Financial institutions are not like other businesses. After all how many other businesses get a daily statement of condition? In what other business is the balance sheet also the product list? It must be remembered that a financial institution’s directors typically come from other industries. For these reasons, it is management’s responsibility to translate the business model, key operating ratios and banking language into terms familiar to directors to insure meaningful dialog.
The banking business model can be described as "money renting." Financial Institutions rent money from depositors on one side of the balance sheet and then rent that money out to borrower (securities can be considered a type of loan) on the other side of the balance sheet. When placed in this context, it is easier to understand interest rate risk. Anyone familiar with rent-controlled apartments understands the plight of the landlord.
One source of assistance to help directors understand the dynamics of banking are the comparative sources. The Sunshine Act of the early 1970’s opened bank statistics to everyone. With this came the development of performance ratios and due to the homogeneity of the industry, allowed a depth of comparison between financial institutions not available to other industries. Initially and still extant today are ratios based on Average Assets. This put all measures into a common dimension. Return on Average Assets (ROA) and its subsidiaries accounts became standard performance measurements. It should be noted, however, that asset size, whether openly acknowledged or not, is for most bankers still the key performance indicator because size does matter.
Of course not all ratios are based on average assets. Some basic investment concepts are easily translated, such as Return on Equity (ROE). Directors and investors use this ratio to quickly compare company performance across all industries. Dividend Yield is also a commonly used statistic. However, as we delve deeper into institution financial performance measurements some of the classic banking terms can be translated into terms common to the non-financial outside directors. Here are a few examples:
| Financial Institution Speak | Business Speak |
| Interest Income | Sales |
| Interest Expense | Cost of Goods Sold |
| Net Interest Margin | Gross Margin |
| Loan Loss Provision | Bad Debt Expense |
| Operating Expense | Operating Expense (Overhead) |
| Net Income | Net Income (Net Revenue) |
Units and unit costs are important terms in many industries. Banking references volume or balances and yields or cost rates instead of unit price or unit cost.
Where industry speaks of other income and operating expense, bankers often use the terms Non-Interest Income and Non-Interest Expense to separate them from interest categories. They are also referred to in combination as Net Overhead. Financial Institutions typically derive about 80% of total revenue from Interest Margin and 20% from non-interest income. Some large institutions generate as much as 60% to 70% of their total revenue from non-interest sources such as trust activities, but these are exceptions. Most financial institutions’ income is still coming from the interest spread.
Operating Overhead is common to all businesses. Salaries, fixed asset expense, and others need no special explanation. However, these are commonly presented as a percentage of Average Assets for comparison purposes. This can be misleading since asset size is not always the driving force. Here is just one example of making a ratio more relevant.
The Efficiency Ratio always interesting. It is Operating Expense divided by Total Revenue. A confusing aspect of this ratio is that the lower the value, the higher the efficiency which is contrary to our senses. To improve this ratio the bank must lower either Operating Expense or Increase Income – certainly an insight to be pondered.
A colleague of mine, Andy Sigl developed a better measure of efficiency may be the volume of Loans and Deposits per employee. Banking is a human resource business, true efficiency should relate to operating efficiency of the employees. It is precisely because a financial institution has Loans and Deposits that it has employees. If a financial institution only purchased CDs and made investments, it would not have more than a few employees regardless of asset size. So measuring their "Handel" ratio is really an effective approach.
Financial institution statistics are readily available and should be used by management to help directors understand and appreciate the meaning of the measurements even if they are a quarter old. At least they provide some reference point or benchmark. If boards are to be more effective, management must bring more meaning to the numbers and use a language that speaks to the target audience.