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Risk & Relationship based Pricing Part 2

Bank Pricing Strategy 2

The opportunities and issues to organise a pricing strategy and develop pricing models that can enhance value based management.

I mention value based management as the ultimate objective of good banking strategy. This needs a short explanation. Value based management refers to the management of future bank profitability, not on the budgeted profits of the year. What we want to maximise is the value of the firm calculated as the present value of projected profits streams resulting from existing financial contracts on the books of the bank (assets, liabilities and off balance sheet) plus the present value of profits derived from future sales of financial contracts. The later good be described as the goodwill of the bank i.e. the premium over net book value that shareholders are willing to pay to acquire the shares of the firm.

By itself value based management is important for all companies, but it takes even more importance for financial institutions because the profits of all the financial contracts sold to the customers are dependent on future volatility, as we discussed in the first blog of this series. In this case management will need to discover and manage the value driver.

To achieve a value based management capability all activities must align to that concept.

  • Financial accounting does so partially through the accounting fair value model (it is only a partial alignment as the banking book is still value on an accrual basis).
  • Risk management is the most sensitive to this approach and good risk management principles all focus on future cash flows and their sensitivity to market volatility. This includes the management of economic capital through capital budgeting and allocation as per the Basel recommendations.
  • Sales and Marketing has developed a set of statistical and probabilistic tools to predict future client behaviours, but that capability is often in an independent silo and not integrated into other management domains.
  • Management accounting has evolved rapidly, but is still mainly focused on current profitability. Product and client profitability is in nearly all cases still a simple calculation that does not integrate future risk sensitivities.

It is evident that moving towards integrated value based management requires substantial reengineering of current processes and management information, with substantial organisational and IT consequences. The appropriate solution will depend on the banks strategic vision and strategies; hence the organisational and technical solution is not a standard “one size fits all” solution. In regards to the pricing aspects of this note that:

  • Different pricing strategies and models will apply to different business models, hence the problem and the solution are different by bank, but the approach is strategic and must be designed and managed top down.
  • There are no “off-the-shelf” technical solution/ application for a quick fix, because pricing is integrated in many other process and business support systems. Best of breed pricing will rely on the existence of robust risk analytics, risk transfer pricing capabilities, appropriate cost allocation systems, capital management capabilities…
  • Many of the management skills and capabilities required to implement a value based pricing strategy were developed post crisis and within the new regulatory environment (think liquidity risk…).
  • The project will imply revisiting Policies and Procedures, Process Flows, Competencies and skills, Organisational structures.
  • The technical solution to improve these business capabilities is data centric and rule based. It also requires systems integration between all the management domains of the bank.
  • Managing enterprise culture and change is essential as the new banking model that emerges from these approaches will require adaptations of skills and competencies and changes operational and management process.

Pricing is only one element of a global sales strategy.

We can summarise the main areas of competition in banking as being function of pricing, convenience and confidence:

  • The Price Function: The cornerstone of competitive positioning, but is all a question of price? And what is price? Does collateral requirements constitute a pricing variable and how?
  • The Convenience Function: Convenience has multiple facets. It can include: distribution channels and reach, the number & quality of products offered, the quality of documentation etc… Some of these issues are becoming increasingly more important, think of mobile banking versus internet and branch banking.
  • The Confidence Function: More than ever this is important, trust in the banking industry is at its lowest ever. Reputational risk is high. Bank solvency management is a priority. The European banking crisis is a constant reminder that this must be managed in anticipation of the risk not when it is basically too late.

One or the other way all these factors will influence product pricing, through cost allocations, solvency premium etc. This of course takes us to a fundamental question: if the theoretically correct price as calculated by the banks’ pricing model exceeds the competitors price, should the bank adapt its price to that of the market, or should they decline to do the sale? It sounds like a trivial question with an obvious answer, while in fact there is not a single answer and to make the correct decision we need to understand all the variables included in the contract price. This can only be done with the appropriate drill down and drill through capability of the price components, which is a technical problem requiring high data granularity and good analytical capabilities.

Strategic importance of Pricing

Many banks will say that they are not market leaders so can’t influence prices and they must follow market prices because they are supposed to be efficient. This position is of course un-defendable as pricing differences are often due to

  • internal inefficiencies which the bank must recognise and correct,
  • differences of marketing strategies,
  • differences in the behaviour characteristics of each bank’s client/ prospect base.

Another way of looking at this problem is to analyse the consequences of pricing. Pricing will influence many crucial and strategic management domains:

  • Client acquisition and retention;
  • Product innovation and management;
  • Product risk adjusted profitability and value contribution;
  • Client profitability and value contribution;
  • Risk Adjusted Return on Capital (RAROC) and Economic Value Added (EVA);
  • Operational efficiency (cost to income management);

The question I ask banks is simple: How do you measure the impact of your pricing decisions on all these variables? This capability is essential if you want to manage efficiently each of the domains.

Principles of Good Pricing for Financial Contracts

With all this in mind I have developed a list of 13 pricing principles that I believe are important in a pricing strategy and thus should be integrated in the pricing model of the bank.

  • Principle 1: Price the volatility (risks) of projected future Cash Flows;
  • Principle 2: Individualise all risks then price and manage them to optimise their variance and integrate whenever possible their covariance;
  • Principle 3: Integrate price elasticity to client solvency (their risk rating), not only to client segments characteristics;
  • Principle 4: Define, quantify and manage business risk;
  • Principle 5: Define cost allocation strategy and models;
  • Principle 6: Define, quantify and manage current and future client profit and value contribution (Life Time Value or Customer Fair Value);
  • Principle 7: Adapt the pricing strategy to the banks market strategy and the value proposition the client is seeking from your bank;
  • Principle 8: Manage competitive pricing;
  • Principle 9: Manage the complexity of management models;
  • Principle 10: Adapt the organisation to the requirement of risk and relationship based pricing;
  • Principle 11: Integrate pricing process with an efficient process flow from the origination of the client request to its fulfilment;
  • Principle 12: Integrate risk underwriting and pricing in a seamless strategy;
  • Principle 13: Optimise risk appetite, risk budgeting and allocation within the pricing model and define related clear and precise performance criterias.

Conclusion

Pricing strategy and pricing models are important developments; they are strategic and touch most management domains of the bank. The solution must be adapted to the vision, strategy and organisation of each bank but is based on a robust, flexible, data and rule centric technical architecture.

The implementation of such a capability will allow management to substantially enhance its control of the bank’s value based performance.

In the following weeks we will review the core principles of efficient pricing models.

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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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