A company's efficiency ratio is supposed to measure how well a bank is managed. But some experts consider the ratio less relevant as banks earn so much more from fee-based businesses.
Bankers are divided on the ratio's importance, depending on their business mix.
Not surprisingly, the bankers who give it the greatest importance are those with one of the better ratios in the industry. And when measuring the efficiency ratio, best means less, because it assumes a bank with a low ratio gets more for its money.
Joseph R. Ficalora, the president and chief executive officer of New York Community Bancorp Inc., which has one of the lowest ratios in the industry, is a big fan.
"Over the course of our entire public life, the efficiency ratio has always been a meaningful measure of how well a company is being run. It depicts, in the simplest of terms, for every dollar you earn what it cost you to earn it," he said in an interview last week.
Mr. Ficalora's enthusiasm for ratio, which calculates expenses as a percentage of revenue, is not surprising. His $25.2 billion-asset Westbury, N.Y., company has worked to keep its efficiency ratio low, and for several years it has been ranked near the top among the nation's banking companies.
Last year its ratio was 23%, second only to First Financial Holdings of Renton, Wash., with 19.1%, according to Highline Data LLC.
In 2003, it ranked third among the nation's banking companies, rising from fourth in 2002. That's a vast improvement from 2000, when it fell to 87th place, with a ratio of 52%, because of higher expenses associated with its acquisition of Haven Bancorp Inc. But the ratio recovered to 38% in 2001.
James M. McCormick, the president of First Manhattan Consulting Group, does not share Mr. Ficalora's enthusiasm for the ratio. "A bank's efficiency ratio can be highly influenced by factors unrelated to expense management, such as the business mix," he said in an interview Wednesday.
Lawrence White, a professor of microeconomics at the Stern School at New York University, agreed and said that the expense ratio is outdated.
"In the old world, where basically banks were interest income institutions and fee income just wasn't an important thing, then maybe the efficiency ratio may … [have made] some sense," Prof. White said. But now, "comparing bank to bank, or even comparing the same bank over time … it does not make sense."
Net interest income made up 59.2% of the $497.9 billion of revenue at insured institutions last year, according to the Federal Deposit Insurance Corp.
Fee income businesses, like transaction processing, made up the rest of the revenue mix. Observers say those businesses require substantial investments in technology and back-office improvements.
When measured by the efficiency ratio, noninterest revenue in general is less profitable than traditional banking business, observers said.
It's not surprising, then, to discover that at New York Community, which focuses on multifamily lending, only 16.7% of its $179 million of second-quarter revenue came from noninterest businesses.
Nor is it surprising that executives at companies with more diverse lines of business than New York Community say the efficiency ratio is less important as a measure of their institution's success.
"We constantly evaluate our performance in the context of what our peers are doing," and the efficiency ratio is one of the factors used for that purpose, Richard J. Johnson, PNC Financial Services Group Inc.'s chief financial officer, said in an interview Thursday. (PNC recently announced an initiative to cut $300 million of expenses by cutting 12.5% of its work force; the cuts would allow it boost revenue by $100 million by 2007. )
However, total shareholder return, earnings growth, and risk profile are more important measures than the efficiency ratio, Mr. Johnson said. "It's important to recognize, but to follow slavishly would be a mistake," because it could put a lid on revenue growth or even hurt certain business lines, like payment transaction processing.
In the second quarter the $90.7 billion-asset Pittsburgh company's ratio was 71%. PNC has a lot of fee-based businesses; only 36.9% of its $1.5 billion of second-quarter revenue was interest income.
Wachovia Corp., which generated 47% of its $6.3 billion of revenues from fee businesses in the second quarter, also puts less value on the ratio. For the second quarter the $511.8 billion-asset Charlotte company's ratio was 59.29%.
During a recent conference call with investors, Wachovia chairman G. Kennedy Thompson said he has "no desire to be in the top quartile of our competitors" in terms of the ratio. "That may be the only metric that we wouldn't want to be top quartile in."
Since Wachovia is a growth company, lowering the ratio to 40%, for example, would be impossible, Mr. Thompson said on a June 30 call hosted by the Prudential Equity Group LLC analyst Michael L. Mayo.
While Wachovia focuses on cost savings - it's trying to decrease cost growth by between $600 million and $1 billion by 2007, through initiatives that include outsourcing jobs - it also invests what it saves to generate more revenue, Mr. Thompson said.
The average efficiency ratio for banking companies was 56.47% in the first quarter, according to the FDIC. For companies with more than $1 billion of assets, it was slightly better, 55.52%, while for companies with less than $100 million, it was 69.19%.
Over the years, the average ratio has not improved much. Last year the average at large companies was 57.16%, down from 63.62% a decade earlier. And 50 years ago the ratio for all banking companies was 63%, said Jacqueline Reeves, an analysts with BankAtlantic Bancorp's Ryan Beck & Co.
"Intuitively, I would have thought it would have been better today," she said. "The expectations on the efficiency front were huge" in many of the large mergers and acquisitions that have happened in the intervening years, she said. However, the lack of material improvement in efficiency might illustrate why some simply disregard the ratio.
For that matter, First Manhattan's Mr. McCormick said, investors are "valuing revenue momentum, particularly organic growth, higher than most other measures of performances."
And shares of companies with a low efficiency ratio are not necessarily the best performers. Last year shares of New York Community fell 27.9%, mainly because investors were concerned about the company's balance sheet management. The American Banker index of 225 banks rose 25.4%, while PNC's rose 5% and Wachovia's rose 12.8%.
Wachovia's Mr. Thompson said Wachovia would be perfectly happy to get its cash efficiency ratio to the average level. Mr. Johnson said that for PNC, a ratio of about 68% "is probably the best running rate benchmark," but excluding his company's asset management business would lower its ratio to 63%.
A spokesman for Bank of New York Co. Inc., which focuses heavily on fee-based businesses, said it has had an efficiency ratio of around 65% for years.
"For a company like ours, investors are primarily focused on our ability to generate positive operating leverage," he said, which means that revenue grows faster than expenses.
Ms. Reeves said she gets more questions from clients about the operating leverage than the efficiency ratio these days, though she and other observers were quick to add that investors still pay attention to the ratio. In fact, Mr. Johnson said that attention is one reason PNC continues to talk about the ratio during investor presentations.
Its attraction is apparent. "It is an easy measure," said Prof. White of the Stern School. "It's like the drunk who spends all his time looking for his keys under the lamppost, not because he dropped the key there, but because the light is better there."
Adding staff to an existing branch, for example, does not require capital and will create revenue, he said. "That's going to be all to the good; your shareholders will love it" - but the efficiency ratio will drop.
That is why Commerce Bancorp Inc. of Cherry Hill, N.J., which is growing aggressively by opening branches, has one of the industry's highest efficiency ratios. Vernon W. Hill 2d, the chairman, president and chief executive, has often shrugged off a narrow focus on expenses. But in January he told investors during a conference call, "What is happening particularly in New York is the store economics are getting so good that that alone is driving the efficiency ratio down."
His $33.4 billion-asset company's ratio was 68.8% in the first half. "Don't expect it to go to 40% but it seems to be that we can make 0.5% to 1% improvement a quarter," he said.
Gerard Cassidy of Royal Bank of Canada's RBC Capital Markets said that improvement will be noted positively by Wall Street. Like Ms. Reeves, he follows a mix of companies with high and low efficiency ratios, including the $60.4 billion-asset North Fork Bancorp. Inc. of Melville, N.Y., which had a ratio of 36.43% in the second quarter.
But if Commerce's ratio were to drop to, say, 45%, it would be as troublesome as North Fork's rising to 45%, he said.
Commerce's "model is not a low-cost delivery model," Mr. Cassidy said. "They have been successful because of their high-profile, high-cost retail expansion, and if they were to go down and trying to cut costs, they would suggest that the model they've been working so successfully for the last 20 years is no longer working."
