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Risk & Relationship based Pricing Part 3.2

So what was your recommendation to the bank for the quiz in my last blog?

  • Client A (20 year mortgage at 4.803%)?
  • Client B? (4 year consumer loan at 4.734%)?
  • 80% A, 20% B a mixed portfolio?
  • 20% A, 80% B, a mixed portfolio?

And the answer is… Well it is not an easy straight forward one. First let’s check if:

  • We have all the information needed to make an informed decision?
  • We are sure that we know and understand, the performance criterias used by the bank?
  • We know and understand the financial models used to calculate all the decision variables, the risk and relationship value drivers?

To make a good decision, we must:

  1. Focus on the value drivers of the different opportunities. But how to define and measure value?
  2. Analyse the risk adjusted financial performance of each opportunities. But which risk and how to measure them?
  3. Analyse the value of the relationships we will gain and the value of the one we will lose! But what is customer value and how should we measure it?
  4. Plus, plus, plus…

A very simple question, but a complex problem to model and a tougher management decision than it looks! The data used in the calculations of this simple example are simple indication of the real world conditions. The models use standard, simplified formulas. I will not go into the detail of the calculations (if you need to understand the methodologies proposed you will need to contact me on
The financial performance analysis.
To start the analysis let’s decompose the total interest rate revenue for the four portfolios. The results of this decomposition is summarised in the following table.


Interest Rate Revenues

Gross Interest Margin

Interest Margin less   Liquidity premium

Risk adjusted Margin

Net Operating Margin

Client A






Client B






C = 80% A +   20% B






D = 20% A +   80% B






Notice the huge differences in the results depending on the level of the analysis and the total reversal of conclusions: Portfolio B starts as the best option with 1.43% gross interest margin, but drops to the worst position if the margin is credit and liquidity risk adjusted (the interest rate risk is hedged in the Gross Interest rate Margin) and adjusted for operating expenses!

Based on the models used, the cost of hedging risks and the allocation of fixed and variable direct operational expenses, the asset portfolio with the highest return is Portfolio A which is a surprise, as it is higher than diversified portfolios C and D. This of course is due to the fact that the diversification benefits are not integrated in the price, in other words they are not handed over to the clients but reserved to the shareholders.

The shareholders need to invest in the bank enough capital to cover the expected risks and unexpected risks (as defined in principles by the Basel Accord). That amount of equity should include the diversifications benefits or deficits. The Economic Equity calculations indicate that the minimum requirements (Basel II without the additional cushions of BIII) as expressed as a % of the total asset (loan portfolio), are of:

Portfolio A:         0.78%

Portfolio B:         1.35%

Portfolio C:         0.80%

Portfolio D:         1.17%

Surprisingly portfolio C requires more capital than portfolio A, it is this more risky than A, although it is a diversified portfolio. This is due to the relative levels of the expected losses (a function of the Probability of Default, Exposure at Default and Loss Given Default), the variance of Probability of Default and the covariance of the portfolio PD’s.

The RORAC (risk adjusted Return on Risk Adjusted Capital) is calculated of the Economic Equity based on expected and unexpected risks, i.e. using the loan loss provision estimations and the diversified value at risk of the portfolios. On that basis the bank should decide on investing in portfolio A as the risk adjusted return is the highest, although Portfolio C is also attractive thanks to the benefits of diversification:

Portfolio A:         25.65%

Portfolio B:         11.12%

Portfolio C:         23.66%

Portfolio D:         13.70%

In theory, and in practice, the bank needs to generate value for its shareholders, hence the risk adjusted return (RAROC) must be greater than the Cost of Equity as this and only this will produce economic added value for the shareholders.

I used some hypothesis to calculate the minimum return to cover the cost of equity or “hurdle rate”. These cover the solvency strategy of the bank (single A), the beta of the shares, the market premium… i.e. all the variables of a classic economic value model as per the Capital Asset Pricing Model (CAPM). The hurdle rate calculated is 18.63% and consequently the Economic Value Added contributions (EVA) of the 4 portfolios are:

Portfolio A:         + 7.02 %

Portfolio B:         –  7.51 %

Portfolio C:         + 5.04 %

Portfolio D:         –  4.93 %

Only two portfolios create shareholder value the other 2 destruct value potentially because loans B is mispriced! Can I improve those conclusions by looking at a Return on Risk as defined in the Sharp Ratio (excess return on the standard deviation of returns)? This show that the diversification benefits of portfolio C would favour that investment rather than portfolio A.

Portfolio A:         1.27

Portfolio B:         0,63

Portfolio C:         1,41

Portfolio D:         0,83

Anything above 1 indicates that expected excess returns exceed the risk associated with that return, and C with a ratio of 1.41 is a clear winner.

The diversification benefits will be influenced by multiple factors and dependant of the valuation models used.

Diversified Portfolio STD   Undiversified Portfolio STD    Diversification benefit

A:  0.15789%                                0.15789%                                      0.00000%

B:  0.23844%                               0.23844%                                     0.00000%

C:  0.13501%                               0.17400%                                      0.03898%

D:  0.19335%                              0.22233%                                     0.02898%

We have not optimised the portfolios on a variance, covariance basis (correlation of 0.60), nor have we optimised pricing en operational efficiency. These management strategies would be defined in a pricing strategy and model.

Is the financial analysis complete? There is a last aspect that should be analysed.

If we calculate the Present value of the future Net Operating Profit contribution of each portfolio, we will also integrate another important aspect of annual profitability, which is the fact that each contract will produce annual returns over its whole life. In other words RORAC is an annual profitability measure not a measure of value of the whole stream of revenues! The equity values of contract with a return of 1% per year maturing in one year, is different to one producing 1% every year for the next 10 years.

We can estimate the value of the contract profits flows as the Present Value of those cash flows discounted at the appropriate risk adjusted discount factor. Again note I’m not calculating the total value of the contracts but only of the value of the excess returns after cost of risks and operational costs allocations.

Taking some calculation shortcuts, the values are as indicated in the table below. We can now calculate the “Fair Value” of the excess net returns generated. Without surprise Portfolio C remains the best choice if you look at the relative excess value to per value of risk unit, between ( ).

Portfolio A:         € 2,549 (462%)

Portfolio B:         € 529      (  63%)

Portfolio C:         € 2,117  (449%)

Portfolio D:         € 899      (133%)

This indicated that the sustainable long term excess value of portfolio A outweighs the reduced risk of portfolio C.

Relationship Adjusted Value decomposition

The last missing factors to be integrated are the relationship variables: the value of the expected behavioural attitudes of clients with the existing product holdings (attritions, prepayments, drawdown…) but also probability/ propensity that these clients will “buy” other products because of the relationship built on the back of the initial contract A and/ or B (cross sale, up-sale…).

There are many approaches to estimate the value of this potential activity growth (positive or negative growth). The most logic being to estimate the “fair Value” of the expected contracts sold, adjusted for their sales propensities, attrition risks and financial risks.

Combining both values will give us the true Life Time Value of the client or Client Fair Value.

From a financial perspective we are calculating the financial value of the bank’s goodwill created by the growth generated by using its business capacity (distribution network, operational back offices…). Hence we can try to reconcile the market capitalisation value of the bank by adding the fair value of the goodwill with the accounting fair net asset value.

Is this important? I believe that if you don’t measure something you will not manage it. By making the effort of measuring the drivers of value contribution you will define client relationship variables to be managed and priced. Examples of value drivers and business risks that can be quantified and managed include: cost of attrition risk, return on marketing campaigns, and contribution of next best product… plus of course “price the relationship value”!

It is not uncommon to see (even large and advanced banks) budget marketing strategies based on incomplete and sometimes misleading information. One was planning campaigns to reduce attrition of the least profitable clients will doing nothing to retain the more profitable ones, only because they were using average profitability data to segment their client base. Using Life Time Value over 85 % of the client would have been assigned a different profitability segment!


The consequence of mispricing and of approximate profit and value contribution are not trivial.

The mathematics does not need to be rocket science, but a robust analytical model adapted to the business model of the bank and its sales and marketing strategy should be implemented.

In the following blogs I will review the core principles of good pricing strategies.


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April 6, 2013 · 4:56 pm

Risk & Relationship based Pricing Part 3.1 – A simple quiz.

Before we dig into our pricing principles, I’d like to propose a very simple pricing exercise.Imagine you are the bank’s new business officer. You have to recommend one and only one loan. Which one will it be? The bank is short of equity following Basel III, so cannot take both but would be ok with a certain portion of both, say 80% A and 20% B or vice versa.

Client A
Loan type Annual fixed instalment
Credit Rating 2
Loan Amount € 150,000
Maturity(years) 20
All-in Rate 4.79%

Client B
Loan type Annual equal reimbursement
Credit Rating 3
Loan Amount € 150,000
Maturity(years) 4
All-in Rate 4.78%

Other elements you are given before you can make any decision are:
1. The prospect borrowers have been scored and rated as 2 and 3 (on a rating scale of 1 to 10, with 1 being the best).
2. The current Yield Curve for risk free interest rates, from 1 year to 20 years is as follows:

YC pa in %
1 year 3.35%
2 years 3.45%
3 years 3.75%
4 years 3.85%
5 years 4.00%
7 years 3.95%
10 years 3.90%
15 years 3.75%
20 years 3.50%

3. The bank is under huge stress to maximise profits because it needs to attract new capital and compensate the huge costs it has been faced with following the latest large compliance investments and liquidity crisis.
So, which one will you recommend for financing by the bank, Client A, Client B or a mix of both?
Send me a word ( or give your opinion through the poll!

I’ll give you the answer in a few days.


April 3, 2013 · 9:25 am

Retail Bank Strategy & Performance Training

Retail Bank Strategy and Risk Based Performance Management Masterclass, with BankStrat computer based simulation game, by BC&T Ltd

A framework to provide bank managers with the essential competencies to develop Value Based, Risk Adjusted, Compliant bank Management Strategy and the opportunity of testing those skills in a quasi-real life bank management simulation.

A Masterclass Program:

The aim of the programme is to develop retail bank global and operational strategies to: create value for all stakeholders, within risk constraints and in compliance to regulatory constraints. As all bankers know this is complex and technical. Managers must have a good understanding of these financial and quantitative models to structure their business strategies. Relationship based management implies selling the right product to the right customer at the right price and risk based management implies that the underwritten risks are managed within board and regulatory policies and limits.

It is not sufficient to “hear about” the underlying financial concepts; managers must experience the outcome of strategic management decisions to fully understand what is required to generate a winning strategy. We have developed a program that includes the main strategic management domains that the managers must master, and linked the review of these with a hands-on pragmatic, near real-life computer aided bank management simulation.

The training is not intended to create technical specialists in any of the management domains, but to help the participants become truly bankers that can think globally and generate winning strategies that maximize the bank’s risk rewards.

The content and case studies are proprietary and cannot be copied without the explicit approval of Clive Wykes of BC&T Ltd.

Targeted audience and Course Duration

This is a 3 to 10 day training. Ten days may appear to be a very long break from work. To review all the concepts and apply then in the simulation game is a major effort and 10 days will be required for staff without general or departmental management experience. Shorter versions of 3 or 5 day are also available either because we concentrate on only one or two management domains or because the participants already have a strong knowledge and understanding of bank management models (senior managers), in which case they are interested in looking for the integration and dependencies of management domains and the art of strategy development under constraints.

The training is organized for approximately 10 to maximum 24 Managers. They should all have a good understanding of finance and banking.

The programme is focused on a strategy development and implementation to optimise all the drivers of bank value (growth, risk and profitability). Theoretical concepts are supported by a bank management simulation programme, where participants define their bank’s policies, strategies and tactical implementation plans by managing:

  1. Sales and marketing strategies,
  2. Treasury strategies,
  3. Enterprise Risk Management (focused/ limited to Interest Rate Risk, Liquidity Risk, Credit Risk)
  4. Risk appetite and economic equity budgeting and allocation,
  5. Solvency (the bank’s credit rating) management,
  6. The equity compliance (Basel 3).

This course has been very successfully delivered at Board level, senior management level, and specialised business units, down to entry level management teams. Specialised business units have found it very useful including:

  • Risk (credit, ALM, compliance) Management Business Unit (BU),
  • Retail Sales & Marketing BUs and retail distribution units,
  • Private Banking BUs,
  • Corporate Relationship Managers,
  • Management Accounting and Financial Control units
  • Strategy and planning BUs,
  • Audit teams,
  • As well as IT and solution vendors.

Course Material

All the course material is delivered in electronic format. This will include presentation slides, descriptions of the main financial concepts, the simulation information of which the participants guide and initial simulated bank financial package.

Course objectives

Provide bank managers with the essential skills to build a framework for enhanced performance. The programme will help to:

  • Define the bank value metrics and risk adjusted value drivers (RAROC, EVA,      Economic Equity, VaR, EaR…)
  • Develop value based operational strategies based on the bank’s mission and      shareholders’ vision, and integrate them in the global strategic planning      process;
  • Develop of risk optimisation strategies including risk quantification, risk      budgeting and pricing as well as risk management (Including: credit risk, market risk, interest rate  and liquidity risks (ALM), operational risks, business risks, solvency risks…)
  • Analyse competitive positioning and differentiation, including product development      and management (piecing etc), marketing and Client Relationship Management      as well as Event Based Marketing
  • Define, measure and manage Client Profitability and Value (Customer Value      Management)

This is an intensive, high value programme with a steep learning curve.

Content and Methodology

Content description:  Bank Performance Management

Bank strategic management requires quantitative and qualitative analytical competencies. They are confronted to new regulatory constraints and enhanced competition in a global financial market! A rigorous management framework is of vital importance to ensure leadership and management success.

All management domains need to be integrated into a global strategy, in order to ensure the balance between growth (commercial strategies), risk (Enterprise-wide Risk Management strategies) and value (sustained profitability strategies). Without sound and robust risk based management the financial industry will continue to be submitted to regular and very severe financial crisis!

We will also analyse the consequences of the great Banking crisis of 2008 and learn from these events to improve the quality of the management responses to extreme volatility. We will also discuss the new capital constraints (BIII) and ICAAP requirements.

Case Study description: management of a simulated bank under risk constraints and in a competitive environment!

The course is based on the principal that the learning experience is enhanced by hands on exercises that replicate real management situations, where participants can test the concepts learned and analyse the result of their analysis and management decisions. Hence we have created this course with a high level of integration between theoretical concepts, valuation models and risk management methodology descriptions and computer aided Bank Management simulation.

In the simulation and all class room discussions and workshops the participants are divided into a number of management teams (maximum 4). These are typical management team of a small bank. The size of the group will vary on the basis of the specific training objectives and characteristic. Teams can be constituted by a single individual to a maximum of 4 to 5 participants.

Each team will make management decisions in different management domains:

  1. Strategy definition including markets, risk policies & limits, performance criterions…
  2. Marketing & Sales i.e. client and product  management (pricing, sales volume budgeting, marketing campaign investments)
  3. Risk management (credit risk, interest rate risk, liquidity risk and solvency risk)

Decisions made by the management teams are input into the computer simulation programme, which calculates the effects of all the decisions and prints a Management Information Report with the results. All the information required to develop and justify the management decisions are in this Management Report including:

  1. General Market information (economy, interest rates…);
  2. The Bank’s Balance Sheet and Income Statement;
  3. Profitability report;
  4. Risk reports;
  5. Compliance reports;
  6. Marketing reports.

The simulation is organised in such a way that each management domain is isolated to improve the analysis of causalities of results with participants’ decisions. In the final decisions participants are required to manage all the variables together and report on their strategy and the outcome of the decisions..

The objective of the simulation is to develop a strong understanding of the key factors that contribute to the optimisation of a Bank performance. Strategic Value Based Performance requires a sound understanding of many management variables sometimes complex and very quantitative. We have simplified some of these domains to make them accessible to non-specialists. For the participants it is important to understand the dynamic of all the management domains and their impact. To illustrate this point the Bank must manage its risks (credit risks as well as Interest Rate Risk, Liquidity risks and Solvency risks). The way to do this is to assume risk (“buy or sell risk”) for an optimised amount, under risk constraints (equity compliance) under profitability constraints (revenues and cost efficiencies) and under value constraints (Economic Value Added performance metric and share price).

For further details please refer to our information brochure “Bank Management Simulation to enhance the results of training”.


The participants will gain useful understanding of bank performance dynamics and more importantly will have a real experience of managing the bank and responding to the challenges of the environment in a near life experience. They will have a good (but general) understanding of three major management domains in Retail, which will be of immediate application on their day-to-day responsibilities.

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April 1, 2013 · 12:44 pm

Bank Management Training and Education

BC&T is focused on Bank Management Consulting and Bank Management Training. We have added two new categories of subjects to this blog to discuss related subjects and offers of services. To receive detailed information financial conditions please send an email to Clive Wykes at

In the Bank Management Training & Education category we will describe our approach and some of the courses available.

General comments

We prefer to organise in-house courses not only because this is a cost efficient option for the client versus public courses, but also because it allows us to tailor-make the course to the clients’ specifications. That offers direct and important benefits to the client, of which:

  • Customised content and training objectives,
  • Customized training duration,
  • Convenient date & training location,
  • Cost efficiency,
  • Confidentiality.

In-house training is desirable if:

  • you have large numbers of staff to train,
  • if you need specific content and teaching approaches,
  • if you want to use internal information and discuss specific internal methodologies and issues,
  • if the trainees are senior officers of the bank or board members.

We underline that our courses are management courses aimed principally at middle and senior management. But we also have introduction level courses directed to entry-level or junior staff. As we adapt the programme to the specific requirement of the client each programme can have different levels of complexity, focus and detail; consequently the programme duration can be from 1 day to 10 days.

Training methodology

Each programme is a mix of classroom sessions and hands-on management sessions.

  • Classroom sessions: we review core concepts from a theoretical perspective, show real life examples and explain, if needed, the technical model required.
  • Hands-on management sessions: the participants apply these concepts and skills in bank management simulation games, role-play case studies and/ or qualitative exercises and case studies.

This dual approach allows an optimisation of the learning experience and facilitates the implementation of the new skills in the day-to-day management responsibilities of the learners.

A deep body of theoretical literature asserts the power of simulations to change behaviour by giving learners and practicing managers the opportunity to apply concepts immediately, experiment and test their assumptions, and learn from their mistakes in a risk-free environment.

Simulations will reinforce business concepts and accelerate learning because they are highly involving, realistic and give immediate feedback about the trainee’s judgment and choices. After the simulation, participants can easily reflect on their outcomes, good and bad, and form memorable conclusions about what they should do when faced with a similar business problem in their organizations. Finally simulations are competitive and fun.

Rather than rewrite a blog on the advantages and use of simulation games in training (also referred to gaming), I suggest you check out what was written on Wikipedia:

A question often asked is: How do we keep our programmes up-to-date? After all, the world of banking is evolving at a rapid pace, especially since the big banking crisis that started in 2008.

The answer is simple. We are primarily bank management consultants working on solving day-to-day management problems of banks in many countries. To achieve the expected results we must have a hands-on approach, and propose solutions for implemented that integrate the current best practices as applicable for each bank. We can then transfer those best practices into our training programmes.

Indicative programme list

The table below indicates some of the available (off-the-shelf) courses that can be organised as they are or adapted to client specifications. The level of depth and the target audience can also be adapted to the requirements.

As we focus on tailor-made in-house programmes pricing is specific to each assignment.



Training methodology




computer simulation

role play

case studies

Retail   Bank Strategy and Performance Management introduction   to advanced






from 1 to 10 days

Wholesale   Corporate Relationship Management advanced






from 3 to 5 days

Corporate   Finance for Bank Managers introduction   to advanced






from 3 to 5 days

Credit   Portfolio Management mid   level to advanced






from 3 to 5 days

ALM   and Compliance of the banking book mid   level to advanced






from 3 to 5 days

Operational   Risk Management and compliance introduction   to mid-level






from 1 to 3 days

Basel   II and III introduction   to mid-level






from 3 to 5 days

Introduction   to Asset Management introduction   to advanced






from 1 to 5 days

Risk   and Relationship based pricing introduction   to advanced






from 1 to 3 days

Retail   Client Relationship Management introduction   to advanced






from 1 to 5 days

 Retail Branch Management introduction   to advanced






from 3 to 5 days

We will describe these programmes in further posted blogs. Meanwhile do not hesitate to contact at

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April 1, 2013 · 11:02 am