The efficiency ratio is the traditional measure for bank productivity. Simply put: it is the cost required to generate each dollar of revenue. Simplicity is an advantage, but the ratio needs a business context and respect for any of the complicating factors discussed below.

The common way to calculate bank efficiency, the cost to revenue ratio, is to measure non-interest expenses as a proportion of of operating revenue. Costs include salaries, technology, buildings, supplies, and administrative expenses. Revenue includes net interest income (interest revenue less interest expenses) plus fee income.

How to interpret the efficiency ratio?

A bank's non-interest expense level reflects its efficiency in converting inputs into revenue. So, the lower the ratio the better, all other things being equal. A cost to revenue ratio of 50%, or below, is admired.

Yet things are not equal. You need to consider other factors when interpreting the efficiency ratio:

1. Strategy. Banks that see themselves as retailers will operate with high-touch customer service models. This is an expensive business model, which means 70%+ efficiency ratios, but has the huge benefit of pulling in low-cost deposits.
2. Shape. By shape, I mean the business mix. Fee-focused banks, who process transactions for a fee, will have high efficiency ratios. Their strategy is to concentrate on scale-driven processing businesses, which means high fixed costs and, superficially, a poor efficienccy ratio.
3. Scale. The efficiency ratio handles scale- or fee-based businesses badly. In a scale business, banks need to recover their high fixed costs by increasing the volume of transactions processed. Maximizing volumes, not minimizing expenses, is the focus. This leads to a high efficiency ratio, despite the highly profitable operating leverage created, which will eventually show up in higher fee income.