“Yeah, that makes sense, but you have to understand that we are in a VERY competitive market. I’m not sure that stuff will work here, because we just have to price to the market if we want to win any deals.”
We hear some version of that statement on a daily basis from clients and prospects. In the same way that all of the children in Lake Wobegone are above average, we joke that all bankers are apparently in the most competitive market in the country.
The thing is, though, that the bankers are not wrong about the competitiveness. If you need convincing, just look at the trend in net interest margins over the last 20 years.
We see the same thing in the $20 billion in loans we are pricing each month. Spreads are tight, and there are more competitive offers on the best deals. We do, however, take issue with the idea that you “have to price to the market to win.”
You certainly can’t ignore the competition and price in a vacuum, but we see far too many banks that let the competition shape their entire pricing strategy. In fact, they often take “competitive awareness” to the extreme, and pay big money for services that show them the average price levels in their market. We get asked for this kind of data on a regular basis, but we view it as a “We supply the gun, you supply the foot” kind of solution. Here are three reasons why:
1: The Data is too Messy
The wonderful thing about commercial loans is that all of the deal terms move the needle for risk and profitability AND they are all negotiable. You can mix and match terms, and create hand-crafted solutions that work for the bank and the borrower (the elusive “win-win deal”). However, that makes comparison of two deals really tricky.
To truly compare two deals, you have to use a risk-adjusted return measurement, and there is currently no good way to gather that kind of data. Sure, you can look at average rates for a Pass credit with a five-year term and a twenty-year amortization. But who is guaranteeing the deal? How good is the collateral? Is it cross defaulted with another loan in the bank? Did they get a break because they also carry big deposit balances? Do they refer a lot of other business to the bank?
We simply can’t know all of the moving parts of enough deals to get a handle on what “average price” really looks like. And, even if you do manage to find a couple of deals that are exactly the same, is that really enough data points for you to be comfortable using it as your baseline?
If I am pricing many millions in loans, I want to at least be using good data, and it just doesn’t exist for commercial loans, at least until you get to very large syndicated deals. Banks should think of each deal and its competitive offers as being unique, and should proceed accordingly when considering price.
2: The Strategies Don’t Align
I had an early boss tell me during a deposit pricing discussion that banks are only as smart as their dumbest competition. That view may be a little harsh, but the point is well taken. We hear banks say all of the time, “You won’t believe what the bank down the street is doing.” If that is the case, then why are you letting them play such a key role in determining your pricing?
Even if you ignore the “dumbest competitor” in the market, it is still a bad idea to match someone else’s pricing. We do business with a couple hundred banks, and they all have a unique set of circumstances and strategies in place.
We do business with banks that are desperately trying to deploy excess capital, and are willing to trade margins for growth. We also do business with banks that are actively trying to shrink, and will make the opposite trade. Within those groups, of course, there are banks that are targeting specific product types, specific customer types, or even growth in specific zip codes. The only thing we know for certain is that their strategy is different from yours.
Pricing is the most important lever you have for executing your balance sheet initiatives, so why would you match someone else’s tactics to try to execute your strategy?
3: Over Time Your Results WILL Suffer
Last but not least is the fact that “pricing to the market” leads to poor results.
Carl has a great analogy that explains this phenomenon. He asks banks to imagine that they decided to optimize the height of their doorways. To do this, they set the door height at the average height for their customer base. What do you think happens to the average customer height?
Obviously it will go down, because your above average height customers can no longer walk through. Without them, the average will drop. The same happens with loan pricing. The averages are obviously built with some very profitable deals that offset the unprofitable deals. What we find when banks “price to the market” is that lenders tend to use that as a cap on pricing. The deals that would have been priced higher get moved down to the average (after all, that is the market rate), while lenders will continue to dip below the average to land bigger deals from good borrowers. The result? Lower profits.
We aren’t saying you should ignore competition. That is obviously a path to lost volume, and maybe even a lost job. Competitive awareness is absolutely vital to effective pricing, but using simple “market averages” is not sufficient.
Instead, banks need to treat each deal as its own unique situation. That will take better systems and better training, but those are sound investments given that they translate to better performance AND happier customers.
For more, check out Earn It: Building Your Bank’s Brand One Relationship at a Time.