The efficiency ratio is a measure of a financial institution’s expenses in relation to income production. Expressed as a percentage, the efficiency ratio translates into the costs incurred by a financial institution to generate one dollar of revenue. A lower percentage represents higher operational efficiency as more revenue is generated from an expense base. The formula is:
(Net Interest Income + Non-interest Income - Prov. Loan Losses)
Credit union efficiency trends declining
June 2006 data shows that the credit union industry had a collective efficiency ratio of 79.7%, which has increased from 73.9% since June 1996. Over those years, credit union operating expenses grew at an average annual rate of 14.0% while income grew 12.4% annually. While the growth rate in operating expenses has slowed over the past five years, indicating a more cost conscious mentality, income growth has gained momentum – thus slowing the ratio’s increase.
Bank efficiency trends improving
Data from the Federal Deposit Insurance Corporation (FDIC) illustrates that banks exhibited opposite efficiency trends when compared to credit unions. Ten-year growth patterns for banks show the efficiency ratio decreased from 57.1% in December 1996 to 56.0% in June 2006.
Similar to credit unions, banking expense and income growth has slowed in the last five years. However, a falling efficiency ratio indicates that banks’ operating expenses grew at a slower rate relative to income.
Business model and scale lead to efficiency differences
As depicted in the above graph, credit unions and banks exhibit diverging efficiency ratios over time. This deviation can be explained by the fundamental differences between the business models of credit unions and banks. Banks tend to have more sources of income from multiple business areas outside of traditional banking, such as investment banking and investment management. Credit unions, on the other hand, tend to have more conventional product offerings with a business model based on traditional lending and savings operations.
There is also the scale difference between the two industries. As of June 2006, the average bank has $1.3 billion in assets while the average credit union has assets of $81 million. Based on the size disparity between credit unions and banks, it is difficult to analyze their efficiency in a comparable manner. More insight is provided when comparing the banks with less than $100 million in assets with credit unions of the same size.
As shown in the graph above, the efficiency ratio trends for credit unions with assets under $100 million have diverged from similar sized banks over the last five years. This again indicates that credit unions are not growing at a high enough rate given their expense base – even against comparably-sized banks.
The bottom line is member value
Why is it important for credit unions to pay closer attention to this ratio? The competitive environment has changed dramatically for credit unions over the last decade. More investments are being made in branches, technology, and marketing. Product sets are changing to meet the needs of new members. While these investments may have long-term payoffs, credit unions must continue to focus on delivering value to members through efficient operations. With divergent efficiency trends than their competitors, credit unions need to analyze their own expenses and income streams to optimize the efficiency of their business.
To see how your credit union is performing against the latest data trends, try a complimentary demo of Callahan and Associates’ Peer-to-Peer Financial Analysis Software.