Efficiency ratio: use with ‘extreme caution’
Using this metric as a benchmark measure can harm members.
Most credit union pre-pandemic strategic planning sessions I attended focused on a consistent (if not singular) theme: Reducing friction.
That included many discussions around transforming from lending companies that happen to use technology to technology companies that happen to make loans. Almost every discussion focused on shortening the time frame from a member’s moment of need to acknowledgement, to credit union resolution.
The pandemic magnified and accelerated the need for these discussions as well as for real progress on this front. “Digitization” is front and center.
In many respects the goal is for credit unions to improve efficiencies. Credit unions have a lot of experience attempting to measure efficiency.
As the saying goes, “what gets measured, gets done.” But when it comes to efficiency, this makes me a little apprehensive.
Ratio analysis can be a handy way to uncover areas that need attention and to track progress toward goals. That’s because ratios allow us to make useful comparisons by normalizing financial and operational information.
In general, this makes financial comparisons between institutions more meaningful. And it makes comparisons to our own institutions’ results over time easier to understand.
While $500,000 in total annual earnings may be exceptionally high for some credit unions, it would be a disappointingly low for others. Similarly, that same $500,000 in earnings may be a decent result for my credit union 10 years ago but not so much now.
After all, we’ve grown over the years. If we divide earnings by average assets the resulting ratio—return on assets or ROA—provides a more concrete measure of success. When I tell you my credit union recorded 1% ROA, you can form some definite and useful opinions.
But we need to use ratios carefully. It matters how they’re calculated. And, when making comparisons it’s important to choose peer groups carefully.
The efficiency ratio
When credit unions track efficiency, they often use a metric benchmark referred to as the “efficiency ratio,” which is widely used in the banking world.
The efficiency ratio is calculated by dividing operating expenses by total revenue (i.e., the sum of interest income and non-interest income). All else equal, a higher efficiency ratio indicates greater inefficiency and a lower efficiency ratio indicates greater efficiency.
The credit union movement’s collective efficiency ratio was 61% in 2020, though this number varies substantially by asset size. It has been trending down from a high of 66% in 2015.
But while efficiency ratios are easy to calculate, they’re notoriously difficult to decipher.
And they don’t necessarily measure what they claim to measure.
For instance, institutions that slash costs aren’t necessarily efficient, and excessive cost cutting can severely damage service quality and cause earnings to plummet.
Similarly, peer comparison groups comprised of institutions with dissimilar strategic focus can lead to false signals of inefficiency and may produce perverse decisions.
A $20 million asset, low-income-designated credit union, for example, might incur substantial costs related to the critically important work it does to provide financial counseling services to a large segment of its membership.
Other, similarly-sized credit unions with more diverse membership fields would likely not have the same need to interact so closely with so many members. As a consequence, this second group of credit unions might have lower staffing requirements and a lower efficiency ratio.
Should the low-income-designated credit union cut staff and counseling services to look as efficient as these asset-size “peers?”
More generally, unlike banks, credit unions seek to maximize member service, not profits. This makes efficiency ratios not only difficult to interpret, but nearly irrelevant.
Because of their key structural difference, credit unions strive to offer more service (and more services), which puts upward pressure on the numerator of the efficiency ratio.
And because they are not profit maximizers, this puts downward pressure on the denominator of the efficiency ratio. Combined, the effect of these two pressures is to increase apparent (but not real) inefficiency.
Any credit union, small or large, that wants to drive efficiency ratios down to appear more efficient could do so by cutting back on service (and services) and/or by boosting income (i.e., raising fees, lowering dividend rates, increasing loan interest rates).
These ideas are especially important in the wake of the coronavirus (COVID-19), which has disproportionately hurt those on the lower rungs of the economic ladder.
Lower-income members are more likely to want to do business face-to-face in a branch setting. Managing these relationships—with a laser focus on the credit union of mission improving financial well-being for all—is more important than managing to a ratio.
Certainly, efficiency may be a desirable goal and most would agree there’s always room for improvement. But it’s clear that using efficiency ratios as a benchmark measure can harm members.
Use this measure with extreme caution, if at all. Your members will thank you.
MIKE SCHENK is chief economist and deputy chief advocacy officer for Credit Union National Association.