An Important Insight About Bank of America

By John Maxfield Markets Fool.com

If you read what most analysts and commentators say about Bank of America (NYSE: BAC), you'd be tempted to conclude that its profitability problems are the result of inefficiency, which seems to explain the bank's focus over the past eight years on cutting costs.And to a certain extent, you'd be right.

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Bank of America's efficiency ratio, which measures the percent of revenue spent on operating expenses, was 66% last year. That's 4 percentage points higher than its peer group average, 6 percentage points above the standard industry benchmark of 60%, and more than 10 percentage points over banks like PNC Financial and U.S. Bancorp.

The Bank of America Tower in Charlotte, North Carolina. Image source: Getty Images.

The problem with drawing this conclusion, however, is that it's a mistake to equate efficiency with expenses.

Consider this: The three big banks with the lowest efficiency ratios (PNC Financial, Capital One, and U.S. Bancorp, respectively) all spend more on expenses than Bank of America does after you adjust for size. You can see this by ranking these banks' operating expenses as a percent of their total assets:

Bank

Expenses as a Percent of Assets (2016)

Bank of America

2.51%

PNC Financial

2.59%

U.S. Bancorp

2.62%

Capital One

3.80%

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Data source: Regulatory filings.

If Bank of America's expenses aren't a problem, then, what explains its dismal efficiency ratio? The answer is -- its revenue.

You can see why by looking at how the efficiency ratio is calculated -- that is, by dividing a bank's noninterest expenses by its net revenue. A bank can have a high efficiency ratio, in turn, either because its expenses are too high, or because its revenue is too low.

In Bank of America's case, it's the latter, as you can see by comparing Bank of America's revenue as a percent of total assets to these three other highly efficient banks:

Bank

Revenue as a Percent of Assets (2016)

Capital One

7.14%

PNC Financial

4.92%

U.S. Bancorp

4.73%

Bank of America

3.83%

Data source: Regulatory filings.

Capital One leads the way in terms of revenue generation, as its concentration of high-yielding credit card loans translates into more revenue than its more traditionally diversified peers. Meanwhile, Bank of America is on the other end of the spectrum, generating markedly less revenue from its assets than the other three banks.

The takeaway for investors is that Bank of America's primary focus going forward should be on growing its revenue in a responsible way. Higher interest rates will help, as rising rates should bolster the bank's net interest income. But to close the gap in terms of its efficiency ratio, Bank of America will need to seek out businesses where its expertise, or skill set, enables it to generate outsized returns.

How it will do so remains to be seen, but the North Carolina bank's progress since the financial crisis is an auspicious sign that things are going in the right direction.

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John Maxfield owns shares of Bank of America and US Bancorp. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.