Our contention is that all banks need to get to a sub-45% efficiency ratio over the next five years. We say this based on the current rate of change of operating efficiencies we see at fintech companies and national banks. As these entities become more efficient, they can offer better rates and fees on banking products and spend more money on both customer engagement and customer acquisition. If you roll this concept forward, the model shows that it will be harder and harder for community banks to compete to grab new customers and harder still to retain them. In this article, we look at why getting more efficient is so important and how banks can proactively get to a place where they can be sustainable for the long-term.
Why Efficiency Matters
Consider third quarter 2017 bank performance. Most banks that are trying to improve performance have a current milestone benchmark of bringing their efficiency ratio to 60% or below by the end of 2017. If you are the average $1B community bank and have an 80% efficiency ratio, the difference between an 80% and 60% efficiency ratio means an approximate $14+ million in operating profit. That is more than $14mm that you can spend on compensation, marketing, lower interest income or higher interest expense.
Improving your efficiency ratio is not the only way to improve performance, but it is one of the best ways. A low-efficiency ratio is a hallmark of a top performing bank (above) and accounts for approximately 15% of performance. That is, there is both a correlation and causation of how efficiency relates to net income. Of all the items that make a difference in bank performance, efficiency has the major advantage of being the most controllable. While customer mix, credit performance, interest rates, regulation and hundreds of other variables have a direct impact on the bottom line, the elements of efficiency, cost, and scale are largely in every banker’s control.
We interviewed hundreds of top performing banks, looked at the data and have experimented with various ways to improve efficiency. We will assume that most unneeded costs are already cut. After that, we have distilled the below six ways to best effect efficiency performance.
Formalize Strategy: No bank falls into a 45% efficiency ratio by accident. In fact, the opposite happens. Bank operations will evolve towards greater entropy if not managed. Getting your efficiency ratio below 45% takes an active, multi-year plan and should be a central focus of your 2018 strategic plan.
For example, we see that several banks have formalized tactics to migrate more of their customers from traditional channels to online or mobile. This is a marked departure from the mindset of some banks that are passive on this point that takes the attitude that they should allow their customers to use whatever delivery channel they want. Change takes energy and if you don’t put energy into teaching and training your customers to use your mobile platform it won’t happen to the extent that you need it to.
Community banks that are passive on channel delivery tend to have only 10% of their customers online. This compares to 75% or greater for banks that are proactive. This difference is material as not only are those banks with more online/mobile customers operating at lower costs, they are already primed to accept future technology. This faster prospective adoption rate ends up making a monumental difference for future profitability.
Branch Channel Transition: Branch expenses are bank’s largest functional cost and are easy pickings for improvement. While branch efficiency is a whole other topic, the practical answer is that bank’s need fewer branches. The average bank has $65 million of deposits per branch while the average top performing bank has $182 million. We posit that in five years’ time, top performing banks will need to have more than $500 million per each branch.
With the rise of mobile banking, branches are too expensive to maintain at the ratio we have now. Every bank should consider a strategic theme whereby they increase the effectiveness of the branch. Within a long-term strategy, banks should consider how they can transition their branch customers to online, mobile and other non-branch channels. This means a concerted effort in developing mobile and online products around core banking applications such as a website to handle chat, problem resolution, and customer service.
Another key element of a branch transition strategy is to assign a specific banker or client action team to your most important customers. Our research indicates that while customers can live without a branch, having an assigned banker within text or call proximity is important for retention.
Next week we will tackle the remaining four major ways that banks utilize to bring their efficiency ratio down to 45% or below. Until then, be sure to create an effort within your strategic plan to leverage your branches and transition your customers to mobile.
Submitted by Chris Nichols on November 06, 2017