Thinking Beyond the Efficiency Ratio

efficiency-7-18-18.pngBank executives regularly compare their efficiency ratio to peers and often set strategic goals for reducing it. Given the changes in competition, customers and technology, it is strategically imperative that banks focus on their efficiency.

The efficiency ratio, which is calculated by dividing total operating expenses by total operating revenue, broadly indicates the ability of the bank to cost effectively generate revenue. Management should not, however, use the metric as a primary guide for efforts to improve bank performance. The ratio can be skewed by factors unrelated to the efficiency of bank processes, such as business mix, product margins, investment returns, borrowing costs, legacy costs associated with real estate and technology, and short-term cost-cutting programs.

To permanently improve efficiency and cost effectiveness, bank management must go beyond the efficiency ratio and focus their efforts on the following:

  • Reducing unit costs for specific products and processes 
  • Managing unneeded capacity in operating areas and channels
  • Optimizing the cost of delivering quality service
  • Increasing the speed of completion internally and for customers

Improvements in each of these areas require management to dive deeper into existing practices, use data to analyze processes and proactively change the way the organization functions.

Unit Costs
The cost to produce the next batch of products, be they new deposit accounts opened, new loans booked, wire transfers sent or payments processed, is fundamental to efficiency and profitability. Over time, if these costs are higher than necessary for the quality delivered or higher than competitor costs, the bank will have subpar profitability. Measuring, monitoring and trending these costs for each product and process will focus managers and teams on improving performance. Management should have specific initiatives to analyze and improve these costs through workflow redesign, automation and the reduction of low value-added activities.

Unneeded Capacity
Unfortunately, the legacy of past investments in branches, channels and products in the face of changing customer behaviors, technology and competition has resulted in banks having more capacity in certain areas than needed to serve customers and deliver products. Some of the evidence for this unneeded capacity can be seen in branch staff sitting idle waiting for customers, in technology expenditures for processing power and storage capacity to handle peak demands and in commercial lenders having the time to handle small loans. Banks must identify this unneeded capacity through benchmarking, analyzing portfolios and trends, and through managers investigating current activities. By knowing where unneeded capacity exists, management can set strategies for rethinking processes, channels and products, reallocating resources and realigning performance management. These changes can be some of the toughest decisions to make.

Cost of Quality
Customer perception ultimately determines the quality of the service they receive and its value. Bank efforts to design products, craft marketing, train staff, automate, provide new technology, avoid errors, promptly resolve customer concerns and comply with regulations are all costs intended to create quality service and value for the customer. Whether these costs are more or less than the value delivered to the customer and received by the bank should be a constant matter for management attention. A clear understanding and analysis of customer profitability, product profitability, customer perceptions and the incidence of errors is needed to balance the cost of quality with its value and optimize performance.

Speed can be a competitive advantage. Providing answers to customers, delivering service or completing transactions more quickly is often perceived by customers as beneficial. Within the bank, speed of completion of tasks and activities between departments can enable the organization to be more efficient by reducing employee time spent and capacity costs. For the key activities most impactful on the customer and the bank itself, management should analyze and trend the time it takes to complete the process. Trending this speed metric can help identify the root causes of slowness, which may be inadequate technology, unnecessary risk controls, poorly aligned job roles or unclear performance expectations. With an understanding of the root causes affecting speed, management can initiate positive changes.

By tracking unit costs, identifying unneeded capacity, aligning costs with quality and value and by understanding the dynamics of speed, banks can make changes to improve the real efficiency of their processes and products. The success of these efforts will be seen in the efficiency ratio and overall profitability.


Tim Reimink