Measuring Bank Cost Efficiency:
Don’t Count on Accounting Ratios
This article explores the challenges and misconceptions of measuring cost efficiency at financial institutions.
We illustrate situations in which accounting-based expense ratios are misleading and show that statistics-
based “efficient cost frontier” approaches often measure cost efficiency more accurately. We also demonstrate
a less complicated “fix-up” technique that combines the best qualities of both approaches. Finally, we
summarize the existing literature on cost inefficiencies, scale economies, scope economies, and technological
change at commercial banks, and conclude that any thorough treatment of bank efficiency must analyze
revenues as well as expenses.
The deregulation of financial markets in the 1980s
led to a massive restructuring of the commercial
banking industry. Barriers to geographic expansion and
ceilings on interest rates were eliminated, and
commercial banks experienced dramatic increases in
actual and potential competition from in-state banks,
out-of-state banks, and non-bank rivals. Over 1,000
banks became insolvent after 1980, succumbing to the
combination of unfamiliar competitive conditions and
unfavorable macroeconomic events. Thousands more
were acquired by rival institutions, leaving the US
banking system with about 25% fewer banks today
than at the start of the 1980s.
These trends are likely to continue, and perhaps
accelerate, when the final provisions of the Riegle-
Neal Interstate Banking and Branching Efficiency Act
become law in 1997. What kind of banks are likely to
flourish, fail, or be acquired as the industry continues
to consolidate? If the past is pr elude to the future,
the banks that disappear will be those that are
inefficiently run. Inefficient banks have relatively
high costs and earn relatively low revenues, and as
a result generate smaller capital cushions to protect
Robert DeYoung is a Senior Financial Economist at the Office
of the Comptroller of the Currency, Washington, DC, 20219.
The opinions expressed in this article are those of the author
and do not necessarily reflect those of the Office of the
Comptroller of the Currency or the Department of the
Treasury. The author thanks Tara Rice for excellent research
assistance and Kevin Jacques, Larry Mote, and two anonymous
referees for invaluable comments on earlier drafts.
themselves during bad times. Inefficient banks also
tend to make attractive merger targets, because they
can often be purchased for low price-to-book ratios
and then be made to run more efficiently.
Bank analysts generally measure “efficiency” in
terms of spending on overhead, such as physical plant
and bank personnel, relative to the amount of financial
services produced by the bank. Based on this notion
of efficiency, one would expect the banking industry
to be turning in some impressive efficiency gains,
because reducing overhead is a stated goal in many
bank mergers and bank holding company
reorganizations. However, a close look at the data
suggests otherwise. For example, the commercial
banking system currently spends more on labor than
it did a decade ago. Although total employment at
commercial banks has fallen by about 5% over the past
decade (and by about 13% per dollar of real assets),
this has been more than offset by a 19% increase in
real salaries and benefits per employee.
banks also operate more branch locations now than
they did a decade ago. The number of banks has
declined dramatically, but the number of branch offices
In 1985, the 14,373 commercial banks with insured deposits
held $3.646 billion of assets (in 1994 dollars), employed the
equivalent of 1,561,339 full-time employees, and paid them
an average of $34,200 in salaries and benefits (in 1994 dollars).
In 1994, the comparable figures were 10,444 banks, $4.012
billion of assets, 1,488,583 full-time employees, and $40,710
in salaries and benefits. Source: Reports of Condition and
Income, 1985, 1994.