Many small and mid-sized businesses hate negotiating with bankers. They find it laborious and often intimidating. This was the thesis when one bank thought they would change the paradigm and offer a “no negotiation, lowest price loan.” The theory was that this bank would produce a term sheet with their lowest price and the customer could either accept it or not. No matter what the case, it was implied that the bank had the incentive to put the lowest price in the market and the customer would not have to be bothered going back and forth in price and term negotiations. The bank tried this and what happened might surprise you.
The No Negotiation Loan
To be fair, this isn’t a new idea as lots of companies have “no haggle” policies. Tesla, for example, is famous for offering their cars at the same price no matter who you are or how many you buy. We wrote about it last year (HERE) and implied it might be a good cultural position for banks to take and suggested that banks may want to consider this position for deposit pricing and fees. The problem is we should have explicitly stated that you should not do this for loans.
Taking the hassle out of loan negotiations sounds like a good idea. As our subject bank found out, employees and the general public applauded the notion. In fact, by many early accounts, the program was a success as the win rate for term sheets to closed loans were in the low nineties, or about 35% higher than the average bank. Success, however, has many facets.
Why This Doesn’t Work For Credit
Unlike cars, clothing, cash management services and deposits, loans contain a large element of credit risk. How much credit risk in any given loan is subjective and therein lies the problem. The party that knows the risk best is the borrower themselves, and the bank often has to deal with imperfect information. This asymmetry in information causes a problem.
With a “no haggle” policy, borrowers that are strong and are able to negotiate go elsewhere. Conversely, borrowers that have been turned down elsewhere or know that they are weak come to our subject bank, many of whom get approved. As a result, the mix of borrowers gets quickly skewed to the negative, so the subject bank not only gets a sub-optimal return but also becomes under-reserved.
It Gets Even Worse
Matters are made worse by the fact that the Bank, once they have publically stated the policy, now feels compelled to offer a lower than average price to win business. The Bank intuitively knew that if it offered an above average price, average borrowers could easily get better offers at other banks.
You can see the tragic illogic. On the one hand, the Bank theorized that the public would value this pricing position, yet it was not willing to charge a premium price. Had the bank also instituted premium pricing, then two things would have happened: A) the public would have valued the pricing policy and the bank would have enjoyed greater profitability as more loans would have been priced above their actual risk level; or, B) the public would not have valued the position and the Bank would not have been able to gather material volume. While this would have been a “failure” at least, it would not have put missed price credit on the balance sheet.
Unfortunately, the Bank failed to properly understand game theory and pricing and ended up with the worst of all worlds – mispriced loans, at volume. By having a lower price, not only did the bank not get paid for the risk, but it allowed a wide swath of borrowers to take advantage of them.
Because credit is in large part subjective, a “no haggle” policy is flawed when it comes to loan pricing. Moreover, a “no haggle” policy combined with a low price strategy is a recipe for disaster. The self and adverse selection that occurs can destroy a bank as it almost did to the one mentioned above. While a “take it or leave it” position might sound good, it also robs the bank of an opportunity to negotiate other terms and condition such as additional covenant that might move the bank into a better risk-adjusted position.
Part of every lender's job is to match the appropriate price to the appropriate risk. Creating pricing mechanisms that doesn’t allow for flexibility, sends a signal that stronger credits need not apply. While information is never perfect for both parties during a transaction, loans are more lopsided than most products because of the future uncertainty around the credit risk.
Submitted by Chris Nichols on May 17, 2017