Cost-income ratio

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Cost income ratio (CIR) is emerging measure of bank's efficiency and a benchmarking metric. As a standard indicator of the bank's efficiency, CIR measures the operating costs of the bank in relation of its total income. CIR also affects bank's profitability[1].

The efficiency in banks is mainly based on the cost income ratio (CIR), which is also known as efficiency ratio. Despite this prediction CIR power is not clear at all, this ratio is widely regarded as a measure when comparing productivity and efficiency of banks. However that high CIR is equivalent low producitvity and low efficiency, and vice versa. Consequently, then a revised CIR is suggested. The procedure allows orientation and pragmatic, which is performance measurement in banks[2].

Cost income ratio algebraic formulation[3]:

The cost income ratio structure

The cost income ratio puts administrative costs (expenses) and operating income (earnings) of the bank relation to each other. The cost income ration shows how many dollars (or euros etc.) were needed in a given period of time to generate one dollar (or euro etc.) in revenue. Namely,the CIR measures the output of abank in relation to the contribution used. Figure 1 shows ingredients needed to determine CIR[4].

Factors that affect the cost income ratio

Additional factors influence the CIR further reduction of the predictive power efficiency. These factors are not connected to and therefore irrespective of the level of service production. However, they have a direct impact on earnings and expenses of the bank, and consequently effect the CIR[5]:

  • Business model: a specific business model a the bank has a direct influence on CIR.
  • Regional focus: As shown above in the example concern margins, commission fees and factor costs vary greatly in individual countries as well.
  • Cyclical improvements of income: it seems that CIR be more favorable in times of boom due excessively high earnings. Characteristic times by the deterioration of the economic situation generate a decrease in earnings, which results less favorable CIR.
  • Non-recurring effect: Non-recurring income, such as the sale of shares or non-recurring costs caused by restructuring programs, is allowed the CIR calculation. Banks rarely reveal corrected CIR values.
  • Risk affinity: bank's risk affinity with regard to granting loans has a significant impact on CIR. Higher affinity for risk leads to higher interest margins causeto higher risk premiums. In this way, interest salary increase and profits CIR decreases. Deferred risk adjustments are not included in the CIR calculations.
  • Balance sheet management: The balance sheet the bank's policy influence the refinancing costs along the yield curve. These costs are taken into account in interest income and thus have impact on CIR.

Examples of Cost-income ratio

  • Cost-Income Ratio of a Bank: The cost-income ratio (CIR) of a bank is the ratio of operating costs to total income. It is usually expressed as a percentage, and is calculated by dividing total operating costs by total income. For example, if a bank has total operating costs of $100 million and total income of $200 million, its cost-income ratio would be 50%. This means that the bank is spending 50% of its total income on operating costs.
  • Cost-Income Ratio of an Insurance Company: The cost-income ratio of an insurance company is calculated in a similar manner as the cost-income ratio of a bank. The ratio is calculated by dividing the total operating costs by the total income of the insurance company. For example, if an insurance company has total operating costs of $50 million and total income of $100 million, its cost-income ratio would be 50%. This means that the company is spending 50% of its total income on operating costs.
  • Cost-Income Ratio of a Retail Company: The cost-income ratio of a retail company is calculated by dividing the total operating costs by the total income of the retail company. For example, if a retail company has total operating costs of $1 million and total income of $2 million, its cost-income ratio would be 50%. This means that the company is spending 50% of its total income on operating costs.

Advantages of Cost-income ratio

One of the advantages of the Cost-income ratio (CIR) is that it is an effective measure of a bank’s efficiency and a benchmarking metric. The following are some of the advantages of using the CIR:

  • It is a widely accepted and easy to understand measure of banks’ efficiency and profitability.
  • CIR is a good indicator of how well the bank is managing it’s operating costs in relation to its total income.
  • CIR can be used to compare the performance of different banks and to assess the performance of a bank over time.
  • It can also be used to identify cost-saving opportunities.
  • CIR can also be used to identify potential areas of investment in order to improve the bank’s efficiency.

Limitations of Cost-income ratio

The Cost-income ratio (CIR) is an indicator of the efficiency of a bank, and is used as a benchmarking metric. However, the CIR has certain limitations, including:

  • The CIR does not differentiate between the different types of income and expenses. This approach fails to provide an accurate picture of the bank's efficiency, as it does not take into account the value of the different types of income or expenses.
  • The CIR does not account for the size of the bank, and does not factor in the costs associated with different levels of operations. This means that the ratio may not accurately reflect the efficiency of a bank with a large customer base, as the costs associated with servicing those customers are not taken into consideration.
  • The CIR does not take into account the financial health of the bank, nor does it consider the impact of macroeconomic factors on the bank's performance. This means that the ratio can be misleading, as it does not take into account any external factors that may affect the bank's performance.

Other approaches related to Cost-income ratio

There are several other ways to measure banks’ efficiency, such as:

  • Return on assets (ROA) - This measure looks at how much profit a bank makes after taking into account the amount of assets it holds.
  • Return on equity (ROE) - This measure looks at how much profit a bank makes after taking into account the amount of equity it holds.
  • Efficiency ratio - This measure looks at the costs incurred by banks to generate income.
  • Cost-to-income ratio (CIR) - This measure looks at the operating costs incurred by banks in relation to their total income.

In summary, Cost-income ratio is an important measure of bank's efficiency, but there are several other ways to measure banks’ efficiency such as Return on Assets, Return on Equity, Efficiency ratio and Cost-to-income ratio.

Footnotes

  1. Capital Adequacy, Cost Income Ratio and the Performance of Commercial Banks: The Kenyan Scenario 2009
  2. Capital Adequacy, Cost Income Ratio and the Performance of Saudi Banks 2013
  3. Cost to income ratio in Australian banking 1998
  4. Productivity in banks: myths & truths of the cost income ratio 2009
  5. Productivity in banks: myths & truths of the cost income ratio 2009


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References

Author: Wojciech Ślusarczyk