Banks are either hated or loved, depending on when you ask customers. If they’ve been approved for that loan or denied a refund of any fee, you will get different answers. As a value investor, banks and financial institutions can be a frustrating experience to try to value. They don’t fall into the same category that other companies do, so therefore they often get ignored. Today we will continue with our series of looking at the different formulas that can help us unravel the mysteries of these institutions. In this post, we will delve into the efficiency ratio and what it means, and how to calculate it.

“In the end, banking is a very good business unless you do dumb things.”

Warren Buffett

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The cool thing about learning to value banks is that once you learn how to analyze one, you pretty much can analyze all of them. There are about 500 banks that trade on the major exchanges, so this should give you plenty of options to choose.

Now, don’t get me wrong they can be very complicated with all the financial instruments, heavy regulations, old account rules, macro factors, and the intentionally vague jargon to try to throw you off.

But at their core, all banks are similar in that they borrow money at one interest rate and then hopefully, lend it out at a higher interest rate, pocketing the spread between the two. Which is the main avenue that banks use to make money.

“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”

Warren Buffett

Definition of Efficiency Ratio

The Efficiency Ratio is calculated by dividing the bank’s Noninterest Expenses by their Net Income.Banks strive for lower Efficiency Ratios since a lower Efficiency Ratio indicates that the bank is earning more than it is spending. … A general rule of thumb is that 50 percent is the maximum optimal Efficiency Ratio

Sageworks

Sounds and looks pretty simple, doesn’t it? And as ratios go it is pretty simple and straightforward.

But there are some accounting terms I want to go over, so we understand what it is we are looking at, and what the terms mean so we comprehend the meaning behind this ratio.

The nice thing about this ratio is that we don’t need a degree in finance to figure it out or years in banking to decipher the meaning behind it.

This ratio is nothing more than a bank’s operating costs, referred to on a bank’s income statement as “noninterest expenses.”, divided by its net revenue ( a bank’s total revenue minus interest expense ).

Efficiency Ratio = Net Interest Income + Non-Interest Income – Provision for Credit Losses / Non-Interest Expenses

Pretty simple, huh? No higher math here, just need to explain some accounting terms, so we understand where the numbers are coming from and what impact they have on our formula.

First, we will only be using the data from the income statement to calculate this formula, so that is easier.

Next, let’s break down each term in the formula, so you understand what they mean.

Net Interest Income: Net interest income is the difference between the revenue generated from a bank’s assets and the expenses associated with paying out its liabilities. A typical bank’s assets consist of all forms of personal and commercial loans, mortgages, and securities. The liabilities are the customer deposits. The excess revenue generated from the interest earned on assets over the interest paid out on deposits is the net interest income.

The types of assets earning interest for the bank can vary quite radically from mortgages, car loans, personal loans to commercial real estate loans. This product mix will greatly affect the interest rate a bank earns on its assets. For example, Wells Fargo, who is the nation’s largest home mortgage lender, can have big fluctuations in their interest earned based on what types of mortgage interest rates their customers carry.

If they have fixed or variable rates on their mortgages than the interest rates they earn can vary as well. The fluctuation in interest rates can make Wells Fargo very sensitive to interest rate fluctuations in the housing market.

Quality of the loan portfolio is also a factor affecting net interest income as situations like a crumbling economy, and losses of jobs can cause borrowers to miss payments which can lower the bank’s net interest income.

As per usual when you read through a company’s 10-k you will find differences in how these terms are laid out. Some banks are going to be more open and have many more line items laying it all out for you.

Others will be a little more closed up about revealing all the information easily. It will all be listed, but you will have to do a little more digging.

Noninterest Income: Noninterest income is a bank and creditor income derived primarily from fees including deposit and transaction fees, insufficient funds (NSF) fees, annual fees, monthly account service charges, inactivity fees, check and deposit slip fees, and so on.

Institutions charge fees that provide non-interest income as a way of generating revenue and ensuring liquidity in the event of increased default rates. Credit card issuers also charge penalty fees, including late fees and over-the-limit fees.

Noninterest income is the fun one, and the one in which most customers hate banks for the most.

This category is used by banks as a source of revenue when the interest rates are low like they have been for the last eight years. They will use this category as a marketing tool when interest rates are high.

Financial institutions and banks make the majority of their money from the sale of money. Borrowing money and then lending it out at a higher interest rate than they borrow it for is the bread and butter of most banks.

Banks will lean on the fees from this category when interest rates are low, and some banks will rely more on fees from automated teller machines, while other banks will rely on general transaction fees.

Business banking is a big driver of fees as there tend to be fewer incentives to reduce fees for businesses, usually viewed as the cost of doing business.

Noninterest Expense: Noninterest expenses can include employee salaries and benefits, equipment and property leases, taxes, loan loss provisions and professional service fees. Companies will offset noninterest expenses by generating revenue through noninterest income.

Employee compensation (salaries and benefits) usually make up the largest component of a bank’s noninterest expenses. Usually, these expenses are related to activities that are not involved in targeting customers to deposit money in the bank.

Keep in mind that these expenses are before removing income tax expenses from the income to arrive at the net income. But that is a whole different discussion.

Provision for Credit Losses: This term is not one of the variables listed in the formula. However, it is a line item that needs discussion.

“The provision for credit losses is treated as an expense on the company’s financial statements as expected losses from delinquent and bad debt or other credit that is likely to become the default and unsatisfied (default probability).”

Investopedia

This provision is an estimation of potential losses that a company might experience due to

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