When it comes to pricing commercial deals, your relationship managers are right: Trying to win the business of the best borrowers can sometimes feel like a bloodbath.
So is it time for a tourniquet? Or will that do more harm than good?
One of the captivating aspects of working at PrecisionLender is having a front row seat to the nation’s commercial lending market. Last quarter, our clients priced $100 billion in commercial loans, and from that we can see all markets, large and small, continue to be brutally competitive.
Yes, You Are Pricing in a Competitive Market
We have two primary criteria by which to judge competitiveness. First, we look at the data. With that much volume spread across a couple hundred banks, we get a unique view of the marketplace. And no matter which way we slice it, it tells a similar story. There is a ton of capital chasing a few viable deals, and the bidding can get downright silly.
Second, we listen. We have dozens of conversations every week with bankers about pricing, and they tend to use the same words to describe what they’re seeing. The fascinating part is that the word usage has changed with the changing markets.
We used to hear words like “slippage,” or that deals were “leaking” spread. Now they tend to be much more graphic. We’ve heard multiple bankers describe their pricing as “hemorrhaging basis points.”
Price Setting vs. Price Getting
The graphic wording makes it clear that banks are worried by the tiny spreads, and we are seeing them take a wide spectrum of actions because of those fears.
One solution used by far too many banks is what we’ll call “pricing by tourniquet,” and is used when a bank is “hemorrhaging basis points.”
There is no doubt that tourniquets provide an effective means to stop 'catastrophic hemorrhage' - serious bleeding wounds to the extent that death is imminent due to blood loss. Tourniquets are commonly used by the military worldwide, by Emergency Services in the US and - to a lesser extent -in the UK.
The use of a tourniquet is actually very straight forward. You simply squeeze the afflicted area tight enough that you restrict all blood flow. The source of the bleeding can then be identified and treated, and the tourniquet is released.
Pricing by Tourniquet
“Pricing by tourniquet” is intended to work the same way. The bank creates a series of restrictive “check with me” type processes for pricing approval, allowing them to get a better handle on the deal flow. Overly aggressive pricing can be denied or reprimanded, and exceptions can be limited. This exercise is an introduction of one of our key ingredients to successful pricing, which is accountability, and because of that, banks typically see swift and tangible results. As in 10 basis point (or more) jumps in spreads.
This, though, is exactly where “pricing by tourniquet” gets dangerous. The early wins cause banks to double down on the approach. If a little more control was good, then a LOT more control should be even better!
More and more steps get added to approval processes, flexibility on structure is reduced, and everyone in the bank becomes more focused on exceptions and the approval process than on serving their customers.
Let’s quickly go back to that article on tourniquets:
There is also, however, evidence to support the negative consequences of inappropriate or prolonged use of tourniquets, including, but not limited to, nerve damage, tissue death and blood clots.
And this is the crux of the argument; tourniquets are effective and appropriate but only if their use is warranted and the person applying the tourniquets understands what they are doing, how to do it and why.
Much like tourniquets, more restrictive pricing policies have unintended consequences that can cause long-term damage, in the form of inefficient processes, low RM morale, and unhappy customers.
The Scary Story of Flow Chart Bank
Let’s take a look at a real-life example from a large regional bank in the United States. We’ll call them Flow Chart Bank for reasons that will become all too clear.
When we first met Flow Chart Bank, they were frustrated by the lack of flexibility in some of their current systems. This is a common complaint of banks, and it tends to open a lot of doors for us. We dug in, expecting to find the usual complaints, which almost always come back to rigidity from the finance and credit functions being imposed on relationship managers. Complex and difficult to use pricing tools are inflicted on the front line, and both production and profitability end up suffering. While that was somewhat true at Flow Chart Bank, it wasn’t exactly what they were describing.
Instead, they were looking for a pricing tool that could handle their process. They needed to be able to track approvals with a proper audit trail, and were trying to move approvals of all kinds from email threads to a software platform. Again, this is all in a day’s work for us, so we asked for more details on their current process to make sure we could accommodate it. What we found was shocking.
They couldn’t really describe their approval process very well, so they started sending us the flow charts that they had circulated amongst their relationship managers. Each department had their own customized version, and they were multiple pages long!
A small business loan meeting a certain set of criteria (found in a separate flow chart, of course) needed a total of four signatures and 14 steps to be approved for pricing that was below the hurdle rate.
Let that sink in for a second … four signatures for a loan that, in their case, would never be big enough to need a second comma.
The scary part is that a couple of divisions had exception rates of more than 70%. The hurdle rates were high enough, and the “acceptable” set of structures so limited that most deals qualified as exception pricing. RMs were emailing deals around for approval for weeks before underwriting could even start. With this kind of an approval maze, the bank started seeing all sorts of unintended consequences, including:
- Slow approvals and funding lead to unhappy customers. Once this reputation started to spread in the marketplace, RMs had to get continually more aggressive on pricing to convince borrowers it would be worth the hassle.
- RMs decided that because deals would most likely be exceptions anyway, they may as well get hyper-aggressive in reducing spreads. Basically, “If you’re already asking, no need to be shy about it; go for the win.”
- Getting boxed in on pricing caused RMs to seek out deals that were less competitive, and of course there are usually fewer competitors for a reason. Credit quality in the pipeline started to slip, causing the credit group to spend time underwriting unqualified deals. This only added to the bottleneck and slowed down funding time even more. Wash, rinse, repeat.
With results like these, it was inevitable that finger pointing would start, and the pricing tools took the blame. The bank felt all their troubles could be solved if they had a system that could better handle approvals. In fact, that became the only criteria that mattered when they were vetting new pricing solutions.
After mapping out a few of the processes, we finally went back to Flow Chart Bank with our answer. Yes, we could technically get the approval process mapped to PrecisionLender, and we could provide an audit trail. But, we had no interest in doing so. We call these “gun and foot” problems, because we run the danger of us supplying the gun and our client supplying the foot.
Our prescription was not better software workflows, but an entirely revamped and overhauled approval process. The bank needed to give their RMs clear targets to aim for, as well as clear boundaries that could not be crossed. But within that range, they also needed to give the RMs flexibility and the freedom to choose between multiple deal structures. And the bank needed to get their RMs this information in real time. That way the RM would know the deal’s approval status while the customer was across the table, instead of finding out several weeks and several steps on the flow chart later. It wasn’t exactly what the bank wanted to hear, but it’s the only way they would be able to treat the disease instead of the symptoms.
When facing a severe trauma situation, a tourniquet very well could be the difference between life and death. It can stop the bleeding. But that immediate success can’t be followed with more of the same. Tightening or adding another tourniquet doesn’t solve the original problem, and can do severe damage. Pricing by tourniquet works exactly the same way. You will get immediate, short-term results. But that should only serve to help you find where the real damage lies, and then you can start applying fixes. Adding more tourniquets leads to a very bad outcome, and the “nerve damage and tissue death” it causes at your bank will be MUCH harder to recover from than the original problem.
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