Comments

• Vendor

  Mike Higgins May 15, 2018 at 12:05pm

  I would echo David's comments regarding the efficiency ratio.  It really is more of a financial metric than a productivity measure.  There are two shortcomings of the ratio.  First, it includes interest rates and rates are not productivity.  If margins are widening, efficiency improves, but productivity may actually be declining, so you get a false positive.  A false negative can occur if rates are compressing too.  I would also consider excluding PLL from the ratio, to reduce volatility and get a better read.  The second shortcoming is if you have a line of business that consumes no net worth, but throws off a decent profit margin, it can also make efficiency worse.  For example, if you have a large investment or insurance operation that runs at a 15% profit margin, it's really an 85% efficiency ratio.  It will create a drag on efficiency as the line of business grows, but because it consumes no capital, an unlimited amount of volume at 15% profit margin would be a great thing to have.  This same example would create a false negative reading on Expense to Assets.  Expense to assets counts all expense incurred in the generation of non-interest income but ignores the revenue.  A slightly better measure would be net operating expense to assets.  Bottom line:  There are a number of ways to look at “efficiency” and “productivity” and digging into each provides the most insight.
  • CU Employee CULytics Founder

    Naveen Jain > Mike Higgins May 15, 2018 at 1:33pm

    Hi Mike,

    Thanks for your comments. Few things that I will like to point out.

    1. Efficiency ratio is just one the factors to consider. It is by no means an end-all, be-all financial measure. 

    2. The efficiency ratio as mentioned in the blog does not include interest rates. It does not include interest expense. It is the ratio of Non-Interest Expense/Net Income. So, if the margins are widening because of lower interest expense then there is no impact on efficiency ratio.

    3. In your example, if there a slight twist. The large investment that runs at 85% efficiency and insurance operation that runs at 80% efficiency. Where should credit union focus its efforts? I would say, it depends. Since efficiency ratio is just one of factors to consider when making a decision. It depends on the size of the opportunity, competition, barriers to entry, and so on. However, efficiency ration is one of the factors to consider when making a decision.

    What are the key financial measures that credit unions should use to keep tab on their financial health? What are the top KPIs for looking into efficiency and productivity from your perspective?

    Thanks.
  • Vendor

    Mike Higgins > Naveen Jain May 15, 2018 at 5:49pm

    Good comments by all.  I think we are in clear agreement that a "single" measure of efficiency or productivity is probably like sasquatch ... rumored to exist, but never proven.  Also, as Jon noted, the reason for your analysis drives what you use.

    Regarding your questions … assuming no capital requirement, I would pursue both the 85% and 80% efficiency opportunities with equal rigor.  Why?  The ROE is infinite … it can’t be computed because there is no capital required.  In a capital constrained industry (banks, credit unions) a source of income that does not require capital opens up other areas that do require capital (or provides a dividend opportunity).

    If I had only one measure of productivity, it would be the following: (non-interest expense less non-interest income) / (loan balance plus checking & savings account balance).  Effectively, it is net cost of operations per strategic balance dollar.  It is efficiency divided by effectiveness.  The lowest cost is the best.  I would exclude MMkt, CD and IRA from the denominator because they should require minimal resource to attract and manage.  Those funding sources are also rate sensitive – and because of that, have lower strategic value.  In the research I have done, the top third performers take less net interest spread from their members and at the same time, have a higher ROA, because of superior operating leverage.  The bottom third take the most net interest spread and have the lowest ROA, because of poor operating leverage.  Again, any single measure of productivity has its shortcomings, but this is my favorite when evaluating credit union performance.  For banks, my favorite is efficiency ratio as computed by FDIC formula because of the profit focus there.
• CU Employee

  David Mooney May 15, 2018 at 11:09am

  A couple of comments. Efficiency ratio can be a misleading measure of credit union operating efficiency, because credit unions return to their members "above the line" through higher rates on deposits, lower rates on loans, and lower fees. Depending on member giveback, this can depress reported income. Expense/Assets may be a better measure of relative efficiency. I would also challenge the assertion that 50% is the optimum efficiency ratio. The efficiency ratio is driven by several factors, including operating model. At Alliant, for example, our relatively low operating expense derives from a low-cost acquisition model (SEG and word of mouth) and high member reliance on remote and self-service channel access. This hasn't prevented us from investing in talent and technology, nor has it limited growth, and giveback is in the top 2% of credit unions.
  • CU Employee CULytics Founder

    Naveen Jain > David Mooney May 15, 2018 at 1:51pm

    Hi David,

    Interesting perspective.

    1, What are your thoughts on using Efficiency Ratio for comparing branches and/or products to get a better sense of how they are performing?

    2. I have been thinking more of non-interest expense/Assets as a measure. This measure will favor credit unions where members have higher balances, since then credit unions have to serve less members for the same asset size, which reduces their non-interest expenses. Looking back, even Efficiency Ration tends to favor credit unions where members have higher balances. 

    Interestingly, with this StarOne is still the most efficient credit union. 

    CU Name	Non-Interest Expenses over assets
    NAVY FEDERAL CREDIT UNION	3.10%
    STATE EMPLOYEES'	1.96%
    PENTAGON	1.71%
    BOEING EMPLOYEES	2.43%
    SCHOOLSFIRST	2.10%
    THE GOLDEN 1	2.41%
    FIRST TECHNOLOGY	2.38%
    ALLIANT	1.35%
    SECURITY SERVICE	2.94%
    STAR ONE	0.62%

     

    3. Another metric might be interesting is non-interest expense/member, which shows how much a credit union is spending to service each member.

    cu_Name	Non-Interest Expense Per Member
    NAVY FEDERAL CREDIT UNION	$ 347.46
    STATE EMPLOYEES'	$ 318.89
    PENTAGON	$ 239.62
    BOEING EMPLOYEES	$ 392.86
    SCHOOLSFIRST	$ 367.02
    THE GOLDEN 1	$ 294.68
    FIRST TECHNOLOGY	$ 503.30
    ALLIANT	$ 344.55
    SECURITY SERVICE	$ 372.96
    STAR ONE	$ 563.86

     
  • CU Employee

    David Mooney > Naveen Jain May 16, 2018 at 7:47am

    I think the problem with using efficiency ratio for evaluating branches is accurately determining revenue or asset attribution. What revenue/assets are directly attributable to a given branch? With products, the challenge is cost attribution.

    Your observation about higher average balances is correct. Also, revenue (adjusted for giveback) tends to be a function of balances, while operating expense is a function of number of members, so it makes sense that CUs with higher average balances would be more efficient - i.e., generate more revenue relative to expense.

    I agree that a better relative efficiency measure for CUs is non-interest expense/assets. And yes, it tends to be correlated with efficiency ratio for the reasons above.

    I agree that non-interest expense/member is a useful metric for managing productivity.
  • Vendor

    Jon Voorhees > Naveen Jain May 15, 2018 at 2:10pm

    Interesting comments. My original commentary was focused on branch dependent financial services firms. Different business models that are more dependent on digital or mobiile channels might yield different efficiency ratios. I agree that the efficiency ratio is not necessarily a productivity measure, and certainly not the only measure one should look at when examining their business, but it is a telling metric. Higher rates are an incremental expense and can either be seen as a "member benefit" or a "cost of doing business". If you were a bank instead of a credit union, and you offered higher rates, it would be seen as a cost of doing business. Shareholder dividends would be the equivalent of member giveback.

    Average cost to serve a member is an interesting metric. The bottom line with any retail branch-dependent FI is that it has a heavy fixed infrastructure cost, so like any fixed-cost business needs big customer volumes to first meet those breakeven expense levels, but anything above those levels yields higher profitability, which can be returned to members. One other point. My short speech on this topic was limited to 12 minutes so I was unable to go into the nuances of all the other key metrics one should examine. Perhaps at a future event I can expound on these topics in greater detail.