Most bankers do not have a pricing strategy. They price with the competition, become reactive and thus eliminate their bank’s strategic value. Every bank faces a different cost structure, different set of objectives, different risk profile and has different capabilities. Meeting each competitor’s price ensures that you will have the lowest margins in your area over time. You may succeed when times are good, but you won’t when the next shock happens and the cost of credit and capital become monetized. When it comes to a pricing strategy, if you stand for nothing, you will fall for everything.
The Cost of Capital Proof And The Destruction Of Value
If you doubt our above thesis, consider that the correlation of banks that do not have an articulated pricing strategy and banks that make below their cost of capital is more than 90%.
The irony here is that many of these are the same banks that want to grow. This is why they want to match the competition when it comes to pricing. They add overpriced deposits and underpriced loans. What these banks don’t realize is that with every mispriced loan and deposit they add the probability of failure increases. Their growth sows the seeds of their destruction. Once they get past the tipping point, their capital is leveraged and their fate rests in the hands of the market.
The Best Strategy For A Bank Without A Pricing Strategy
The best hope for a bank without a pricing strategy is to sell to a larger bank that also doesn’t have a pricing strategy. Banks that tend to misprice their own assets also tend to misprice other bank’s assets.
Of course, relying on the bigger fool theory is not sustainable. Pretty soon, this industry will be short foolish acquisitive banks. The good news is that foolish banks are getting harder and harder to find.
The bad news is that there are still plenty of foolish banks.
The further irony here is that banks without a pricing strategy do not always misprice a target bank’s assets. Banks involved in the M&A game often will apply rigor to another bank’s portfolio while mispricing their own. They criticize the target bank and see the monetization of taking on too much interest rate risk or too much credit risk, but fail to make the connection to their own portfolio.
These banks may acquire correctly, but risk ultimately succumbing to the mispricing of risk.
What A Pricing Strategy Looks Like
Search “Pricing Strategy” on our blog and you will find half dozen articles that cover a variety of pricing tactics. In short, it comes down to intention. Price thin to win high-quality credits or price thick to adequately price risk, either way, you now have a plan.
Your pricing strategy might be wrong, but at least you have a shot at being right. Being able to understand interest rate, credit and liquidity risk while taking into account your cost of resources allows your management team to now have a discussion about how to strategically architect your bank to succeed against the competition in any given market.
Maybe it is about driving your cost of operation down. Maybe it is going after niche markets. Or, maybe it is about building the brand and abstracting premium pricing. No matter what the case, banks that have a clear and articulated intention stand a chance to succeed.
An Expert-Level Approach
Know what loans and deposits to turn away is even more important than what assets or liabilities to book. Make a bad pricing decision and you will likely have to live with this decision for a long period of time. Worse yet, you will train your staff to continue and amplify bad pricing decisions.
Stay tuned as next couple blog post we will show you a dual-pronged pricing strategy that will serve to dissect your competition and get your bank both the credit and the spread you want. They don’t teach this strategy when you get your MBA or your CFA and they don’t teach this strategy in banking schools but when you learn it, it will become clear how this counter-intuitive strategy will add value.
Until then, consider that a pricing strategy doesn’t guarantee success but it is an indication that a bank understands its core business. Being 8 to 10 times leverage, every pricing decision has far-reaching implications. If there is one process you need to get right, it is pricing.
Submitted by Chris Nichols on May 05, 2016