In banking, this is one instance where lower is better.
Banks strive for a lower efficiency ratio since it indicates that the bank is earning more than it is spending. It’s not only an important measure for internal strategic planning, it’s also a key metric looked at by potential investors and current stakeholders.
Noninterest expense: Employee salaries and benefits, equipment and property leases, taxes, loan loss provisions and professional service fees.
Net interest income: The difference between the revenue generated from a bank’s assets and the expenses associated with paying out its liabilities. Quality of the loan portfolio affects net interest income because situations like a slowing economy and job losses can cause borrowers to miss payments, which can lower the bank’s net interest income.
Noninterest income: Income derived primarily from fees: deposits and transactions, insufficient funds (NSF), annual and monthly account service charges, ATM, inactivity, check and deposit slips and others. When interest rates are low, banks rely on these fees for income. Fee income is generally higher for business banking accounts since businesses are more likely to view fees as a cost of doing business and therefore don’t push as hard for them to be reduced or eliminated.
Provision for credit losses: Estimation of potential losses due to credit risk or loan defaults.
A general rule of thumb is that 50 percent is the maximum optimal efficiency ratio, meaning it costs the bank $.50 to generate $1.00 in revenue. If your bank is not near that benchmark, here are some considerations.
A rising efficiency ratio trend could indicate the bank is not as profitable as it once was. This can be due to internal actions like excessive fee waivers that reduce noninterest income or rising noninterest expenses such as salaries.
A decreasing efficiency ratio is often the result of prudent cost cutting for a reduction in unnecessary noninterest expenses, or an increase in interest income because the bank is making a better spread on its loans with strategic marketplace pricing. Both of these factors contribute to an increase in profitability.