Pricing with Precision

By Rick Spitler, Sherief Meleis and Phil Vaccaro

To maximize the revenue potential of their deposit operations, banks need to take a more scientific approach to pricing.

Crisis? What crisis?

Many bankers likely have that attitude about their deposit situation. After all, the stock market swoon that began in 2000 sent a flood of money sloshing back into bank accounts, helping to lower institutional funding costs.

Yet, statistics clearly show a decades-long stagnation in savings and checking account balance growth for commercial banks as non-bank money market and mutual funds siphoned those funds away. And the debilitating trend surely will re-assert itself when confidence in equity markets is restored. Deposit growth rates will continue to limp, and non-bank competitors, such as Merrill Lynch & Co. and E*Trade Group Inc., will keep grabbing market share by offering consumers better combinations of rate and access.

Moreover, banks are not doing as well in the current low interest-rate environment as it might appear. While overall deposit volumes may well be robust, profitability is decaying as balances continue shifting from checking and savings accounts to lower-margin products, such as money market accounts and certificates of deposit.

Now, more than ever, it is critical to price deposits intelligently. The traditional method of "supply-side" pricing, whereby rates are set according to what competitors are paying and what the bank estimates it can afford, will no longer suffice.

Instead, it's time for more of a "demand-side" view that recognizes the underlying demand elasticity of deposits, or the degree to which customer demand varies according to the rate offered (or fee imposed, in the case of fee-based products). This demand elasticity must be analyzed and quantified in terms of products, geographies and prime customer segments.

Such an approach can help providers avoid needlessly raising rates to attract deposits (thereby lowering profitability) in situations where customers are price-inelastic, or unlikely to respond. Alternatively, these models can be used to fine-tune pricing for products and customer segments where a better rate really counts. They also permit better-informed tradeoffs — there are situations where it's a better use of resources to spend money to improve service or convenience than to raise deposit rates.

Deposit pricing will always remain something of an art form, of course, requiring judgment and experience. But building a more scientific foundation for this exercise will at least frame the issues in a manner that leads to better decisions.

Segmented Appeal

The traditional bank method for deposit pricing can be described as a "supply-side" approach, whereby rates reflect what competitors are paying and what a bank can afford, given its earnings targets. Prices, at least for rate-based products, are reviewed weekly and adjusted based on changes in market or competitor rates.

The inadequacy of this approach is becoming more apparent in the current environment of the lowest interest rates in a generation. Banks simply don't have much room to maneuver. Transfer pricing credits — the revenue received for deposits — are currently so low for money market balances that they impose a concomitant low "ceiling" on pricing overall. However, the presence of non-bank players in the market is forcing banks to compete for funds by raising rates to the break-even point, leaving only a thin sliver of profitability. Margins on both money market accounts and certificates of deposit have been in steady decline since the Federal Reserve began lowering interest rates last year.

Even more importantly, supply-side pricing ignores both the needs of customers and the underlying demand elasticity of deposits. As a result, specialized competitors with targeted strategies, such as Merrill Lynch, E*Trade and ING Direct, part of Netherlands-based ING Group, have been able to cherry-pick some of the more desirable customer segments by offering combinations of rate and convenience that banks can't match. The competitors can afford this approach because they don't have to worry about cannibalizing existing accounts, as the large banks do.

Retail banking's dilemma thus resembles that facing the credit card and airline industries before they learned to segment their customers and price accordingly. Essentially, banks are trying to sell a commodity product that is under assault from all sides. Escaping from that trap requires, at the very least, careful analysis and modeling of deposit elasticities. Ideally, it involves targeting offers to discrete customer segments and even individuals.

Credit card companies, for example, now have the capacity to negotiate rates for individual customers over the phone. Segmented pricing in banking, by contrast, seems to be mostly confined to balance tiers and certain demographics, such as student or senior accounts. Few banks thoroughly understand customer elasticity in deposit pricing and many don't study the subject at all.

Deposit Flows

It's important to understand the major drivers of deposit growth. The first involves exogenous factors, such as the economy and stock market, which govern the ebb and flow of deposits into the banking system. The economic and interest-rate environment is an ever-changing tide that carries bank deposits either higher or lower. Individual banks can do little to influence macro-scale demand.

But it helps to understand the counter-intuitive nature of these flows. When the economy is expanding and interest rates are high, the banking system struggles to grow deposits, except for rate-driven CDs. In such times, the opportunity cost of keeping money in a checking or savings account is high, so customers gravitate to higher rate CDs, as well as to the stock market. During down cycles, by contrast, customers prefer to be short and liquid (and safe), which is why the system is now flush with checking, savings and money market accounts. For example, bank money market balances surged over 20% last year.

When formulating deposit pricing strategies, institutions ideally should model the growth of each deposit category given likely macroeconomic and interest rate environments. Such forecasts can help substantiate aggressive or conservative pricing approaches, given the anticipated deposit flows.

These trends, which can be delineated with reasonable accuracy, should then be incorporated into the annual planning and budgeting process, giving the bank a better idea of how well it's doing within the macroeconomic context. For example, a bank that "exceeds plan" with an 8% growth in money market accounts may actually be losing market share, given the overall deposit flows into the industry.

The second factor affecting deposit flows has to do with a bank's own promotions and pricing. A bank influences how much of the overall flow it captures during the current year by the prices it sets. Since the relevant measure is the "share" of deposits a bank attracts, pricing should be measured as a percentage of the average market price.

A key issue in pricing strategy is the time it takes for the target customer base to respond to new prices with new balances. In general, six months is the best time horizon over which to measure the impact of a pricing change. Promotional efforts can shorten that span, but generally it takes longer for prices to take effect than most bankers believe. For that reason, monthly pricing changes can confuse the market. Adjustments need to be made according to what competitors are doing, but one's price position relative to the market should become a strategic decision and moved only slowly over time to avoid an over-response.

Area of Indifference

Greater precision in pricing is also needed. Historically, banks made competitive pricing decisions based on an intuitive assessment of the potential impact of pricing below or above competitors. Best-practice banks are now increasingly analyzing customer price elasticities by product, to quantify very specifically the potential volume and revenue impact associated with a price position.

Such an analysis reveals an "area of indifference" around the average market price for each product. Within this zone, consumers are apparently indifferent to small pricing changes. Outside the zone, demand rises dramatically in response to rate increases, and then flattens out again. Above a certain point, higher rates do not have a commensurate impact on balances.

Understanding these price elasticities allows a bank to identify areas of mispricing. For example, a bank that is priced within the area of indifference is giving up spread without gaining balances in return. Depending on strategy, a more optimal price position could be outside the zone, with rates that are either slightly below-market or substantially above-market.

Fee-based products, such as non-interest checking accounts, display a slightly different dynamic because of customer shopping behavior. For example, fee increases have differing impacts on established and new customers. The primary frame of reference for the former is not fees advertised by competitors, but rather the previous fees they were charged. New customers, by contrast, comparison-shop.

Banks therefore need to model customer elasticity around fee increases and incorporate the effect of customer attrition. Separate elasticity curves can be constructed for new customers, reflecting their focus on competitors, with the two views combined to develop an overall view of the impact of fee changes on balance growth.

Once these overall price elasticities are understood, an institution can begin to focus on elasticities as they pertain to specific customer segments. Much in the same way that airlines price business travelers differently from the leisure segment, banks need to understand how price elasticity varies by balance (high vs. low) and relationship (single product vs. multiple products), and other potential attitudinal/behavioral segments.

A final factor influencing deposit flows is the long-term value proposition of the institution as reflected in its service levels, product array, network density and brand positioning. When it comes to establishing or affirming a long-term relationship with a financial institution, customers are not guided by price alone.

Smaller banks typically have to "pay up" in pricing to compensate for comparative weaknesses in distribution networks and brand strength. We estimate that this pricing premium ranges from 10% to 15% of the average market price, depending on the product, which small banks must pay to grow at the average market rate.

In order to develop an integrated deposit-pricing strategy, each bank must decide how it wants to balance these various non-price features against its price position to come up with an overall value proposition. Often, factors such as branch manager quality, branch staffing levels and branch density can be as important as relative pricing in driving deposit growth.

Banks intuitively determine such trade-offs now, but more analytical precision is needed in an environment where net interest spreads continue to narrow. Banks that attain such precision should be able to generate balance and revenue growth even in a level-balance environment.

Long-term Value

An effective deposit-pricing strategy based on a demand-side approach involves several discrete steps. The first is to diagnose consumer demand across different price points for each deposit product, normalized for macroeconomic effects. This can be done through historical data analysis — observing how balances in each product category respond to pricing changes relative to the average market price.

Once these demand elasticities are understood, banks need to develop an overall pricing strategy, including revenue/balance objectives and a targeted price position vis-à-vis competitors. Within the framework provided by this strategy, the pricing committee can then periodically review and set prices based on competitor actions. These decisions should incorporate an elasticity analysis applied to various pricing scenarios in order to anticipate the resulting changes in balances and deposit volume.

While product-level understanding of customer elasticity is useful, the real value comes with segment-based pricing. Finding pockets of inelasticity across key customer segments, and pricing those pockets accordingly, will unlock revenue for banks at the expense of competitors.

Initially, these pockets can comprise simple demographic and behavioral segments, which might then lead to special offers to seniors or high-balance customers, for example. The ultimate goal is to reach the "segment of one," where special offers can be made to individual customers. While some banks are already moving to upgrade their technology to allow for precision pricing at the individual customer level, much remains to be done to achieve this goal.

Many banks have found they lack the data to understand segment-specific elasticities. In such cases, the solution is to generate new data through structured testing. The key is to understand the "gray areas" in the elasticity analysis, the places where new information is needed, and then to structure a test matrix that allows the bank to compare the effect of different price points against different segments. This approach is similar to that pioneered in the credit card industry, although banks will have fewer test cells and a different strategy for marketing their products. Unlike credit cards, which are mostly sold through direct-mail offers, deposit products are mass-marketed through many channels, including branches.

The last step is to analyze pricing strategy within the context of the institution's overall value proposition. The task here, essentially, is to manage the tradeoff in dollars spent in price promotion versus resources devoted to service, branch density and advertising. Whereas establishing a new price point relative to the average market price drives both near-term balance growth and the longer-term growth trajectory, the basic value proposition a bank offers in relationship to its relative market price establishes its long-term growth potential.

Once this stage is completed, an institution should be able to maximize the revenue potential from gathering deposits. Given the shrinking margins and long-term negative trends in that business, such a capability will likely become a competitive necessity in the years ahead.

Mr. Spitler and Mr. Meleis are partners and Mr. Vaccaro a principal with Novantas, a management-consulting firm based in New York City.

Copyright © 2003 by Banking Strategies, published by BAI.

back to top