Does bigger mean more efficient?
With size comes economies of scale. Larger institutions can “scale” to meet challenges that many smaller institutions find hard to handle. Being better equipped to meet regulatory demand comes to mind amidst other advantages: marquee clients, specialized positions, brand recognition, etc. A recent post by Jeff Marisco, author of Jeff for Banks, highlighted trends in efficiency among financial institutions with respect to asset categories.
Jeff’s methodology was to segment banks into seven asset size categories, and to then assess their respective efficiency using the efficiency ratio metric. He pulled numbers from both 2007 and 2014 to elucidate differences in asset categories at present, as well as how they compare over time.
The efficiency ratio measures…well…efficiency (no surprise there). More specifically, this metric shows how much it costs a financial institution to generate $1 of revenue, hence, the lower the better. A threshold of 55 percent (in other words, taking $0.55 to make $1) is often used to delineate “very efficient” from “not as efficient” institutions.
As many may have suspected, a fairly strong correlation exists between average efficiency ratio and asset size. The tendency is that banks become more efficient as they scale up – to a point. After the $100B mark, efficiency ratio actually increased in both the 2007 and 2014 time periods. The $20B – $100B asset range boasted the lowest efficiency ratios in both 2007 and 2014.
One interesting note to mention is that when examining the 55 percent efficiency ratio threshold, we see that far less institutions are meeting that benchmark. Nowhere is that more apparent than in the “most efficient institution” range of $20B – $100B. An impressive 60 percent of institutions of that size had efficiency ratios below 55 percent in 2007, whereas now less than 30 percent enjoy such levels of efficiency.
On a larger scale, we notice a decline in the percentage of institutions below 55 percent in each and every asset category. More simply put, it is costing financial institutions more to make money in 2014 than it was in 2007. Delving deeper, it is costing smaller institutions even more across the board, as they constitute the group with the fewest percentage of institutions achieving the sub 55 percent milestone.
This may seem discouraging to smaller institutions, or may sound as though banks must be large to be efficient; however, this is simply not the case. Despite certain economies of scale and distinct advantages that larger banks have over smaller ones, it is worth noting that while only 11.24 percent of sub $500M institutions had an efficiency ratio of <55 percent, this comprises the largest figure of overall banks. That is, there are more small banks who meet this <55 percent measure than any other asset category.
While yes, this asset category has the largest sample size by far, it means that efficiency can be obtained independent of asset size. At the end of the day, while efficiency may come easier to larger institutions, and while a higher proportion of larger banks enjoy lower efficiency ratios, many smaller institutions can perform in line, and even better than their larger counterparts.