The cost-to-income or efficiency ratio of a bank is useful efficiency and profitability ratio. It links operating expenses to operating income generated by a business.
Let us discuss what is a cost-to-income ratio and why it is important for banks.
What is the Cost-to-Income Ratio?
The cost-to-income ratio (CIR) is an efficiency metric that compares the operating expenses and operating income of a business.
It is a financial ratio that shows how well a business is utilizing its operating resources to generate income. It is used by every business sector but is more common in the banking industry.
We can compare the CIR with other efficiency ratios like operating margin, ROA, and ROCE used widely in other industries.
How to Calculate Cost-to-Income Ratio?
The cost-to-income ratio follows a simple process and can be calculated with readily available figures from the financial statements of a business.
Cost to Income Ratio = Operating Expenses ÷ Operating Income
It can be expressed as a ratio or in percentage terms.
Since operating expenses are in the numerator and operating income is in the denominator of the formula, a lower ratio is desirable.
CIR can be calculated in a few simple steps.
The first step is to calculate the operating expenses for the given period. Operating expenses can be traced from the income statement when available.
The categories of operating expenses may vary by industry but generally, they will include:
- Professional support services
- Taxes on property
- Provisions for Loan losses
- Staff and personnel expenses (retirement plans, pensions)
- Employee wages and salaries
- Sales and marketing expenses
- Utility expenses
- Telecommunications expenses
- Office and work supplies
The second step is to calculate the operating income of the business. For a bank, it comes from interest and non-interest income sources.
The interest comes from invested amounts with other banks and the central bank. Banks also earn interest on loans provided to customers and other banks.
Similarly, the non-interest income comes from commission, fees, and service charges.
This figure can also be taken from the income statement directly.
The third step is simply to use the efficiency ratio formula to calculate the CIR of the business.
How Does Cost-to-Income Ratio Work?
The CIR or the efficiency ratio is an important metric to analyze the financial health of a business. It uses two basic input metrics from the income statement; operating expenses and operating income.
The CIR calculation should begin with the calculation of total revenue. The revenue figure is the top line item in an income statement.
Revenue is the result of direct sales from the core operations of a business. For instance, banks generate revenue by offering loans and offering banking services.
Then, CIR considers only operating expenses. Again, these are direct expenses related to the core operations of a business. If you start with the total revenue figure, you’ll need to first deduct the cost of goods sold.
It will give you the gross income figure. Then, you’ll deduct the operating costs from gross profit to find the gross income of the business.
Using these two figures gives you the cost-to-income or efficiency ratio of the business.
It is a simple and easy ratio and it is widely used. It shows the operational efficiency of a business in simple terms.
It offers great insights to any business about its core operations. It is helpful in decision-making about cost reductions, primary sources of income, and improving pricing strategies.
Why Cost-to-Income Ratio is Important for Banks?
The banking industry is one of the leading service industries. Its efficiency can be analyzed in different ways. One such simple and effective metric to analyze the operational efficiency of a bank is CIR.
The cost-to-income ratio in the banking industry has been used widely for several years now. It is simple to calculate and universally understood. However, its interpretation requires careful analysis.
CIR is a widely used financial metric in the banking industry globally. Thus, using a universally accepted metric helps in understanding a key challenge.
Managers and shareholders alike can use CIR to analyze the efficiency and profitability of a bank.
CIR compares operating income and operating expenses. It means it creates a direct link between the efficient use of core assets to generate core income.
Thus, it is a good tool to analyze the operating efficiency of banks.
CIR can be expressed as a ratio or a percentage and global banking CIR benchmarks have been set for years now.
Therefore, using CIR as a global benchmarking tool is easy and comparisons are relevant.
Better Decision Making
Financial ratios like CIR help banks with a better financial decision-making process.
CIR is directly linked to the operations of a bank; thus, it helps in improving operations, services, and induction of new services.
Cost-Cutting and Income Diversification
Improving CIR requires a balanced approach to reducing costs and improving income. However, both these metrics affect each other directly.
Therefore, a bank must plan carefully when creating an optimal balance between cost-cutting and income generation.
Also, CIR can help a bank identify new banking services and income diversification such as the introduction of online banking, phone banking, and other services.
Cost-to-Income Ratio for Global Banks
The global CIR benchmarks in the banking industry have changed significantly over the years. Digitalization and internet banking have forced banks to layoffs and other cost-reduction measures.
Even then, banks fail to cope with the increasing operational expense trends and reduction in income. New entrants and fintech companies have also grabbed a significant share of conventional banks.
A CIR of around 70% would be considered excellent for a bank a few years ago. The increased performance pressure means the benchmark has intensified.
These days global leading banks set a CIR benchmark of around 50%. Anything less than 50% is considered an ideal CIR.
A recent S&P Global report suggests that the CIR of US banks has increased from 58% in the last year to around 61% this year.
The decreasing operating efficiency is largely linked to the Covid-19 pandemic restrictions. However, other factors like decreasing profits and new entrants capturing market share are also significant influencers.
Similarly, another report suggests that the average CIR across EU banks remained at 63% ending the year December 2021.
Drawbacks and Limitations of Cost-to-Income Ratio
Although CIR is a useful metric in the banking industry, it comes with some drawbacks and limitations.
Gross Revenue Vs Operating Expenses
CIR directly compares gross revenue and operating expenses. These metrics define two different aspects of a business.
The gross revenue figure is affected by several external factors. Thus, using it as an efficiency metric solely can be misleading at times.
Interest Rates Vary Drastically
The biggest revenue source for banks comes from interest-based earnings. Interest rates vary greatly in the banking industry and are largely dependent on government and central bank policies.
Therefore, it is important to consider these differences when comparing the CIRs of banks in different geographies.
Affected by Labor Costs
Service costs and labor costs also vary by the geographical location of a bank. Thus, operating expenses can vary greatly for banks of similar sizes in different areas.
Again, banks should use adjusted input metrics for operating expenses and operating income to reflect the proper economic effects.
Affected by Risk Affinity
Banks may charge higher or premium interest rates with risky products. It would increase their interest margins and hence interest income.
The risk affinity of banks means the CIR will decrease. It will cause deferred risk adjustments such as writing off assets in the future.
Thus, even a decreasing CIR does not necessarily mean profitability for banks in the long term.
Alternatives to Cost-to-Income Ratio
Banks can use different financial metrics to analyze their profitability and efficiency performances. CIR is an important link between the profitability and efficiency of a bank.
Here are a few suggested alternatives to CIR.
Banks should use an adjusted CIR for different factors. These factors include the risk affinity of the banking industry, inflation effects, labor costs, and macroeconomic factors.
Adjusting CIR would reflect an appropriate approach for banks in different areas and of different sizes.
Process-Based Efficiency Analysis
CIR is a value-based approach to assessing the profitability of a bank. A better approach would be to create a process-based efficiency and profitability analysis.
Banks can categorize their operations into several categories. Hence, different types of operating expenses can be compared against relevant operating expenses.
Return on Equity (ROE)
Return on equity is another popular financial ratio for the service industry. It provides a useful analysis of how well a bank or financial institution is utilizing its equity resources to generate income.
Operating Asset Ratio
Banks can also use operating asset ratios by comparing operating assets against operating income. It is another useful efficiency ratio that considers the efficient use of assets owned by a bank.