For good reasons most bankers esteem the importance of relationships. Unfortunately, many bankers casually transfer that esteem to “relationship pricing.”
We have come to realize that bankers must be more discerning in their decisions. In the wake of the financial crisis, we’ve seen banks purge credits and customers as the system itself purges bankers and banks. The surviving institutions must establish enhanced processes for sifting out the acceptable from the unacceptable when it comes to risk, profit and volume. To make more productive decisions what processes and tools do we need and how should bankers use them?
Profitability tools are common in the market today and financial institutions have been implementing this technology to evaluate relationships and their profitability. I completely support the use of such customer profitability analysis. The installation of a relationship profitability analysis system was one of my top priorities as a bank CEO.
However, I am concerned about well-intentioned bankers distorting the use of customer profitability into “relationship pricing.” Customer profitability estimates should help relationship managers better manage the accounts within the existing relationship. Yet, once they’re armed with the analysis, I’ve observed relationship managers pro-actively impacting the pricing of the next new account opportunity with a compromising/compensating strategy.
Consider that we have four situations occurring in our banks every day: One, profitable accounts that we book; two, potentially profitable accounts that we fail to book; three, potentially unprofitable accounts that we avoid; and four, unprofitable accounts that we book.
Effective pricing strategies and systems facilitate doing more of numbers one and three and less of two and four. The use of poorly conceived relationship pricing models often causes banks to diminish performance rather than enhance it because they tend to lead bankers to diminish the profitability of profitable accounts and fail to book potentially profitable accounts.
Questionable Pricing Discounts
Michael Devine, president of Dime Savings Bank, recently wrote an article on the strategy of adding armor to the damaged sections of WWII planes that completed their mission. Eventually, it was determined that the additional armor was detrimental to the agility of the planes and that it was more important to fortify the vulnerabilities that prevented other planes from completing their missions. Can you observe the parallels to pricing?
The general proposition of a relationship pricing model is based on giving pricing discounts for the next new account to high-volume or highly-profitable customers (Compromise) and conversely requiring pricing premiums for the next new account to low-volume or unprofitable customers (Compensate). But this should raise questions.
Under what conditions does modification of the pricing of the next account opportunity by considering the volume and profitability of the body of existing accounts actually add value to the financial institution? How does compromising the profitability of the next account to a previously high-volume or highly-profitable customer (who has already demonstrated a propensity to bank with you) enhance the bank’s performance? And, how does pricing above market on a loan or below market on a deposit to a previously low-volume or unprofitable customer in order to compensate for existing accounts add value to the bank as that customer can go to competitors offering market rates for their next potentially profitable account?
Instead of relationship pricing models, we need legitimate, financially beneficial pricing models and customer relationship profitability models. A worthwhile pricing model respects the impacts of proposed account pricing alternatives on the bank’s performance. It focuses on the options and alternatives for the next pricing decision. The primary focus for these pricing models should not be discipline as many lenders suspect, but rigor. It seems relationship managers feel compelled to note the need for flexibility when talking about pricing models. Wouldn’t a good pricing model that develops numerous pricing options that are equally beneficial to the bank naturally contribute to flexibility, rather than reduce it?
The rigorous pursuit of pricing alternatives that produce win-win results is the key. Having more options to offer gives the bank a competitive advantage. Having a system to generate these well-designed options that produce equally beneficial results for the financial institution should be a priority in banks today. The ability to produce valid pricing alternatives for customers that are equally attractive to the financial institution is essential in this highly competitive banking environment.
A quality relationship profitability model estimates the profitability of a customer’s total relationship on the basis of gross profit, net profit and economic profit. I find it to be ironic when bankers insist that their commercial loan customers have a thorough understanding of their enterprise profitability, while many community bankers themselves don’t apply that same standard for their own bank. We need enterprise and customer profitability analysis.
However, when a relationship manager skips past the pricing tool and instead makes pricing decisions on the basis of a quick read of the relationship profitability model results, potential problems arise. What can a banker discover from a conclusion that this customer is profitable and that one is not? How will that knowledge help the banker better price the next accounts of those two customers? Instead of diminishing the profitability of your “good” customers and losing out on future opportunities of your “yet-to-be-profitable” customers, spend your energies on redesigning the pricing of the next deals that you would otherwise book that are not profitable and those that you would otherwise not book that would have been profitable.
If you do implement customer profitability analysis, be intentional about avoiding the diminished results that arise from bankers over-reacting to the combination of data and fears regarding their designated most-profitable customers. Likewise, relationship managers should be encouraged to fight for market rate pricing that would create a new and profitable account with a customer who has been declared to be unprofitable by the customer relationship profitability model.
To quote Carl Ryden, chief technology officer of PrecisionLender: “You don’t really price relationships. You price opportunities (new business) to meet portfolio needs and profitability goals. But, you do so with competitive awareness and relationship awareness.” In other words: build relationships and price opportunities.
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