Few things are more important when it comes to identifying a great bank to invest in than efficiency. But as a review of the most efficient big bank in the United States proves, this doesn't necessarily mean that highly efficient banks spend the least amount of money on expenses.
The bank I'm referring to is PNC Financial (NYSE:PNC), a $366 billion regional bank headquartered in Pittsburgh. In 2016, its efficiency ratio, which measures the percent of revenue spent on expenses, came in at 52.5%. The average among big banks, meanwhile, was 62%, or nearly 10 percentage points higher.
WILLIAM DEMCHAK, THE CHAIRMAN AND CEO OF PNC FINANCIAL. IMAGE SOURCE; PNC FINANCIAL.
This gives PNC Financial a major advantage. It means that a larger share of its revenue falls to the bottom line and is therefore available to reward shareholders, be it through an increase in retained earnings, dividends, and/or buybacks.
There's also reason to believe that efficient banks are better at minimizing loan defaults. This is because less efficient banks have an incentive to make up for the lost ground by reaching for yield (and therefore risk) in their loan portfolios. This increases the revenue an inefficient bank earns from its loans, as less creditworthy borrowers pay higher interest rates, but it raises the likelihood of defaults on those loans in the future.
This is why there are few metrics more important for bank investors to be familiar with than the efficiency ratio, which is calculated by dividing a bank's noninterest expenses by its net revenue. Most banks target a ratio below 60%, but PNC Financial's is obviously much lower.
It's tempting to think that PNC accomplished this by driving down expenses. We are, after all, talking about efficiency. But if you dig deeper into how PNC Financial has separated itself from the pack, it's clear that expenses aren't the main driver.
You can see this by looking at how much PNC Financial spends on expenses relative to its size. Last year, it spent the equivalent of 2.59% of its assets on operating costs. That's not bad by any stretch of the imagination, but there are multiple banks that come in below it, including Bank of America, JPMorgan Chase, and Citigroup.
Expenses as a Percent of Assets (2016)
|Bank of America||2.51%|
So, if expenses aren't the main driver of efficiency, what is? The answer is: revenue. Take a look at the table below which compares how much revenue these same four banks earn as a percent of assets.
Revenue as a Percent of Assets (2016)
|Bank of America||3.83%|
DATA SOURCE: REGULATORY FILINGS, AUTHOR CALCULATIONS.
As you can see, while PNC Financial may spend more than these other banks do on expenses on a size-adjusted basis, it more than makes up for doing so by generating more revenue per dollar of assets.
In sum, the efficiency ratio should be one of the principal metrics that investors consider before buying a bank stock. But delivering on a low ratio is, counterintuitively, more about driving the top line than it is about saving on the bottom line.