The Keystone Trait of Prudent and Profitable Banking

The more you study banking, the more you realize
that succeeding in the industry boils down to a handful of factors, the most
important of which is efficiency.

This seems obvious, but it’s worth exploring
exactly why efficiency is so critical.

A bank, at its core, is a highly leveraged fund, with the typical bank borrowing $10 for every $1 worth of capital. This makes banks profitable. However, it also means that banks, by design, are incredibly fragile institutions, using three times as much debt as the typical company.

Warren Buffett wrote about this in his 1990 letter to shareholders:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks.

The primary source of mistakes in banking, Buffett
noted, is what he refers to as the institutional imperative, “the tendency of
executives to mindlessly imitate the behavior of their peers, no matter how
foolish it may be to do so.”

Buffett was writing about a commercial real estate crisis in the early 1990s that was laying waste to the banking industry. As competition for commercial loans heated up, banks cut rates and eased terms in order to win business. When real estate prices crashed, banks paid the price for doing so.

It was during that time, for instance, that
Security Pacific Corp., one of the great California banking dynasties, sold
itself to BankAmerica Corp. to stave off insolvency.

These pressures – the fear of missing out, if you
will – have not gone away. They factored into the financial crisis, causing
lenders to move down the credit ladder in order to make subprime loans. And the
word on the street is that these same pressures are causing some banks to cut rates
and ease lending terms today.

The key is to insulate yourself from these

Part of this is psychological – understanding how
emotions, particularly fear and greed, play into decision making. And part of
it is practical – operating so efficiently that it eliminates the temptation to
boost profitability by easing credit standards.

The direct role of efficiency in a bank’s operations is obvious: The less revenue a bank spends on expenses, the more that’s left over to fall to the bottom line.

But the indirect role of efficiency is even more
important: A bank that operates efficiently can relinquish some of its margin
to attract the highest-quality credits. It also eliminates the need to stretch
on credit quality in order to earn one’s cost of capital – a return on equity
of between 10% and 12%.

“Being a low-cost provider gives one a tremendous strategic advantage,” Jerry Grundhofer, the former chairman and CEO of U.S. Bancorp, once told Bank Director’s Jack Milligan. “It allows you to deal with challenges, be competitive on the asset and liability sides of the balance sheet and take care of customers.”

Indeed, it’s no coincidence that the most
efficient banks when it comes to operations also tend to be the most prudent
when it comes to risk management.

But not all efficiency is created equal. In
banking, efficiency is expressed as a ratio of expenses to revenue. The key is
to have the right mix of the two.

The temptation is to drive efficiency through cost control. The problem with doing so, however, is that a bank can only lower its costs so far before it begins to cannibalize its business.

The same isn’t true of revenue, which tends to be twice as large as expenses. Consequently, the most efficient banks through time generally are those with the highest revenue to assets, not the highest expenses to assets.

The archetype for a high-performing bank isn’t just one that operates efficiently, but one that drives its efficiency through revenue, the denominator in the efficiency ratio.


John Maxfield


John Maxfield is a freelance writer for Bank Director magazine. He was previously the senior banking specialist at The Motley Fool. He regularly writes for Bank Director magazine and His work has been syndicated widely to national publications including USA Today, Time and Business Insider, and he’s been a regular guest on CNBC. John has a bachelor’s degree in economics from Lewis & Clark College and a juris doctorate from Southern Methodist University. He’s a licensed attorney in the State of Oregon.