When Pricing, Context is King

November 14, 2016 George Neal

 

During our daily work with banks, we see a lot of different variations of the term “Relationship Pricing.” Product bundling, share of wallet cross-selling, and even customer segmentation have, at various times, been put under the banner of “Relationship Pricing.”

In reality though, the term is a bit of a misnomer. There actually is no “relationship pricing,” for the simple reason that you never price or sell a relationship. Rather, you price a full opportunity (we wrote about this more fully here). You price the existing opportunities in the context of existing relationships, and when done successfully, those relationships provide the insights necessary to structure a great deal for the customer and the bank.

The Shifting Sands of Context

The key word here is “context.” It’s dynamic. The strategic value of products changes over time as the needs of the bank change. The bank’s concentrations of risk, costs of funds, and overall market position also shift, affecting the contribution of various products.

Consider the importance of a CRE relationship when the bank is underrepresented in that sector versus when the bank is brushing up against CRE concentration limits. Similarly, the value of deposits changes with the funding needs of the bank.

Additionally, many loan products suffer from natural profitability decay, with amortizing fixed rate loans being the most obvious case. Over time, fixed costs continue while interest income declines, and given the expectations for rate, net interest margin also declines.

Of course, the most significant changes in context come from the customers themselves. Changes in credit worthiness, collateral values, deposit balances, etc. all work to alter the value of that existing relationship.

In a sample of 2000 relationships across more than 50 banks, we found that more than 62% showed significant negative ROE migration over a 5-year period. Given this, the context against which a new transaction is priced for an existing customer is more time sensitive and far more volatile than many banks realize.

The Risks of Anchoring

Top-notch relationship managers are aware that relationships evolve. Their task is to manage the bank/customer relationship to maintain value for both parties. However, even the best RMs struggle to stay current with every relationship as their books develop. As information gets stale, or becomes difficult to obtain, RMs rely on memory and experience to guide their actions. Unfortunately, this has some well documented risks.

We all have a tendency to anchor our perceptions at a given point in time. Absent clear information to the contrary, we view once-great teams as great and hold long-aged mental images of friends and family. In some extreme cases, people are so anchored to their perceived self-image that they fail to recognize themselves in the mirror after receiving a makeover or cosmetic surgery.

The same concept holds true for commercial lending relationships. Absent a current context, an RM will have no choice but to rely on an outdated view of the customer relationship. They’re hardly alone in this. A study in 2006 showed that even experienced professionals are subject to anchoring in their field of expertise¹.  Imperfect memories will impact the perception of a customer relationship absent clear and timely contextual information.

Pricing, Not Guessing

Given all of this, how should banks address the idea of “relationship pricing” or “full opportunity pricing?”

They must make sure the context needed to make pricing decisions is up to date and available to the RM. They need to make sure that that the strategic goals of the bank are clear, the current state of the relationship is easy to see, and the customer information’s is current.

Banks must view the “relationship” as evolving, dynamic, and unique, and empower their RMs with all the information needed to clearly evaluate it. Otherwise, they’re not asking their RMs to price; they’re asking them to guess.

1. Englich, B.; Mussweiler, Thomas; Strack, Fritz (2006). “Playing Dice With Criminal Sentences: The Influence of Irrelevant Anchors on Experts’ Judicial Decision Making”. Personality and Social Psychology Bulletin. 32 (2): 188–200. doi:10.1177/0146167205282152.

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