Pricing Effectively – The Need to Know
Years ago, I attended a seminar where the presenter made a statement that struck me as odd but has proven to be quite prophetic. He simply stated, “Margins will continue to narrow … forever!” He was spot on. At that time, a variety of loan products (such as mortgage loans) were becoming ‘commoditized’. This emerging market acted as an intermediary for needed cash to provide banks the wherewithal to continue to lend in their respective locales. But more importantly, he went on in his discussion by making the call for a systematic and effective pricing methodology then, and “forever”. There are several viable options to consider when pricing loans in a market where the margins continue to shrink. Most importantly, it is imperative that the financial institution “know” what level of return on a given opportunity it should expect. Pricing loans in a competitive market does not necessarily have to translate into lesser yields. Nor should banks be forced to accept lesser yields for less than quality loans unless they decide to do so. First, price it and then decide.
Generally, a financial institutions first reaction when faced with narrowing margins is to cut operating expenses. Periodically the chaff does need culling, but most entities run pretty efficient shops depending heavily on technology to create those efficiencies. And they continually measure themselves with efficiency ratios which, in part, help drive their strategic operating decisions. So when the edict comes from above to “cut operating expenses”, there just aren’t too many options. One option that can supplement these strategic decisions is be found in the “Power of Pricing” which simply means that the power of pricing can be more effective in offsetting the crunch of narrowing margins when compared to simply reducing operating expenses. The example below illustrates the point.
The example compares a base case Line of Credit priced at Prime + .50% to the same line priced 2.5% higher in interest income. This 2.5% increase equates to 11 basis points in rate. As seen, an increase of 2.5% in loan interest equals to a gain in net income of more than 6.5%. In comparison, a decrease of 2.5% in operating expenses increases net income by only 3.5%. Further analysis shows that an increase of loan interest by only 6 basis points equates to the same benefit derived from decreasing operating expenses by 2.5%.
So why is a financial institution’s first reaction usually an all-out call to cut operating expenses? Generally, it’s because the operating expenses are more easily identifiable and banks still don’t have effective tools to measure the value of their customers and relationships. Couple that with the perception that they have no control over a competitive market with narrowing margins so they price accordingly just to get the deal. Consequently, their efficiency ratios will look good but what about the potential impact on their returns, service, and not forgetting internal morale. Community lenders pride themselves on customer service and, in fact, site it as one of their strengths in competing with large financial institutions. Do you give up that advantage?
After running the simple math, it easy to say, “Price more effectively and we will preserve our margins”, but how? One way is to shuck old habits such Prime plus a quarter or plus a half and start looking at pricing off the eighths or sixteenths. In the previous example, it only takes 6 basis points on a $100,000 loan to equate to a 2.5% reduction in operating expenses.
Of course, in some competitive situations, even one basis point can be the difference in winning or losing the deal. But by implementing an effective systematic loan pricing strategy, one uses all the tools available to them. In the following example, a mere $100 in fees provides a bottom-line return boost of 5.79%. Again exceeding the benefit derived by reducing operating expenses by 2.5%. Not many customers would balk at a small fee in order to get the lower rate that they want.
Up and to this point, the discussion has been primarily focused upon loan pricing. But to price effectively in a market where margins have narrowed, the bank must consider the relationship’s value. The value of deposits should be measured and included to allow for more competitive pricing. In the example below, a deposit credit has been applied to the second column. The influence of deposits on the relationship allows the lender to be more aggressive in its loan pricing or can enhance the relationship yield itself.
While only deposits credits are included in the calculations, other non-traditional products such as cash management fees and trust fees should be considered in the value of the relationship.
Pricing loans in a competitive market does not necessarily have to translate into lesser yields and/or credit quality. The key to staying ahead of the competition is measuring the value of the relationship and applying any or all the effective pricing methodologies to position the financial institution to win the deal while meeting return objectives. While the phrase “Margins will continue to narrow … forever” may seem to hold true, lenders can counter this trend by using the “Power of Pricing” … when you need to know!
You may also like:
Process Improvement Value Propositions
Funds Transfer Pricing – Simple Can Work
Posted on Friday, November 1, 2019 at 10:45 AM
by John Robertson