Pricing loans and deposits is far and away the most significant thing that banks do every day. Not only is it vitally important, but the pricing process is also probably the most actionable and manageable. Surprisingly, many financial institutions, even very large ones, do not have a robust and disciplined pricing management system in place. The reasons for this are discussed in detail below. The good news is that most banks can improve their margin (often from 10 to 50 basis points), improve asset quality, and grow faster with an increased focus on loan and deposit pricing.
The Pricing Dynamic
Obviously pricing is discussed and debated endlessly at virtually every bank. Over many years of helping banks think about pricing, and through the deployment of Pricing Management Systems and pricing models to well over 700 institutions (ranging from very small community banks with assets less than $50 million to much larger banks with assets over $150 billion), we have developed what we call The Pricing Dynamic. In essence, it states that your pricing for any given product should be driven by portfolio needs, relationship awareness, solid risk-based profitability goals, and competitive awareness.
Pricing is at the center of what you can manage. It is where the rubber hits the road – where your strategy meets execution. It is the most important lever that you can pull as it directly and tangibly impacts:
- which deals you win, which deals you lose,
- how much you get paid on those that you win,
- what types of deals you win (asset quality, duration, risk, collateral, rate structure, etc), and
- the quality of the resulting relationship (here we are talking about not only a broader, more profitable set of accounts but also the resulting interpersonal relationship & trust between your lenders and your borrowers).
What is a Pricing Management System? What does it do?
In short, more than anything else, pricing today determines the portfolio in the future. Pricing Management, done correctly, continually balances competitive demands, risk-based profitability, portfolio needs and relationship awareness. This balanced approach is based on the following simple principles:
- You cannot ignore the competition, but you can’t let the competition build your portfolio. You need to know where they are pricing and what your profitability would be if you choose to just match them. That said, you can’t just blindly follow them and hope that they know what they are doing or assume that what works for them will work for you. You need to track competitor pricing and the opportunities that you lose due to pricing so that you develop a proactive strategy to compete and win.
- You must understand the relative risk-based profitability of each new Pricing Opportunity. You need to fully incorporate interest rate risk, credit risk, etc. and the profitability of any other new business like deposits or other fee-based business that will be a part of each Pricing Opportunity. It is important to be able to quickly determine the profitability of the business that is in front of you. It is even more important to be able to quickly and easily find the exact deal structure that works best for the borrower…AND the bank.
- Your portfolio needs and goals should drive your profitability targets. You should use product profitability targets to steer the portfolio based on your portfolio needs (e.g. concentrations by product, region, and repricing duration). For example, if you have an over-concentration in commercial real estate loans in your western region, you can raise the return target for that product in that region relative to your competition, slow the rate of acquisition and allow runoff to re-balance your portfolio.
- You should be aware of the Strategic Value of existing account relationships. Relationships present a very interesting dynamic and are often at the root of pricing challenges and missed opportunities. For example, you don’t ever price relationships, you can only price new business or renewals (what we call Pricing Opportunities) in the context of existing relationships. When you are pricing a new loan to a new borrower, you might accept a lower return on the loan if that borrower brings over their commercial deposits and the total Opportunity return works. But what if you were the bank with the commercial deposits as opposed to the one trying to take them? One bank’s full Pricing Opportunity will often include some or all of another bank’s relationship. Effective Pricing Management requires an awareness of how valuable relationships are to your competitors and to what degree they could be used against you if pricing goes competitive. Much more on this important topic in future blogs.
Why do so few banks have strong pricing practices?
The short and simple answer is that, well…it is not that easy. There are quite a few reasons. Some are more obvious and some are more subtle.
First, pricing management is extremely cross-functional. To get it right requires involvement and input from:
- the Chief Lending Officer to understand the markets in which you compete and how all of this will work “in the field”.
- the Chief Credit Officer to understand credit risk, risk-based capital & loan loss provision,
- the Chief Financial Officer to understand the bank’s funding curve and its portfolio needs, and
- the Chief Executive Officer to provide leadership and commitment…and the budget.
Second, typically a bank’s core transaction processing system is not designed to track or even understand all of the necessary data to manage pricing effectively. Add in a few core system conversions, a few acquisitions and this even gets more difficult…if not impossible. More often than not, limitations imposed by the “core” system focuses pricing management on “what can we do with what we can get from the core” instead of on “what must we do to compete and win.”
Third, there are often basic cultural and change management issues that prevent a robust pricing management system from being put in place. These range from self-inflicted things like an entrenched lender compensation system that is inconsistent with the bank’s current strategy to external things like heightened demands from regulators for reporting that allocates management time and attention to “the urgent” in lieu of “the important”.
We’ll have much more on all of these topics over the coming weeks on our blog, including in-depth discussions on PrecisionLender’s approach to Pricing Management. Enter your email address to the right to subscribe to future blog updates or please feel free to contact Precision Lender to discuss.
We always welcome your thoughts and comments. How do you handle Pricing Management? Is there something that we missed in the above discussion?