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Most credit union decision-makers I know are a restless bunch—constantly looking for ways to improve operations and make (and keep) members happy.
Ratio analysis can be a handy way to uncover areas that need attention and to track progress toward goals. Ratios allow us to make useful comparisons by normalizing financial and operational information. In general, this makes financial comparisons between institutions more meaningful. And it makes comparisons to our own institutions’ results over time easier to understand.
To illustrate, one-half million dollars in total annual earnings might be exceptionally high for some credit unions, but it would be disappointingly low for others. Similarly, that same half-million in earnings might have been respectable for a credit union 10 years ago but perhaps not so great now for that same credit union.
If we divide earnings by average assets, the resulting ratio—return on assets (ROA)—provides a more concrete measure of success. When you hear that a credit union recorded ROA of 1% in a given year, you can form definite and useful opinions.
But we need to use ratios cautiously; it matters how they’re calculated. And when making comparisons, it’s important to choose peer groups carefully.
Several papers recently crossed my desk that drove this point home. Each contained a summary of credit union operations with a focus on efficiency. The benchmark used to calculate efficiency was something referred to as the “efficiency ratio”—a benchmark widely used in the banking world.
The efficiency ratio is calculated by dividing operating expenses by total revenue (the sum of interest income and noninterest income). All else equal, a higher efficiency ratio indicates greater inefficiency (less efficiency) and a lower efficiency ratio indicates less inefficiency (greater efficiency). The overall efficiency ratio in the credit union movement was 55% in 2010, though this number varies substantially by asset size.
Although easy to calculate, efficiency ratios are notoriously difficult to decipher. And they don’t necessarily measure what they claim to measure. Institutions that slash costs, for example, aren’t necessarily run more efficiently, and excessive cost-cutting can severely damage service quality and cause earnings to plummet.
Similarly, peer comparisons of institutions with different strategic directions can lead to false signals of inefficiency, and might produce perverse decisions. A $20 million asset low-income designated credit union, for example, might incur substantial costs related to the critically important work it does providing individual financial counseling services to a large segment of its membership.
Other similarly sized credit unions with more diverse memberships probably don’t need to interact so closely with so many members. They might have lower staffing requirements and a lower efficiency ratio. Should the low-income credit union cut staff and counseling services to look as efficient as its asset size “peers”?
Credit unions, unlike banks, don’t strive to maximize profits; they strive to maximize member service. This makes efficiency ratios not only difficult to interpret, but nearly irrelevant, for credit unions.
Because of their key structural difference, credit unions’ goal is to offer more and better service (and more services), which tends to put upward pressure on the numerator (operating expenses) of the efficiency ratio. And credit unions don’t aim to maximize profit, which tends to put downward pressure on the denominator (total revenue). Combined, the effect of these two pressures is to increase apparent (but not real) inefficiency.
Any credit union, small or large, that wants to drive efficiency ratios down in an effort to look more efficient could do so by cutting back on service (and services) and by boosting income (increasing fees, lowering dividend rates, increasing loan interest rates).
Some say, “What gets measured gets done.” Efficiency might be a desirable goal, and most would agree there’s always room for improvement. But it’s clear that using efficiency ratios as a benchmark can negatively affect members.
Use efficiency ratios with extreme caution, if at all. Your members will thank you.
MIKE SCHENK is CUNA’s vice president, economics and statistics. Contact him at 608-231-4228.