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No room for error with deposit pricing

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A bank’s ability to execute surgical pricing strategies on its deposit portfolio is one of the most potent competitive differentiators in the current interest rate environment.

Banks that can’t deliver this will experience net interest margin declines that will erode overall profitability.

When most consumers think about their deposits at a bank, they probably don’t realize that they are providing the basic, raw materials that a bank needs to function. Deposits to banks are analogous to sheet metal for the automotive industry, or what crude oil is for the petroleum industry.

Stretching that analogy further: If the cost of sheet metal goes up, either the cost of cars will increase or the profitability of the car company will go down, if the costs are not being passed along to the end customer.

How does all of this translate to banking? Well, the competition for these "raw materials" (that is, bank deposits) is heating up significantly.

If history is any guide, the intensity of this competition will only increase over the next few months. As a consequence, bank margins that are already being squeezed will continue to decrease well into 2020.

There are three implications for banks.

First, banks need to understand the competitive market, and know when to lead or lag pricing changes. Second, banks need to understand how various segments of the portfolio will react to rate changes. And third, banks will need to be able to detect and execute on smart trades within their portfolio.

Analysis from the last flat-to-falling rate environment (July 2006 through September 2008) reveals several insights.

First, the cost of deposits continued to increase, by 58 basis points, while the Federal Reserve held rates steady from July 2006 through June 2007.

Next, cost of deposits was relatively flat for the first six months of the falling-rate cycle, starting in July 2007. During this period, the Fed dropped rates by 100 basis points — an entire percentage point!

Finally, for the 10 months between January and October 2008, although the Fed lowered rates by 275 basis points, the cost of deposits dropped by less than half that amount (128 basis points).

All of this points to the fact that competition for deposits increases dramatically in a falling-rate cycle, putting downward pressure on margins and profitability.

Simply put, banks will need to cut back on the rates they offer to customers on savings, money market and certificates of deposit. But they will need to be smart about it. Traditional practices of reactionary or follow-the-leader pricing can lead to dissatisfied customers and inefficient financial results for banks.

A key problem confronting banks is that it is difficult to know exactly how different customers or different segments of a bank’s deposit portfolio will respond to rate reductions. In response, banks must develop scientific customer segmentation techniques as they evaluate pricing strategies.

Rather than using broadly applied “machete” approaches, they need to adopt precise “scalpel” targeting.

By leveraging advanced microsegmentation techniques, predictive models and price optimization, portfolio and product managers can negotiate trade-offs between balance growth, or maintenance and profitability. More important, this helps managers understand how segments of their portfolio will respond to a price change before actually making that change.

The other problem banks frequently run into is that they don’t have the infrastructure in place to execute on these targeted analytical approaches because they are using a one-size-fits-all price execution engine.

An extreme but very common example is where a bank is unable to price their front and back books differently; and any pricing offered to new customers will need to be offered to the entire book of business.

This is equivalent to Amazon offering a great deal for a coffee machine on Black Friday but then going back to all customers who bought the same machine in the past and retroactively offering that discount to everyone.

The value of a surgical approach to pricing is that pricing decisions and execution can support the best outcome for the bank and its customers.

Implementing such an approach begins with objectively understanding customers’ behaviors and preferences; and then creating a corresponding segmentation schema.

What features do various tranches of customers value? What characteristics correlate to decision making?

This will be fundamental in enabling the bank to align a strategy with product pricing and design.

Strategy varies greatly between different institutions. Whether it’s a national bank looking to grow its footprint in discrete markets, or a credit union trying to reward member loyalty, scientific segmentation will be key to implementing and understanding the implications of product or price changes.

In addition, product features and pricing must be carefully crafted to balance customer segments’ needs with the bank’s strategy and broader goals. This involves defining a value equation for each segment and deciding how to reward it.

For instance, fee waivers, premium pricing or introductory offers may not be valued the same by different segments. And these are ideally issued with precision as opposed to being issued broadly, where either profitability or customer needs will suffer for certain segments.

Finally, it doesn’t matter what segmentation, strategy or product approach banks devise in the back office if the right price-execution mechanisms are not in place. The key here is speed and flexibility in implementing product and pricing changes. This is a challenge for most financial institutions.

Whether it’s the need for a sophisticated rules engine to manage pricing and promotional offers, or the integration and compatibility of such with a bank’s core processing systems, many banks simply do not capitalize on opportunities within their portfolio. This results in a loss for their profitability and customers.

Executing pricing at a more granular level requires a broader ecosystem of management and delivery competencies. However, it is a worthwhile effort when managing portfolios amid highly competitive markets or volatile economic conditions.

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