In a competitive banking environment, the efficiency ratio is the lifeline metric of your bank or financial institution.
In short, it outlines how much your middle-market bank spends to earn a corresponding dollar of revenue. So, an efficiency ratio of 70% means your bank is spending 70 cents just to earn one dollar.
However, the calculation for your bank efficiency ratio is more complex than that. In reality, the ratio is calculated in the formula illustrated below:
Efficiency Ratio = (Non-Interest Expenses) / (Net Interest Income + Non-Interest Income)
Understanding and leveraging this equation to your advantage is essential to keeping your business alive and remaining competitive in the marketplace.
The Three Levers Of Your Bank Efficiency Ratio
The formula outlined above gives your bank three levers for improving your overall ratio:
- Your Interest Income
- Your Non-Interest Expenses
- Your Non-Interest Income
First, while you can certainly change your own interest rates, this variable of the equation is primarily guided by the market and isn’t a key variable in improving your efficiency ratio.
Second, cutting costs in your non-interest expenses is a great strategy for improving your overall efficiency ratio. In fact, we’ve already extensively discussed several areas of cost reduction, compliance tactics and process improvement efforts to bolster this facet of your ratio.
Third, and most important, is the revenue side of the equation (non-interest income). If you’re serious about improving your overall efficiency ratio, this is the one opportunity you can’t afford to ignore.
Growing Non-Interest Income Through Greater Share-Of-Wallet
Your existing customers are the easiest to market to, so when you’re trying to increase your non-interest income, start by garnering a greater share-of-wallet from your current customers. We’ve already covered how you should collect customer and transaction data to improve your bank’s sales process, but you need to use this same approach to achieve greater product penetration across all of your customers.
When you collect this customer experience and organizational data, your next step is to analyze the profit that each of your customers brings to your bank. You should also analyze the products (or combinations of products) that are the most profitable and compare those findings against your customers’ lifecycle stages.
With product profitability and lifecycle stages aligned, you’re able to execute more targeted marketing and sales to your current customers – increasing your overall share-of-wallet with each one.
Benefits Of Growing Your Non-Interest Income
By driving a greater share-of-wallet from your current customers, you develop a mix of interest and non-interest income, protecting your bank from the market swings of interest rates and ensuring that the denominator of your ratio doesn’t drop.
Also, growing your share-of-wallet with customers helps you guard against the competition in two different ways.
- First, the more products your customers have through your bank, the more difficult it is for them to switch to another provider.
- Second, with so much competition from non-traditional financial service providers, a more complete banking package of products and services helps you maintain a competitive advantage.
Decreasing your efficiency ratio is a critical function to keep your bank in business. While you certainly need to manage and reduce the numerator of the ratio (non-interest expenses), you must grow the denominator in order to protect your profitability and help your bank thrive for years to come.
Keeping your community or middle-market bank profitable is an ongoing practice – not just a one-time operation. Click below to download a free whitepaper from Big Sky Associates and discover how continual process improvement initiatives directly benefit your bank efficiency ratio.