Risk & Relationship based Pricing Part 4

I believe we have shown in the previous blog postings, that pricing can be complex as it integrates many management aspects. That does not mean the pricing strategy and model used by a bank needs to be complex and based on expensive pricing applications. The pricing model must be adapted to the bank’s business strategy and environment; it should also be based on core principles of good pricing.

In our previous blog we mentioned other concepts that we will review later, such as customer profitability and Life Time Value. We will do so in a separate series that should start early May. Stay tuned and get an email advice by following the blog.

Before we start the review of good pricing principles, I need to discuss a number of requests received from readers of our last post: Can I send them a copy of the models, formulas used in the pricing exercise in post #4 ?

It is difficult to give a complete answer to the request because there are many sub-models in the pricing model. The inputs are also dependant on many additional models used by different units of a bank. Let me give you a few examples to illustrate this.

  1. Cost of Funds. The CoF is based on matched Modified Duration & Convexity or VaR, depending on the market and capabilities of the bank. That also includes all implicit optionalities such as delayed drawdowns, pre-payments… In some instances this includes specific market calculated liquidity premiums; in others best estimations of those premiums using a more deterministic model.
  2. Credit risk is based on PD, EAD, LGD. Each of these is dependent on multiple different models, including different scoring and valuation models…
  3. Customer Value can be a simple estimation of profitability or a more complex Life Time Value (LTV) calculation.
  4. Economic Equity. There are many different approaches of calculating Economic Equity, which as you know goes beyond Basel II and/ or Basel III. They also have different quantification models…
  5. Risk diversification/ concentration uses classic portfolio theory approach. The difficulty is in defining the future/ projected variance and covariance. To estimate these you can use many different models (Bayesian approach or simply historical statistical models…)
  6. Cost allocation. Do you use ABC, PBC… or other models and which costs do you allocate (fixed and variable costs? direct and indirect costs? Cost of Equity?…)
  7. Etc.

The appropriate pricing model is bank specific, as it is dependent on the strategy, activities, markets and corporate vision. It can be based on very complex or very simple models but always needs a full understanding of the variables or value drivers. The bank must control of the calculation models (no black boxes). The calculations I used in this blog are highly simplified models that are just good to illustrate the issues I want to highlight.

We recommend you start with a “pricing policy and process assessment” of your bank’s current state, develop a future state vision (what you want to achieve in line with the bank’s strategy and banking model) and develop a project to bridge the gap between the current state and where you want to go.

My company can help you in such a project. Send me a message at cw@bankstrat.com for any additional information required.

Strategic principles of good pricing:

At this stage I count 13 core principles for good pricing. I’m sure we can add a few but these would be specific to an activity, market, bank, and would probably relate to different sales strategies. I want to focus on the generic principles relating to the pricing of financial products.

Principle 1:   Price integrates the volatility (risks) of projected future Cash Flows

In my first post on pricing, I indicated the difference between financial products and services versus other manufactured goods. Again the main difference is that profit margins are realised during the whole life of the product, by opposition to profits realised at the day of the sale of a manufactured good. This difference is essential because profit margins are dependant of future volatile cash flow. The volatility is generated by all the risks associated with each product sold.

Profitability cash flows of Manufactured Goods versus Financial Products

Profitability cash flows of Manufactured Goods versus Financial Products

What are the risks that need to be defined, quantified managed and expensed to the client in pricing? (1) Credit Risk, (2) Interest Rate Risk, (3) Liquidity Risk, (4) Foreign Exchange Risks, (5) Business Risks, (6) Operational Risks, (7) Regulatory (Compliance) Risk.

Principles of good risk management are based on the separation between expected and unexpected risks. They require differentiated treatments in pricing!

  1. Expected Risks are managed through (1) hedging by collateral or other risk mitigation technics and (2) provisioning strategies. In both cases the      “cost” of managing the risk is passed on to the client through adequate      pricing.
  2. Unexpected Risks are managed through equity. The equity adequacy regulations (BII & III) define the amount required to be invested by shareholders to cover the activities of the bank. The cost of managing those risks is born      by the shareholders.

The quantification and management of all these risks is complex and require fundamental adjustments in the bank’s process, models, competencies and strategies.

Risks are also multidimensional and must also be viewed on a contract basis (variance management) and on a portfolio basis (covariance optimisation). Covariance management is done within each risk portfolios and between different risk portfolios. We can develop different way of integrating covariance costs/ benefits in pricing?

These questions need to be discussed at bank level as different approaches are possible. The approach will be described in the bank’s Risk Policies and Procedures and in the bank’s Pricing Policy and Procedure.

Principle 2:  Individualise all risks, price and manage to optimise their variance/ covariance on a 1:1 basis

Banks are moving from standardised products (amount, maturity, payment frequencies…) towards 1:1 marketing and product adaptation to specific client requirements (if not tailor making). The characteristics of each financial contract are then specific and require 1:1 pricing.

Client behaviour analytics are showing major differentiations between client and even client segments. The future expected behaviour can be defined and analysed. It is a crucial element of the products’ future cash flows and the value of the client relationship. To achieve this, data granularity is important. Technology allows such approaches and must be leveraged.

Risk concentrations and diversifications will be managed at product, client, market and bank portfolio levels. Price and management of all risk classes imply the integration of risk covariance (Interest rate and credit risks; credit risk and liquidity risk…).

To allow the implementation of such a risk adjusted model, the bank must develop a complete set of contract level Risk Transfer Prices (RTPs) with the appropriate valuation models. This includes Fund Transfer Pricing, Credit Transfer Pricing, Liquidity Transfer Pricing… and Expense Allocation/ Transfer Pricing.

The development of such an integrated risk based model is transversal and vertical across the whole organisation. It requires a full impact analysis and feasibility analysis. There are recommended methodologies to define the impact of such a business model, starting with a clear definition of the Business Principles to be implemented, the Assumption underlying the project and the Constraint applicable to the strategy. This is not a trivial project.

Principle 3: Understand the client elasticity to pricing on a multidimensional factor basis.

Most marketing/ sales/ distribution departments measure performance on the basis of volume (new transactions, campaign hit rate and transformation rates…), with very little on 1:1 pricing. Mispricing will negatively impact product sales propensities, in ways that go beyond a simple a sales volume metric.

For example the bank can integrate price elasticity with client solvency. If not there is a high probability of selling the wrong product to the wrong client at the wrong price. Low (good) rating prospects will have zero purchase propensities to high priced credit products, but high risk rating prospects will have high purchase propensities of loan products whatever the price. Pricing on the basis of average risk ratings and rating cut-offs rather than individualised risk based pricing, will lead to a risk degradation of the credit portfolio and of its risk adjusted return!

 
sales propensities per risk rating and risk price

sales propensities per risk rating and risk price

Too many retail banks are still using standard product prices that they only adapt to the customer through a “negotiation/ commercial margin” that is assigned to the sales unit. This is NOT individualised or 1:1 pricing, it just allows weaker sales unit to sell on price, and the strong client to force pricing down.

Bad pricing is a source of attrition of your best clients, those that will create sustainable profits, LTV. This is an important business risk resulting in a steady erosion of the bank’s value (goodwill).

Principle 4:  Define, quantify and manage business risk

What is business risk?

From the bank’s perspective Business risk covers a very wide set of issues, but for our discussion we will limit it to the risk of not achieving the expected (budgeted) performances in client relationship growth and profitability. This may be due to a number of internal and external factors. Again we will restrict this to the business risk from a sales/ marketing perspective, in which case we can define it as the risk that the client and prospect do not meet the projected behavioural estimated targets planned by the bank. That the sales propensities were lower (or higher) than anticipated, that cross sales and up-sales do not meet plans, that attrition rates were higher (or lower) than expected… Consequently the bank does not achieve its planned growth and profitability, its return on marketing costs.

business risk management by targeting improved performance and reduced volatility of the targeted performance

business risk management by targeting improved performance and reduced volatility of the targeted performance

One way of looking at it (and model this) is to estimate an expected result (for example the client’s LTV) and the dispersion around that expectation, measured as the Standard Deviation (STD). Managing the business risk is then the science/ art of increasing the expected LTV from A to B, and to reduce the STD of the return from STD1 to STD2, by implementing the appropriate strategies in:

  • Product development
  • Distribution strategies
  • Marketing campaigns
  • Pricing strategies
  • Etc…

Note that this 100% different to classic satisfaction surveys or other methodologies often used to estimate client behavioural variables. Indeed client satisfaction surveys do not allow the bank to measure and manage its growth and profitability targets, as it does not quantify the factors generating growth and profitability. What you need are behavioural models that can discover those factors and explain the causalities of client actions and expected future behaviours.

Principle 5:   Adapt the pricing strategy to the banks market strategy and client value proposition

Before you can define your pricing strategy, the bank must decide what its market vision and strategy is, what value proposition it wants to propose to the market.

You may want to use the approach developed by Michael Treacy and Fred Wiersema (The discipline of Market Leaders) or any other that focuses on what and why clients are buying from one bank rather than another.

Treacy and Wiersema suggest that customers will seek 3 core values from its suppliers of goods and services: “client intimacy”, “operational excellence” or “product innovation”. They also state that companies that are clear leaders in one of these values and hold a strong at par position in the other two will be the market leaders and have above par performances. Finally, the analysis shows that the business models (process, organisation) and the technical requirements (data, application, technology) are different for the three strategies, hence no one can hope to be the best in the three value sought out by the clients. Note also that Customer Intimacy is not equivalent to Client Centricity! Client centricity is to focus on delivering a product/ service that maximises the client’s satisfaction which can be either operational efficiency or customer intimacy.

In regards to retail banking two of these approaches are clear options: Customer Intimacy (Developing a 1:1 relationship based on analytics and proprietary information) and Operational Excellence (Mass marketing of standard products delivered at the best price and without any operational glitches). Product Innovation is more difficult to apply to banking because of a number of factors which I will not expand on here and now.

Customer Intimacy versus Operational Excellence bank models

Customer Intimacy versus Operational Excellence bank models

Imagine two banks with two different value approaches, where Bank A wants to focus on customer intimacy, while Bank B is targeting operational excellence. They will need to organise and build two very different types of banks, with different organisations, process and skills based on specific technology and analytics. They will also develop fundamentally different pricing strategies.

I will soon continue the review of the remaining pricing principles. Meanwhile give me your comments and be advised by email of the following posts!

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