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After graduating from Georgetown University with a finance degree, I joined RP Financial as an associate and entered the world of community bank consulting, working on a multitude of valuation and strategic planning projects. As I prepare to leave this first stage of my career to pursue an MBA at UC Berkeley's Haas School of Business, I would like to share some insights on community banks from my own perspective.
My favorite measure of a bank's performance is the efficiency ratio (operating expenses/(net interest income + noninterest income)), which considers both revenue and expense. I considered every bank and thrift in the U.S. with assets less than $1 billion (5,473 institutions), and selected the highest and lowest performers, identified as the top and bottom quartiles in return on average assets for the year ended December 31, 2015. As seen in Table 1 below, the bottom performers reported a less favorable efficiency ratio for 2015 than the top performers by 52%; the differential has widened from 37% for 2010. Having analyzed the revenue and expense side, I concluded that in the current low growth environment, most community banks can more readily improve their efficiency ratio by reducing their operating expense; specifically salary expense, because low performing community banks spend significantly more on salaries as a percentage of revenue than high performers (see Table 2). In 2015, for every dollar spent on salary expense, employees at high performing banks generated 40% more in revenue than low performers, a gap that has widened from 29% for 2010.
To ensure that the primary differentiating factor between high and low performers wasn't that high performers generated more revenue, I confirmed that both high and low performers reported declines in revenue as a percent of average assets since 2010 (see Table 3). But for bottom performers, salary expense as a percent of average assets increased, while that of high performers remained constant (see Table 4).
Absent the availability of new revenue sources and the ability to harness them, the only way for community banks to improve efficiency is by re-evaluating salary and other non-interest expense. Here are some efficiency improvement questions to ask yourself:
- Technology: Has technology been appropriately leveraged both in customer facing and back office functions? Does the bank have high revenue products and/or customers that may not be as profitable as they seem, because they are in fact a cause of even higher non-interest expense?
- Training and education: For customer-facing employees, does sales training promote cross-selling of products? Do all staff members have an understanding of the "bigger picture" (vision, mission, plan, sales goals, etc.) and are internal processes streamlined (e.g. accountants with strong knowledge of regulatory capital rules may more effectively assist the CFO in planning and budgeting)? Is cross-training across functions designed to improve productivity and eliminate duplicate roles?
- Data integrity and records: An often overlooked cause of inefficiency, the integrity and consistency of financial data, and the mere maintenance of clear records, is critical for efficient financial analysis. For example, are loans categorized in the same manner in the budget, general ledger and concentration report?
In order to properly evaluate and improve efficiency, before considering major strategy changes or acquisitions, community banks should first look inwards, and assess any areas of efficiency improvement that can be addressed promptly. Similarly, as I embark on the next chapter of my career and evaluate future destinations, I am advised to look to myself and reflect on my inner strengths and weaknesses, as well as all that I have learned so far. The answer to improved profitability, and our true potential, often lies beneath our eyes.
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