Reported and adjusted efficiency ratios worked on one bank, the four adjustments, and what a fall in net interest income does to the number.
A bank's efficiency ratio is noninterest expense divided by revenue, where revenue is net interest income plus noninterest income: the cost of producing each dollar of revenue, so lower is better. On an illustrative bank the reported figure is 65.27 per cent. Put net interest income on a tax-equivalent basis, take out a 14,000 securities loss, intangible amortisation and one-off merger costs, and the adjusted efficiency ratio is 57.16 per cent. The 8.11-point gap is the difference between a bank that looks expensive and one that is not.
Worked in full in Bank Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Analysts, management teams and acquirers all quote the ratio, and most of them quote a different one. The arithmetic is trivial; the definition is where the work is.
| Item | Amount |
|---|---|
| Earning assets | 7,700,000 |
| Net interest income (GAAP) | 211,535 |
| of which tax-exempt interest (municipal bonds) | 9,000 |
| Noninterest income, reported | 52,000 |
| of which loss on securities sold | −14,000 |
| Noninterest expense, reported | 172,000 |
| of which core deposit intangible amortisation | 4,500 |
| of which merger and restructuring costs | 7,500 |
| Tax rate | 21% |
The net interest income is a net interest margin of 2.75 per cent, built in how to calculate a bank's NIM.
Step 1: the reported ratio. Divide reported expense by reported revenue.
Efficiency ratio = noninterest expense ÷ (net interest income + noninterest income)
= 172,000 ÷ (211,535 + 52,000) = 172,000 ÷ 263,535 = 65.27%
In Excel: =NonIntExp/(NII+NonIntInc)
Step 2: tax-equivalent net interest income. Tax-exempt interest is worth more than its face because no tax is paid on it. Gross it up to what a taxable asset would have to earn: 9,000 ÷ (1 − 21%) = 11,392, an adjustment of 2,392. Net interest income on a fully taxable-equivalent basis is 213,927. Without it, a bank that holds municipal bonds looks less efficient than one that holds taxable ones for no operating reason.
Step 3: remove securities gains and losses from revenue. The 14,000 loss on bonds sold is a balance sheet decision, not the cost of running the bank. Core noninterest income is 52,000 + 14,000 = 66,000. A bank selling bonds at a loss to reposition its book, as many did after rates rose, would otherwise report a jump in its efficiency ratio that says nothing about its costs.
Step 4: remove intangible amortisation and one-off costs from expense. 172,000 − 4,500 − 7,500 = 160,000. The amortisation is an accounting consequence of a past acquisition (see how to calculate a core deposit intangible); merger costs do not recur.
Adjusted efficiency ratio = 160,000 ÷ (213,927 + 66,000) = 160,000 ÷ 279,927 = 57.16%
| Basis | Expense | Revenue | Ratio |
|---|---|---|---|
| Reported | 172,000 | 263,535 | 65.27% |
| Expense adjusted only | 160,000 | 263,535 | 60.71% |
| Revenue adjusted only | 172,000 | 279,927 | 61.44% |
| Both adjusted | 160,000 | 279,927 | 57.16% |
Pre-provision profit moves from 91,535 reported to 119,927 adjusted. Less the tax-equivalent gross-up, which is not cash, the adjusted figure is the one a buyer capitalises, which is why the definition is negotiated in every bank deal.
Net interest income is 76.4 per cent of this bank's adjusted revenue, so the ratio is mostly a function of the margin. Each 1 per cent fall in net interest income adds 0.44 of a point with costs unchanged.
| Change in NII | GAAP NII | Revenue | Ratio | Cost cut to hold 57.16% |
|---|---|---|---|---|
| +10% | 232,689 | 301,081 | 53.14% | none |
| 0% | 211,535 | 279,927 | 57.16% | 0 |
| −10% | 190,382 | 258,774 | 61.83% | 12,091 |
| −15% | 179,805 | 248,197 | 64.46% | 18,136 |
| −20% | 169,228 | 237,620 | 67.33% | 24,182 |
A 15 per cent fall in net interest income, the kind a rise in deposit costs can produce, takes the ratio from 57.16 to 64.46 per cent, and holding it would need 18,136 of cost cuts, 11.3 per cent of the expense base. Banks rarely cut that fast, which is why efficiency ratios deteriorate in a margin squeeze even when nobody has hired anyone.
Targets in money. One point of efficiency on this bank is 2,799 of pre-tax profit. Reaching 55 per cent needs 6,040 of cost cuts (3.8 per cent of expense) or 10,982 more revenue (3.9 per cent). Reaching 50 per cent needs 20,036 of cuts, 12.5 per cent of the cost base.
The common mistake is to compare efficiency ratios across banks without checking that they are built the same way. The gap here between reported and adjusted is 8.11 points, larger than the difference between many peer banks. Business mix matters as well: a bank with a wealth management arm runs a higher ratio on capital-light fee revenue and may still be the better business. Read the ratio together with return on tangible equity, never alone.
The opposite error is to adjust too much. Management definitions sometimes strip out every cost described as non-recurring, year after year, until the adjusted ratio describes a bank that has never existed. Allow an adjustment only if the item genuinely did not recur in the prior three years, and show the reported ratio beside the adjusted one so the reader can see the size of the bridge: here 12,000 of expense and 16,392 of revenue.
Divide noninterest expense by net interest income plus noninterest income, then adjust: tax-equivalent net interest income, no securities gains or losses, no intangible amortisation or one-off costs. Here: 65.27 per cent reported, 57.16 adjusted, and 64.46 after a 15 per cent fall in net interest income. The margin before and after a rate shock, line by line, is in the free workbook for this case.
Lower is better, and 50 to 60 per cent is often cited as a well-run level, but it depends on business mix and definition. The illustrative bank reads 57.16 per cent adjusted. Each point is worth 2,799 of pre-tax profit, and reaching 55 per cent would need 6,040 of cost cuts, 3.8 per cent of the expense base.
No. They come from balance sheet decisions, not the cost of running the bank. In the example a 14,000 loss on bonds sold lowers reported revenue; adding it back moves the ratio from 65.27 to 61.97 per cent on its own. Banks repositioning bond books after rate rises would otherwise report a spike that says nothing about costs.
Because net interest income is most of revenue, 76.4 per cent here, and costs do not move with it. If deposit costs cut net interest income by 15 per cent, the illustrative bank's ratio rises from 57.16 to 64.46 per cent with no change in spending, and holding it would require 18,136 of cost cuts.
This article is one calculation from Bank Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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