We all fall victim to the sunk-cost fallacy from time to time, “This movie is terrible, but I’ve already spent an hour watching so I might as well watch the next hour.”
Actually, you should just stop the movie and spend the next hour on something you really want to do!
Dallas and Jess talk about how the same concept can apply to bankers around pricing decisions.
Welcome to another episode of The Purposeful Banker, the podcast brought to you by PrecisionLender, where we discuss the big topics on the minds of today’s best bankers. I’m Dallas Wells, and with me is our co-host, Jessica Stone.
Hi and thanks for joining us. Today we’re going to talk about how to make decisions by focusing on today and the now and what’s ahead, and not getting hung up on investments that are over and done with. This topic was inspired by Dallas’ recent blog post, Why We Use Marginal Profitability for Pricing Decisions.
I’m sure many people can relate to this feeling: You’re sitting down with co-workers on how to approach some aspect of your business. Something that may have been a core competency for years, you’ve been doing this a lot, but you know that it really needs a shakeup, so you start thinking about the options and the potential and the possibilities and then you get that pang. You think of all the time and money and resources that you have put into doing things this way and you just can’t seem to bring yourself to waste all of that by changing it up now.
This concept tracks back to the sunk cost fallacy. In economics, a sunk cost is any past cost that’s already been paid, can’t be recovered, over and done with. Some other examples that might sound familiar in your everyday life, “I’ve been watching this crappy movie, but I’m already an hour in so I’m just going to power through”, or “I already paid for that kick-boxing class. It’s way too easy, it’s not a workout, but you know what? I paid for it, I’m gonna go”, or “I really don’t need to eat the rest of this sandwich but I paid for it so I’m going to eat this.”
I think that’s one of those common things and really the reason for my blog post. It’s like a pet peeve of mine in my personal life. I have this conversation with my kids all the time. They know where I’m coming from when I say “sunk cost” because it’s just this thing we come back to over and over and over again. The idea of the fact that you’ve put time and money and attention and effort into something isn’t necessarily relevant for where you stand now. Where the blog post came from is we don’t have to, just like with those examples you gave, we don’t have to say no to that loan just because it’s not covering the fully loaded overhead to the extent that we think it should. That was the real core example. It’s the one we talk about all the time.
It was the central part of that blog post put it’s really a bigger issue than that. It’s kind of the inspiration poster way of saying this with the artsy photography and the scenic backgrounds, is “You can’t drive forward by looking it the rear view mirror.” That quote really drove the blog post. That’s because, in the case of pricing, there’s some real merit to that. We see banks stumble over this issue over and over and over again.
Dallas, why must pricing decisions be made looking into the future compared to that rear view mirror approach you talked about? Why is it maybe hard for people to accept that?
At its core, what we’re doing here at PrecisionLender is we’re trying to price something that’s going to happen into the future. We’re not saying you should ignore the past. There’s some value in that and there are things we can learn from it and we’ll use that as the basis to shape a lot of what we know about the future, but we’re trying to price that thing for the best optimal outcome going forward.
We have to guess at not just what this one little instrument’s going to do, but also what the markets around us are going to do and how the humans and businesses that are involved in this deal, how they’re actually going to behave. Those last 2 parts are the really tricky ones. You get the point where there’s a whole bunch of variables, and bankers have this tendency to really want to zero in on accuracy, and we’ve talked about this before, it’s inherent with the business where there’s not a lot of room for error. To make up for that, we want to be really, really sure before we make decisions.
One of the ways that we can be really, really sure is we can make sure that things balance. We get a lot of comfort with that old school T account that we learned in accounting. If the debits and credits balance, there’s some comfort to that. The world makes sense now. Bankers want to come back to that when their pricing a loan. “If I can tie out the forward looking pricing of this and it matches what my income statement says, then I know it’s right. I know I haven’t missed anything and it’s realistic and everybody will be able to buy in and say, “Yes, that’s the right number.”
Now you’re talking about using backward looking accounting and backward looking financial statements to make a decision about something that’s going to happen in the future. All that future uncertainty is really unsettling and that’s why it’s hard, but that’s also what we have to try to account for when we’re pricing. Not what’s already happened behind us, but what’s the best way to price this thing so we get the optimal outcome going forward.
Dallas, when bankers get caught up in that uncertainty, what typically happens next?
The reason for the uncertainty is just that there’s a ton of variables, so as you’re pricing a loan, even a fairly simple commercial loan, you have to deal with what are our funding costs, what’s our interest rate risk, what’s the credit risk, how likely is this loan to go bad? How much do we lose if it does go bad, how does that translate to loan loss provisions and capital allocations and you can get really far into the weeds with this stuff.
A lot of it, especially when you start talking about allocating capital to a specific loan, it’s gets a little overwhelming and a little theatrical for some bankers so they want to come back to the thing that we know. The thing we know is, we should know overhead costs. We should know how much it costs us to book a loan. Bankers, just by nature of the environment over the last 7, 8 years, they’ve had to learn their cost and get to know those pretty cold. They’ve been asked to cut any extra stuff out of overhead costs so they’ve been over those time and time again.
It’s also a really easy concept. It’s really highly visible. The lenders, that’s the one that they’ll most often come back to and complain about. They’ll say, “Hey, you put in 12 thousand dollars for origination costs on this loan. There’s no way we spent 12 grand getting it on the books.” It’s the one that ends up being debated and most disputed, so the lenders are saying, “There’s no way we’re spending that much,” and the finance team’s saying, “Well, actually we’re not including all the stuff we should be,” and there’s this debate over a number that … Bankers don’t like it when we say this, but we say, “You know what guys? It doesn’t matter. It’s really not an important part of the decision process here.”
To solve that argument, usually what they do is come back to those T accounts and they say, “Okay, let’s go back to what did we spend last year on just total expenses and let’s divide that up by department, and here’s the loan overhead. Just put that allocation against the loan.” Everything balances, you can’t argue that there’s more or less there because it just is what it is.
It’s nice, clean balancing and takes some of the debate out of it. The problem is now we’ve spent all this time and all this effort, probably money and maybe more importantly, with these internal battles, is some political capital. We spent all that time measuring the wrong thing.
What is that “wrong thing?” What should we be measuring instead?
We’re talking about pricing. Now you’re trying to price this next deal based on what we spend as a bank last year, what we spent as a department last year. Pricing is really about optimizing the return on the capital and on the funding that we currently have available to lend, so the dollars sitting in front of us, how can we maximize the return on those? If we focus on matching total overhead for the bank or the loan department or whatever that backward looking number is. What we’re doing is we’re just tripping head first into the sunk cost fallacy, that basic concept of, “Hey I already paid for this movie so now I have to watch it,” when in reality, maybe the best outcome is that you don’t waste the time on it because your friend told you it was terrible.
The money’s already spent, that ship has sailed. What we need to do is say what’s the now optimal use of the next 2 hours of my life? Is it to watch a movie that I know is terrible? Or do I just take it back to Redbox and move on?
For banks, it’s the same thing. If we take that overhead, the money we’ve already spent on the buildings and on insurance coverage and on executive salaries or on marketing, those should have no impact on that decision in front of us, because at the point of pricing that deal, those dollars are already long gone. It’s not to say that those things aren’t important and that we shouldn’t spend time analyzing and figuring out are we spending the money in the right places, we should, but that’s a separate decision. At this point that money is spent, it’s gone. So the last thing we want to do is to have a loan in front of us and say, “I’m sorry, but it just isn’t profitable enough to cover that insurance policy that we just paid for.” That doesn’t make any sense, right? The insurance policy is paid for. That money has already been gone.
What we need to do instead is say, Well, how do we take the capital we have available, make the most possible money from it, and then put that incremental profit back against that overhead burden that we’re carrying?
We should be doing more marginally profitable loans instead of fewer to try to cover that big weight that we’re carrying around. It’s about looking at where you stand today and making the best decision you can, so even if it feels like, if we make this loan, net interest margins, the percentage net interest margin is going to go down a little bit.
Okay, that’s an important number to measure, it’s one we want to pay attention to, but are we adding dollars of net income to the bottom line, because that’s what shareholders want. They don’t feed themselves on percentages, they feed themselves on dollars, so we have to come back to how can we optimize returns looking forward and not worrying about the overhead, which is a separate discussion. We need to help cover those.
The effort that needs to happen is instead of worrying about balancing to historical numbers, we’ve got to spend that effort instead getting everybody on board with what we’re really trying to measure. The lenders, the finance team, everybody in between. What are we trying to do here?
Everybody’s on board with, “We want to win loans.” Even the guys like me, the stodgy old finance types, we like the idea of loan volume hitting the books because it’s really profitable. We’re not opposed to that. What we’re trying to do is let’s figure out the best way to actually make that happen. If we book that loan, how much extra return will we generate if we book it at this proposed price? That number is not going to match, I’m using my air quotes there on a podcast, but it’s not going to match the bank’s ROE.
That’s one of the big things we get is we’ll calculate the profitability of loan and we’ll say, “Hey, it has an ROE of 19 and a half,” and they’ll say, “Well that’s not possible.” Why not, “Because the bank’s ROE’s only 8, so your number’s wrong.” No, it’s not wrong, it’s just that we’re measuring a different thing.
What we’re trying to measure is, what’s the incremental return on the capital we’re deploying? So how much capital are we using for this loan, how much money does it cost us to get us on the books, and how much dollars of net income does it drop to the bottom? That’s calculating an ROE, it’s just a different ROE than what we’re calculating as a bank.
If we get all those new dollars going out at 19 and a half on a marginal basis, we’ll start to lift that 8 percent bank ROE and that’s what we’re after. We want to figure out how can we lift that number over time? That’s kind of our bogie, is to get above that and to try to lift it if that’s the bank’s goal, but they don’t have to match. That’s the last thing we want to do is try to make them tie up.
That process takes some education, but once it’s in place then he focus can be on the road ahead and making those pricing decisions that make sure we’re making incremental progress toward the big picture goals and we can move on from the accounting and the argument over overhead, which is just not the most important input into that loan.
Okay. Measuring the wrong thing, that seems to be a theme in banks sometimes. Any other examples that come to mind along that?
It’s not just a sunk cost thing. It can also be, and you hear this all the time in the investment world, but focusing on the results rather than the process.
The most classic one, and I’ve been down this road many, many times, of buying bonds for the bond portfolio at the bank. You buy a bond, and maybe the purpose of buying that bond is, “Hey, we’re trying to balance some interest rate risk here so we need some stuff that comes due in 3 years and we want it to have positive convexity and we want it to have this kind of coupon.” There are all kinds of decision processes that go into buying a bond.
So you buy that thing and then next month, rates at that point in the curve move a little bit and you have a slight loss in that bond. You come back and somebody on the management team or the board or whoever, or even the portfolio manager themselves, says, “Gosh, that was a dumb decision. I bought the wrong thing.” Not necessarily, right? The results are going to fluctuate over time and the purpose for buying the bond, balance the interest rate risk, positive convexity, coupon of X, it fit all of those things and it put the cash to use in a place where it was already earning more than if you just left it in fed funds earning basically nothing. So it earned incremental income and if it fluctuates over time, who cares? We’re measuring the outcome rather than the process of picking an investment that fit the right bucket, the right asset class that we needed. The process was right, the decision was sound, what happens in the meantime’s kind of irrelevant.
Another one that happened quite a bit is I did some advising to banks on hedging, using interest rate swaps and derivatives, to hedge interest rate risk. We go through this whole process where we figure out where their exposure is and we say, “Hey, if rates go up you guys are in big trouble. If rates go down you’re golden. No worries. The way your balance sheet’s set up you’re in good shape.
If rates go up very quickly you’re in a world of hurt, so let’s hedge that. Let’s put this interest rate swap in place and that way, if rates do go up it’ll help offset some of the pain. It doesn’t solve your problem but it makes it a little less painful.” They say, “Okay, great, that makes sense. Let me put it in place.”
Then next month rates go down. That’s a good outcome for the bank and all is well with every other piece of their balance sheet, but that hedge that we put in place as an insurance policy looks just Godawful. It’s got a big loss in it too. Then they pick up the phone and they call Dallas and they say, “Hey, what the heck are you doing with this interest rate swap? That was really dumb, we shouldn’t have done that.” That’s sort of like saying, “Hey, you bought a life insurance policy and then you didn’t die yesterday. That was a really dumb thing to do.” It’s the same thing. It’s an insurance policy, the process was sound, and we end up measuring the results all the time.
You’re going to run into the same thing pricing loans. You’re going to price some loans that depending what happens with rates or we price a loan to a borrower that 98.9 percent of the time they’re going to perform well and it’s going to be a great loan. That other small little fraction on the tail, a loan exactly like that will go bad. At some point you’re going to do that one that goes bad and you’re going to go like, “Golly, that was a really dumb decision.” Well maybe not. If you do enough of those, some of them are just going to go bad. Make sure the process is sound and don’t get too wrapped up in the results and kind of taking those really small outlier things and extrapolating deeper meaning to them other than just, that was the one that was going to go bad, or rates move that way and things look the way they do.
The sunk cost and the process versus results, I think those are 2 things that, that’s just human nature and so it’s not picking on bankers, that’s human beings in general. We all struggle with it. Just being conscious of it I think is helpful.
Earlier you said that this kind of process, this frame of mind, takes a little bit of education. If you were to give some tips or suggestions for listeners who kind of want to get others on board at their institution in this kind of way of thinking, what would you say to them?
I think it is general awareness of, and we talk about these things quite a bit and sometimes people look at us a little sideways when we are pricing and profitability company and so what we do is a sort of nerdy, technical math stuff with software no less, and then what we end up talking to them is like, “Hey, don’t kind of fall prey to their lizard brain.” There ends up being some psychology there of your brain’s tricking you into making some bad decisions so be aware of that.
I think any studying that you can do on human decision making and better understanding about where our natural tendencies are leading us astray is going to be helpful. These are a couple of big ones. We’ve talked about some other ones like anchoring to a price point and some of those things that we can use to our benefit as we’re talking to customers. This is one of those where we just need to be aware of the fact that it’s really tempting to feel that emotional and sometimes real dollar cost and feel like that has to now be a part of that future decision when in reality, that was a prior decision. Whatever the outcome was there, we now need to look at what’s the best decision going forward. I rented the movie but now what’s the best use of my time? Is it to watch it or not really?
We spent the money, as a bank, on the overhead stuff. Is it really the best decision to say no to loans because it doesn’t feel like it’s enough, or do we just keep sitting here with this cash in hand, waiting for the deal that covers it all and then some? It never comes and we just end up … That overhead just bleeds us dry even faster. Awareness I think is the big thing of not just the banking part of it, not just the math, but all those other things that go into a decision-making process. That stuff we call price getting, this falls squarely into that, of don’t let your own biases trip you up. Just try to be aware of them. Write those things down as part of your decision process. When you’re talking about measuring profitability of a loan, be on the same page. Write down what are we really measuring here. That 19 percent ROE, what is that? We’ve had some banks say, “Can we change ROE so that everybody doesn’t get tripped up on this?”
It’s important the words you use and how you talk about it so that everybody’s expectations are that’s marginal profitability. That’s how much we’re adding to, that’s how much we’re trying to lift bank ROE by, by doing that loan. Same thing about making decisions with investments or hedging or whatever it may be, make sure everybody’s clear on the purpose. What are we doing with this? Here’s the possible range of outcomes and just because we see this one outcome come out of it, doesn’t mean we made the wrong decision, it just means it was one of the possibilities. Now, again, we go forward knowing what we know and we make the best decision from here.
Okay. Thanks, Dallas. I think that will do it for us for this episode so thanks everyone for listening. We will provide a few resources and links in our show notes for this episode and you can always find those at precisionlender.com/podcast. If you like what you’ve been hearing, please subscribe to our feed in iTunes, Soundcloud, or Stitcher, and we love to get feedback and ratings. Thanks for tuning in. Until next time, this has been Jessica Stone and Dallas Wells and you’ve been listening to The Purposeful Banker.
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