Chapter 7: Sunlight is the Best Disinfectant

Chapter 7: Sunlight is the Best Disinfectant

Choose transparency. When you give out information rather than hoarding it, you empower your lenders and gain the trust of your customers.

We’ve talked about how important the best lenders are, and some of the characteristics they share. Very few bankers will challenge any of those concepts. But, how do we make it happen? How do we enable our lenders to be great?

For many banks, the answer lies outside their comfort zone.

To be successful, banks must find ways to empower their lenders, giving them the freedom and autonomy — as well as the right tools — to make the necessary trade-offs and decisions quickly. It’s not enough to just deliver valuable solutions. Lenders have to deliver them rapidly and in a way that builds trust with the customer at every point.

Providing value to the customers while still earning big returns for the bank is a tricky balancing act requiring a secret ingredient that may make banks cringe: transparency.

The Painful Story of Ryan

Ryan, an initially hesitant client, might just be the best illustration of why this secret ingredient is so critically important.

Ryan understood the power of pricing. He was the treasurer at his bank and a very, very bright guy. His problem was that he didn’t think his lenders were very capable. He didn’t trust them, so he tried to put strict limits on how much pricing information his lenders had access to. He wanted a bunch of progress reports that only he could see. Ryan was afraid that more data in the hands of lenders meant more chances they’d somehow muck things up.

As it turned out, things did go south, but not in the way that Ryan was trying so hard to avoid.

Instead, the lenders grew tired of trying to operate in the dark. They rebelled against management’s pricing strategy, and blamed their lack of profitable production on Ryan.

Ryan’s tale is, unfortunately, also a fairly common one at banks. While Ryan did eventually come around – and his bank’s performance rose as a result – going through those early struggles was a painful process for all involved.

It did, however, have a silver lining. It now serves as a cautionary tale that helps us make the case for transparency with our clients.

We touched on transparency briefly in Chapter 6, but we felt the topic was too important for just a passing reference – it needed a chapter of its own.

And it needed to be divided into two parts: transparency within the bank and transparency with the customer.

Does the bank need to reach these targets because it’s in trouble and it’s trying to climb out of a hole? Or is it just getting greedy?

More than likely it’s neither, but in the absence of information, you’re probably jumping to one of those two conclusions.

Bank Transparency

Nature Abhors an Information Vacuum

We’ll first address transparency within the bank. To do that, let’s go back to Ryan’s bank and take a walk in the shoes of his lending team.

Let’s say you’ve been given some aggressive ROE targets to meet and that those numbers represent a significant jump up from your previous targets.

Why did the goals get pushed up so much? (You don’t know, because Ryan’s not sharing that information.)

How was the ROE target arrived at? Why that number? (You don’t know, because Ryan’s not sharing that information.)

Is anyone else struggling to meet these ROE targets, or is it just you? (You don’t know, because … you get the picture by now.)

Does the bank need to reach these targets because it’s in trouble and it’s trying to climb out of a hole? Or is it just getting greedy? More than likely it’s neither, but in the absence of information, you’re probably jumping to one of those two conclusions.

You can see how the atmosphere at Ryan’s bank quickly became toxic. And you can see how taking this approach nearly doomed any chance Ryan had of getting his lenders to price and structure deals in a way that aligned with the bank’s strategies.

Worse than that, commercial lenders with little insight into the bank’s strategies and even less authority were providing a terrible experience to their customers, who just so happened to be the most profitable segment in the bank. The result: seven straight years of shrinking loan balances and profits well below their peer group.

How can your bank avoid those struggles? Instead of keeping your lenders in the dark, try a little sunlight instead.

Let There Be Light

Ryan’s bank decided to make some wholesale changes to their lending process, including overhauls to pricing, underwriting, and lender incentives. This time, though, they decided to make transparency a guiding principle.

The bank announced it was setting new, aggressive targets for its lenders for both growth and ROE. The management team held a meeting in which they walked the lending team through the numbers. They explained how the targets were determined, and why they were set at those levels. They put the ROE into the bigger context of the bank so the lenders could understand how those targets fit into the overall direction for the institution. And just as important, they rolled out an impressive new set of integrated tools to help the lenders with the sales process.

Keeping Up With the Joneses

Everyone’s performance was then put on display. Lenders could look at their own performances, but they also could see how each of their peers were doing. And they could see how their boss was faring, and his boss, all the way up to how the bank as a whole was performing.

If they thought that initial ROE target was nuts, they now had the facts that could either prove or disprove their assumptions. Without transparency, they likely would have just moved straight to, “These numbers are absurd.” With transparency, they may still have concluded in a month or two that the goals were ludicrous, but since everyone in the bank had visibility into the results, they wouldn’t have been alone in that conclusion and it wouldn’t have been hard to quickly change direction.

Or they may just have discovered that most of the other lenders weren’t having a problem with the new targets. Now they could see why the shift was made, and that they needed to get it in gear. A motivated lender is a better lender, and nothing motivates quite like good old fashioned peer pressure. In fact, this bank went from a laggard to a market leader, and has grown loans by more than 40% since the change was made two years ago.

Meanwhile, as the bank transformed, so did Ryan. He has a newfound appreciation for working WITH his lenders instead of against them, and has become one of his bank’s most vocal advocates of transparency.

Going Granular

Transparency makes sense in managing and motivating lenders, but how does it translate to production? What do lenders at banks like Ryan’s do differently to book more deals at higher profit levels?

We gained some valuable insight into this area when we did research into how the best lenders at our client banks were performing. These top lenders were the beneficiaries of transparency. They’d been given clear targets and a clear understanding of all the terms in a deal. Then they were given the freedom to choose the path that would lead to a deal that satisfied the customer and met the bank’s goals.
One example of this was in the area of rate granularity. We looked at how often lenders priced deals in quarter-percent rate increments (e.g. 3.25%, 4.75%, etc.) and how often they become more granular in their approach, opting for rates between the quarters instead (3.28%, 4.68%, etc.).

Rates on Non-Quarter Increments for Fixed-Rate Loans

Focusing on fixed-rate loan originations from the last 12 months, we found that top lenders priced in non-quarter increments 27% more often than their lower-performing peers.

Those numbers had even more impact when we looked at the dollar amounts involved. Deals with non-quarter rates accounted for 64.7% of the top lenders’ notional amounts on fixed-rate loans in the past 12 months, as compared to 46.2% for other lenders.

Notional Amounts on Non-Quarter Increments for Fixed-Rate Loans

Put simply, top lenders priced on rates between the quarters more often, to win much bigger deals.

This difference actually flies in the face of a lot of conventional wisdom in the industry. Many banks have trained their lenders to price on quarters and eighths, with the assumption being that if the real rate needed to make the deal “hurdle” on profitability is 4.18%, then rounding up to 4.25% will expand margins over time.

The reality, though, is that this tactic is rarely being used when rounding up. Instead, lenders are looking at a competitive offer from the bank down the street, and offering a rate that is the next rung down on the ladder. A competitive offer at 4.25% often means that a lender will offer 4.00% to win the deal. You can guess at the competitive reaction, which in part explains the multi-decade trend in net interest margin for the banking industry.

In contrast, the best lenders have a clearer picture of exactly where the line of profitability lies for any particular deal. Their banks have clearly communicated the targets, and thus the lenders know precisely where they stand for any rate, including those between the quarters.

In short, they know the value of every basis point, especially on the larger deals. A basis point on their entire portfolio often translates to the annual salary of someone on their support staff.

But pricing between the quarters isn’t just a way to add in the occasional basis point to help profits. It can also be a way to win a deal without having to jump all the way down to the next rung. If the real hurdle rate is 4.18%, and the competition is at 4.25%, why drop all the way to 4.00%? The bank can still undercut a competitor to win business, but it can be won without making the sacrifice too painful.

Rate granularity is a clear argument for why banks should practice transparency with their lenders. But what about being transparent with their customers?

Customer Transparency

Making “The Inside Deal” Just “The Deal”

“You’ll see. First they stick you with the undercoating, rust-proofing, dealer prep. Suddenly, you’re on your back like a turtle.”
“Look at these salesmen. The only thing these guys fear is the walk-out. No matter what they say, you say, ‘I’ll walk out of here right now!’ ”
— George Costanza, Seinfeld, “The Dealership.”

George Costanza, Jerry Seinfeld’s neurotic malcontent friend, uttered these two memorable lines during the Seinfeld episode that centered around Jerry’s trip to the car dealership to buy a new Saab. Throughout, George constantly rails at Jerry to trust no one, and to treat his deal negotiations with the salesman like a fight to the death.

Jerry though, tells George to relax. The salesman, Puddy, is Elaine’s boyfriend. So Jerry is going to get “the inside deal.”

The episode works because George is in all his way-over-the-top glory, veins popping out of his forehead as he snaps at even the slightest hint of provocation. But it’s also funny because Seinfeld’s writers are tapping into something the audience feels as well: When you go to buy a car, you’re not collaborating with the salesperson to reach a deal that pleases both sides. You’re stepping into a battle, one in which the salesperson has more information and thus, the upper hand.

But what if the salesperson voluntarily gave away some of that information and leveled the playing field? What if “the inside deal” was actually just a typical deal?

Transparency > Mystery

And what if commercial lenders took that approach?

Rather than drawing a line in the sand on rate and trying to make the customer blink, what if lenders opted instead for transparency over mystery and vulnerability over power?

Here’s how that might work. A customer comes into the bank looking for a real estate loan at a specific rate. The lender plugs those numbers in and sees that the deal in that form won’t reach his ROE target (transparency within the bank at work!). But he can see there are several other ways the deal can be adjusted so that it can work, with the rate the customer wants – perhaps by changing the rate type, or the length of the loan, the initial fees, etc.

Now for the crucial part: The lender then explains all this to the customer.

The lender opens himself up a bit, letting the customer “inside” and essentially giving a glimpse of what it’s like on the lender side of the table. The customer doesn’t have to guess at what the lender’s goal might be. Instead, that information is out in the open, along with multiple ways in which the lender is willing to craft the deal.

Now the ball is in the customer’s court, and they have a real voice in the pricing decision. And now that the lender has given a little, the customer is more likely to do the same – often by sharing some additional information that will help the lender create even more options that are suitable to both sides. The conversation changes from haggling over the bank’s rates to an in-depth discussion of the borrower’s business. What are their current struggles and future plans, and how can the bank best support them?

The alternative to that vulnerable approach is the power play, holding your cards close to the vest and waiting until the customer’s need for capital overcomes his caution and discomfort. Sometimes that works, but sometimes, the customer pulls a Costanza and bolts for the door.

If your lenders open themselves up a bit, trust is built and the customer comes away feeling empowered. The lender comes away with a deal that meets targets and a customer who feels like they just got “the inside deal.” And that’s a customer who’s likely to bring more business to the bank in the future.

Caps & Floors

Let’s take this concept of transparency with customers out of the hypothetical and into the practical.

Banks and their customers are both afraid of sudden changes in interest rates. Banks fear movement in either direction that might have a negative impact on net interest income, so they constantly try to match structures on the two sides of the balance sheet. That’s Asset Liability Management 101, and it is manifested in pricing through higher rates for longer durations and an inherent preference for shorter, variable rate structures.

Customers fear sudden changes in rates for a much more direct reason; higher rates mean higher payments. This is most painful early in the loan, when the balance is highest.

Customers aren’t frightened that rates will go up steadily over time. What keeps them up at night is the prospect of rates suddenly shooting up the next day, leaving them in financial turmoil. Their response is a high demand for the certainty of longer terms and fixed-rate structures.

How do bankers reconcile this borrower demand for “cheap, fixed, and long” with the bank’s preference to provide “expensive, variable, and short?” Most lenders seek the path of least resistance, avoiding conflict with their customers and offering the lowest and longest rate they think their boss will allow. This is the path the entire industry has been on for years now, and it is exceptionally painful and risky given the current levels of interest rates.

The best lenders, on the other hand, have a very different solution for the same problem. They have a conversation with the customer, touching on the customer’s fear of a rate spike, while also acknowledging the bank’s need to have more NIM certainty. They often find a solution for both sides through the use of caps and floors.

When we looked at our data, we found that top-performing lenders offered variable-rate loans more often than their lower-performing peers (50% vs. 39%). What’s more, top lenders were five times more likely to use caps and floors on their variable rate deals.

Chapter7-chart3
By using a cap on a variable rate, lenders are able to provide the benefit of the lower rates at the short end of the curve while still providing risk mitigation to customers. Customers know the payments can only climb so high, but they don’t have to pay the relatively expensive cost of a fixed rate loan to get that insurance. In exchange, most customers are willing to trade a floor on the rate as well. A floor comes with little additional cost to the customer, yet it helps the bank guarantee a minimum rate of earnings. The bank and the customer are able to share the interest rate risk in the most efficient way possible.

In addition to more effectively solving their customer’s problem, these top-performing lenders were also able to generate superior returns for the bank. The deals they won that used caps and floors had an average ROE of 30%.

Why is this structure so profitable? The first reason is simple: supply and demand. If your competitors are all trying to offer the cheapest and longest fixed rate they can stomach, they will be battling in a race to the bottom. A variable rate with caps will have a lower nominal rate but still alleviate the fear. It is not simply a commoditized offering that’s the cheapest rate in town.

For the second reason we had to dig one level deeper in the data. The best lenders don’t just book five times more caps and floors. Their cap/floor deals are 1/5th as long as the ones other lenders book.

Constructing shorter-term deals is a critical difference. This tactic allows the best lenders to utilize the structure of the deal to solve the borrower’s problem in a way that is also beneficial to the bank. This balancing act hinges on the uncertainty surrounding forward interest rates and the volatility around possible future outcomes.

Specifically, the markets have a good idea about what short term rates will look like in the near future – 3 months or even 2 years out. But the uncertainty increases dramatically for a longer time horizon, such as 5 years out. Thus, banks can offer caps within a near-term window at a low cost, while longer-term protection becomes an expensive proposition.

The good news is that customers don’t fear gradual increases five years from now, because by that time the debt will have amortized down. Instead, customers fear the spike in the short term. A short-term cap allows customers to sleep soundly at night at almost no cost to the bank, providing the classic (but hard to find) win-win scenario in loan negotiations.

For lenders to be able to provide solutions like this, they must first be aware of their borrowers’ fears and their unique situation. That requires a completely different kind of conversation, and it all starts with lenders being able to transparently show borrowers exactly where their deal stands relative to the bank’s “line in the sand.”

This kind of communication borders on blasphemy in many banks. But, your customers are experiencing transparency now in all walks of life, from buying cars to deciding medical care. Heck, part of the appeal of mobile services like Uber is that you can see all parts of the transaction (cost, driver ratings, car type, even current location) before finalizing the deal.

How long will your customers put up with a bank that uses asymmetrical information to bully them in negotiations?

Last Chapter

Chapter 6: What Makes a Great Lender?

Great lenders can have a tremendous impact on a bank’s performance. What if great lenders are made? What if we can train and develop the next generation of stars from within our own ranks?

Next Chapter

Chapter 8: Building a Pricing Ecosystem

Banks spend much of their total technology budget on maintaining core systems, but that is not where value is created.

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