Income Or Expense Management?

Mid-sized credit unions report significant variation in both the operating expense and efficiency ratios for several reasons.


Credit unions have focused on expense management over the past three years as they were pressured with corporate credit union write-downs, NCUSIF stabilization expenses, and increased credit losses.

Credit unions’ financial statements show they responded to those pressures. The operating expense ratio (without stabilization expenses), which peaked in 2008 at 3.60%, has hovered around 3.07% for the past two years. That 53-basis-point decrease has never occurred before in credit unions’ history.  Now with some of those expense burdens easing, credit unions are turning their focus to income streams.

The last few years have seen pressures put on non-interest income at many financial institutions, but credit unions were only minorly affected by changes to fee income. The CARD Act in 2009 regulated credit card fees as changes to Regulation E which required members to opt-in for overdraft protection and limited the charges for overdraws of accounts. And the Dodd-Frank Act’s Durbin Amendment limited interchange income for institutions with more than $10 billion in assets.

Instead, credit unions’ focus will be on interest income in the near future. With the continued historic low-rate environment, how can credit unions effectively manage their operations and generate earnings?

One of the more interesting pairings of financial metrics to consider with this is the operating expense ratio and the efficiency ratio. For both of these metrics a lower value is better, though credit unions that do well in one area may not do well in the other.

The operating expense ratio measures expenses relative to the asset base that must be serviced by those expenses. The implication is that with some scale of operations, expenses may be maintained relative to the asset base instead of increasing. There is also an assumption that the assets generate income

The efficiency ratio measures operating expenses relative to core revenue, which is interest income, fee income, and other operating income less interest expense. The underlying premise in this formula is that the continued day-to-day operations should be covered by the income from the underlying assets.

While there is a correlation shown below, there is variation. All credit unions with assets between $100 million and $1 billion have an average expense ratio of 3.16% and an efficiency ratio of 70.6%.  There are approximately 200 credit unions of this group of 1,213 that have both ratios below the peer average. And 661 of the credit unions in this group are above the peer averages for both metrics. That leaves approximately 400 credit unions with mixed results. Why do some credit unions have excellent efficiency ratios but poor expense ratios?

Operating Expense Vs. Efficiency
Data as of December 31, 2011
Callahan & Associates' Operating Expense Vs. Efficiency
Source: Callahan & Associates' Peer-To-Peer Software.

Consider the credit union point in red. This institution, just more than $650 million in assets, has an expense ratio of 4.30% but an efficiency ratio of 45.37%. Looking at its detailed financials, the institution posted high levels of non-interest income (from shared branching activities). Those activities may require additional expenses to perform and the credit union recognizes the income, but they aren’t measured as part of the credit union’s assets, leading to a higher-than-average expense ratio.

Consider the credit union point in gold. This institution, roughly $180 million in assets, has an expense ratio of 1.14% and an efficiency ratio of 88.59%. Its financials show that it is primarily an investment shop and needs fewer front-line employees to service members’ accounts. Expenses are lower, yet with today’s low-rate environment, the credit union’s assets aren’t generating as much income as its peers.

Although these are two extreme examples, they demonstrate how two key financial metrics interact. How might your credit union’s demographics, strategy, or product mix affect your expense ratio and efficiency ratio?




April 23, 2012


  • Nice article. Helps provide a good prospective between the two metrics.
    Russ Dalke
  • This article makes some valid points that have some real world implications for our credit union, and probably many others as well. In the case of our CU that has $460 million in assets on our balance sheet, through our financial services arm and wholly owned mortgage CUSO we service an addtional $560 million in off balance sheet investments and mortgages. Even though those revenue producing assets are not considered by GAAP as part of our balance sheet, there are still substantial expenses required to service them. We are glad to incur those costs because the revenues they generate far exceed them. However, they certainly drive up our operating expense ratio substantially, which is always a cause for examiner concern. That's because those folks are trained to only focus on balance sheet asset-based ratios and "peer groups". (Unfortunately, this agency practice seems largely driven by Callahan's history of using the same down and dirty, and generally inappropriate, method of determining who our peers are for purposes of industry analysis.) However, the reality is that our efficiency ratio, and therefore our profitability, are both healthy. In turn, that serves to increase the overall capital strength of our institution. Yet such facts can be easily obscured when so many of the metrics being used to evaluate us are based on balance sheet assets.
    Wally Murray
  • The credit union industry approach the last few years of controlling expenses in a down market was absolutely the right approach. Lydia is correct that now is the time to grow fee and interest income. With all the low interest deposits on hand; credit unions need to find ways to put those excess deposits to work in lower risk higher yielding non-prime loans. Many former prime members have been rescored as non-prime because of the economic climate. These members were prime when their credit union last extended them credit. Just because they have been rescored as non-prime, credit unions owe them the non-prime loans they now need. Looking away from these once prime members is not the correct attitude for credit unions. Finding a way to continue to service these non-prime members is a must which will help you grow your loan interest income. The problem is that you can't afford to build the infrastructure necessary when dealing with the non-prime member. It does require a different skill set that dealing with prime members. CU Lender Management has developed a turnkey program for credit unions that want to continue servicing their once former prime members without the costs associated with the infrastructure build necessary to do so.
    Frank Mercer
  • Great article. I hope examiners are privy to this kind of seemingly elementary information. What I do not understand is the tendency for many to focus so much on expense control, while so much potential revenue is ignored. It seems to me that in tough times, the most effective managers will attack expenses and simultaneously seek new income sources.