People hate banks. Well, not all of them, but bank hatred has been a widely held option by most people. Some blame it on poor customer service, others because they are regressive and serve to enrich the rich by taking from the poor, while others despise their credit collection processes.

Inasmuch as these may be valid reasons for one not to save their money in a bank or take out a loan, they are abstract and rather vague reasons. One of the ways to conclusively make a rational decision is to use financial ratios, in this case, the efficiency ratio.

What is a bank efficiency ratio?

Efficiency ratios are used to calculate quantitatively a business’ profitability. For banks, the formula is as follows:

Efficiency ratio = Non-interest Expenses / (Operating Income – Loan Loss Provision)

or

Efficiency Ratio = Noninterest Expenses / Net Interest Income + Noninterest Income - Provision for Credit Losses

From the formula, it shows that banks should ensure that their non-interest expenses are always less than their operating income. The formula provides for the allowance of failed credit payments so that banks don't take unmerited blame.

The optimal efficiency ratio for banks is anything less than 50%. This means the bank is using up less revenue to deal with expenses. It also shows that the bank is spending less to earn more.

An increase in the efficiency ratio shows that:

• The bank is spending more. Expenses are increasing.
• The bank is earning less. Revenues are decreasing.

The vice versa works for lower efficiency ratios, which are better preferred.

Let's break down the components of the formula.

Net interest income

Net interest income is a financial measure that calculates the difference between income from assets that bear interest with expenses spent on liabilities that bear interest. It can also be calculated as the difference between what the bank makes as income with how much it pays out to its clients as interest.

The sources of net interest income include loans, such as personal, commercial, and auto loans. The interest earned differs with each bank, meaning the efficiency ratio for each bank is not the same.

Non-interest income

Banks are known to earn their money by borrowing at low-interest rates, then lending at higher interest rates. However, this is not the only way banks make money, at least in terms of earning interest.

Non-interest income refers to other sources of income, such as:

• ATM charges and other bank service charges.
• Selling insurance.
• Brokerage activities.
• Mergers and acquisitions.
• Real estate.
• Trading stocks, bonds, and securities.
• Rent on properties.

Non-interest income is considered a substitute for interest income for banks since the core role of banks is to lend money. For other businesses, non-interest income may be the primary source of revenue.

To check a bank's effectiveness, its non-interest income may be used to cover expenses or increase profits. Also, non-interest income shows that the bank is more equipped to survive negative financial situations.

Non-income expenses

When a bank spends its money on items that are not part of the core operations, we call this a non-operating expense. Non-income expenses may affect a bank's profitability because a single expense could write off all profits earned.

Some of these non-income expenses include:

• Salaries, wages, and remunerations.
• Payments such as rent and utility bills.
• Travel and allowance expenses.
• Repairs.
• Office supplies.

Provisions for credit losses

Treated as an expense in a bank's financial statements, the provision for credit losses protects banks from possible losses. These losses may result from the following:

• Bad debt.
• Credit defaulters.
• Unrecoverable debt.

These are actual provisions for credit losses so that banks set aside part of loan repayments towards offsetting loan losses that may occur in the future. The provision for credit losses reduces the bank's profits.

Credit losses shouldn't be squarely blamed on the banks' customers; the banks also have a lot to answer for. Sometimes, banks assess creditworthiness less objectively and critically, thereby increasing the chances of default risk.

A suitable example of calculating efficiency ratios is as follows:

The Supreme Bank has the following financial statistics:

Net interest income - $43,984

Non-interest income - $32,989

Non-interest expenses - $19,878

Credit losses - $5,468

Its counterpart, the Major Bank, has the following financial statistics:

Net interest income - $4,827

Non-interest income - $7,278

Non-interest expenses - $4,567

Credit losses - $2,545

We shall calculate the efficiency ratios for both banks.

Supreme Bank: $19,878 / $ (43,984 + 32,989 – 5,468)

Efficiency ratio = 27%. Excellent, but too good to be true.

Major Bank: $ 4,567 / $ (4,827 + 7,278 – 2,545) * 100%

Efficiency ratio = 47%. Recommended optimal, at least below 50%.

While Supreme Bank has a better efficiency ratio than Major Bank, the latter has a more realistic efficiency ratio in the real world. However, any bank with a lower efficiency ratio than another is generally more profitable.

Why larger banks may have lower efficiency ratios than smaller ones

Bigger banks may have lower efficiency ratios than smaller ones as they can earn from more avenues. This diversification also spreads out risk so that income is retained rather than used to cover expenses.

Also, larger banks provide more services than lending or at least pay attention to other sources of income. This ensures that they are protected from financial upheavals such as recessions. This ensures that their provision on loan loss reduces, thereby ensuring the denominator does not decrease too massively to cause a high-efficiency ratio.

The loan application process for large banks is drawn-out and more stringent. The requirements may be more than those of smaller banks. Loan borrowers may be required to provide securities in case of default, which means credit non-repayment reduces by a huge margin.

The effectiveness of the efficiency ratio

When calculated correctly, the efficiency ratio provides a quick glimpse into the bank's operations in terms of profitability. It also provides important information about how effectively the bank can offset future loans using its loan loss provision.

Considering this ratio, one can also accurately speculate on whether dividends will increase. It also paints a picture of the extent of bad or good loans.

A bank's efficiency ratio is important in making your next banking decision.