Efficiency Ratio: What it is, how it’s calculated and why it’s important to banks and credit unions.
Efficiency Ratio: [Annualized(Total Noninterest Expense - Amortization Expense And Impairment Losses For Other Intangible Assets)] / [Annualized(Net Interest Income + Total Noninterest Income)]
The Efficiency Ratio is used to compare how much a bank is making to how much they are spending in a given time period. There are many definitions of an Efficiency Ratio, but the FDIC recognizes an Efficiency Ratio to be a measure of the bank’s ability to create revenue from their non-funding related expense base. The ratio tells you how well a bank is using their assets to generate profits. The Efficiency Ratio is calculated by dividing the bank’s Noninterest Expenses by their Net Income.
How it’s used
Banks strive for lower Efficiency Ratios since a lower Efficiency Ratio indicates that the bank is earning more than it is spending. This benefits both the bank as well as the bank’s shareholders. A general rule of thumb is that 50 percent is the maximum optimal Efficiency Ratio. Any ratio above 50 percent indicates that the bank is spending more than half of what it is earning in Net Income on Noninterest Expense.
Often, a bank with a low Efficiency Ratio is strong in profitability. This makes sense when you consider a lower Efficiency Ratio means that the bank is spending less to make the same or more money. The more efficient a bank is, the more profit that it can make. This might bring up the question: Does that mean that the more cash and assets that a bank has, the better their efficiency is? This may seem like the case, but it doesn’t always hold true. By measure of the Efficiency Ratio, Smaller banks can perform just as well, if not better, than some larger banks that have a larger pool of assets.
When comparing Efficiency Ratios across multiple banks, there are other important factors to consider as well. Such factors include whether the institutions are community banks or larger banks and where the banks are located. Community banks face different non-interest revenues and non-interest expenses than their larger regional and national counterparts. Community banks are much more dependent on the current local market. Other important differing expenses are employee-related. Community banks generally pay less per employee, but they spend a higher portion of their expenses overall on employee expenses. A final factor that should be considered in comparing bank efficiency is the location of the bank. Certain areas of the country will require higher operating costs. Comparing a bank that operates in an extremely expensive city to a bank based in an inexpensive rural area will supply slightly skewed results as a result.
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