Jim Young sits down with Dallas Wells, our Chief Success Officer, to discuss Dallas' recent blog post about the 7 Deadly Sins of Pricing. You'll learn about each one, diving deeper on a few of them to talk about real-world examples from Dallas' experience working at and with banks.
- 7 Deadly Sins of Pricing (Blog)
- Zipf's Law and Your Lenders
- Setting ROE Targets - What NOT to Do
- What's Your Bank's Backup Plan? (Podcast)
- Register for BankOnPurpose 2017 - 10% off with the code "podcast17"
Jim Young: Hi and welcome to the Purposeful Banker Podcast, the podcast brought to you by Precision Lender where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, Director of Communications as Precision Lender. I'm joined by Dallas Wells, our Chief Success Officer. Thank you all for joining us today. Dallas is our Chief Success Officer which means he works with lots of banks that are doing great things in their markets. Along the way and also during his career in banking before he came to Precision Lender Dallas has seen firsthand where pricing can go off the rails. He recently cataloged some of the biggest blunders in a blog post titled The Seven Deadly Sins of Pricing. That piece and those since will be the focus of our discussion today.
First Dallas, this piece has rapidly become one of the most popular pieces of content on our site. It was in our newsletter and it was pretty remarkable how people, how often people clicked on it. Why do you think this story is resonating with readers?
Dallas Wells: Well, I think everybody loves a countdown of course.
Jim Young: True.
Dallas Wells: For being honest, that's part of it. I think also the sins of pricing. I think everybody knows that pricing's really hard, everybody struggles with it. That's one of the interesting things that we've come across and we talk to bankers. There's some that respond really well to the here's the warm, fuzzy, upside, the things that we can help you do better and the potential that's there for you. A lot of others just want to know, "Where am I really screwing this thing up? Where am I really stepping in some big potholes?" Let's fix those first. I think it's, that naturally ties to pricing just because pricing is one of those places where you can really lead yourself astray. That is essentially the filter on the front of your balance sheet, helps determine which deals you win and which ones you lose.
If we're winning the wrong deals that feels like a very dangerous thing. I think bankers see that and they want to know am I filtering for the wrong things and getting some of the wrong kind of deals on the books.
Jim Young: If I understand you correctly, you're telling me that bankers tend to be risk averse, is that right?
Dallas Wells: Surprisingly, yes. They don't like to take big risk so yeah, I think that's part of it.
Jim Young: Wow, learn something everyday. All right, let's real quick just list off what those seven sins of pricing were. Number one was failure to scale; number two, wrong users at the wrong time; number three, applying vinegar instead of honey; number four, death by accuracy; number five, death by acronyms; number six, ignoring the real world; and number seven, pricing in a vacuum. As a reminder, all of those ... We're not going to go into all seven of these on the podcast today. We're going to take about three or four of them and go deeper on it. If you want to check out everything we had to say on them that blog post is up on our site at explore.precisionlender.com, and The Seven Deadly Sins of Pricing is the name of it.
Again, for today let's take four of those and we'll go with failure to scale, wrong users at the wrong time, applying vinegar instead of honey, and ignoring the real world. Dallas, I just want you to talk a little bit more about those. In particular, without naming names, how are you seeing these sort of things play out in the real world with banks. First one, failure to scale. I got to be honest with you, I just came back from a marketing tech conference. Scale is a buzzy word, it feels like one of the words that is in sort of the Fintech startup world. How does that apply to pricing at banks?
Dallas Wells: I think this is one of the growing pains that a lot of banks have in that pricing feels like something you can do yourself because it's math and bankers are good at math. Frankly, most of the math is not that hard. There's a lot of it but it's not overly complicated and it's at the core of our business. It makes sense that we can try to build this ourselves and so we break out the trust Excel spreadsheets and we build an Excel model. That frankly works just fine for most small banks, very small community banks. The problem comes when you have to actually start managing that across a much larger footprint, across larger user base, more people in and out of that thing.
You've got to keep it updated, you've got to keep fresh assumptions and market interest rates in there. You end up with a bunch of different versions and everybody saves it to their desktop. You're now trying to deal with different pricing across many different product types, across many different markets. What happens is these spreadsheets end up becoming kind of their own animal and it effectively becomes somebody's job to manage this thing. They almost always will err towards let's make it right for the finance and credit side of the shop and if it's a little painful to use then just too bad.
What really, what the leads to ... We've come across a few of these where we're talking to a potential client for us, we're talking to a bank and we're saying, "Well, show us what you're doing now so we have a feeling for where you're coming from." Somebody's always very proud of this spreadsheet and as far as spreadsheets go they should be. They're impressive, there's a lot of stuff going in there. As an example we saw ... This was a large regional bank, one of the top 10 banks in the country, and they are pricing with a spreadsheet. They've build some calls out from the spreadsheet to other systems to get some information.
One of the things that they have to send out for is credit information. They send out, and I won't name the system, but they send it out to another system which does a good job but what they're doing is Monte Carlo simulations of this particular deal so that they can spit back some expected loss rates and some capital to allocate to the deal. There's two inputs that their model really needs but this thing has to go through thousands of calculations to get that back. They would push go on their spreadsheet and then go make a cup of coffee, and come back and as long as it hadn't crashed their computer they would have an answer in maybe 10 minutes or so. You can see why that's frustrating, number one, and problematic, number two. There's all kinds of potential problems that can happen there.
That's one example of many where you're starting to try to feed market interest rates in there so somebody doesn't have to key them in. Keying it in has its own set of problems, but you start trying to feed things into a spreadsheet and they're just not designed for that. They will accommodate it up to a point but most banks that we talk to have really stretched Excel to its breaking point. They start to enter into all kinds of model risk, on top of it just being a pain to use. They've got formula errors inside those cells, they've got bad data sitting inside there. Then worse than that, they've got users who aren't really using it properly and there's very few controls about that.
Jim Young: Yeah, we'll get to the users in just a moment. It seems like, from my layman's perspective here, one of the areas where we start to see banks bump into this scaling and starting to realize it actually is ... They've sort of realized in terms of customer relation management, CRM area, they've sort of realized, "Okay, we've got to get up to speed on that." Then they get one of those and then they go, "Well, wait a second, how is that going to interface with this Excel spreadsheet?"
Dallas Wells: Yeah, and we've actually seen, again, people pushing it as far as it'll go. They try to say, "Well, let's just write a little script that will grab this cell of the spreadsheet and put it back where we need it." Again, you do enough of those and it's just going to break things and cause some problems. From there we typically see banks, they start to try to put a web interface on top of this thing but it's still in the background, essentially an Excel spreadsheet. The problems that go along with that, especially as you're getting larger, across a bigger footprint, you're probably pricing tens of millions, hundreds of millions, maybe billions of dollars of loans through that on a quarterly basis.
Being wrong somewhere is potentially disastrous and so it's just not worth what you feel like you may be saving, especially when you look at all the effort that goes into maintaining that thing. We've actually come across some where they've become this kind of Frankenstein's monster spreadsheet where one spreadsheet won't actually accommodate it. You've got one that calculates the credit risk, and one that calculates the funding cost, and another one that the RMs actually use. They have to go get the inputs from all the other ones and then plug it in. You can't negotiate a deal like that and so that'll lead to some of the other sins that we'll talk about here too.
Jim Young: Yeah, yeah. You and Jess a few weeks ago talked about a need for backup plans at banks.
Dallas Wells: Yeah.
Jim Young: That's an area if your Excel guy happens to not get his flu shot this year you can be in some serious problems.
Dallas Wells: Quite honestly, I think that's where some of this comes from. It starts out with good intentions but it eventually becomes somebody's job security. I'm the only person here who knows how to run that spreadsheet. There's some comfort and maybe some dollars in your paycheck for that.
Jim Young: Yeah, good point. Let's go back to something you started to touch on and that leads to the second one of these sins, the wrong users at the wrong time. Just from first-hand experience with our content, sometimes we have stuff that we've produced in 2013-14 which tends to still be some of the best performing content on the site. Inevitably, someone new will come in and say let's do more of that and we will say, "Actually, that content is being seen by the people that don't necessarily apply to what we're talking about." I suspect those people are probably also the wrong users in this situation?
Dallas Wells: Well, pricing is an interesting thing in that it's not necessarily they're the wrong users, it's kind of the focus on an exclusive set of users that some banks make this. Pricing is inherently cross-functional, it's one of the things we talk about a lot in all of our content, including the book that we wrote. We kind of divided roughly, and this is again poor terminology maybe, the back of the bank, front of the bank. You've got the credit, treasury, finance folks in the back of the bank who are building a lot of the math, the guts of the model itself. Their job is to really help shape the balance sheet with whatever platform, whatever system you're using. It has to select for the right types of deals with what makes sense for your bank but that's where a lot of folks stop.
That's really where this become problematic is when everything is designed for that back of the bank function you get this comfort about how accurate everything is. The math is beautiful and there's some integrity in the numbers but there's this little problem that we forget about and that the equations don't always consider which is you've got human being negotiating both sides of that deal. You have a customer who doesn't always cooperate with the math and you have then users, relationship managers who actually have to make these deals happen.
Relationship managers, the core of their job is really two sets of negotiations; number one, they negotiate with their customer, so let's come up with a deal that I think I can make fly. I can make this thing actually happen in the bank. It'll pass the credit standards and the pricing will be sufficient that I won't get smacked upside the head for it. Then the second set of negotiations is they actually have to go make that happen. They have to go back to the bank and they have to convince the underwriters that the deal's good. They have to make sure that it hurdles, in most bank's terminology, and that it clears the hurdle rate and is profitable enough so that the pricing's acceptable.
You can't build a system that ignores that whole component and that's what a lot of banks have done. Is they make these really ugly, difficult to use systems so that everything lines up nicely in the back of the bank but it's really hard to use. It's, in fact, impossible to use with a customer. What a lot of banks do then is they actually have their credit group actually putting the deals through the pricing system, again because it's not of any use the way it's designed for the RMs to actually use it. They negotiate their deal, kind of a finger to the wind method usually, they know roughly what'll work. They try to negotiate that as best they can.
Again, every deal is different, that's got to be difficult. Then they hand it off to the credit analyst who starts underwriting and as one of the things on their checklist they put it into a profitability model and they see if it hits the hurdle rate of not. Our question is always, "Okay, well what do you do with that information?" If it does hurdle, great, you check the box and you move on. If it doesn't you've got two choices. Number one, you go crawling back to your customer and you re-trade a deal that you've kind of already shook hands on or you just say, "Whoops, we'll try to do better next time." You chastise your RM and you just move the deal forward anyway.
At best, in that scenario your pricing tool is being used to kill deals, that's the best possible outcome. Is that you find some deals that maybe you shouldn't have agreed to and you kill them before they actually hit the books. Which is problematic for your customer, for your brand out in the marketplace. That is very ugly for you to agree to a deal and then back track on it. Your underwriter, your credit group just spend some of their precious time and resources working on a deal that's not actually going to fly. It was never a qualified deal in the first place.
Our view is always that pricing has to start with the customer and the relationship manager, you have to start there and work backwards. If you have the wrong set of folks putting everything through whatever system you're using you can't actually create any value. Again, at best you'll be a goalie and you'll try to stop a deal before it goes that maybe you shouldn't be doing. If that's the case catch it early, catch it when you can actually still reshape the deal into something that will work. At least stop it before you've made a commitment to a customer and wasted some time from your credit group.
Jim Young: Yeah, and that, again ... You're doing a great job of segueing right into the next one, by the way. It's almost like you knew this ahead of time. That is applying vinegar instead of honey or in sort of the parlance that I have for this time of year, watching my favorite team go down in the NCAA Tournament in flames, also is sort of the concept of playing not to lose, I guess would be sort of that. Kind of keep going on the route you've gone here with this and talk a little bit about what we mean with vinegar instead of honey.
Dallas Wells: Yeah, so again, we see banks take two possible approaches to whatever pricing system they're using. One option, and actually the most common one is, let's keep these ... I'll try to use a nice word, these pesky lenders from doing bad deals.
Jim Young: Reckless, can you use reckless?
Dallas Wells: I think maybe reckless is good. Actually, we heard it this way from a prospect once. They said, "Look, everybody knows that lenders are just coin operated. Just pay them for exactly what you want and that's what they'll do." I've done both those jobs, the back of the bank and the front of the bank. I happen to think it's a little more nuanced than that. The approach is, "Okay, we have to put enough guardrails in place that nobody can ever make a mistake." Really what you're protecting against is your lower volume, less experienced relationship managers. Those are the ones that you're like, "Man, they're going to do something dumb and I have to keep them from doing that."
What you do is you restrict everything about the system. You only let them do very out-of-the-box, plain vanilla things. You can't do anything creative, anything out of the ordinary because the system just won't allow it. These are our guardrails. You might keep a few of those low volume lenders from doing something slightly out of the ordinary but, again, they're producing very little volume anyway. We've found much more success with folks at the other end of the spectrum, so find your very top producing lenders. We've got some content willing to adhere about [inaudible 00:17:34] distributions and how most loan portfolios actually tend to look like that where there's a few lenders or RMs at the very top carrying the bulk of the load.
Get them onboard with creating some value and responding well to their very best customers which is who they're handling. Give them tools that enable them to do a good job and worry less about restricting the very low volume lenders from making a small mistake. Now, we're not talk about credit mistakes, right?
Jim Young: Right.
Dallas Wells: A deal still has to pass muster, it still has to be an acceptable credit risk to the bank. If they go slightly out of your normal structure and it's something that is not your favorite structure in the world and they do one of those deals a year, is that that big of a deal? If you give some flexibility to your very best, most experienced RMs and they can win another two, three, five very good deals by that added flexibility and ability to be creative and responsive to, again, your best customers.
What happens is, is when you restrict those lower producers and you put all the guardrails in place then you end up with your very best customers coming to your most trusted employees and your most trusted RMs and says, "Here's the deal I want." It looks a little funny but, again, they're a very good credit risk, they're a very profitable customer to you. If you asked any executive at the bank, "Would you do this deal?" They would say, "Yes," in a heartbeat. "We love this customer, we want to keep him happy, this makes sense for what they're doing." You make them jump through a lot of extra hoops, you make it difficult for your RM to be responsive to them. You add time to getting that deal done because there has to be extra sign-offs to do this exception.
You end up providing bad service to your best customers so that you can not misstep on a handful of deals a year. Again, we're not talking credit, we're talking not off of a rate sheet kind of pricing. You know?
Jim Young: Right. I guess we try a little devil's advocate push-back here though, because I think you've wrote in a piece of content at one point about one your old bosses saying, "If Sam Walton's right on about 95% of things that's awesome, but if I'm right on 95% I get fired." I can definitely see why that makes sense for your best ones. Are we basically saying you're going to have some screw-ups but they're just not going to be on big accounts? How do you account for the ones ... Once you take the guardrails off ... I see how it helps your top producers, but what happens with those ones that maybe you wish they had guardrails?
Dallas Wells: Yeah. Let me give you a couple of examples, maybe that'll help, for folks to figure out exactly what kind of exceptions to the rule are we talking about. We have one particular bank that we've worked with that says, "We do not do caps on any variable rate loans, you just cannot put a cap on there. Would you please remove the cap functionality from Precision Lender, just turn it off so that they can't even get to it?" Our response is, "Look, if you want to make an internal policy that says it's against our policy to do caps. If you want to do one it's an exception to that policy and it requires approval from X, fill in the blank, go for it." "Don't you want to be able to do the math when that comes up? Don't you want us to be able to show you if you put a cap on here's the impact on the profitability of the deal?" They're like, "Nope, if it's on there they'll want to do it, just turn it off."
They're using the tool to try to police something that is really about what are the expectations internally, how do you hold people accountable to those and create a clean and easy process. If you need to get a cap to win a big deal to your best customer, again, would the CEO of that bank actually say no to a cap to one of their best customers? Well guess what, they have some on the books so they do actually do them. We want to be able to measure that and show them the impact when it does come up. Similar thing of rate locks. You want to price a fixed rate loan and you want to lock in that rate for X number of days.
Some banks say, "We don't do those, we do not lock interest rates." Again, you're trying to win a 20 million dollar deal and you have to commit to it for 30 days. You going to do that if it's a very profitable deal? Probably so, so again, why are you making it impossible for somebody to actually make that happen? We want to build in kind of maximum flexibility in the tool, let people find a way to make the deal happen. Then you make the business decision of is it worth us doing that. Is it worth us doing an exception to our general practice and now we can at least see the impact. We lose the deal and we get none of this income or we do the deal slightly out of our comfort zone with a cap and we make a 25% ROE. Do the deal, do the exception.
It opens people's eyes to the possibilities, to the ways to make a deal happen. That's what you want your very best lenders for your very best customers to be able to do. If your lower producing lender keeps bringing in deals with caps because it's in the tool, stop that. Deal with that behavior instead of just turning it off for everyone.
Jim Young: Okay, all right. Final one here, ignoring the real world. That's a pretty loaded phrase here, what are we talking about there?
Dallas Wells: This is another one where if you're sitting in the headquarters of the bank and you work in the treasury group and you see the deal flow ... We hear this all the time. "Man, they just price these deals too skinny. There's just not enough spread, there's not enough profitability in them, they're chasing the market down and we need to not let them do that. This goes back a little bit to the vinegar versus honey, are you rewarding people for very good deals or are you punishing ones that are below your hurdle rates?" Similar concept in that you can't just say, "Well look, our hurdle rate ..." We don't actually like that terminology, there's other stuff we've written on that but bear with me on it. Our hurdle rate is 15% across the board. If the market rates in one of the markets you're competing in says that you just plain do not win deals unless it's at 10%, what's your solution to that?
Most of them say, "Look, just add another 120 basis points and problem solved, you meet the hurdle." We can quote that right all day long and we're not going to win any deals. In fact, if somebody does agree to that rate we should probably say, "You know what, never mind."
Jim Young: Exactly.
Dallas Wells: You cannot just price things so that they make sense for the bank, you have to include context. That context is things like, "What else does this customer have with us? Do we make a bad decision about this transaction right in front of us and it jeopardizes the whole relationship?" This is one of the things that RMs bring up all the time. You can't kill this deal or we lose the other five that we already have on the books, and they're right. The other piece of that is you can't just ignore what's going on in the rest of the marketplace. Other banks are pricing deals cheaper, why is that? Well, maybe they have a different strategy, maybe they're new to that market. Maybe they are completely full up on real estate loans and they have to book C&I, it's the only way they can grow. It makes sense for them to do it at a much lower ROE threshold than you're comfortable with.
Jim Young: Maybe they're just doing it wrong.
Dallas Wells: Maybe they're just doing it wrong, right? That's one of a bankers favorite phrases, it's one of the early ones I was taught is, "Look, you're only as smart as your dumbest competitor." There's a dumb one in every market and we don't want to be that competitor but we also can't ignore that one. That is a reality for our customers, for our borrowers, they are seeing those rates out in the marketplace. It doesn't mean you should always just race to the bottom and gas station's across the street putting the gas price up on the sign. That's not what it's about but you have to be realistic about saying, "If the market's at 10 and I'm asking for 15 I'm going to get very little volume. The volume I get is going to be self-selected to be a little riskier than maybe we're comfortable with."
Let's have a more strategic discussion about that and say, "Because of that extra context, what we know this other bank or these other banks, competitors, are doing in the marketplace, are we willing to accept less?" The important part of that is you have to be really granular and very specific about it. If they are chasing C&I loans because of concentration issues and real estate don't lower your rates across the board including on real estate. Do it for that particular market, that particular product. Which means you have to be paying attention to what your own portfolio segmentation looks like and what the profitability looks like for all those different things.
Do it where it makes sense and where it applies but you have to be open minded to that discussion. It amazes me how many banks just say, "Nope, our rate is 15 or our rate is 12, always has been, always will be." Well, you can see the volume move up and down as either that's too cheap ... There are some banks that saw that in 2009, credit dried up. There was a lot more return to be had if you were a bank that had capital and were willing to lend it. They just kept chucking it out at 10, 12, 15, whatever the number was when there was more to be had. Then vice versa, now it's a good credit cycle, everybody's trying to grow, things are very competitive. They're blaming the lending teams, the front of the bank and saying, "Why aren't you guys producing more?" They're saying, "Look, pricing's out of the market."
Yeah, RMs will always say that but you have data that'll tell you whether that's true or not. You have to be willing to adjust accordingly based on what's actually happening.
Jim Young: Yeah, and in this vein we have, if you want to go really in depth on this. Joel Rosenberg, a consultant, wrote a piece on our blog answering some of these similar questions. Why don't we just use that same rate across the board? Why do we have to adjust it for various products? That sort of thing.
Dallas Wells: Yeah. For you folks that are math inclined you'll like all of the stuff Joel writes. He Joeled the neck out of that one so go check it out, you'll like it.
Jim Young: All right, well that will do it for us today. Thanks for listening. If you'd like to learn more visit our resource page at explore.precisionlender.com. Again, the article is The Seven Deadly Sins of Pricing but we'll have links on this post to several of the other articles and chapters from our book, Earn It, that we referenced today. If you like what you've been hearing make sure to subscribe to the feed in iTunes, SoundCloud, Google Play or Stitcher. We love to get ratings and feedback on any of those platforms. Thanks for listening. Until next time, this has been Jim Young and Dallas Wells. You've been listening to the Purposeful Banker.