Would you like to reduce your noninterest expense?   Then you need to start looking at what drives expense and identifying the costs originating from product features and costs driven by factors other than volume.

A recent evaluation of the efficiency ratio showed us that 70% of Minnesota banks had an average efficiency ratio of almost 61% for the six months ended June 2004.  In plain English, it costs $61.00 of noninterest expense to generate $100 of tax equivalent interest margin and fee income.  Exactly half of the noninterest expense was devoted to salary and benefit expense.  The efficiency ratio has been between 61% and 64% for the past three years and salary and benefit expense has generally been consuming 50% of the noninterest expense ratio on average.

Despite all the fee income from refinancing, etc. the noninterest expense ratio hasn’t changed much for most of the banks.

Noninterest expense is an inherent function of the products the financial institution sells and services.  Moreover, the cost to service a product is what creates operating expenses.  Even though noninterest expense is so easily defined, the process of reducing operating expenses is difficult and time-consuming.  This is because the servicing cycle on your products encompasses months and even years for loans and deposits.  Therefore, you need to change your sales and servicing model in order to reduce operating costs.

All employees, whether they are lenders, tellers, customer service representatives, or operations personnel, provide your institution with opportunities to reduce costs.  Your challenge as a manager is to help employees understand how they impact revenue negatively or positively by their everyday decisions.

Let’s look at a classic example of a decision that becomes a negative impact annuity—the “menu” or list of services the lender presents to borrowers at the time a loan is granted.  The expense annuity starts when the lender leads a customer to paying the monthly payment with a coupon.  The financial institution orders the coupon book, pays for the book, and then processes payments at the teller line until the loan is paid off.  This may seem expensive already, but it doesn’t stop there. 

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

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

Think about the fact that the lender’s decision ensured an expense annuity for 36 to perhaps 60 months.  When the Federal Reserve Banks were performing the functional cost analysis, they estimated the cost to process a loan payment was around $5.00.  In this time of increasing pressure on interest margin, it is important for you to develop strategies to continue to reduce operating costs.

So why aren’t more financial institutions promoting automatically debited loan payments?  The reason is there are myths associated with this strategy.  The first myth is that the institution is already doing a great job to sell this benefit when a loan is granted.  The second myth is that the institution should discount the loan rate to encourage the customer to elect the auto-payment option.

First, let’s deal with the myth that these lenders are getting a respectable penetration of electronic loan payments.  I have been working in or consulting with financial institutions for 30 years and have found that if you collect 20% of your loan payments via automatic debit to a deposit account, you are doing an outstanding job relative to your peers. 

A strategy some institutions use is to discount the loan rate a quarter percent if the customer makes payments via direct debit to an account.  Instead, challenge yourself to think that the rate you currently offer is your best rate, the same rate for electronic payments.  Then, add 1% if the customer wants to make payments with coupons and checks.

The financial industry can and needs to focus on this important source of operating expense.  Start looking at your different processes.  Start looking at streamlining your efforts.  Start looking at new strategies to increase revenue.  The sooner you start looking, the faster you’ll reduce your noninterest expense.