Precision Deposit Pricing

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1 Precision Deposit BY PABLO DE LOS SANTOS AND RICH SOLOMON Deposit pricing analytics offer substantial opportunity in banking, but each management team faces the challenge of establishing a clear developmental path. Precision deposit pricing has emerged as a key lever for optimizing bank performance. Large banks around the world have invested heavily in advanced deposit pricing analytics, both to drive higher margins and to tap the best opportunities for balance growth. Successful banks have typically discovered opportunities to enhance deposit margins by anywhere from 5 to 25 basis points via analytic deposit pricing. At the individual bank level, however, each management team faces the challenge of establishing a clear development path for improving deposit analytics. Especially given the high financial precision required for healthy growth and competitive shareholder returns in banking, executives want to minimize expensive explorations in favor of focused investments with measurable returns. The analytic and technological components of deposit pricing require careful nurturing. While each institution has unique variables (size, strategy, structure, markets, competitors, etc.), Novantas global multi-bank research shows four general stages of deposit pricing, each with specific characteristics and opportunities. The basic level, still seen at many institutions today, is pricing against the market to gather funding for loans. At the next level, pricing evolves into a profit driver in managing the deposit line of business on a portfolio basis. From there, pricing is honed for precision responsiveness across varying geographic territories, customer segments and competitive settings for local networks. The ultimate level, rarely seen, is an integrated deposit pricing framework, supported by a skilled team and advanced modeling and analytic tools. In managing this journey, complexity is reduced by staging developmental efforts across five logical dimensions, including: 1) methodology; 2) analytics; 3) funds transfer pricing; 4) process and governance; and 5) resources. Figure 1: Price Elasticity Framework Mastery of price elasticity helps to optimize account profitability or balance formation, depending on strategy. Demand for bank deposit balances Profitmaximizing point Uncompetitive pricing X Area of customer indifference to price changes No man s land, where neither margin nor growth objectives are maximized Rate offer (relative to competitors being considered by the customer) Opportunities to pick up balances Source: Novantas Inc., New York 1

2 DEMAND FACTOR A key consideration in deposit pricing is the strength of customer demand. Expert systems for deposit pricing feature systematic calculations of price elasticity of demand, or statistical measures of the extent to which customers adjust deposit balances in response to rate changes. In our work we have found that strong statistical correlations between rate and balance fluctuations typically take the form of an S curve (Figure 1: Price Elasticity Framework). Such curves include a subtle but significant central area of indifference, in which small rate changes have little impact on balances. By learning to analytically establish prices within this range, retail bankers can support deposit strategy by identifying where to price for growth and where to price for margin. There are many applications of this concept. The more skilled the bank becomes, the more it is able to optimize pricing across the franchise. Examples include: Optimizing regional and local market pricing, considering differing competitive circumstances and geographic patterns in balance formation relative to pricing. Anticipating balance flows between products in a changing rate environment. Using targeted pricing to attract additional balances from core customers. Using targeted promotional pricing for renewals. For portfolio optimization, making efficient use of rates to ensure the retention of core customer who are more price sensitive (e.g., renewal promotions) while de-emphasizing price with less sensitive segments. for balance retention in liquid accounts after introductory rates expire. Segment-level optimization of balance formation and retention. Price optimization for multi-channel direct marketing and sales. One common perception about deposit pricing is that sophisticated techniques are only suitable for the very largest global banks. Our global research, however, shows extensive incorporation of elasticity-based pricing among mid-sized players as well. Novantas has identified four distinct stages of deposit pricing excellence, each containing its own set of performance improvement priorities (Figure 2: Four Stages of Deposit Sophistication). 1. Balance Sheet Funding. Institutions in this category view deposits as a funding source for loans, not as a distinct business. Deposits typically are priced within the context of available asset yields and market rate trends. The use of pricing analytics is rare, as is the presence of dedicated pricing staff. 2. Portfolio Valuation. Institutions in this category view deposits as a key profit driver, and they carefully evaluate the impact of pricing changes on overall deposit portfolio value. The business is evaluated on a franchise-wide basis, with little pricing variation across markets at this stage. Valuation assessments are incorporated into funds transfer pricing decisions, although in a more limited way that does not anticipate customer variations in price sensitivity and expected balance retention. A basic product management 2

3 staff is in place, but dedicated analytic staff typically is limited, with most deposit pricing analysis instead being conducted by the finance staff. 3. Customer Responsive. Along with highly refining their understanding of what deposits are worth to the bank, institutions in this category have developed an analytically-based understanding of what deposits are worth to the customer, in terms of how rate variations affect balance formation. These banks price more granularly, including regional and local variation. Funds transfer pricing methodologies are much more advanced, with finer granularity in assigning matching rates, and more frequent incorporation of liquidity premium metrics that explicitly recognize the value of loyal deposit balances. These banks have advanced analytics and tracking, although much is still done in an ad hoc fashion, and pricing activities remain critically dependent on a few highly skilled staff members. 4. Integrated. Banks at this stage are rare. They understand the full value of deposits and accurately reflect it into funds transfer pricing, with tailored FTP prices for different tranches of the portfolio based on a methodical comprehension of customer elasticities and behaviors. is even more granular, with gradations including sub-state markets, metropolitan statistical areas and, increasingly, individual customers. Banks at the integrated pricing level have advanced analytics, including customer-level modeling; are able to conduct price testing; and have adopted continuous learning and refinement into their activities. They have invested in a high degree of automation, both to improve market responsiveness and reduce the execution risk associated with Figure 2: Four Stages of Deposit Sophistication There are four stages of pricing sophistication, progressing from the balance sheet funding level, to the portfolio valuation level, to the customer responsive level, to the integrated level. BALANCE SHEET FUNDING PORTFOLIO VALUATION CUSTOMER RESPONSIVE INTEGRATED Methodology Deposits are priced to fund the loan book One price in all markets Deposits are priced relative to FTP as well as major competitors Limited price differentiation between markets Product- and market-level competitor prices and customer elasticities are factored into decisions Regional pricing differentiation Segment- and customer-level pricing Optimization based on competitor analysis, FTP & customer elasticities Analytics Minimal Financial modeling to optimize margins Basic tracking of competitor rates Elasticity modeling at regional / product level Ad hoc models Customer-level pricing analytics; predictive modeling of competitor rates; optimization algorithms Automated and integrated pricing tools and systems Rigorous testing methodologies Funds Transfer Not in place Basic matched maturity methodologies in place Advanced methodologies, including liquidity premia and options cost More granular segment-level FTP Process & Governance Highly centralized decisions, typically made by Treasurer Typically decentralized, with FTP metrics provided to regional managers who run their own P&Ls Typically more centralized, with product management running analytics and making decisions Input and market color provided by regional managers Federal model of central decisions w/ regional input Separate strategy & tactical meetings, annual planning includes pricing strategy Standardized processes & approvals to cut errors & risk Organization & Resources No full-time analysts Integrated product management and pricing analysis Dedicated pricing analytics team Dedicated team with substantial resources (2 3+ staff per $25B in deposits) Source: Novantas Inc., New York 3

4 their complex pricing activities. analytics for performance optimization are integrated with those required for regulatory liquidity purposes. Substantial staff resources have been allocated to support a comprehensive effort. CAPABILITIES CONTINUUM To assure overall progress, five aspects of deposit pricing need to be nurtured: Each management team faces the challenge of establishing a clear development path for improving deposit analytics. Especially given the high financial precision required for healthy growth and competitive shareholder returns in banking, executives want to minimize expensive explorations in favor of focused investments with measurable returns. methodology. Here the emphasis is on the principles and practices used to set pricing, ranging from one-size-fits-all to fine granularity across markets, channels, customers and products. In addition to geographically-based price tailoring, banks are introducing more product-based pricing variations, permitting more flexibility and precision in targeting different price-elastic and -inelastic portions of the customer base. granularity continues to increase, with the most advanced banks moving to segment- and customer-level pricing. Banks that still apply one-size fits all pricing to their vast franchises will necessarily fall behind. Analytics. Banks are investing substantially in pricing analytics and technology, and modeling techniques and applications are constantly being refined. In our global multi-bank research, almost all survey respondents named pricing analytics and optimization as one of their top three development priorities, making this the number one area marked for performance improvement. Leading banks are investing in data-driven market definitions, competitor rate forecasting, and customer-level price elasticity modeling and price optimization. In addition, the increased complexity that comes with more granular pricing has led many banks to invest in the automation of deposit pricing analytics many are moving away from ad hoc SAS and Excel analyses to fully integrated pricing analysis systems. Funds transfer pricing. Deposit balances can vary sharply in their value to the bank, not only relative price but also longevity. To improve internal decision-making and performance assessments, banks are advancing their thinking on FTP and valuing deposits more precisely. FTP metrics are becoming more granular, with increased focus on institution-specific liquidity premiums and the assignment of funds transfer prices to product segments based on analyses of customer behavior and price elasticity. Process and governance. Given the complexity of their regional branch networks and the need for advanced analytics, banks are becoming more centralized, with many implementing a federal model of central pricing supported by regional input. Most often, product managers are the final decision-makers. Many banks are also integrating pricing strategy with annual planning and budgeting. In addition, given the complexity of pricing and the associated risks when fielding a large number of price points, banks are using more structured pricing implementation processes and approval routines to avoid pricing errors in the field. Organization and resources. As pricing applications expand, so too must staff resources and technology investments. Leaders build skilled and well-equipped teams. Among major U.S. banks, for example, deposit product groups range from a few dozen to more than 200 staffers. 4

5 MANAGEMENT AGENDA In building the agenda for deposit pricing, executives will have different priorities based on the stage of progress at their bank. Generally for banks in the early stages of development, there are four main questions: Where do we stand relative to industry best practices? It is helpful to review current pricing practices in light of overall industry trends, both to get a fuller sense of the possibilities and to clarify developmental priorities. What are the specific issues and opportunities at our bank? Management needs to decide on a prioritization of effort to capture pricing-related opportunities for margin enhancement and balance formation. What capabilities will be needed? Our research shows that pricing-related investments can be staged in a manner that smooths organizational transitions and provides positive returns at each stage of the development cycle. What is the likely development path? It is important to come to grips with build or buy questions which capabilities can feasibly be developed internally, and which should be acquired from external sources. Spend levels and timelines also must be set. Pablo de los Santos and Rich Solomon are Managing Directors at Novantas Inc., respectively in the Madrid and New York offices. They can be reached at pdelossantos@novantas.es and rsolomon@novantas.com. ABOUT NOVANTAS Novantas is the industry leader in analytic advisory services and technology solutions for financial institutions. Novantas advisory services translate our relentless focus on analytic insight into rapid, measurable results for bank clients e.g., superior understanding of customers; optimizing pricing, risk and profitability; reconfiguring channel investment; differentiated product design; improved sales productivity; modeling risk, liquidity and stress testing; M&A targeting and valuation. And as a FinTech 100 Company, Novantas technology solutions embed strategic insight from our advisory work into easy-to-use platforms, applying advanced analytic techniques to improve pricing, grow revenue and manage risk. Learn more at 5