The other secret of NIM: tight spreads eroding your profits? Cost-accounting offers another way...

The near-obsessive attention of community bankers to interest spread" and earning asset yield levels--the most visible components in increasing or decreasing profitability--tend to override the attention paid to all other ingredients in assessing performance levels.

Because these two

Yet there's much more to the picture. My primary objective here is to draw attention to recent significant changes in noninterest expense levels in community banks. In addition, I'd like to offer another look at a measure of successful performance beyond traditional interest spread analysis.

A standard challenged by reality

Over the years, community bankers became quite accustomed to benchmark statistics regarding noninterest expense categories. In time, they accepted the traditional industry standard 3% of average assets in total noninterest expenses.

Yet, in recent periods this norm has been challenged, and successfully defeated with ever-increasing efficiencies in technology, information processing, automated support systems, and management control tools.

Several periods ago, total noninterest expense (on average) for community banks dipped below the 3% norm, and is currently in the 2.75% to 2.8% range--a significant decline. This decline played a key role in profitability, yet it was consistently overshadowed by net interest spread stats. In fact, in many community banks, this component of profitability often offsets an under par performance in interest margins, and results in higher overall earnings.

What comprises noninterest expense? Where have most efficiencies occurred? While this varies greatly among banks (and market areas), a database of performance in this area provides good insight. The database consists of about 23 community banks, with average assets ranging from a low of $300 million to about $2 billion. Here are some findings from this sample:

* Of the average 2.80% (of average period assets) in noninterest expenses, a bank's profit centers (lending, branches, etc.) comprise just over half, averaging about 1.46%.

* Cost/support centers (back office support functions) generate the remaining 1.34%.

* The significant declines in recent periods have occurred in the latter category, which has seen a reduction of about 20 basis points.

* Profit centers, with their continued delivery costs, talent costs, and product development costs, absorb a higher (and increasing) share of noninterest costs.

* With an effective, in-place departmental profitability system, cost statistics by department/function are readily available, and an excellent tool to assess the efficiency (or lack of!) by department and compare to other "peer" group members.

Getting in the ballpark While the database is admittedly a bit limited, it has proven to be quite effective as a gauging tool in assessing performance versus averages. Statistics are gathered quarterly, categorized, and averages, as those shown in the table below, are generated. The operating expenses of each department shown are just that; direct expenses relating to the specific department, with any unrelated or questionable expenses removed and posted to the proper responsibility center. The objective, of course, is to identify the total cost (unembellished) of each department, so that reasonable comparisons can be made.

As an example, probably the most frequent error in posting departmental expenses occurs in the human resources area. Often, the postings include the total bank costs for pensions, employee benefits, etc. Of course, as with any other general type expenses, these costs must be removed, and re-allocated throughout the bank on specific bases.

Since much has been written and discussed regarding efficiency in profit center functions, we will concentrate on the bank's "cost/support" departments, the primary area of improvement in recent periods.

Regardless of how detailed a bank's general ledger is departmentalized, the typical community bank operates essentially eight to ten cost/support centers. Most others are simply supplemental parts of existing departments, structured separately largely for monitoring purposes. The table on page 24 reflects the average costs of each support center, along with a "high" and "low;" demonstrates an effective way to monitor expenses at the cost centers; and shows budgeting and projection data, and other analyses.

Banks reflecting costs in a specific department that are noticeably above averages usually launch a study to assess the reason. In one recent example, one of my clients noted that its deposit services function (back office branch support) was well above its peers. A detailed study reviewed such stats as number of support FTEs per branch personnel, $ support costs per $ deposit base, etc. The problem turned out to be a combination of an unnecessary and obsolete process and simple overstaffing. By the next quarter, the client had fixed both of these problems and its stats were a bit lower than the average.

Consistency over time

It's true that departmental expenses can vary widely within community banks, based on specific conditions and timing. Over an average period, however, the stats shown in the accompanying tables are surprisingly stable--with most respondents consistently falling within single basis points of each other. A noted exception at your bank, of course, may occur occasionally in marketing, when specific products are being promoted. Another exception may be loan servicing during a refinancing boom. Both would be departures from the normal tend, obviously.

With continued emphasis on efficiency in costs as a primary tool in profitability management, many community banks are able to perform under the net interest margin stats shown by competitors, yet generate stronger bottom line earnings. Try it--you may like it!

Tom Flynn, president, Community Banking Concepts, Somerville, N.J.

Community bank norms
2nd quarter 2005 *
(condensed version)

                                  1st Qtr   2nd Qtr    B.P.    YTD your
Category                            2005      2005    change     bank

Total operating expense/average     2.78      2.79     0.01
 assets (non-int)

Branch offices

Gross return/deposits (before       1.56      1.53    (0.03)
 overhead)
(Funds credit less interest +
 direct expense)

Direct expense/branches             1.00      0.99    (0.01)
Fee income/deposits                 0.44      0.43    (0.01)
Deposits per employee              $6.99     $7.06     0.07
 (millions)
Direct expense offset per         $6,108    $6,209     $101
 employee (per month)
Pool funds costs/deposits           3.41      3.54     0.13

Lending departments

Gross yield on loan portfolios      1.99      1.89    (0.10)
 (pre-overhead)
(Yield less funds cost +
 direct expense)
 Commercial
  Direct expense (% port.)          0.91      0.93     0.02
  $ Portfolio/employee            $18.09    $18.94    $0.85
   (millions)
  Net income per employee           0.14      0.16     0.02
   (% port.)
 Consumer
  Direct expense (% port.)          0.95      0.97     0.02
  $ Portfolio/employee            $16.27    $17.27     1.00
   (% millions)
  Net income per employee           0.23      0.24     0.01
   (% port.)
 Mortgage
  Direct expense (% port.)          0.59      0.58    (0.01)
  $ Portfolio/employee            $22.99    $23.22    $0.23
   (millions)
  Net income per employee           0.23      0.23     0.00
   (% portfolio)
Fee income/% portfolio              0.24      0.23    (0.01)
 Commercial mortgage
  Direct exp. (% port.)             0.71      0.72     0.01
$ Portfolio/emp. (millions)       $26.41    $26.66     0.25
Net income per employee             0.17      0.16    (0.01)
 (% portfolio)

* Responses 23; Period YTD 6/05

SOURCE: Community Banking Concepts database

Cost (support) centers
operating expenses
Shown as basis points on average period assets/portfolios

            Audit    Marketing   Human res.   Financial   Info. svcs.
          % assets    % assets    % assets     % assets    % assets

Average     0.07        0.16        0.10         0.10        0.23
High        0.13        0.24        0.22         0.14        0.32
Low         0.03        0.09        0.05         0.07        0.16

             Loan svcs.        Deposit svcs.
          % Ins   % assets   % dep.   % assets

Average    0.18     0.13      0.41      0.32
High       0.27     0.19      0.58      0.39
Low        0.11     0.07      0.27      0.22

Your bank

SOURCE: Community Banking Concepts database