Despite the complexity in execution, banks have only two ways in which they create value (and therefore make money). They build relationships with providers and users of capital, ensuring that they act as the facilitator in as many transactions as possible. They also recognize and quantify risk so they receive adequate returns for their exposure.
Pricing is fundamental to both functions, and yet many banks still price by sticking their head out the window to see what the guy down the street is doing. Why is this? Why is pricing, which is the essence of the banking business, such a struggle for so many?
To answer that big question, let’s start with the research of Stephan Liozu, author of “The Pricing Journey.” Liozu describes two dimensions of pricing capability, Price Setting and Price Getting, and shows that in order to excel at pricing, companies must master both dimensions.
Price Setting is the one that gets all of the attention in the banking business. Why? Because it’s math. Most bankers pride themselves on analytics, and on being able to quantify a deal in a neat and tidy box. Now, even though Price Setting is the dimension that gets the most attention, that doesn’t mean all banks are good at it. We have all seen plenty of evidence to the contrary in the marketplace. Still, given the comfort level with the concepts and the fact that progress should be quantifiable, bankers almost universally choose fixing this dimension as the way to correct their pricing woes.
The problem is that without mastering the second dimension, Price Getting, all of that Price Setting work is for naught.
Price Getting covers people and process issues, but it essentially boils down to one question. How good are we at actually booking that price after we set it? What many banks are now figuring out is that they can’t just “out-math” the competition. It does no good to be really great at setting prices if we end up having to discount to get deals on the books, or losing deals because we couldn’t find a creative way to make it meet our targets.
While determining the exact cause of the failures in pricing can be difficult, the outcomes are pretty straightforward. Are you wondering which aspect of your pricing approach needs work? An honest appraisal of where you fall on the diagram below should point you in the right direction.
The Reckless Gunslingers
These banks are a dwindling breed (since they keep failing), but we still run across more than you might expect. They are the banks that are terrible at setting the right price for their credit and interest rate risk, and are willing to discount from there when necessary. These banks are dangerous, not just to themselves, but to everyone else in their market. The good news is that if you have any borrowers that you are worried about, this is exactly where you should point them.
The Stubborn Old Mules
These banks struggle with Price Setting, but stick to their guns once they come to a decision. The problem is that the prices they are defending don’t always make sense. Sometimes they are stubbornly staying with above market rates in search of margin, and are sacrificing top line growth to get it (look for the giant bond portfolios). Other times they have set prices for certain structures too low, and stick to them even when the outsized production should tell them they got it wrong (look for the concentrations in risky loan types or long term fixed rates). These banks have the shortest path to improvement, but in our experience, are also the least likely to actually take it. Because they already have it figured out, thank you very much.
This quadrant represents most of the larger banks. They have sophisticated tools and entire teams dedicated to calculating the right price … usually out to four decimal places. The trouble is that the lenders trying to book deals at those rates find it impossible, because they don’t have access to those same tools, they haven’t been properly trained, or they know they can simply ignore the nerds with the calculators. These banks are the hardest fix, as massive organizational change is far more daunting than simply improving the math. The good news (or bad if they are a competitor) is that a growing number are willing to try, as the results are impossible to ignore.
Finally we have the rarest of all, the banks in the top right corner that are good at both Price Setting and Price Getting. You can spot these banks from a distance, because they are the ones that are growing like crazy while still generating top decile earnings. When asked about performance, their leaders never talk about pricing methodology. Instead they talk about relationships and their strong teams. What they are really saying is that they’ve mastered the Price Getting component that eludes most of their peers.
So, which category best describes your bank? The right fix depends on a proper diagnosis, and in most cases, better math alone won’t fix your performance.