The Efficiency Ratio: How Good a Tool?

Article excerpt

In 2004 Synovus Financial Corp. produced an efficiency ratio of 52%--a good number, by itself, when anything below 60% is considered doing well--but something that Synovus promised to better. In its annual report, management pledged to improve processes and cut redundancies not only in its central functions but also throughout its system of affiliate banks.

"We think the efficiency ratio is a good measure of how well you invest in infrastructure to provide revenue over time," says Thomas J. Prescott, executive vice-president and CFO at the Columbus, Ga., regional. "Over time" is something Prescott considers a key point. He doesn't think the efficiency ratio means much as a snapshot; he looks at performance in five- and ten-year blocks.

Nor does Prescott intend to be a slave to a single ratio. Such measures are best viewed as one among many gadgets in the bank manager's toolbox.

"To do well," says Prescott, "you have to use all of them."

A heyday in the 1990s

Though it predates the period, use of the ratio rose during the 1990s, when cost-chopping was the order of the day, "because it was something that everybody could hang their hat on," recalls James Koltveit, director at RSM McGladrey,

However, if the efficiency ratio didn't already exist, it would have to be invented for our market-driven economy, says Keith Leggett, senior economist at ABA.

In many industries, a good efficiency measure is operating expenses to average assets. However, Leggett explains that banking, where most of the assets are not physical, needs a better measure than that. Hence there is the traditional formula: noninterest expense/(net interest income + noninterest income).

"In my opinion, it's a little bit misnamed," says David Furnace, managing director, at Alex Sheshunoff Management, Austin, Texas. "If I knew no better, I would expect it was a metric of how efficient I am at getting things done. But it's not a 'widgets per dollar of expense' rating. It's more a measure of how much I spend to how much I make."

In some situations, a focus on efficiency ratios can mask good opportunities. Take Central Financial Corp., a multibank holding company based in Hutchinson, Kan., which makes a big part of its business investing to varying degrees in fledgling banks. Young banks typically have horrible efficiency ratios, says Robert Wholey, vice-chairman. He says the management team looks most closely at a potential partner's people.

Strengths of the ratio

"This is a very informative ratio," says John Walker, director of BNK Analytics, a division of BNK Advisory Group, Inc., Bethlehem, Pa.

Walker says there are six essential facts an analyst must know about a banking company. The more important three are its net interest income, net overhead, and capital efficiency, expressed in the leverage ratio. Of secondary importance, he says, are the provision for losses, the balance between earning and non-earning assets, and the bank's tax management position.

With the exception of the final point, all of these factors are reflected somewhere in the efficiency ratio, says Walker. The "elite" banking group that Walker's firm tracks (the group's median asset size is $500 million) maintains an average efficiency ratio of 57%, while their peer group efficiency ratio is 75%.

Clearly, then, Walker argues, a good efficiency ratio is an indicator that a bank is doing something right in the most important areas of bank performance. Walker notes that, beside not capturing the bank's tax strategies, the efficiency ratio doesn't reflect anything indicating the institution's risk profile. Hence it isn't, by any means, a standalone indicator.

Yet "it's a good ratio to hold out there to challenge our employees," says R. Scott Smith, president and COO at Fulton Financial Corp., Lancaster, Pa. "It helps them to understand that there are both revenue and expense components to it. …