The Other Secret of NIM: Tight Spreads Eroding Your Profits? Cost-Accounting Offers Another Way to Fix This Besides the Obvious

Article excerpt

The near-obsessive attention of community bankers to interest spread" and earning asset yield levels--the most visible components in increasing or decreasing profitability--tend to override the attention paid to all other ingredients in assessing performance levels.

Because these two components are no doubt the most visible stats, the result is that cost-control factors relating to non-interest expenses consistently tend to take a back seat when bankers are reviewing overall performance.

Yet there's much more to the picture. My primary objective here is to draw attention to recent significant changes in noninterest expense levels in community banks. In addition, I'd like to offer another look at a measure of successful performance beyond traditional interest spread analysis.

A standard challenged by reality

Over the years, community bankers became quite accustomed to benchmark statistics regarding noninterest expense categories. In time, they accepted the traditional industry standard 3% of average assets in total noninterest expenses.

Yet, in recent periods this norm has been challenged, and successfully defeated with ever-increasing efficiencies in technology, information processing, automated support systems, and management control tools.

Several periods ago, total noninterest expense (on average) for community banks dipped below the 3% norm, and is currently in the 2.75% to 2.8% range--a significant decline. This decline played a key role in profitability, yet it was consistently overshadowed by net interest spread stats. In fact, in many community banks, this component of profitability often offsets an under par performance in interest margins, and results in higher overall earnings.

What comprises noninterest expense? Where have most efficiencies occurred? While this varies greatly among banks (and market areas), a database of performance in this area provides good insight. The database consists of about 23 community banks, with average assets ranging from a low of $300 million to about $2 billion. Here are some findings from this sample:

* Of the average 2.80% (of average period assets) in noninterest expenses, a bank's profit centers (lending, branches, etc.) comprise just over half, averaging about 1.46%.

* Cost/support centers (back office support functions) generate the remaining 1.34%.

* The significant declines in recent periods have occurred in the latter category, which has seen a reduction of about 20 basis points.

* Profit centers, with their continued delivery costs, talent costs, and product development costs, absorb a higher (and increasing) share of noninterest costs.

* With an effective, in-place departmental profitability system, cost statistics by department/function are readily available, and an excellent tool to assess the efficiency (or lack of!) by department and compare to other "peer" group members.

Getting in the ballpark While the database is admittedly a bit limited, it has proven to be quite effective as a gauging tool in assessing performance versus averages. Statistics are gathered quarterly, categorized, and averages, as those shown in the table below, are generated. The operating expenses of each department shown are just that; direct expenses relating to the specific department, with any unrelated or questionable expenses removed and posted to the proper responsibility center. The objective, of course, is to identify the total cost (unembellished) of each department, so that reasonable comparisons can be made.

As an example, probably the most frequent error in posting departmental expenses occurs in the human resources area. Often, the postings include the total bank costs for pensions, employee benefits, etc. Of course, as with any other general type expenses, these costs must be removed, and re-allocated throughout the bank on specific bases.

Since much has been written and discussed regarding efficiency in profit center functions, we will concentrate on the bank's "cost/support" departments, the primary area of improvement in recent periods. …