Third in a four-part series on creating profitability POWER.

Noninterest expense is an inherent function of the products a financial institution sells and services, and it's an expense every institution would like to reduce. Moreover, the cost to service a product is what creates operating expenses.

A recent evaluation of efficiency ratios for Wisconsin financial institutions over a nine-month period showed 60% of organizations had an average efficiency ratio of almost 64%. In plain English, it costs $64 of noninterest expense to generate $100 of tax-equivalent interest margin and fee income.

Despite all the fee income from refinancing and the like, the noninterest expense ratio hasn't changed much for most institutions. In fact, for the past three years, efficiency ratios for institutions in our state have been between 61-65%. On average, salary and benefit expenses have generally consumed 58% of the noninterest expense ratio.

Every institution should remember that there is Profit Opportunity Within Every Resource (POWER) and that includes noninterest expense. An institution can begin reducing noninterest expense by recognizing the factors that drive it and identifying the costs originating from product features, as well as those costs driven by factors other than volume.

Good decisions = positive impacts

Even though noninterest expense is easily defined, the process of reducing operating expenses can be difficult and time-consuming. This is chiefly because the servicing cycles on products encompass months, even years for loans and deposits. Therefore, an institution must change its sales and servicing models in order to reduce operating costs.

An institution must also help employees understand how their everyday decisions impact revenue, positively or negatively. All employees, whether they are lenders, tellers, customer service representatives, or operations personnel, provide an institution with opportunities to reduce costs.

Consider the classic example of a decision that becomes a negative impact annuity—the "menu" or list of services a lender presents to borrowers at the time a loan is granted.

The expense annuity starts when a lender leads a customer into making monthly payments with coupons. The financial institution orders the coupon book, pays for the book, and then processes payments at the teller line until the loan is eventually paid off. This is already an expensive scenario; however, it doesn't stop there.

The lender's decision also ensures that the expense annuity continues by requiring the employment of tellers, proof operators, and personnel who must file the coupons and clear the checks used to make payments. The extra labor creates a significant, negative impact on revenue . . . still there's more.

To support the ever-increasing number of loan payments, the institution purchases teller and proof machines, which depreciate and require ongoing maintenance and repair. In addition, it must purchase ribbons, power, and paper to feed the mechanical monsters.

The lender's decision created an expense annuity for 36 to perhaps 60 months. When Federal Reserve Banks were performing functional cost analyses, they estimated the cost of processing a loan payment at around $5.

So why don't more financial institutions promote automatically debited loan payments? Perhaps because of the myths associated with the automatic strategy.

The first myth is that the institution feels it is already doing a good job of selling the auto-payment benefit when loans are granted. The fact is that lenders aren't gaining a respectable penetration of electronic loan payments. An institution should be collecting at least 60% of its loan payments via automatic debit for it to be considered a successful effort.

The second myth is that an institution should offer discounted loan rates that will encourage customers to elect the auto-payment option. Some institutions even discount the loan rate a quarter percent if payments are made via direct debit to an account.

An institution should instead believe that its current rates are the best it offers, which then become the rates for electronic payments. Should a customer prefer to make payments with monthly coupons and checks, the institution can then add 1%.

The time to start looking is now

In this time of increasing pressure on interest margin, it's important to focus on sources of operating expense and develop strategies to reduce costs. Examine all the different processes. Look for ways to streamline efforts. Explore new strategies to increase revenue. The sooner an institution starts looking, the faster it can reduce its noninterest expense and achieve profitability POWER.