Real Estate Decision-making and the Efficiency Ratio

The ratio of non-interest expenses to revenue is certainly one of the most important yardsticks by which bank executives and shareholders gauge an institution’s overall financial health.  It’s called the Efficiency Ratio, and its trajectory – whether it’s trending higher or lower than the generally accepted 50% benchmark – is frequently the impetus behind a fundamental reassessment of the business, everything from employee salaries to branch locations.

Attention to the efficiency ratio is universal, regardless of whether a bank operates thousands of branches nationwide or dozens regionally. The 2017 average efficiency ratio of all FDIC-Insured Institutions was nearly 58%, though smaller banks tended to have a bit of a higher efficiency ratio than their larger counterparts, partially because large banks outsource some I.T. and H.R. functions back-office jobs to low-labor-cost countries, where smaller banks cannot.

As one might imagine, real estate decisions exert an oversized influence on the efficiency ratio. Decision-makers can impact both the expense and revenue sides of the equation by optimizing their real estate portfolios, including branches, headquarters and bank operation offices, to maximize revenue potential, reduce operating expenses and increase capital efficiency.  

Real estate is a key contributor to the efficiency ratio and can have a long-term impact on a bank’s operations.  These decisions often have long-term implications and cannot easily be reversed.  A number of real estate factors contribute to an uptick in a bank’s efficiency ratio, including:

•    Underperforming branch revenue and profitability
•    Misalignment with key location and market demographics
•    Capital tied up in non-strategic owned assets
•    Performing low-cost operations in high-cost markets
•    Underutilized assets
•    Redundant locations
•    The absence of a pre- and post-M&A approach

When banks think proactively about their real estate portfolios, they strategically position themselves for growth while mitigating downstream real estate risks that have adverse impacts on a bank’s efficiency ratio.  For example, if the underlying issue with branch revenue and profitability is a shift in customer demographics, that bank can choose to take advantage of early lease terminations to reduce ongoing losses.  By consolidating bank operations to lower cost locations, banks can save a significant amount on operating expenses.  By optimizing the real estate portfolio, banks can be in a better position to absorb M&A targets without long-term adverse impacts to the business.
Ultimately there are many disciplines that can help financial institutions achieve the efficiency ratio targets they establish. It’s a goal to be pursued both tactically over 1-2 years, through activities aligned with lease expiration (improving lease management, for example), and strategically, with 5-10-year consolidation or relocation planning. Regardless of strategy, the overarching objective – as always – is to minimize total overhead as a percentage of revenue. 

Robert Peck
Senior Financial Analyst

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