Article

Banking by a New Set of Numbers

Bankers have always focused on "the spread," or the difference between the cost of funds and the rate at which they are lent, as a barometer of profitability.

By Christine Detrick and Scott Tanner

First published on abril 20, 2004
min read


BANKERS HAVE ALWAYS focused on "the spread," or the difference between the cost of funds and the rate at which they are lent, as a barometer of profitability. But another set of numbers—the cost-to-income ratio—holds even greater significance for managing the financial performance of banks. That's good news for Bank of America and its shareholders, who have seen the company's stock price gyrate since announcing in October of 2003 that it would merge with Fleet Boston. Prior to the merger, Bank of America managed to keep its cost-to-income ratio among the lowest in the industry. And if history is any indicator, Bank of America's cost-conscious organization should now transform Fleet Boston—an institution in which frugality sometimes took a back seat to expensive growth initiatives. The power of the cost-to-income ratio lies partly in its simplicity. In skillful hands, it serves as a lens to keep bank executives and employees focused on efficiency even when income is rising. It turns out that holding costs in check has a greater effect on banks' financial performance than even robust growth. That pattern emerged when we looked at the performance of the world's 150 largest banks. Those with slower revenue growth but low cost-to-income ratios performed admirably, generating average annual shareholder returns 14% higher than their home-country indices. The picture reversed for banks with strong revenue growth but weak efficiency: Those with the highest top-line growth—but the least efficiency—returned just 3.5% more than their country indices annually. In other words, slow-growing efficient banks outperform their less-efficient, higher-growth peers by a factor of four to one. Of course, banks that can do both—grow revenues and manage costs with the world's best—generate the largest rewards. Those performance leaders produce returns twice as high as the efficient slow-growers and six times as high as less efficient, growth-oriented banks. To get a sense of what it takes to join this group, look at Fifth Third Bancorp in Cincinnati, Ohio. Fifth Third has achieved its star status by aggressively acquiring smaller banks, and assimilating them into a culture deeply rooted in cost control. Its total income increased by almost 25% per year over the past five years as a result of this serial acquisition strategy. But its success is really based on holding down costs during the efficient—and rapid—integration of its purchases. Fifth Third was able to keep its cost-to-income ratio steady at a lean 50%, including nonperforming loans. It did so by turning cost reduction efforts into something of a game. In a contest that would have appealed to the penny-pinching comedian Jack Benny, Fifth Third managers competed to out-save each other. The savings also went to shareholders, who saw returns increase an average of 9% per year during that period, while the market was falling at 8% per year. In Bain's study, only 16 banks out of 150 achieved this level of performance leadership. Bank of America could become the 17th. Banks with a strong efficiency and cost focus have the best shot at breaking into the performance leaders group. Our research found that nearly two-thirds of banks that were cost-focused at the beginning of the study succeeded in increasing revenue growth. And 13 of the 16 performance leaders started off as cost leaders. Bank of America's acquisition of Fleet Boston could provide a catalyst for such a leap. Consider B of A's recent history: In 1996, Ken Lewis was named CEO and quickly realized he had to control costs incurred during a series of mergers. He linked executive compensation directly to profitability, measured partly by total shareholder return, among other metrics. Mr. Lewis then set about focusing the organization on cost efficiency. For instance, in 2001, B of A launched a novel program combining a Six Sigma quality approach to eliminating expenses with a reduction in low-margin loans. Bank of America next applied its cost-conscious ways to the integration of NationsBank, acquired in 1998 for $43 billion. Today, Bank of America's cost-to-income ratio, including nonperforming loans as a cost, is about 10% below the industry average. It will be instructive to watch Bank of America insert its cost-efficiency focus into Fleet Boston. B-of-A management has already announced plans to scale back redundancies in the former Fleet Financial Corp. credit-card center. In the process, it may elevate itself to performance leadership. Not a bad role model for the industry's next round of megamergers. Ms. Detrick, based in New York, directs Bain & Company's North American financial services practice. Mr. Tanner, based in Sydney, directs Bain's Asian financial services practice.

BANKERS HAVE ALWAYS focused on "the spread," or the difference between the cost of funds and the rate at which they are lent, as a barometer of profitability. But another set of numbers—the cost-to-income ratio—holds even greater significance for managing the financial performance of banks.

That's good news for Bank of America and its shareholders, who have seen the company's stock price gyrate since announcing in October of 2003 that it would merge with Fleet Boston. Prior to the merger, Bank of America managed to keep its cost-to-income ratio among the lowest in the industry. And if history is any indicator, Bank of America's cost-conscious organization should now transform Fleet Boston—an institution in which frugality sometimes took a back seat to expensive growth initiatives.

The power of the cost-to-income ratio lies partly in its simplicity. In skillful hands, it serves as a lens to keep bank executives and employees focused on efficiency even when income is rising. It turns out that holding costs in check has a greater effect on banks' financial performance than even robust growth.

That pattern emerged when we looked at the performance of the world's 150 largest banks. Those with slower revenue growth but low cost-to-income ratios performed admirably, generating average annual shareholder returns 14% higher than their home-country indices. The picture reversed for banks with strong revenue growth but weak efficiency: Those with the highest top-line growth—but the least efficiency—returned just 3.5% more than their country indices annually. In other words, slow-growing efficient banks outperform their less-efficient, higher-growth peers by a factor of four to one.

Of course, banks that can do both—grow revenues and manage costs with the world's best—generate the largest rewards. Those performance leaders produce returns twice as high as the efficient slow-growers and six times as high as less efficient, growth-oriented banks.

To get a sense of what it takes to join this group, look at Fifth Third Bancorp in Cincinnati, Ohio. Fifth Third has achieved its star status by aggressively acquiring smaller banks, and assimilating them into a culture deeply rooted in cost control. Its total income increased by almost 25% per year over the past five years as a result of this serial acquisition strategy. But its success is really based on holding down costs during the efficient—and rapid—integration of its purchases.

Fifth Third was able to keep its cost-to-income ratio steady at a lean 50%, including nonperforming loans. It did so by turning cost reduction efforts into something of a game. In a contest that would have appealed to the penny-pinching comedian Jack Benny, Fifth Third managers competed to out-save each other. The savings also went to shareholders, who saw returns increase an average of 9% per year during that period, while the market was falling at 8% per year.

In Bain's study, only 16 banks out of 150 achieved this level of performance leadership. Bank of America could become the 17th. Banks with a strong efficiency and cost focus have the best shot at breaking into the performance leaders group. Our research found that nearly two-thirds of banks that were cost-focused at the beginning of the study succeeded in increasing revenue growth. And 13 of the 16 performance leaders started off as cost leaders.

Bank of America's acquisition of Fleet Boston could provide a catalyst for such a leap. Consider B of A's recent history: In 1996, Ken Lewis was named CEO and quickly realized he had to control costs incurred during a series of mergers. He linked executive compensation directly to profitability, measured partly by total shareholder return, among other metrics. Mr. Lewis then set about focusing the organization on cost efficiency. For instance, in 2001, B of A launched a novel program combining a Six Sigma quality approach to eliminating expenses with a reduction in low-margin loans.

Bank of America next applied its cost-conscious ways to the integration of NationsBank, acquired in 1998 for $43 billion. Today, Bank of America's cost-to-income ratio, including nonperforming loans as a cost, is about 10% below the industry average.

It will be instructive to watch Bank of America insert its cost-efficiency focus into Fleet Boston. B-of-A management has already announced plans to scale back redundancies in the former Fleet Financial Corp. credit-card center. In the process, it may elevate itself to performance leadership. Not a bad role model for the industry's next round of megamergers.

Ms. Detrick, based in New York, directs Bain & Company's North American financial services practice. Mr. Tanner, based in Sydney, directs Bain's Asian financial services practice.