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Measuring Economy of Scale and the Importance of Non-Interest Income

The expense to asset ratio is one of the most used performance indicators for credit union productivity. Despite it being a widely used measure, major flaws can lead to erroneous conclusions.

  • Mike Higgins Managing Partner at Mike Higgins & Associates

One of the benefits of my work is that I get to attend a lot of board meetings. They provide board members with an update on the direction of the credit union and its financial sustainability. When discussion turns to productivity, the expense to asset ratio is the most used measure – but it has a major shortcoming that can produce the wrong conclusion about productivity, operating leverage, and economy of scale.

Expense to Asset Ratio

Most people (wrongly) assume a lower expense to asset ratio means greater economy of scale and higher return on assets (ROA). Why would they draw such a conclusion? 

Using NCUA 5300 data from 2021, let’s look at the chart that follows. It is the expense to asset ratio for credit unions by different asset size.

What is interesting is there is very little difference in performance until assets exceed $5 billion, which is only 59 credit unions (the top 1% of asset size).

What about ROA, surely there is a correlation between that and the expense ratio? Using NCUA data from 2021, the chart that follows refutes that assumption.

The correlation between ROA and expense to asset ratio is high in the under $100 million asset size group, but it is effectively zero (or slightly negative) for credit unions larger than that. Wait, what? For credit unions over $100 million in assets, there is no correlation between ROA and the expense to asset ratio. How can that be? Enter, non-interest income.

Non-interest Income

Non-interest income is a key driver of ROA that does not require an asset. It does not show up in the expense to asset ratio. Worse yet, the expense associated with generating non-interest income does show up in the expense to asset ratio, but not the income – it is ignored.

NCUA 5300 data from 2021 shows us how much non-interest expense is being offset by non-interest income by asset size.

As credit unions scale in asset size, they generate more non-interest income which reduces reliance on net interest income as the primary driver of return on assets. Most non-interest income sources require no regulatory capital, so they are not a burden on net worth and risk-based capital ratios. In fact, the opposite is true: non-interest income sources improve regulatory capital ratios.

So, if the expense to asset ratio is such a misguided metric of performance, how do we measure economy of scale? There is an answer. At its most basic level, economy of scale is input versus output. As an organization scales, output should grow faster than input. Let’s look at a way to measure this relationship to see if your organization is realizing economy of scale.

Economy of Scale Ratio

Input is defined as net cost of operations. It is non-interest expense less non-interest income. It addresses the fact that non-interest income is such a large part of modern-day banking.

Output is defined as loan balance plus transaction share (draft, regular, money-market) balance. We don’t count rate sensitive funds (certificates, individual retirement accounts, borrowings) because they consume little or no expense resource and can be obtained via posting a rate, or a simple mouse click (brokered deposits, borrowings).

The Economy of Scale Ratio is net cost of operations divided by the sum of loan and transaction balance. Credit unions with the lowest input costs producing the most output are the most productive. Because this measure does not include interest income and expense, it is not clouded by changing interest rate environments, making it easy to trend over time to see if economy is being realized as a credit union scales. NCUA 5300 data was used to compute the Economy of Scale Ratio for credit unions in 2021.

As you can see from the chart, the impact of non-interest income on economy of scale is clearly demonstrated – credit unions over $5 billion in assets have doubled the economy of scale of credit unions under $100 million in assets and over fifty percent more economy of scale than credit unions $500-999 million in assets.

The Economy of Scale Ratio is much more positively correlated with ROA than the expense to asset ratio. ROA is impacted by interest rates and credit losses, so there will never be a perfect correlation, but in terms of evaluating productivity and operating leverage, it is far superior to the expense to asset ratio.

The Economy of Scale Ratio is highlighted in the Filene Quarterly Financial Trends report starting on page 19. Be sure to check it out and use it to evaluate if your credit union is realizing economy as it scales.

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