Jeff Judy

Jeff's Thoughts - August 19 , 2009

The Lowest Number, or the Right Number?


In the last issue of Jeff's Thoughts, I wrote about the difference between number crunching and decision making, between blindly obeying analysis software and thinking about what the numbers you get from your software really mean.

My point was that results are most meaningful in the context of targets and expectations, and that those targets and expectations should come from your own thinking and knowledge about a wide range of factors. But just as many of those who work in our industry take too simple a view of the numbers and "objective measures" they have about their borrowers, bank management frequently overlooks the subtleties of setting targets for the bank's own performance.

Take the concept of "efficiency." Efficiency in our industry, of course, refers to the ratio between expenses and income. (It is computed in several different ways, but one very common "efficiency ratio" divides the sum of all expenses except interest expense by the sum of interest and fee income. A lower ratio means that higher revenue is being generated from lower expenses.)

Investors, stock analysts, and many bank executives have figured out the ideal efficiency ratio: "the lower, the better." That approach certainly makes it easy to assess trends over time. But is that a good rule for your individual bank?

My biggest complaint about this simplistic approach to the efficiency ratio is that it leads so many management teams (and investors and analysts) to focus too heavily on the expense side of the equation. "Improving efficiency" comes to mean "cutting costs" and nothing else.

Unfortunately, cutting expenses can only do so much for you. After all, if you want the lowest possible efficiency ratio, have NO expenses: spend nothing on acquiring or serving customers. Yes, you'll be out of business, but you'll have reached your goal, "the lowest possible number."

Many businesses, in banking and other industries, should be working at least as hard on raising margins and finding new income opportunities as they do on minimizing expenses. When you focus too much on the expense component of efficiency, you eventually decide that every business should look like Wal-Mart, that there is no future for a Nieman Marcus.

Still, even "maximize revenues, minimize expenses, all the time" is not a strategic plan! When we work with borrowers in longterm relationships, we know that their expense profiles may change to deal with challenges and opportunities. A new product or service may be wildly successful, but the expense-to-income ratio will look a little worse until the new income comes in. We're willing to work with them when we have a reason for those fluctuations in their efficiency.

Identify your revenue goals and create plans to develop more income sources, with better margins. Realistically predict the expenses that support your plan, while you ferret out costs that can be reduced without hurting your chances of success.

Then put them together to develop an "efficiency profile," a predicted trend that will help you see if you are on track with your strategic plan.

Good management sets targets for important ratios -- sometimes higher, sometimes lower -- and they know why those targets fit their businesses. But it takes courage to try that at your own bank. Letting the efficiency ratio rise (that is, becoming less efficient) for a while in order to prepare for a better, more profitable future stills gets you a short term beating from investors and analysts.

Some people won't be happy with anything but a nice straight line, sloping slightly downward. True management requires more vision, and more courage, to set targets that reflect a well-conceived plan for maximizing success over the long haul.