Chapter 11: The Power of Continuous Improvement
“The journey of 1,000 miles begins with a single step.” – Lao Tzu
“Forget about perfection; focus on progression, and compound the improvements.” – Sir Dave Brailsford, British cycling coach
In order to get your bank where it needs to go, all you have to do is change its pricing culture, create a new C-level position, break down siloes, share more information, create a new ecosystem of tools, figure out which tools to purchase and then get everyone to use them once they’re put in place.
If that last sentence just made your eye start twitching or led you to curl up in a fetal position in the corner of your office, we understand. If it seems overwhelming, that’s because it is.
But it’s only overwhelming if you think of it in those terms – as one huge, gargantuan undertaking.
If you take the advice of Lao Tzu and Dave Brailsford though, you’ll have a place to start and a path to follow.
At the risk of being repetitive, let’s go back to what we wrote in Chapter 2, when we introduced the concept of “Price Getting.”
As much as it pains bankers, when it comes to Price Setting, they need to live by the old saying, “Don’t let perfect be the enemy of good.” Pricing is a forward-looking, prospective exercise, and as such, it can get messy.
There is no such thing as 100% accuracy, and bankers (especially the finance types) get uncomfortable with the uncertainty. They know the importance of pricing, so there is an urge to get the assumptions just right. And many, like Frankenstein Bank, will spend years trying to get everything perfected. In the meantime, they are pricing millions of dollars in loans with an old tool that they know is flawed.
Instead, banks should use the “continuous deployment,” mentality whereby they can roll out the improved methodology (After all, it is better than what you have!) and then slowly refine it over time. All of this should happen with the understanding that perfection is not the goal. There will come a point when gaining the extra degree of accuracy is not worth the time, resources, or interference with end users needed to achieve it.
Nice words, to be sure, but in order to bring them from theory to reality, you need a framework. That’s where Dave Brailsford and the story of the British Cycling Team can help.
What British Cycling Can Teach Your BankThings may be tough in banking right now, but chances are your bank is in much better shape than British cycling was in 2002.
That’s when Dave Brailsford took over the program. In the 76 years before Brailsford came on board, the British track cycling team had won a grand total of one Olympic gold medal.
Just six years later, the Brits dominated track cycling at the 2008 Olympic Games in Beijing, winning seven of the 10 available gold medals. Four years later they replicated the feat in London. Meanwhile, in 2010 Brailsford undertook a similar challenge with the British professional road cycling team, Team Sky. Just two years later, the team produced the first-ever British winner of the Tour de France, beginning a string of three British winners in five years.
How did Brailsford improve British cycling from irrelevant to dominant? One percent at a time.
The Theory of Marginal Gains
When Brailsford took over British cycling, he was well aware of just how far removed the program was from reaching the top of the podium in the Olympics. To avoid being overwhelmed by the task at hand, he went back to some of the process-improvement research he’d read about while getting his MBA.
“It struck me that we should think small, not big,” Brailsford said in a Harvard Business Review interview. “Adopt a philosophy of continuous improvement through the aggregation of marginal gains. Forget about perfection; focus on progression, and compound the improvements.”
Brailsford and his team were relentless in seeking out all the ways they could make small, steady gains. They did everything from improving hand washing to avoid illnesses at events, to keeping the mechanics area at the track free of dust. Equipment, aerodynamic positioning on the bike, power needed at the start of a race – British cycling looked at all sorts of ways in which they could get just a little bit better, and a little bit closer to gold.
Don’t Confuse the Peas for the Steaks
It wasn’t that straightforward, of course. The marginal gains needed to be made in the right areas – “the steak” as Brailsford put it – and not on the periphery (“the peas”). That was a mistake Brailsford admitted to making initially when he switched from running a track program to a professional road cycling team. Poor results in the first few races helped the team realize they were concerned about too many bells and whistles and that they needed to shift the focus of their efforts.
Is the Gap Bridgeable?
Even if the improvements are made in the right areas, they need to be able to add up to the desired result. For British cycling, that meant medal-winning performance. Cyclists whom they felt could be improved to that level made the cut. Those whose gap between their current status and their future goal was too wide were dropped.
What’s Your Bank’s Benchmark?
So what would this look like if you tried it at your bank?
You’d start with where you want your bank to go in the future.
“If you don’t know what you’re aiming for, you’re never going to get there,” Brailsford said in a 2015 talk he gave at the Investors in People Outperformance Roadshow. “Get a true understanding of what it’s going to take to get there, then come back and do an audit.”
Remember this chart on the right from Chapter 5? Figuring out where you want your bank to fall in this diagram can be a helpful way for a bank to determine its goals. But the mark you plan to reach needs to be quantifiable. Vague platitudes like “We want faster growth and more profits,” don’t get you anywhere. Something like “We want to grow our portfolio by 15% without sacrificing margins,” gives you a much clearer goal.
“Boy is it easy to do an audit once you know what you’re benchmarking against,” Brailsford said.
Identify the Steak
The big juicy T-bone of potential improvement at your bank isn’t cost-cutting or compliance – it’s revenue. There you’ll find numerous places – the customer experience, pricing, etc. – where you can make those marginal improvements that served British cycling so well.
A small increase of basis points on certain loans, a tiny improvement in the number of deals you win each month, a slightly shorter duration on some of your loans, a gradual streamlining of the loan decision-making process … the list can go on and on.
Those cost-cutting moves? They’re the peas. As we noted back in Chapter 1, McKinsey & Co. made that point back in 2003, in their influential article, “The Power of Pricing.” In its research of S&P 1500 companies, McKinsey found that a 1% increase in pricing had an impact on profits that was “nearly 50 percent greater than that of a 1% fall in variable costs such as materials and direct labor.”
Become a Positive Place
Brailsford believes that once the marginal gain process gets rolling, “it creates a contagious enthusiasm. Everyone starts looking for ways to improve … Our team became a very positive place to be.”
Banks can become that positive place. They can set ambitious goals for the future and reach them. They just need to identify where they can improve and then start making gains, 1% at a time.
Continuous Improvement, Portfolio Level
Where can those potential improvements be found at your bank? On two levels – transactional and portfolio.
Let’s start on the portfolio level. Bear with us here as we again go to an example outside banking to make our point – a fighter pilot.
During the Korean War, American fighter pilots were outnumbered and outgunned.
At the time, the Air Force’s state of the art fighter jet was the F-86 Sabre, and the North Koreans were using the Soviet produced MiG-15.
The MiG-15 was the world’s first swept-wing fighter, and it had superior range, speed, turning radius, climbing ability, and weapons. However, despite flying in what appeared to all experts to be inferior equipment, the American Sabre pilots racked up a kill ratio of nearly 14:1 against the MiGs in the world’s first ever all-jet dogfights.
What was it about the American pilots that allowed them to completely dominate with slower planes? The answer may surprise you, and can teach us a lot about how the world’s highest performing banks are putting distance between themselves and the competition.
One of the brash young pilots of those F-86 Sabres was John Boyd. After the war he sought an explanation for the lopsided kill ratio. He found that, while the MiG-15 was superior in the ways planes had traditionally been measured, the F-86 Sabres had two important differences. First, they had a large canopy with clear visibility in all directions. Second, they had a hydraulic boost to the flight control system (the “stick” in pilot terms).
These two advantages allowed the American pilots to better see what the enemy was doing, and start counter maneuvers. By the time the enemy reacted, they would be starting a new maneuver. The enemy was reacting too slowly to old information, and after several iterations, they would find a Sabre close on their tail in the kill zone.
Boyd took this insight and perfected a new technique. He became an instructor at the exclusive Fighter Weapons School (FWS), which was basically Top Gun in the late 1950s. Most of the world’s best pilots eventually came through FWS, and Boyd had a standing bet for all of them. Starting from a position of disadvantage, Boyd would have any taker dead in his sights in less than 40 seconds, a bet he called “40 seconds for 40 bucks.” In reality, he rarely needed more than 20 seconds, but Boyd liked the idea of winning $40 a lot more than winning $20. In more than 3,000 hours of flight time at FWS, Boyd never lost his bet. He was a combination of John Wayne and Doc Holliday.
Boyd formalized his approach, which he called the “Boyd Cycle”. It later became known as the “OODA Loop”, which stands for Observe, Orient, Decide, and Act. The OODA Loop became (and still is) the standard for all fighter pilots, and has since been used in broader military and business strategy.
The basic concept is that if you can “get inside” the competition’s loop, you can quickly form a hypothesis, test it, observe results, and form another hypothesis before the competitor can get through their first loop. Instead of worrying about getting the action exactly perfect, the goal is to quickly make the best possible decision and test the outcome. More iterations will get to the right outcome much faster (and better) than stubbornly trying to perfect a hypothesis before it ever goes to market.
For example, in the software business, instead of spending 18 months on perfecting the next release (all while the market continues to evolve) and finding out your product isn’t exactly what customers want, the successful companies are making their best guess at what customers want, building a minimum viable product quickly, and then releasing it to be tested. That minimal product can then be perfected and improved in stages, all with constant feedback from real paying customers.
How does this compare to the banking world? Are banks good at making quick decisions and learning from them?
Paralysis by Analysis
We recently saw a classic example of what this process looks like in a bank we’ll call First Paralysis. This particular institution is a well-known and respected regional bank with more than $20 billion in total assets. Their performance has been inconsistent of late, and the focus of nearly every quarterly earnings call has been the competitive marketplace and pricing pressure across all business lines. Management was tired of missing both earnings and growth estimates, and was curious about the impact of meeting the pricing of some of their more aggressive competition. In banking, when a question like this is asked, the finance team springs into action.
First Paralysis paid a third party for in-depth surveys of average market pricing by product in each of their markets. A team of analysts then compared that market data to all of the bank’s deals that had been booked in the last two years, running regressions to find the pricing that would have generated optimal pricing to maximize growth and earnings. The result, after six months of work, was an impressive 96-page document detailing a back-tested model that met all of their thresholds for statistical significance. Based on about a dozen variables, they claimed they knew how to adjust pricing in the future to optimize results.
Despite the heft of this impressive document, though, it contained a few fatal flaws.
First, no one on the senior management team was able to wade through the entire report. It was mind-numbingly boring, and strayed way too far from reality into theory. Management simply wasn’t comfortable making decisions derived from a model they couldn’t understand or easily explain.
Second, the analysis was completely stale. Two of First Paralysis’ primary competitors had merged, rates had moved, elections were on the horizon, regulations had been added, and on top of all that, there had been a shakeup on the senior management team. So even if the analysis had not been based on retrofitted decisions from the prior two years, the bank was still reacting to the competition’s old strategies.
In short, their OODA loop was way too long and slow to be effective.
The vast majority of banks make decisions this way. Just by the nature of the business, bankers are generally more concerned about being wrong (and losing money) than being right (and at best getting paid back with a small interest rate).
The incentives of a highly leveraged business make bankers overly cautious. In many cases, this is the right approach, such as when making credit decisions. But what about rolling out new technology? Or trying new products? Or changing loan and deposit pricing? All of these decisions should be made the same way John Boyd engaged enemy pilots. Form a hypothesis, quickly test it, and learn from the result. Wash, rinse, and repeat.
For First Paralysis, that would have been as simple as choosing a few products in a few of their markets, and reducing pricing. Gauge the change in volume relative to all of the other markets, and quickly learn how demand changes. That results in nearly real-time feedback, and those experiments should be running constantly in order to find the pricing “sweet spot” in an ever evolving marketplace. Of course, that also means you need to re-wire the decision making process once you have that information.
Waiting until the next quarterly ALCO meeting to enact pricing decisions creates a long, unwieldy OODA Loop that can easily be exploited by the competition. Instead, you need someone manning the pricing controls, i.e. the Chief Pricing Officer (Chapter 5), who will use the data generated by the tools in the pricing ecosystem to make quick decisions. The ALCO meetings should be used to discuss the results of all of those little tests, and to give the CPO guidance on the bank’s high level strategy.
Bankers can generally get on board with the incremental improvement concept at the portfolio level, but often feel that it doesn’t apply to individual transactions. After all, “the market is the market,” and there is only so much room to deviate from the competition, right?
Continuous Improvement, Transaction Level
Early in our discussions with almost every bank, we have some version of this exchange.
Bank: “Can you show us how you change the hurdle rates?”
Us: “Actually, we don’t use hurdle rates. We think you should use targets instead.”
Sometimes it feels like we can actually hear the eyes roll over the phone. We know exactly what they’re thinking. “Yeah, whatever, that’s just semantics from the pricing nerds.” But this is far more than just semantics. In fact, this subtle change in mindset actually has a transformative effect on decision making and performance.
The Case Against Hurdles
Let’s start by talking about why we don’t use hurdles. It’s a long list, so we’ll summarize it.
Hurdle rates are, by definition, the absolute lowest return the bank will accept on a deal. Is this really the number you want driving all the pricing decisions in your bank? If you have a hurdle, it should be treated as a state secret that requires security clearance. Publishing them, or worse, using them as the guidepost on your pricing system, results in two substantial problems.
First, if this is truly a hurdle rate, you take all flexibility (and common sense) away from your lenders. We recently saw an instance in which a lender was working on a deal for one of the bank’s most profitable customers and, due to competitive offers, was a few basis points short of meeting the hurdle rate. Those few basis points translated to about $200 per year, but since it didn’t meet the hurdle, the lender couldn’t meet the critical terms.
As we all know, deals are rarely priced in a vacuum. The competing bank started cross-selling, and pretty soon the entire relationship was at stake, nearly $250,000 of annual profits,, because of refusal to bend a few basis point on one deal.
That scenario is exactly why the term “pricing model” has been banned in the PrecisionLender offices. When you think of your tool as a “model,” you treat “hurdle rates” as the gospel. That removes all ability for experienced lenders to negotiate deals within the context of very complex and unique circumstances.
Even if your bank is not as dogmatic about hurdle rates, there is still a second major issue. If you aim at the hurdle rate on all of your deals, guess what? That’s exactly what you’ll get on the majority of them.
The chart below, sent to us by a client, summarizes the monthly results from their old hurdle-based pricing tool. Can you guess what the hurdle rate was?
Since a hurdle is a minimum return that will be accepted, it generally has to be set well below current market rates. Otherwise, volume will dry up completely. However, once that low hurdle has been set, it acts as a magnet for ALL of your production, drawing each deal as close to that hurdle as the lender can possibly get it. Get a couple of banks in a market to start doing this and you can imagine the results. It is one of the biggest contributing factors to this long-standing trend:
Set Your Sights Higher Than “Acceptable”
If hurdle rates aren’t the answer, then what should we be using? We believe wholeheartedly in using profitability targets. We are measuring the same thing (risk adjusted return on capital1), but the mindset is completely different. Targets are not set as the bare minimum that will be accepted. Instead, they are just as advertised: the target at which we are aiming. Ideally, we will find the current market level for a specific loan type, and then set the target slightly above that. This ensures both that we are competitive in the local market, and that we are also pushing lenders to stretch every deal just a little. We’ll ask for a couple more basis points, or perhaps a little more collateral, a slightly shorter term, or for another account or two. Trying to reach those targets will make us incrementally better deal by deal. On the typical bank volume, that soon translates to big dollars.
The bank we referenced above is small (about $2 billion in assets), and is booking about $100 million per month in loans. Those couple of basis points translate to nearly $250,000 per year in additional interest income.
Stretching Requires Flexibility
Targets should be a bit of a stretch, just above what the competitors are likely offering. But they should also be paired with significantly more flexibility.
First, we want to give lenders lots of options in how they can reach those targets. Again, this is not just about rate, but all deal terms that will move the needle in terms of risk and profit. Second, there will inevitably be times when the right business decision is to book a deal below the target. Maybe the deal is for an existing customer that is highly profitable, or maybe it’s the “foot in the door” for a growing prospect that will pay off the down the road.
Whatever the reason, banks must trust their lenders. Commercial loans are complex, and each has nuances that cannot be easily captured in one profitability metric. That context and judgement is WHY lenders are well paid; it is their job to not just build relationships, but to structure each new deal in a way that makes sense for both the customer and the bank. Using concrete hurdle rates restricts that flexibility, and does so with the added pain of lower returns.
Trusting your lenders to be flexible allows them to channel their inner John Boyd. Back in Chapter 4 we described the benefits of moving the decision-making process closer to the customer. That faster, more efficient process allows your lenders to outmaneuver competitors on an individual deal. Since they have clearly defined targets, they know how they can adjust deal terms to meet customer needs.
For example, consider a deal where a competitor is offering a lower rate, but is doing so by shortening the amortization schedule and requiring additional guarantees. And that guarantee just happens to be from his father-in-law. Your lender should be able to quickly offer several alternatives, allowing the borrower to remove the pain points, which in this case is most likely that guarantee. Your borrower might just pay a higher rate to have a more comfortable Thanksgiving dinner with the in-laws.
The typical competitive bank will take weeks to respond with a counter offer, and if they do, your lender can again instantly react to that offer. Borrowers eventually figure out which bank is being responsive, creative, and helpful, and will get tired of waiting for something better to come along from the competition. Even when challenged by competitors with superior product offerings or lower funding costs, your lenders have that one key advantage – the ability to see what the enemy is doing and quickly change course.
So, yes, insisting on saying “targets” instead of “hurdles” is a bit of semantics from the pricing nerds. But this subtle change in phrasing and approach can have a massive impact at both the lender and bank level. So we believe it’s worth being a stickler on it.
In many ways, managing a bank can feel like trying to steer an aircraft carrier. It is an asset-based business, meaning the vast majority of today’s earnings are based on decisions you made several quarters or years in the past. Correcting even small issues can seem daunting, but turning around a bank with poor earnings or a bad reputation in the market seems impossible.
The lesson from Dave Brailsford and the British cycling team, though, is that small, continuous improvements can get you to the end goal. It just takes a little time and perseverance.
In 2013, a community bank in Oklahoma sat at a crossroads familiar to much of the industry. Though they weren’t in any imminent danger, they also didn’t see a clear path to continued growth. Competition in their market had become brutal, and their commercial loan portfolio was shrinking, both in terms of balance and yields. Historically, they had weathered a period like this with their residential lending arm, but with regulatory changes, much of that volume was also gone. Margins were declining, and the management team was contemplating a sale.
However, the bank was family-owned, and the chairman was a proud man who didn’t want to see the bank sold on his watch. They decided instead to embark on a pricing and process overhaul for commercial lending.
The start was slow and frustrating, but the results soon started showing up, and this is where they saw the upside of being an asset-based business. Once they got forward momentum, the positive results started compounding, and the financial performance speaks for itself.
The bank had transformed from slowly shrinking away into a dynamic growth story, all with better earnings. They shifted from contemplating a sale to shopping for other small banks, and have since more than doubled in size. They’re proof that taking that first small step, and then continuously improving, can truly transform a bank, even in the current environment.
Don’t have the right pricing tool? Then go out and get one. They’re out there. (See Chapter 9: “Choosing the Right Tool.”)
Don’t trust your lenders enough? Then teach them how to be better lenders. Or find new ones. (Chapter 6: “What Makes A Great Lender?”)
Don’t think your bank can change? The reread this chapter. It doesn’t have to happen all at once. Just a little bit a time.
The good news? Every little bit counts, sometimes more than you know.
It doesn’t matter how good your pricing tool is if you can’t get your lenders to use it.