Should You Price Loans with a Pencil or a Space Pen?

October 27, 2017 Dallas Wells

“If you can’t explain it simply, you don’t understand it well enough.” – Albert Einstein

 

During the height of the Cold War and the tangential “space race,” American and Soviet engineers were pushed to solve innumerable technical challenges. 

Apollo 17 Cernan on moon

One such problem was that atsronauts needed to be able to write things down, like checklists, notes on various studies and experiments, and daily journals, while in space. But with no gravity, an ink pen wouldn’t work.

So NASA commissioned studies and hired contractors to design and build prototypes. After several years of effort and millions of dollars, Paul Fisher and his synonymous Fisher Pen Company finally solved the problem and won the coveted contract. American astronauts would travel to space in style, toting the best high-tech space pen that money could buy.

Soviet cosmonauts, on the other hand, would be traveling with a much simpler (though perhaps more elegant) solution. They just decided to use pencils.

A Tall Tale 

Just so we’re clear, it didn’t really happen this way. The first space travelers all used pencils. But pencils were a known risk because they tend to break, and tiny floating debris among a gigantic collection of delicate (yet explosive) equipment is dangerous. Both the Americans and the Soviets actually ended up solving the ink problem around the same time.

While this story may be a stretch of the truth, the tale has persisted on the internet precisely because of how much it resonates. Every day we seek simplicity and clarity when confronted with all of modern society’s complexity and confusion. And sometimes, we come across straightforward solutions to really difficult problems. These simple solutions are like rays of sunshine, but they are so outside the norm that often we fight them out of habit. “This is way too simple; it just can’t be right.”

Incumbents vs. Innovators

This story lines up with a fascinating transition happening in enterprise software. The cloud has matured to the point where outside vendors can now offer superior services and feature sets at lower costs than enterprises can build and manage on their own. And enterprises are consequently looking outside of their walls for more and more solutions.

The result has been a leap in efficiency and effectiveness, as well as explosive growth in the cloud computing and software industries. 

All of that goodness, however, has had some ripple effects inside the enterprise. Specifically, it is breeding conflict between the owners of the incumbent solutions and the champions of the new solutions. We’ll call them the “innovators.” 

“Can a third-party platform really handle our very specific and unique needs?”

The incumbents have built their solutions from the ground up, either as homegrown systems or as vendor-provided tools with extensive customizations. They’re built specifically for their organizations, with answers for all the unique workflows that are an inevitability in large enterprises. They require specialized care and feeding, but the benefit is a proven track record and a perceived accuracy gained over years of tinkering and adjustments.

The champions of the new solutions, on the other hand, feel that innovative new tools offer efficiency and vital new functionality. These tools introduce modern design and a focus on user experience, as well as access to the exciting new worlds of analytics and connectivity to surrounding systems. In short, the cumbersome legacy tools (i.e. the incumbents) can finally be replaced, taking with them their silos of compartmentalized data and reliance on dedicated internal resources.

The Writing Was on the Wall

To go back to our space pen story, the innovators believe the new tool is the pencil: the simple and perfect answer to a problem that has been made overly complex and expensive. The interesting thing is that the incumbents often agree; the new tool is the pencil. But while it might work for others, “This organization needs the expensive pen that has been designed exactly to our needs,” the incumbents say.

For years, the incumbents were right. The third party tools couldn’t quite solve the problems, at least not at the enterprise level. But the writing was on the wall. Someday, winners would emerge from these packs of startups, and the benefits would outweigh the risks.

That day has come. Configuration and integrations can now match the effectiveness of customizations, but at a fraction of the ongoing cost. Trailblazers such as Salesforce, Workday, and Veeva made it over the hump, and now the world’s largest companies are wrestling with the transition from homegrown, on-premise tools to powerful, cloud-based and connected systems that open exciting new opportunities for the future.

Forging a New Path

At PrecisionLender, we are on the front lines of this transition in some of the world’s largest banks. PrecisionLender is a platform for pricing and profitability management, which has traditionally been a “back-office” function. The finance, treasury, or credit teams developed custom models for calculating required pricing, and that pricing was then dicated out to the “front office.” These models were originally fairly simple, and were intended to generate “take it or leave it” pricing. Today’s versions, however, are nowhere close to that original intent.

For starters, the sophistication of the calculations has ramped up considerably. New capital rules require allocation methodology that is slightly different for each bank. In addition, the assets have greater variety in structure than ever before, requiring new approaches to funding costs, liquidity premiums, and optionality. Spreads are tight and margins have compressed in the majority of asset classes. This means that banks should be including competitive data and market idiosyncrasies, and they need to do all of this while incorporating existing relationship profitability and future balance sheet needs. It is a monumental task.

In most large banks, the result of that mess of requirements is a tangled collection of homemade Excel models. Some banks have hired consultants to build cleaner versions that scale better and can be updated. A few others have hired custom-build software vendors to create formal pricing models based on the spreadsheets.

But all of them still have the same basic approach: Calculate a required rate on a given structure and tell the bank’s relationship managers to charge that rate. Anything less is a pricing exception that requires formal approval from management (click here for more on the pitfalls of this “tourniquet” approach to pricing).

That approach has a consistent and unsurprising outcome. Pricing is adversarial, both internally and with the customers. The “take it or leave it” rate and the subsequent haggling is inefficient, breeds animosity, and leads to overall portfolio returns that are below the expected (i.e. required) level.

A Different Approach to Pricing

At PrecisionLender, we believe that pricing should have a fundamentally different approach. In order to be effective, the process must start at the relationship manager and work backwards. The relationship managers are the direct link to the customer, and they need to be able to negotiate and reshape the deal early while it is still malleable.

If your pricing system can’t easily be used by your relationship managers, then it can’t create value. At best, it becomes a calculator that serves as a pass/fail test.

We have designed our platform with relationship manager usability as the foundation. All of our product decisions incorporate the relationship manager/customer conversation, and the improved customer experience translates to our clients achieving better loan growth and superior margins to their peer group.

Andi® To The Rescue

We find some resistance to this approach. Both our competition and the owners of the incumbent systems will often point to that relationship manager focus as a weakness.

We hear things like, “If you make it simple enough for the relationship managers to use in real time, there is no way that it can also handle our complexity and customization.”

In reality, this is the power of modern software. Through a combination of deep domain knowledge and cutting edge technology, PrecisionLender can handle complexity while also providing a clean, simple user experience.

With PrecisionLender, every relationship manager gets access to Andi®, our AI/machine learning-powered virtual pricing analyst. Andi works 24 hours a day, 7 days a week. She sees every deal and every relationship in the bank, and through the power of machine learning, sees what is working and what isn't.

 

Andi allows for the great equalizer to complexity: context. We can be aware of what type of loan is being priced, in which region, to which customer, on what day, and with what specific risk factors. This context allows us to eliminate any unnecessary complexity and decisions. Settings and options that are not relevant can be hidden, allowing the relationship managers to focus only on what is necessary and applicable. Andi can point out which factors are most important to any given opportunity, and help relationship managers discuss and negotiate those factors with their customer.

Explain It Simply

For loan pricing, complexity is a necessary reality. The naysayers are correct in claiming that taking shortcuts around the complexity, or oversimplifying calculations is not an option. We agree with that, and have spent many years and millions of dollars refining our workflows and perfecting our calculation engine.

But being precise with calculations and diligent around security are simple table stakes in this business. The real differentiator is taking our understanding of the challenge, combining that understanding with powerful modern technology, and using it to do as Albert Einstein suggests in his famous quote: Explain it simply.

By doing so, we help banks make pricing a way to add value instead of a source of conflict.

 

About the Author

Dallas Wells

Dallas is a writer, speaker and former consultant who has held executive roles at two banks with experience in capital planning, liquidity forecasting, investments, budgeting, financial reporting and mergers and acquisitions.

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