Loan pricing is both an art and a science. While there are three primary ways to price bank products, one methodology is consistently used by top performing banks. Since we talk and see the pricing at hundreds of banks each month about loan pricing and we monitor credit risk, cost and non-bank competition in every state, we have a unique vantage point to see what works and what doesn’t when it comes to banking profitable commercial customers. In this article, we look at the three primary ways and highlight the best, and worst, practices to drive relationship value.
The Three Ways of Loan Pricing
The three ways to price loans are as follows:
- Price to competition. Banks determine where competitors are charging for similar loans in the marketplace and price accordingly.
- Cost-plus pricing. Here, banks calculate their risk, cost of capital, funding costs, all direct and indirect costs and add a margin to determine the price.
- Perceived value to the customer. While more subjective, the bank determines the maximum a borrower will pay for the perceived value of the banker’s expertise and problem that the bank is solving.
Most banks can survive by pricing loans to competition or on a cost-plus basis. However, banks that price their loans that way are unlikely to become top performing banks.
First, let’s consider some basic characteristics about desirable community bank borrowers. Desirable community bank borrowers are smart, and the internet, allows them to compare banking products and pricing. Through an easy search, potential borrowers can get access to a variety of indices and pricing data. Second, most of these customers have multiple banks vying for their business. This is to say that while some banks find a steady stream of borrowers asking for a loan, top performing banks know that the best way to get highly profitable customers is to go out and proactively get them.
Third, these borrowers are likely discerning and not only want to like and trust their banker but want a bank that can deliver value in some fashion. This might be the speed of execution, loan terms or insight. They don’t care about products per se, but what problems our banking products solve.
How Not to Price
Pricing to competition is the worst pricing choice for banks. Pricing to competition, in most industries, is the abdication of management’s duties. It is effectively the transfer of pricing power to a competitor or to the customer. While bankers should be motivated to understand pricing in their market, the information is properly used to make buy or sell decisions (make a loan or buy a security), not to match or follow the competition. The above is true in most industries, but in banking, pricing to competition is, even more, a dereliction because the decision is not just about revenue, but also the extension of credit. Credit that puts capital and jobs at risk for a period of time. We see banks that price to competition make pricing mistakes in good economic cycles and squander capital in down cycles.
When competing on a cost-plus basis, banks attempt to differentiate their products and can usually generate industry average returns on capital. This pricing method pressures banks to strategically seek the most efficient way to originate a loan in order to be one of the lowest cost providers in the market. Banks that can execute on organizing their bank and creating efficient workflow end up driving the most value. This is to say that value creation is derived from the process instead of the customer. While this is a proven way to produce above-average returns, most banks that pursue this path lack the ability to innovate fast enough to provide value to the market.
Over the long-term, and in competitive markets, pricing loans on a cost-plus basis is often a poor strategy because of this process execution risk. Most banks are not able, or not willing, to invest in automation, digitize the loan process, centralize credit processing and choose specific markets to leverage efficiencies.
Not pricing loans to cost does not mean that banks should not calculate their net interest margin, credit spread, or return, but over many cycles, these banks will only earn industry average returns because the emphasis is on price and not value.
Why Price on Value
Successful banks understand the difference between price and value. The price of a product or service is the monetary equivalent that the customer pays for that product or service (spread, fee, or payment-in-kind). However, value is the benefit that the borrower perceives from the product or service. Banks that price to competition are often matching the lowest cost provider as a strategy. Banks that price on cost-plus basis do not position to differentiate on anything other than price. But banks that price to value are highlighting why their product bundle is a higher benefit to the borrower then the competitor’s offering.
We have seen various banks successfully price loans based on different value propositions. There is not one value that works and good banks find multiple value propositions for their target customers - exceptional banks will aggregate a number of value propositions. The reality is that most banking products are commodities because of how we, not the market, treat them. If you can differentiate bottled water, you can differentiate banking services. Banking services, not the loans is what needs to be distinct. Here are some of the major value propositions that we see successful banks offer when differentiating their value proposition:
- Bankers are selling knowledge of the borrower’s market and business model. The banker comes to work for the borrower as a trusted financial advisor on business matters and the loan is a side product that comes with the banker.
- The speed of execution is great value for borrowers. As banks mature and increase in size, processes become centralized, convoluted and complicated. Decisions take longer and execution slows down. Banks that can deliver funding faster add substantial value to certain customers. Decisioning can be a substantial value for certain customers. While funding can take days or weeks, being able to commit to borrowers (subject to underwriting due diligence and documentation) is of value to customers. Banks that can make a quick decision (within 24 to 48 hours after being provided the major parameters of the loan) add value for most borrowers.
- Ease of use can also separate a bank. Bankers that make it easy for the customer to apply receive a commitment and close a loan can differentiate themselves.
- Continuity of relationship is another value that we see appreciated by borrowers. Borrowers do not want to switch service providers if possible and want to establish trust with one banker who they can count on being their primary contact. Bankers that have a long and stable history with an institution add more value to a borrower, and this is especially true for relationship banking where the borrower expects to be with an institution for five or more years.
A banker that is well-liked and that has a large network is always good to have but it can only take a bank so far. For banks to create strategic long-term value, bankers need to add process, marketing, sales and expertise to set themselves apart when it comes to banking products. We differentiate our banks based on the people that provide service to the customer but our bankers must have the tools and training necessary to create value. There are a few ways to add value to our borrowers and pricing loans for the perceived value to the customer is the most effective way to become a top performing bank.
Submitted by Chris Nichols on April 18, 2018