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Price Setting

Following the financial crisis of 2008-09 and the subsequent deep recession, a multi-billion dollar bank in the Midwest was at an important crossroads. The bank had in essence been born during the crisis, as a large investor arranged several shotgun weddings of smaller banks that were either failing or simply run by management teams that didn’t feel equipped to deal with the changes facing the industry.

The resulting bank in some ways resembled Frankenstein’s monster, as the various pieces didn’t seem to fit together exactly right. In fact, for this story we’ll call it Frankenstein Bank. There was a core piece that was a traditional community bank, with high concentrations in commercial real estate, but there were also smaller offices spread all over the country, with lending focuses in areas such as energy, entertainment, and gaming. They all had different management teams, and each had its own culture that dictated everything from credit standards to pricing practices. The new leadership at Frankenstein Bank had their work cut out for them, to say the least.

After putting the basic underwriting process in place, the bank’s management team shifted its attention to pricing. Like a lot of banks, they turned to trusty old Microsoft Excel, and went about expanding on a risk-adjusted return on capital (RAROC) model from one of the precursor banks to price loans.

The finance folks did their homework and covered all the bases. They built a bank-specific funding curve with a built-in liquidity premium. They debated on which interpolation method was best. They did extensive studies of overhead costs, and they built credit migration assumptions. They even started a massive project that would enable them to use stochastic modeling to allocate economic capital for individual loans based on their specific credit profile.

However, despite the thousands of dollars and hundreds of hours spent on pricing over a three-year period, Frankenstein Bank’s results were lagging far behind those of its peers. Specifically, despite growing the loan portfolio at an impressive clip and improving the loan/deposit ratio, the bank’s net interest margins were shrinking. And not just by a little. As the chart below shows, net interest margins declined by more than 100 basis points. For a bank that size, that’s about $70 million per year worth of margin.

So, why didn’t these efforts translate to results? After all, Frankenstein Bank clearly realized the importance of pricing, and was willing to spend the time and money necessary to improve in this area. Why were the prices they had spent immense effort to calculate so precisely not the ones that were actually landing on their books? And why weren’t they building valuable relationships with their customers that would translate to premium pricing?

This is an excerpt from the book, "Earn It"

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