As we have said in the past, you have to “buy” growth past the normal expansion in the marketplace. If your regional economy, as measured by production, is growing at 5%, then to achieve growth beyond that you need to “purchase” the incremental business with marketing dollars, sales effort, and risk. Growth doesn’t come free. We have taken this concept to the next level and utilize the “Growth Efficiency Ratio” in addition to the “Growth Efficiency Differential Ratio” for looking at potential M&A transactions. In this article, we discuss the formula and the application of this ratio in banking.
The Problem With The Efficiency Ratio
The Efficiency Ratio in banking takes the non-interest expense less amortization and impairment of intangible assets and divides by total net interest income and fee income. What you get is a nice operating ratio that tells you how efficiently a bank produces revenue. As of the end of last quarter, the average efficiency ratio for the industry was 58.6%, while community banks below $25B in asset size averaged 62.6% and community banks under $1B in assets were at 69.0%. In general, the lower the efficiency ratio, the better. Top performing banks strive to get (or stay) below 60% in 2017.
However, the efficiency ratio is incomplete. Here is a classic, real-life example, which bank below would you rather be from the graph below? The bank with a 75% efficiency ratio that produces 13% earnings growth or the bank with a 57% efficiency ratio producing 6% growth? More interesting, if you were going to purchase either bank, what would be your price differential?
To find the answer, you need some additional math, and you can take the growth rate and divide by the efficiency ratio, so you get growth per unit of efficiency. This becomes a second derivative equation but allows the efficiency ratio to be put in a little different perspective.
Here, you would rather have the higher efficiency ratio but, the higher earnings growth rate of Bank B since it has the higher ratio. In other words, Bank B is more efficient at producing both earnings AND growth. To put this in perspective, the average growth efficiency ratio for the industry is 0.3% and for a top performing bank it is 26.0%. While we use earnings growth, this can be applied to deposit growth, loan growth or even fee income growth.
Another way to look at it is that a bank could cut all marketing and reduce customer service plus infrastructure expenses to achieve an attractive efficiency ratio, but it would put its long-term growth at risk. Further, we also have another derivative of this ratio where we subtract the regional production growth from the earnings growth number which we call the “Excess Growth Efficiency Ratio.”
Finally, we will add that this ratio doesn’t say anything about the quality of that growth as we fully acknowledge that not all growth is good. We have played around with risk adjusting earnings and discounting growth in segments where margins are compressing, but we have yet to arrive at a suitable measure.
Putting This Into Action
The Growth Efficiency Ratio is helpful when comparing two banks or even when managing your own. Efficiency is a major driver of profitability and is one of the highest statistical predictors of bank performance. However, if you expand your analysis period over a time series, the Growth Efficiency Ratio is more prescriptive to bank earnings.
Later this week, we will take a look at the related Growth Efficiency Differential Ratio as we compare two banks and look at how this ratio can translate into value creation. This will be very interesting for banks involved in M&A or for banks looking to help set strategic priorities.
Submitted by Chris Nichols on February 21, 2017