Banks have failed to understand the true nature of their complex cost structures, and have seriously underpriced their products and services to reflect the value they provide, geographic differences in relative price sensitivity, and the specific risk of commercial borrowers. Banks need to systematically reprice their product lines to reflect value and risk.

Moreover, banks attempting to adjust the inadequate pricing of the past must now battle both consumer advocate groups and antitrust regulators, who will make repricing in the future even more difficult.

Corrective Formula

An approach that focuses on customers' perceived value and risk profiles can help correct past errors in pricing and lead to a 15% to 20% increase in a bank's noninterest income with negligible, if any, account runoff.

This is the first of a series of three articles, to appear over the next couple of weeks, on how banks can approach the necessary reegineering. We will present the reasons for the underpricing phenomenon and its impact in this first part, then move on to a technical foundation for a better understanding of pricing and, in part three, show how to link price to value.

Simply put, bankers often do not know how to price. But they have the opportunity, with repricing, to increase pretax income by $10 billion to $15 billion annually. Capitalizing on this potential should be one of the top priorities for CEOs.

Historically, bankers had little need to develop expertise in setting prices for transactions, which has resulted in a general lack of pricing sophistication. Interest rate regulation provided a subsidy that made it unnecessary to understand the specific value customers placed on individual services and transactions.

Products were bundled for pricing purposes, services were cross-subsidized, and it was not important to understand costs, margins, or relative geographic and borrower risk differentials.

With deregulation, institutions were forced to set their own prices. Cost-based pricing and competition-based pricing became popular. Both were inward-looking approaches that resulted in gross mispricing.

Faulty Methods

The formula used in cost-based pricing is cost plus margin, which obviously means that a bank must first know what its costs are. The fact is that most banks don't have a true understanding.

While many have embarked on the painstaking task of allocating costs to products or customers, they have used the standard unit costing methods of manufacturing companies (which are essentially meaningless in banks) to allocate the common costs of shared branch networks, back-office processing, and so on.

Knowledge of competitors' prices is a valuable but insufficient element of optimal pricing. Price leaders often do not know any better than followers what constitutes the right price in terms of perceived value.

Value-Based Pricing

The limitations of current pricing practices should be contrasted with value-based pricing, which is rooted in customer behavior, and only then factors in cost and competition. Such an approach focuses explicitly on customer price elasticity (i.e., the percent change in demand for every 1% increase in price) at the transactional level.

Relative sensitivity to price is a function of many financial and psychological factors, most typically: amount of payment, frequency of purchase, complexity of product, pricing structure, switching cost, availability of information, and image.

Market research provides compelling evidence that customers value bank services far more than bankers think. In a recent American Banker survey, consumers ranked price as the seventh-most-important factor in dealing with a bank.

One indication of customer loyalty is that almost 50% of "room and pop" businesses have been with their primary bank for 10 years or more. Among consumers, that number jumps to more than 60%. Three out of four small-business customers and 66% of individuals are "very satisfied" with their bank.

Reaction to Price Increases

But the true test comes when actually raising prices. If a bank does so beyond the value that customers attach to its products, they will simply take their business elsewhere. Prices can be selectively raised, however, provided products and services are unbundled and reviewed based on perceived customer value instead of cost-plus pricing.

This is not restricted to markets where competition is scarce. Even when customers have the option of switching institutions, banks can increase their transaction revenues by 15% to 20% simply by adopting selective repricing based on customer value - with less than 1% account runoff concentrated in very-low-balance accounts. This amounts to about $8 to $10 billion in forgone pretax earnings for the industry.

This is not to suggest that a thorough knowledge of costs - at least direct costs - and competitor prices has no place in the price-setting process. It enables institutions to see what price levels are unsustainable in view of existing capacity and current competitor prices.

Customers' perceived value, however, should be the dominant driver of pricing.

Geographic Differences

Banks have also seriously underpriced transaction services and interest margins to reflect geographic differences in price sensitivity. They have begun to address this issue largely as a result industry consolidation.

Recent Federal Reserve studies have found that, as bank mergers cause power to be concentrated in fewer hands (particularly in states like California, where the market is already more concentrated than elsewhere), customers tend to earn lower interest rates on deposits.

And borrowers, particularly small businesses, are charged higher rates for loans. This does not imply, however, as consumer advocates charge, that there is cause for concern that "the little guy will pay" for consolidation. Underpricing by Weak Thrifts

Deposit and lending yields that vary geographically are most often a reflection of past irrational pricing by weak savings institutions, not price gouging. From the customers' perspective, competitors.are rewarded for having both a higher share of distribution locations and the right type of distribution (such as branches or ATMs) in the right place. In short, location is everything.

The pricing potential of concentration - provided it does not overstep the bounds of antitrust constraints - is both significant and justified by customers' behavioral preferences. A rough estimate of the potential of such price differentiation is as high as $4 billion pretax annually for U.S. banks. Yet many banks have failed to capitalize on this potential for local pricing.

Borrower Risk Pricing

Finally, banks have failed to price effectively for their true cost of lending, once the relative risk of borrowers is taken into account. This is especially true in commercial lending because of the changes in demand and supply factors during the 1980s.

Commercial loan demand has decreased because capital market alternatives such as commercial paper, medium-term notes, junk bonds, and derivatives have provided more efficient and less expensive for all but the riskiest borrowers. Meanwhile, alternative suppliers such as foreign banks, insurance companies, and finance companies have made significant inroads into the market. The result is overcapacity without rationalization.

Banks have simply been underpricing for the commercial loan risk - often essentially equity risk - that they have assumed. Such underpricing costs the U.S. banking industry roughly $2 billion a year pretax.

To fix their past failings, banks must do the following:

* Price to value. Since transactions and services have a definable and quantifiable value to customers, bankers must refrain from cost-based charges or competitor-matching prices, and follow consumer product marketing standards of value pricing.

* Price geographically. Understand that customers will pay more for local convenience. Customers are not irrational in failing to arbitrage geographic price differences; they understand the forgone income or cost, but trade it off against what they value more highly.

* Price loans for differential risk. Bankers must break down the respective risks of different borrower segments (just as investment bankers do with mortgage-backed securities or insurance companies do with pools of car insurance risks) to differentiate their loan pricing. If banks cannot be the engine of a recovery from the "credit crunch," there are alternatives available, such as middle-market and small-business loan securitization, which can provide companies with financing while giving a fair return to investors.

* Lobby for rational pricing. A significant educational process is required to illustrate the justification for future repricing to allow price and value to be brought back to equilibrium.

By PAUL ALLEN and JACQUELINE CORBELLI Aston Limited Partners First of Three Parts

Mr. Allen is chairman of Aston Limited Partners, a New York-based bank investment and reengineering firm, and author of the recently published book "Reengineering the Bank: A Blueprint for Survival and Success" (Probus Publishing). Ms. Corbelli is managing director of Aston.

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