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Reprice My Best Deal? WHY!?!?
No bank likes to reprice a winner. In fact, most banks put structures in place specifically to avoid this scenario. Prepayment penalties are all about that, and they occasionally work (maybe less than you think, but more on that another time).
However, the reality is there are times when we need to bite the bullet and down-price our best deal. We need to know when to be receptive to a customer refinance request, or - perish the thought! - proactively reprice a profitable deal.
First, let’s look at why we would even consider repricing.
Keeping Customers Happy
From a relationship and reputation perspective, it can be damaging to have a customer who feels, or might be led to feel, that we are making an unfair profit from them. Very few of them will conclude: “Well this deal was fair when I made it.” More likely they’ll ask: “Is this deal fair to me right now? And if it isn’t, whose fault is it?” They’ll likely conclude that the fault lies with the bank.
You can be reactive and adjust the deal once a customer complains, but while that might address the short-term problem, it can also lead to long-term trust issues. Clients may wonder: “What if I’d never said anything? Was the bank just hoping I’d never notice?”
Keeping Competitors at Bay
Certainly, your competition would like your customers to feel that way. Lucrative deals are like shiny, red apples in an orchard. They’re easy for your competitors to spot and they’re eager to pluck them away. If competitors can plant the idea that your customers are the victims of unfair deals, it can push your clients out the door and establish the kind of market perception that banks constantly fight to avoid.
But if your customers aren’t swayed by the whispers of competitors? What then?
Repriced Value > Current Value
From a purely financial perspective, there is only one justification for repricing a highly profitable deal: The long-term value of the reprice is greater than the value of the current deal.
To make that determination, you need to know the long-term value of the relationship, as well as what the current deal is worth. It sounds simple, but let me challenge you for a moment: Do you really know either of these things?
Any relationship manager (RM), or indeed any data scientist, will tell you that predicting the long-term value of a good relationship is far from easy. As with most things in commercial banking, your ability to understand the long-term relationship value hinges on how well you really know the customer.
The RM needs to be aware of the client’s current and future possibilities. The RM’s research efforts, communication with the client, and overall expertise should help them understand the client’s forward outlook. Is this a sole proprietor headed to retirement with limited future growth, or an established, growing firm with a proven record and lots of market growth ahead of them? It reinforces the critical lesson: Building better relationships is key to the success of a commercial bank.
Most of the great relationship managers I've had the privilege of working with are very good at that. They view that as their core competency. Their job is to understand that relationship and know where it can and should go.
The Importance of Strategic ROE
Still, there are sceptics out there that will read the paragraphs above and say, “All that future conjecture is vapor. Given dreams against dollars, I will take the dollars thank you. Let’s keep that profitable deal the way it is.”
That leads to the last, and perhaps most often missed point. Do you really know how valuable the deal is?
Banks often work on Funds Transfer Pricing (FTP) and lock in the funding cost of the deal at origination. They then measure the deal against those origination numbers. That works well for the people in Treasury, but it does not reflect the reality of the RMs and their conversations with clients. The RM is dealing with an external environment that does not care what the cost of funds was when the deal was originally booked. That market cares about what the deal is worth today! Here at PrecisionLender we call that view of value “Strategic ROE”. It answers the question: “How profitable would this deal be if we made it exactly like this today?”
Whatever the value is called, banks need a way to answer the current value question. Having that answer allows the bank to put itself in the position of its competitors. If you knew a good relationship was out there, and had a deal that was this profitable today, what would you do to get it? Would you pay the prepayment fee for the client? Would you discount the rate substantially? Do both? At a minimum, knowing the current value of the relationship gives the bank an idea of how far the competition would be willing to go to win it away. Despite all their virtues (and there are many), FTP values do not provide that insight.
Even if your bank does not value the growth potential of existing relationships, it still makes sense to have a measure of the market value of existing relationships and deals and to use that information when clients comes in and asks to be repriced. If you are like most of our clients, and agree that relationship development and growth are key to your success, you might even try to set a “market value” at which point you proactively offer to reprice.
Review Where to Reprice
Of course, all banks look at the risk inherent in the portfolio, but some fail to look past that risk and more closely examine profitability. They need to identify the relationships with loans that are mispriced to the current market and make sure that the strategy for that relationship matches the strategy for the loan.
For example, if the lucrative loan is helping to offset some loss leaders elsewhere, there’s no need for action. But if the market has shifted and the bank is now in an overly advantageous position relative to the customer, it’s time to have a frank conversation with them. Let them know what’s happened and why you’re coming to them to discuss repricing. It’s an act that builds customer loyalty, your bank’s brand, and could well lead to an expanded opportunity.
A little proactivity can lead to a lot of value.
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About the Author
George is the rare combination of banker, data scientist, and educator. He has held executive roles in both retail and investment banking focused on risk management, predictive analytics, and profitability. George’s love of data and all the ways it can be used to make better financial decisions brought him to PrecisionLender, where he heads our Data Insights Team.More Content by George Neal