LAKE FOREST, Ill.—A new study indicates that the optimal operating size for any FI is $5-$10 billion in assets, as that is the asset class achieving the greatest economies of scale.
At institutions above that mark expenses rise and keep rising, moving them into the “Too Big To Fail Club” of systematic risk (see chart), according to a new report from Moebs $ervices.
The Moebs $ervices report also shows that while banks are more efficient than credit unions, CUs have significantly improved efficiencies post recession and have closed the gap on banks. Meanwhile, thrift efficiency has fallen.
“Banks, credit unions, or thrifts with assets between $5 billion and $10 billion, are best at controlling expense and achieving economy of scale,” said Michael Moebs, economist and CEO at Moebs $ervices. “Moebs Services has developed an algorithm to identify depository economy of scale by examining expenses.”
Moebs said that before 2008 thrifts were best at controlling expenses. Prior to that year, taking non-interest expense to assets, including the provision for loan loss but excluding taxes, thrifts’ non-interest expense to assets stood at 2.60%, banks at 2.87% and credit unions at 4.05%.
Dodd-Frank Costly
Fast-forward nine years and banks stand at 2.78%, thrifts 2.89% and CUs 3.42%.
“Bank and credit union expenses declined while thrifts’ increased,” said Moebs. “The increased expense to comply with the new regulations introduced in Dodd-Frank was hard on all depositories, especially thrifts.”
The regulatory impact on financial institutions, especially thrifts, is not only evident in their expense ratios, but also in the dramatic changes to their number of institutions and branches, pointed out Moebs. From 2006-2015 there are 1,892 fewer banks (25.5%), 442 fewer thrifts (34.6%), and
Michael Moebs, Moebs $ervices
2,252 fewer credit unions (26.4%).
“In that same time banks added 3,983 branches (4.8%), credit unions 310 (1.5%), while thrifts lost 6,738 offices (48.4%),” said Moebs. “There were also far fewer FI employees.”
For any start-up depository the strategic directive is to grow as rapidly to the economy of scale (EOS), said Moebs.
“Yet, any good CEO knows growth comes at the price of controlling expenses,” he explained. “If you grow too fast and expenses rise quickly, there is pressure on capital forcing the financial institution to seek new capital, slow growth, reduce expenses, or be sold or merged.”
Above $5 billion to $10 billion in assets, where optimum EOS is achieved, an “interesting phenomenon” happens, explained Moebs.
“To maintain the economy of scale the management must replace growth as the prime driver with efficiency. This requires reducing services to only profitable services and aligning compensation to productivity,” he said.
Diseconomy Of Scale
Moebs said that management often cannot make this switch.
“The main reason is the FDIC Act in 1950 for the first time allowed a failed depository to be backed by the government until it could be fixed – not merged, sold or liquidated. This was the start of the race to become Too Big To Fail—a systemic risk in your market, state, region, or country. The government got in the bailout depository business,” said Moebs. “Bigger is better. Grow to maximum size, not optimum, as fast as possible. Thus was created in financial services the diseconomy of scale.
“As plans are put together for 2016 remember the key directive: growth with efficiency,” continued Moebs. “Get as big as you can, but do not outstrip capital. Push staff to keep expense as close to 2% expense to assets. When you get to your economy of scale you will be able to continue to grow since you have achieved optimal expense control before you arrived.”