A banks’ efficiency ratio is a measure of how well a bank manages its non-interest expenses as a percentage of revenue.
Bank Efficiency Ratio = Non-Interest Expenses / Revenue
If ABC Bank Non-Interest Expenses total $25 million, and it’s revenues were $50 million, then ABC Bank would have an efficency ratio of $25,000,000 / $50,000,000 = 50%
For every $1 of revenue, it costs .50 cents.
Non-Interest expense includes salaries, rents, general administrative expenses and other such things which a bank can control. Interest expenses are excluded because it is an investment decision and not an operational decision.
What does it tell us?
A bank’s efficiency ratio is a quick and dirty measure of a bank’s ability to turn resources into revenue. In general the lower the ratio the better, but about 50% is considered optimal. An increase or decrease in the ratio shows increasing or decreasing costs.
It is important to note the differences in business models may generate different sorts of efficiency ratios. If a bank generates more on fees then it can concentrate on activities that carry higher fixed costs and would give worse efficiency ratios. Therefore, it is also important to distinguish types of banking activities when considering the ratio.