What is the Efficiency Ratio?
The Efficiency Ratio is a risk measure used to evaluate the cost-efficiency and profitability of a bank.
The operating efficiency of a bank represents its ability to generate revenue – namely the net interest income from its interest-bearing assets in its loan portfolio – relative to its non-interest operating costs.
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How to Calculate Bank Efficiency Ratio
The efficiency ratio is a profitability metric that can determine the operating efficiency of a bank.
Calculating the efficiency ratio involves comparing the bank’s operating expenses to its income.
The core business model of a bank is to provide loans to borrowers in exchange for interest payments and the repayment of the debt principal on the date of maturity.
The borrower, as part of the loan agreement, is contractually obligated to meet its periodic interest payments and principal repayment on time.
Thus, the revenue of a bank consists primarily of the interest payments owed by borrowers, while the costs consist of operating costs incurred to run day-to-day operations, such as:
- Employee Wages
- Administrative Expenses
- Office Rent
- Insurance
- Equipment and Supplies
- Infrastructure and Security
Since a bank’s financial performance is directly tied to the state of the economy (namely, prevailing market interest rates), banks must strive to reduce their operating expenses.
The operating efficiency of banks is most important during periods of economic downturns when lending volume declines and more borrowers default on their debt obligations.
Bank Efficiency Ratio Formula
The formula for calculating the bank efficiency ratio is as follows.
Where:
- Non-Interest Operating Costs = Total Operating Costs – Interest Expense
- Net Interest Income = Interest Income – Interest Expense
Further details on each input in the efficiency ratio formula can be found below.
- Non-Interest Operating Costs → The non-interest operating costs of a bank are the total expenses related to its daily business functions, excluding any costs related to interest (i.e. borrowing expenses to others).
- Net Interest Income → The net interest income is the difference between the bank’s revenue from its interest-bearing assets (e.g. loans, bonds) and the expenses related to its own interest-bearing liabilities.
- Non-Interest Income → The other source of income for banks is their non-interest income, which can come from other divisions such as sales and trading.
- Provision for Credit Losses (PCL) → The provision for credit losses, or PCL, is a deduction intended to serve as a conservative estimate of the potential losses that a company could incur from the default risk of borrowers.
