Capital One Financial (NYSE:COF) turned in another impressive performance last quarter, as my colleague Matt Frankel discussed here, growing both its top and bottom lines in an unusually difficult revenue environment. But aside from the fact that Capital One was one of the rare big banks to grow revenue last quarter, its most impressive accomplishment concerned its expenses.
Now that all of the nation's 10 biggest banks have reported third-quarter earnings, we can say definitively that Capital One was the most efficient big bank last quarter. Its efficiency ratio for the three months ended Sept. 30 came in at 53.6%, meaning only 53.6% of its net revenue was consumed by operating expenses. This outpaced even the notoriously efficient U.S. Bancorp and Wells Fargo, which turned in efficiency ratios of 53.9% and 56.7%, respectively.
A low efficiency ratio is critical for two reasons. First, a low ratio implies that a larger share of a bank's net revenue is available to cover loan loss provisions, pay taxes, distribute to shareholders, and build book value. With this in mind, it should come as little surprise that Capital One has increased its tangible book value faster than any other big bank since 1994, the year Capital One went public.
The second reason a low efficiency ratio is important is because the most efficient banks also tend to be the most prudent at managing credit risk. This follows from the fact that all banks strive to earn between 12% and 15% on their tangible common equity. And because less efficient banks have less revenue remaining after operating expenses, they're incentivized to reach for yield in their loan portfolios to make up the difference. This strategy works in the short term, but it unravels when the economy takes a turn for the worse, triggering an elevated rate of loan defaults.
Capital One is slightly different than its competitors in this regard, as a much more substantial share of its loan portfolio (42%) consists of credit card loans, which are particularly susceptible to default. Capital One offsets the elevated risk, however, by charging a higher interest rate, which has more than made up for the bank's credit card loan losses over the years. The net result is that Capital One has historically had its cake and eaten it, too, with both a low efficiency ratio and a high-yielding loan portfolio.
Suffice it to say that these traits go a long way toward explaining why Capital One has been so successful over the past two decades.
John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.