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Can Wells Fargo Maintain Its Strong Efficiency Ratio?

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Controlling expenses is critical for US banks

Controlling overhead expenses has been a key focus for US banks (XLF) as they struggle to remain profitable while containing rising costs in an uncertain and volatile environment.

Wells Fargo (WFC) is among the most efficient banks among its peers when it comes to drawing the line on expenses. Industry peers Citigroup (C) and Bank of America (BAC) haven’t been as successful at controlling overhead expenses. Wall Street analysts keep a close eye on the efficiency ratios of banks. This ratio is especially important in the upcoming results as low interest rates and global events have eaten into bank’s revenues.

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The efficiency ratio is a measure of non-interest expenses as a percent of net revenue. It shows how revenues fuel a bank’s operating expenses. A lower percentage is better, as it means lower expenses compared to revenues. The efficiency ratio for Wells Fargo was 58.5% in 2Q15, meaning it spends less than 60% of its top line to operate. In contrast, the efficiency ratio for Bank of America (BAC) was 67.4% and 59% for JP Morgan (JPM).

Profitability is driven by expense control

In the current scenario, banks are boosting their profitability through expense control. Banks’ valuations are derived by the returns they are able to generate on assets and shareholder equity. These are key measures to profitability for banks.

In recent quarters, Wells Fargo (WFC) has been among the most profitable banks. During the second quarter, the company earned 12.7% return on equity (or ROE) and 1.3% return on assets (or ROA). For the third quarter, analysts expect ROE to be 12.5% and ROA to be 1.2%.

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