Chapter 1: Why is Pricing So Important?
Wouldn’t it be great if you had your own Clarence Odbody, a guardian angel of banking? Someone who could help you shift your attention from all the frustrations and roadblocks in your job and instead get you to focus on the things that matter most, the ones that build your brand and your relationships?
What’s Urgent vs. What’s Important
In business and in life it seems we constantly struggle to keep the urgent from crowding out the important.
Each day there is a new fire to put out. When we reach our desk each morning there are dozens, sometimes even hundreds, of new emails at the top of our inbox. Each one is begging for just a few seconds of our attention. Before we know it, the day is gone, then the week, and then the year.
This happens not only at the personal level but at the organizational level as well. There, it’s an even harder habit to break. Before you know it, this becomes part of the culture of the organization. Sometimes so much so that the organization completely loses its understanding of what things are, in fact, most important; it only knows what is urgent.
It’s an issue that comes up often when we talk with bankers. Banks, especially now in the wake of the Great Recession and the financial crisis, are particularly susceptible to the urgent vs. important problem. It is completely understandable: For many banks, over the past few years, addressing the most urgent matters quickly was quite literally a matter of survival. As the economist saying goes, banks had to make it through the short term to ever make it to the long term.
Put another way, banks were in the first quadrant of the Eisenhower Decision Matrix. The four quadrant matrix gets its name from the 34th president, who referenced the urgent/important dilemma in a 1954 speech. It’s a way of looking at each task in front of you and determining your actions based on those two factors.
The tasks the banks had to complete to survive during the financial crisis were obviously both important and urgent, a “house on fire situation” for them. Now, with credit portfolios stabilized and improving and rates starting to rise, the importance of some of those tasks has receded, but many banks are struggling to switch out of “urgent” mode. Thus, they’re slipping down into the third quadrant.
The goal is to move instead to the second quadrant, where you can look again at the long-term projects that are truly important. Then you’ve transitioned away from surviving and into thriving.
Putting First Things First
To illustrate this point, Carl often likes to tell the story of the time Stephen Covey, famed author of the 7 Habits of Highly Effective People, came to speak to his class when Carl was a student at MIT’s Sloane School of Management.
Covey started out by placing a large glass jar on the table in front of him and filling it with rocks the size of his fist. When no more rocks could fit in the jar, he asked the room, “Is the jar full?”
“Yes,” was the audience reply. There was no room left for any more rocks.
Covey then pulled a container of pebbles out from below the table, which he poured into the jar, filling the gaps around the rocks.
“Is it full now?” he asked.
The crowd response this time was mixed. The jar certainly looked full, but the students could sense that Covey was in the midst of making a bigger point. He then reached below the table and produced a container full of sand. He poured that in and it sifted between the pebbles.
“Is the jar full now?”
Now they were certain. “No,” was the universal answer.
“Good!” Covey said. Next he poured water into the jar, filling it up to the top.
“So what was the point of this? What is the lesson to be learned here?” he asked.
This was a room full of “Type A” overachievers at a top MBA program. The answer was obvious to all of them: If you are creative, diligent and persistent, you can always find time to do one more thing. You can always add more thing to your to-do list or squeeze one more project into the plan for the next year. Even when your life seems full, you can always add more if you try hard enough.
Covey smiled and then pulled a neat bit of mental jujitsu on the room.
“No, the lesson here is that if I hadn’t put the big rocks in first, I would never have been able to get them into the jar.”
Covey went on, “In your business and in your life, you have to put forth effort to identify the ‘big rocks’ and then make sure that you put those in the jar first, or they will never make it in there.”
Every day banks spend countless dollars and hours on projects such as compliance training, IT infrastructure projects, core data cleanups, mobile apps, and network security projects. All of them have a feeling of urgency, but are they truly central to the mission of the bank? Are they helping to build stronger relationships with the customer and to increase revenue?
If not, then they’re the pebbles and sand in Covey’s demonstration.
The Impact of Pricing
Bankers know this. They know that pricing is one of the primary determinants of performance. But still, they often underestimate the degree to which pricing impacts their bank.
Back in 2003 the consulting firm McKinsey & Co. published an influential article called The Power of Pricing. It reached some pretty eye-opening conclusions.
Using the average income statement of an S&P 1500 company as its standard, McKinsey found that a “price rise of 1 percent, if volumes remained stable, would generate an 8 percent increase in operating profits.”
McKinsey compared that to cost-cutting and found that the impact of a 1 percent price rise was “nearly 50 percent greater than that of a 1 percent fall in variable costs such as materials and direct labor.”
The numbers were even more dramatic when comparing a price increase to a corresponding 1 percent increase in volume. Price’s impact on profits was nearly three times that of volume.
And as McKinsey put it, “the sword of pricing cuts both ways.” A 1 percent decrease in average prices leads to an 8 percent decrease in profits if the other factors remain stable. McKinsey considered a theoretical 5 percent price cut for one of those sample S&P companies and found that the company would have to increase sales volume by 18.7 percent just to bring things back to even in that scenario.
If you’re a bank tempted to drop rates so you can pry a few deals away from the competitor down the street, or perhaps just to keep up with the new bank in town that’s turning heads, McKinsey offered this sober warning:
“A strategy based on cutting prices to increase volumes and, as a result, to raise profits is generally doomed to failure in almost every market and industry.”
The McKinsey piece is a powerful article that’s still frequently cited in business, but it’s worth noting that it came out 12 years ago. This isn’t breaking news; it’s the way of the business world. It’s time for banks to adjust to this reality.
In fact, you could argue that pricing is even more vital to the future of banks than to other businesses.
Before we go further, let’s note that when we discuss pricing in this book, we’re talking about commercial loan pricing. While there are many other areas in which banks price – checking, mobile banking, CDs, etc. – they have become essentially commoditized. Commercial lending is where the most value is left, where improvements in pricing can have the biggest effect.
Make a splash with the big rock of pricing and here are some of the places touched by the ripples:
- How you approach pricing and the management of pricing has a huge impact on the nature of the conversations your lenders can have with borrowers. If your pricing is flawed, you wind up with the “used car salesman” scenario, in which a lender negotiates a deal once with the borrower, then negotiates it again with the rest of the bank and then re-trades it with the borrower. That’s damaging not only to that particular opportunity but to the overall relationship.
- Pricing has a huge impact on which relationships you win, which ones you lose and how much you get paid in each deal.
- The pricing decisions you make today will determine the portfolio you’re going to have to live to with in the future, both in terms of interest rate risk and credit risk.
- Along those lines, pricing is one of the main ways you communicate to the marketplace where you would like to deploy your capital and what sort of assets you’d like to bring in. Sending out the wrong message can have disastrous consequences. As a bank executive once told us: “It’s been my experience in 30 years of banking that you win the most what you misprice the worst.”
Pricing is a Game of Inches
Al Pacino has a great speech in the movie, “Any Given Sunday.” In the film Pacino plays the role of a professional football coach. Before the team’s big game, he gives an inspiring pregame pep talk about “the inches.”
You can check out the full version (with some of Pacino’s more “colorful” language removed) at the end of this chapter. But for now, this excerpt will work just fine.
“You find out that life is just a game of inches.
So is football.
Because in either game
life or football
the margin for error is so small.
one half step too late or too early
you don’t quite make it.
One half second too slow or too fast
and you don’t quite catch it.
The inches we need are everywhere around us.
They are in every break of the game
every minute, every second.”
Now, Pacino is busy trying to rile up a bunch of big, burly football players, but you also could drop him in a banker’s conference and have him give the same speech (although perhaps without the profanity). Because for banks, the inches they need are absolutely everywhere around them. They can be found in pricing, on both the lender and the institutional level.
The competitive landscape in banking right now is such that deals are often won or lost on the tiniest of differences. We’ve all been in those situations where you’re pricing a deal, you feel like you’ve almost closed it, and then at the last second you find out you lost. You missed out because of this tiny, seemingly insignificant thing – maybe something you didn’t even really care about. You would have gladly included it in your offer if you’d known it was going to be the deciding factor. Maybe it was a few basis points here, a pre-penalty payment there, or a personal guarantee that the borrower really didn’t want to add.
The key here is that “the inches” bankers need are not necessarily found by increasing the rates on the loans. Commercial loans have hundreds of variables. Each one of them impacts the risk-adjusted profit to the bank and the appeal to the borrower. Incremental changes to just a few of these variables might just make the difference in winning that deal or losing it.
That’s the lender level. On the institutional level, each of those deals your bank wins (or loses) becomes one of the inches. Every single loan you price goes into the creation of the bank’s balance sheet. Price well loan by loan, inch by inch, and you end up with a stable, profitable bank. Make mistakes like mispricing risk relative to the rest of the market, and each of those bad loans piles up, inch by inch, until you’re Washington Mutual.
Let’s go back to the McKinsey pricing article for a moment and borrow that 1 percent improvement figure. Plug that in for an anonymous bank that has a commercial loan portfolio of around $500 million and yields that are right at 4 percent. So a 1 percent improvement for this bank translates to about 4 basis points. On $500 million those additional 4 basis points (i.e. a 0.04 percent increase in the yield) produce $200,000 a year – just on that commercial loan portfolio. And the beauty is that a commercial loan book usually turns over really fast, so you can get to those results faster than you can in other industries. For the bank in this example, it would actually take a little less than 20 months to hit that number.
And that’s just using the assumption that we’re improving the pricing on the loans we win. What if, on top of that incremental improvement, we found ways to win more of the deals we’d previously been losing by those inches? What if we win just one out of 20 of those deals that we’re missing today? How does that change the picture? What about one in 10? Find ways to pick up some of those, and now the four basis points start to look like chump change.
Treating the Symptoms, Not the Disease
But maybe you’re not convinced pricing is the way to find those inches. What if you went looking for them elsewhere? What if you left pricing alone and simply looked to keep your margins high by cutting costs?
The McKinsey article addressed this, with a bit of a “been there, done that” attitude, way back in 2003, noting that, “at many companies, little cost-cutting juice can be easily extracted from operations.”
Even if, 12 years later, there is still a little bit of blood remaining to be squeezed from the stone, cost-cutting can be only part of the solution, at best. Banks that are looking at cost-cutting as THE solution are essentially treating the symptoms, not the disease.
Again, newspapers have already blazed this grim trail before. When the Internet changed the advertising game forever, newspapers prioritized cost-cutting over searching for new revenue streams to replace the ones that were drying up. Shrinking staffs also lessened the quality of the product, putting a dent in newspapers’ brand image as the most trusted news sources in their communities. Newspapers got short-term profit-margin results (the “symptoms”) but never found a way to solve their long-term revenue problem (the disease).
Actually, maybe newspapers are too bleak an example to use. There’s an argument to be made that there never was a cure to the disease for them – that newspapers are simply an outdated technology that has to go the way of horse-drawn buggies and eight-track tapes.
That’s not the case with banking. Every day we work with banks that are fixing their ailing bottom lines by focusing on effective pricing.
What Effective Pricing Looks Like
The data in this section comes from two groups of banks – those that use the pricing methodology outlined in this book and those that don’t. The former group are banks that have undergone a banking transformation – they just elected to do it with us.
- PrecisionLender publicly traded clients have achieved 93 percent market capitalization growth over the last 5 years (June 2010-June 2015) versus the KBW NASDAQ Bank Index’s 60 percent growth.
- All clients over $1B in assets improved their NIM by 18.9bps more than their peers over the last 2 years (June 2013-June 2015) after implementing PrecisionLender.
- All clients over $1B in assets outpaced their peers by 5.7 percent in annual loan growth over the last 2 years (June 2013-June 2015) after implementing PrecisionLender.
We’ll dive more deeply into an individual bank’s pricing success in Chapter Five, when we make the case for a Chief Pricing Officer. But there are a few more steps we need to take in the discussion before we get there. We’ve argued for why we think pricing is important. Now it’s time to talk about what goes into the actual act of pricing and why relationships are central to that effort.
Banks were once associated with “It’s a Wonderful Life.” Now it’s “The Big Short” and “Too Big to Fail.” And they’re facing a new world of greater regulation and stiffer competition. To survive, and even thrive, banks have to rebuild their brands – one customer relationship at a time.
There are two dimensions to pricing: Price Setting and Price Getting. Banks usually prefer to focus on Price Setting, but that doesn’t mean they’ve all mastered it. What are some of the common roadblocks bankers encounter in Price Setting? And why should we never let perfect be the enemy of good?