Making innovative pricing work

Part 1 of a series.

Different product lines call for different pricing strategies and introduce varying levels of risk to a bank.

At what point do aggressive pricing strategies cross the safety and soundness line?

On the other hand, when does a bank fail in its responsibility to produce profits for shareholders, when taking an overly conservative stance on those same safety and soundness concerns?

In this first article, I'll provide an overview of safety and soundness generally and summarize some basic pricing strategies. Future articles will delve more deeply into pricing for specific product lines. My goal is to lay a foundation for more complex pricing strategies by product line that balance the desire for profitability against the need for safe and sound banking practices.

Safety and soundness considered

"Effective risk management has always been central to safe and sound banking activities and has become more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking."

--FDIC Risk Management Manual of Examination Policies

"Safety and soundness" boils down to effective risk management, and banks have traditionally been held to a high standard. Think of the traditional stereotype of a banker in a pinstriped suit--a conservative pillar of the community, guardian of the life savings of many, and investor in and supporter of local business.

Seems like a relatively straight-forward proposition. But given today's low interest rate environment, the banker's job has been complicated beyond simply seeking a reasonable, yet profitable, margin between what the bank pays for funds and what it charges on loans.

Examiners will focus on the bank's highest risk areas and will assess management's ability to identify and control risks. CAMELS is a supervisory rating system used to classify a bank's overall condition. Although well understood, it's helpful to review CAMELS with pricing in mind.

The components of CAMELS are:

Capital adequacy--Is there an adequate cushion to absorb potential losses?

Asset quality--Will loans pay off?

Management capability--Is the bank well-governed by its board of directors and management?

Earnings--Are earnings steady and coming from appropriate sources?

Liquidity--Can the bank meet the demands of depositors even in a time of crisis?

Sensitivity to market risk--Can management identify and control market risk both today and looking into the future?

In the context of pricing decisions, the main focus may be on asset quality and earnings, with an eye for sensitivity to market risk (interest rate risk). However, management capability always plays a large role, and ultimately capital adequacy may control the make-up of the loan portfolio and deposit base. In other words, loan pricing will primarily reflect asset quality, but will impact, and be impacted by, other CAMELS components.

As asset quality goes down, risk increases. This raises the price of the loan product. However, the increased risk will introduce additional costs in the form of loan losses. Furthermore, rates paid on deposits will necessarily take into consideration the rate of return on the loan portfolio along with fee income associated with deposit accounts.

Higher fees on deposit accounts may make up for narrower margins, but at what point will high fees drive depositors away--thus putting a squeeze on available credit?

A skilled banker guiding the institution to operate in a safe and sound manner must understand how to maximize profit without creating excessive risk and how to attract and maintain customers to build capital reserves.

Exploring pricing strategies

With the explosion of big data and the ability to collect and digest large amounts of detailed information, banks are beginning to explore new ways to price deposit and loan products. They are also revamping old models.

While new and changing models are being implemented, the age-old tension between maximizing accounts versus maximizing profit margins continues to be the driver of all of these models.

Where the lending models diverge is the need to account for default risks and the increasingly hyper-regulated environment. While risk of default and compliance issues certainly affect safety and soundness concerns from a risk management standpoint, insolvency risk stemming from lack of profitability won't reflect well on your next CAMELS rating.

Thus careful design and ongoing evaluation and fine tuning of pricing models are "must do's" for a healthy institution.

Let's examine a few of the general pricing models often used for lending and deposit products. Keep in mind that deposit models consider the total cost of maintaining the account offset through fees and profitability of those funds. Lending models include fee income in addition to interest income and offsets for interest rate and default risks.

Deposit Models

Comparative Rate Pricing

Although short on analytics, the comparative rate pricing model is widely relied upon in banks today. This is especially true in community banks where competition is more localized and institutions may lack the resources to implement more sophisticated analytics.

Simply, this model asks: "What is my competitor down the street doing?"

Some banks have historically thrived using this method--despite its faults. The most glaring fault is the model's assumption that all institutions are created (and exist) equally. Are your competitors' risk profiles, customer bases, and sensitivities to market risk the same? Perhaps more importantly, are their capital positions, earnings, and liquidity the same? Most likely, a resounding "NO!" is the answer.

This amounts to a failure to account for critical safety and soundness concerns due to a hyper-focus on winning accounts.

Margin Pricing

In terms of simplicity, margin pricing may seem like an easy way to maximize profitability on an account-by-account basis. Without additional consideration, it ultimately leads to the same place as comparative rate pricing--but on the other side of the pricing tension scale.

Focusing solely on widening the gap between deposit pricing and the cost of acquiring and maintaining deposit accounts also fails to take into account safety and soundness concerns.

Account Segmentation

Account segmentation allows institutions to compete for key demographic groups based on a variety of factors. Common segmentation factors include balance pricing, regional pricing, business segment pricing, and relationship pricing. Account segmentation has a fault, however. The method can become too conclusory without utilizing analytics to drive segmentation decisions.

If an institution deploys analytics that include safety and soundness concerns in developing pricing segments, then this eliminates some of the safety and soundness risks inherent in the above described models.

Lending Models

Cost-Plus Pricing

This model starts with funding and operational costs as a basis for determining rate. The institution would then decide on an acceptable amount of loan loss reserves to build into the rate and would add in a pre-determined profit margin (or margin range) to derive the final pricing of the loan.

The key part to this and other loan pricing models is the amount of loan loss reserves and how an institution thoughtfully arrives at that figure.

Price-Leadership model

This model starts with the above cost and risk factors, but then attempts to incorporate market competition concerns. The model uses cost and risk factors and then thins out the margin for the least risky customers with the least risky loan products. This establishes a benchmark rate that the institution uses to build out other rate segments for varying customers and products.

Compressing margins has the same drawbacks previously discussed but does address competitive concerns, which could ultimately benefit the institution.

Risk-Based Pricing

This model takes a holistic approach to analyze the varying levels of risk presented by certain borrowers using certain lending products.

Risk-based pricing analyzes what traditionally makes certain borrowers (FICO scores and credit reporting) and certain loan products (interest-only features, high LTV's etc.) riskier than others. The method adjusts the rates accordingly at the loan level. If done correctly, this should ensure that your premium matches potential losses, as riskier loans/borrowers should deliver higher margins.

Safety and soundness demands that banks identify and manage the risk associated with pricing decisions.

What's coming up in this series

The next article explores deposit product pricing strategies. We'll move beyond simply matching competition's advertised rates to explore how new and innovative pricing strategies--including use of behavioral economics--may play a larger role. Following that, we'll look at other product lines in turn, including consumer portfolio lending; mortgage lending; and commercial lending. Each article will analyze the associated safety and soundness concerns that accompany various pricing strategies.