ExEcuTIvE WhITEpapEr

Why Banks Need to Immediately Fix their Pricing Process

This executive whitepaper illuminates the key problems faced by most banks in their pricing practices and processes. It also provides guidance on how to leverage customer response in the pricing process and better manage through a dynamic market.

In a recent survey of pricing managers across the top 30 banks and finance companies in the US and Canada, 90% admitted that their pricing process was in dire need of improvement. Most banks still manage their pricing strategy with Excel spreadsheets. These shortcomings result in profit and volume losses on the order of 10-20%.

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volatility in the financial markets is having a significant impact on bank and finance company executives. It is causing them to reevaluate their current pricing practices and processes. The outlook for 2009 and beyond is marked by: increasing charge-offs on mortgage, home equity, credit card, and auto loan portfolios; decreasing short-term interest rates; intense competition for deposit funds among the major banks; and slowing consumer spending and borrowing in the face of an uncertain economy.

The lack of focus on pricing is surprising. The ratio of risk analysts to pricing analysts in the typical bank is probably 5-to-1 or higher. Similarly, banks have invested significantly in risk-management technology but completely neglected pricing technology.
Below is an example of a typical pricing process in a large uS bank: Step 1 - Executive management, in combination with the asset and Liability committee (aLcO), sets deposit funding and asset lending goals for the quarter, Step 2 - p&L, product management, and risk management try to translate those goals (volume, net interest margin and portfolio mix targets) into a pricing strategy, Step 3 - product management reviews competitor rates to ensure that the proposed pricing strategy is market competitive, Step 4 - The pricing committee discusses and makes changes to pricing recommendations, New prices are posted internally and externally, and Step 5 - The front-line staff negotiates with customers for the final price. There are several shortcomings in this process:
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The root cause of the credit crisis is that banks and finance companies have not managed to connect pricing strategy to a balanced understanding of profitability and customer response, including the impact of pricing on risk. The Pricing Process is Fundamentally Broken
There is a critical need for banks to get back to the basics. at the core of every banking operation are three key questions: 1) From whom do I generate deposit funds? 2) To whom do I lend these funds? 3) Whats the right price for each? The pricing of deposits and loans is at the core of managing the performance of a bank. Yet across most financial lending companies, we have observed that the pricing process is fundamentally broken. In a recent survey of pricing managers across the top 30 banks and finance companies in the uS and canada, 90% admitted that their pricing process was in dire need of improvement. Executives in the top 10 banks in the uS admit privately that their ability to use pricing to drive business results is limited. Why? While executives understand that they have some pricing power in their respective markets, they lack the tools to translate business strategy and corporate goals into the tactical pricing of products, such as mortgages, home equity lines and loans, auto loans, cDs, and money market accounts. Most banks still manage their pricing strategy with Excel spreadsheets.

There is no clear understanding of profit and volume tradeoffs when defining objectives for product and segment performance. Because the review of competitor rates as well as internal rates is manual and judgmental, pricing managers can only focus on a handful of headline rates rather than the entirety of the pricing strategy. Out of thousands of pricing cells, most managers will only look at 5-10 headline rates. 80% percent of rates are too high or too low because price response is poorly understood and often judgmental. adverse selection is not well understood. Most pricing

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managers would not know how much funding is generated by a 25 basis point rate increase in 6-month $5,000 cDs in california or how that would impact the credit mix.
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Even when price elasticity models are in place, there is no infrastructure to optimize thousands of rates simultaneously across products, markets, and customer segments. Pricing guidelines are often based on simplistic rules of thumb. For example, rates must increase in increments of 10 or 25 basis points or all rates must end in five or nine basis points. 3-5 % of all prices have errors because they were manually coded into loan origination or deposit processing systems. 20% of profits are lost at the point of negotiation, because the negotiation rules given to the front-line staff are overly simplistic. For example, the front-line staff is empowered to give customers with a checking account a 50 basis point discount on loans and an additional 25 basis points of pricing discretion on all cDs, regardless of the customers value to the bank. Without a rigorous actual performance tracking process, the pricing and profitability team have a difficult time determining whether or not performance targets where met. and, if they were not met, the pricing team is often unable to identify the reasons why performance varied from plans, which could help them make better pricing decisions in the future. In sum, these shortcomings result in profit and volume losses on the order of 10-20%.

The pricing models that banks had in place were not accounting for the changing customer behavior down the line: on rate-reset, with declining home values, and now a slowing economy. No one was running simulations or optimizations to determine how a portfolio of 620-FICO customers with 90% LTV loans would do under these changing conditions. Poor Pricing Practices Were the Root Cause of the Credit Crisis
What we saw from 2003 through the summer of 2007 was a very aggressive expansion of consumer credit, specifically mortgages, without adequate risk premiums to cover expected and unexpected losses. Because banks didnt have a comprehensive pricing optimization platform in place, they were unable to adequately assess the cost of the adverse selection that was invariably occurring in the near- and subprime markets. In addition, most banks were basing their pricing strategy on what the competition was doing. Lastly, and this is now well understood, the current pricing models that banks had in place were not accounting for the changing customer behavior down the line: on rate-reset, with declining home values, and now a slowing economy. No one was running simulations or optimizations to determine how a portfolio of 620-FIcO customers with 90% LTv loans would do under these changing conditions. Now, since about October of 2007, the pendulum has swung the other way. rather than adequately price loans for near-and subprime customers, the market has effectively shut down completely. This is an overreaction out of fear that every new mortgage to a 620-FIcO customer will default. During the good times, loans were significantly under-priced compared to their level of risk and now because banks dont know how to price them, these loans are simply not offered. Of course there is an optimal price for the 620-FIcO 90% LTv customer, but banks do not have the systems in place to determine that price, so they miss out on the opportunity to capitalize on that business.

however, there is an even bigger issue that was the root cause of the credit crisis: banks and finance companies have not managed to connect pricing strategy to a balanced understanding of profitability and customer response, including the impact of pricing on risk.

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Pricing Optimization Enables Pricing to Be Leveraged As a Strategic Driver of Performance

The problem is that pricing strategy is often the result of a negotiation of various stakeholders in the bank without the benefit of a common information layer. So while times were good, the marketing and sales instinct of the bank took over and loans were priced the same as everyone else in the market priced them, in order to grow volume and gain market share. Now fear has taken over and banks are overreacting in the other direction. What is missing in this process is a pricing and profitability management platform that: provides a common depth of pricing insight to all stakeholders in the organization, translates strategic goals and constraints into the thousands of price points a bank has in the market across deposit and credit products, accurately balances risk and profitability forecasts with an understanding of customer response and competitive prices, allows for rapid recalibration of a strategy as the market and the consumers behavior change, and fixes the process leaks described above.

Pricing optimization enables executives to leverage pricing as a core strategic driver of performance. Pricing should not be treated as a support function, but a core competency because it is the quickest and highest leverage strategy that a bank can deploy to impact results this year.
In this environment, pricing optimization is one of the few ways in which executives can improve net interest margins and keep volume propped up. The rewards are significant. Optimizing the pricing strategy and plugging the holes in the pricing process has resulted in the following performance improvements:
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16% Npv improvement for a top 5 canadian lender 25% volume improvement for a top 5 uS auto lender 18% profit improvement for a top 10 uS auto lender 13% profit improvement for a top 10 uS mortgage lender

Conclusion
Forward-looking banks and finance companies have realized the revenue potential pricing optimization brings and made it a strategic initiative with high levels of executive visibility. In addition to executive sponsorship, choosing the right technology partner is obviously critical, as is ensuring the right level of change management and communication internally. Yet at the same time, pricing optimization starts to show results within weeks and months rather than years and as such is one of the few tools that executives have at their disposal to weather the next 12-24 months. Most importantly, implementing a comprehensive pricing and profitability management platform will prevent a repeat of the irrational pricing and excesses we have seen in the last three years.

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A best-in-class Pricing and Profitability Management approach delivers the following benefits:
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About The Author

Frank Rohde, Chief Marketing Officer & Vice President of Product Management, Nomis Solutions Frank rohde is responsible for leading Nomis Solutions product management in developing world-class solutions that harness the power of analytics, optimization and execution. he is also responsible for global marketing and corporate development. Frank brings 15 years of financial services domain expertise to the company. Most recently, Frank served as vice president of Enterprise Decision Management at Fair Isaac corporation (NYSE: FIc). Over the past 15 years, he has worked with a range of financial services clients on product development, marketing, and pricing problems. Frank graduated from the Wharton School of the university of pennsylvania with concentrations in finance and management.

Achieve Profitable Growth: Effectively deploy scarce capital and improve profits and/or volume by 10-20% Create a More Attractive Portfolio Mix: use valuable and actionable customer insights to originate loans and manage the portfolio at acceptable risk tolerance levels Gain Operational Efficiencies: Leverage a more consistent, repeatable and efficient pricing process that meets regulatory requirements and allows you to make price changes more frequently and with a higher level of accuracy

About Nomis Solutions

Nomis Solutions enables best-in-class pricing and profitability Management for financial services companies. Through a combination of advanced analytics, innovative technology, and tailored business processes, the pricing and profitability Management Suite delivers quick time-to-benefit, and improves financial and operational performance throughout the customer acquisition and portfolio management processes. The pricing and profitability Management Suite of business solutions includes the award-winning Nomis price Optimizer, the Nomis Offer Optimizer, the customer portfolio Optimizer, and the Nomis Navigator. These solutions are designed to meet the specific requirements of auto finance, home equity lending, personal lending, mortgage, and deposits executives. Select customers include abbey, americredit, chrysler Financial, hBOS plc, and royal Bank of canada. headquartered in San Bruno, ca, Nomis Solutions also has offices in London, united Kingdom Visit www.nomissolutions.com or contact us at info@nomissolutions.com or 650-588-9800

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