Risk & Relationship based Pricing Part 1

Bank Pricing Strategy

A forward looking complex management challenge for most big or small banks on all continents.

Jonathan Witter, Capital One’s (COF) president of retail and direct banking, predicts that over time, “we will see the advent of different pricing models, and we will see the advent of different feature models” (extracts from an article in AmericanBanker of March 18, 2013). McKinsey reported that less than 5% of the Fortune 500 companies have a dedicated pricing function.

If you agree with these statements, and I cannot find any reason to disagree, you have to ask yourself:

  • What do the other 95% of the Fortune 500 do?
  • What is the state of business for smaller companies?
  • Are banks better off or not?
  • Is this important and why?

My experience on all continents is that banks are probably worst of because of the nature of the banking products and services. Think of the differences in pricing a commercial good, a widget, sold to the sale of a financial contract.

Industrial/ commercial goods

The widgets are priced on the basis of known historical Cost of Goods Sold (COGS) and Sales Costs and margins adapted to the sales strategy and lifecycle of the product. The sales margins and profitability are easy to calculate and manage. Sales & price strategies focuses on marketing efficiency

Financial contracts

Financial contracts are sold on the basis of future operational costs and risks. Even if these future costs and risks can be estimated, they are uncertain because they are projected. Bankers must manage these uncertainties. The sale is completed only when the product cash flow cycle is completed, that can be in 1 month, 12 months… or 30 years! Throughout the cycle margins will vary. How do you integrate that uncertainty in the bank’s sales strategy and pricing strategy and models, and how do you manage that uncertainty?

To start answering the implied management questions, you should define and quantify these uncertainties and measure their volatility.

Operational cost uncertainties. In financial contracts the margins are contractually fixed (even if some products refer to reference rates or indices to fix the all-in rate as for variable or floating rate products). But the costs related to that product will vary through inflation, operational efficiency etc.

Financial and business risks, uncertainties. We can commonly agree that all financial products contain (1) Credit Risk or solvency Risk, (2) Interest Rate Risk, (3) Liquidity Risk, (4) Foreign Exchange Risks, (5) Business Risks, (6) Operational Risks, (7) Regulatory (Compliance) Risk, plus possibly some more!

All these operational and risk need to be defined, quantified and managed. The cost of managing the uncertainties, hedging the risks must in theory be expensed to the client, and the residual margin will constitute the “sustainable risk and relationship adjusted profit” of that transaction. Note that a measure of the sustainability would be the Life Time Value of the product

The introduction of value management by opposition to profit management is essential, because it is a forward looking measure of profit contribution defined around the all the future volatilities of the product related cash flows. Understanding these value drivers/ destructors and integrating them in the bank’s pricing model is the only way to take control of the commercial and sales strategy of the bank.

Conclusions

Pricing products is not trivial and it is complex.

All banks measure product and client profitability. But what model is used? With what data: average financial data or granular, historical financial data or projected data? Are customer projected behaviour integrated?

All banks price products, by definition. But how efficient, precise, flexible, useful are they?  Are they related to profit or value targets?

These are just a few of the issues possible.

I have prepared a brief slide presentation (available on SlideShare.com) in which I mention 13 good management principles to integrate in a pricing strategy and model. I want to expand a little on the solutions available and the strategic importance of this subject before I review the 13 principles over the following weeks/ months.

With some luck you will give me your comments, criticisms, suggestions as we go. I can then integrate all the ideas into a set of final recommendations.

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