoroughly. The net result is that less efficient banks are left fighting over a pool of less creditworthy customers.
Economists refer to this as adverse selection. "If rivals spend more on screening prospective borrowers, then they will get the good borrowers, leaving rivals with a pool of potential borrowers that has been adversely selected; the remaining pool is of lower quality on average," explains Professor Gary Gorton in The Maze of Banking: History, Theory, Crisis.
This is an incredibly powerful insight. I say that because the effects of adverse selection fuel an ever-widening competitive moat separating efficient banks from their less efficient peers. Thus the latter struggle to level the proverbial playing field by taking more risks. It's an unvirtuous cycle that can lead ultimately to failure.
The takeaway for investors is that, holding all else equal, you should always choose a bank with a low efficiency ratio (less than 60%, like Wells Fargo at 58.1% or US Bancorp at 53.2%) over a bank with a high one (say, Bank of America at 88.3% or Citigroup at 72%).
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Apple, Bank of America, and Wells Fargo. The Motley Fool owns shares of Apple, Bank of America, Citigroup Inc, and Wells Fargo and has the following options: short April 2015 $57 calls on Wells Fargo and short April 2015 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.