Pricing strategy impacts

InfraRisk Pty Ltd. P: +61 3 9602 3396
#203a, 757 Bourke Street F: +61 3 9867 7750
Docklands VIC 3008 E: info@infrarisk.com

White Paper
Pricing Framework Impact for Non Retail Lenders
Quantifying the Benefit

Series 1.1

1st Quarter, 2011

Table of Contents

1. Executive Summary 1
2. Current Practices & Challenges 2
3. Benefits of Improving Pricing 3
4. How to Achieve the Benefits 6
5. Conclusion 10

Confidential
No part of this document may be reproduced or transmitted in any form or by any
means electronic or mechanical, for any purpose, without the express written
permission of InfraRisk Pty Ltd.

InfraRisk Contact
Any questions or requests for clarification or additional information should be
addressed in the first instance to:

Bao Nguyen, Executive Director

Nic Davies, Executive Director

Telephone: +61 3 9602 3396
Fax: +61 3 9867 7750

Email: bnguyen@infrarisk.com
Email: ndavies@infrarisk.com

Page i of 9

1. Executive Summary

Pricing is one of the most critical activities undertaken by Lenders, yet often the
ability to apply Pricing strategy is restrained by current practices that may not
have evolved to support the increasingly dynamic environments for credit.
Lenders will have different competitive advantages depending on the
characteristics of the markets they operate in – and the need to maximise these
and react to changed circumstances is increasing.
Fortunately, the benefits achievable from implementing a pricing framework that
enables strategy to be better executed – are substantial.
In this paper we demonstrate that for a modestly sized $10b Non Retail loan
portfolio, a 5% improvement in Margin / Fee incomes earned can result in a 15%
improvement to Shareholder Value ($1.1bn valuation increases by $153m).
Achieving the sort of improvements that a better pricing strategy can deliver
requires both methodologies and systems to work in harmony. Some of the key
objectives that a good framework will deliver on include:

 A Market focus is critical for pricing strategies to be effective. Many
institutions spend a lot of time and effort on calculations based on ROE or
RAROC (or other acronyms) and in turn use these to set target rates. Whilst
such efforts are important from an understanding and constraint
perspective – the “right” price to charge for credit is the maximum the
market will bear.

 Systems & methodologies need to be both complimentary and dynamic.
The two should be used in concert to build up insight and enable that
insight to be acted on.

 Facility & Portfolio level views of pricing returns are often hard to
reconcile. Whether a lender is using a complex economic capital model or
simple intuition – more capital is needed for segments or industries where
a lender has a concentration. At the facility level, where pricing is
negotiated, this is not always obvious and without an ability to
differentiate strategy at such a level – a Lender risks pricing correctly for a
transaction, but mis pricing in a portfolio context which over time will
destroy shareholder value.

Executing on delivery of a Pricing framework that supports a dynamic strategy is a
readily achievable proposition. The raw materials to do this – being the experience
and intuition of the Lender along with current market environment factors – are
readily found in most institutions – and with a little effort, they can be used to
great competitive advantage.

Pricing Framework Impact Page 1 of 10 © InfraRisk Pty Ltd

2. Current Practices & Challenges

For clarity, it is important to define what we mean by pricing:
Pricing is the activity of setting one or both of fees and margins,
either at a facility level or for a broader group of aggregated
facilities across entities.

Different institutions will price at different levels of complexity - but not
necessarily accuracy! Range of practices includes:

1. “Seat of the pants” relying on experience and gut feel
Typical evolution

of the front line teams.
2. Policy based, often reflecting a customer rating and
some other variable such as collateral coverage
3. Spreadsheet based calculation, which allows for some
sort of return / profitability targets to be generated.
4. Dedicated system that delivers a particular pricing
calculation or strategy – but can be at varying levels of
sophistication.

Although there are many challenges faced by banks using approaches 1- 3 (and
some on 4!) such as inconsistency, operational risk from errors, and outdated
information – the more significant impacts from not having a sound pricing
framework in place include:

 No leveraging of information. Lenders have an enormous information
disparity advantage over borrowers that can be used to great benefit in
pricing negotiations. This requires a dynamic ability to source and analyse
information that comes in daily from across their network.

 Limited reactive capability. If recent financial market turmoils have
reminded us of anything, it is that market conditions can change – and
quickly. Increased volatility coupled with capital scarcity will drive lender
business models for the near future. A pricing strategy can become out of
date very quickly. Successful lenders with an ability to react - will see
volatile markets as an opportunity.

 High cost of ownership. The „ownership cost‟ incurred for what at face
value seems a low cost solution of executing a pricing strategy through say
a spreadsheet – is the opportunity cost of lost income or transactions that
are directly and indirectly caused by mis pricing.


3. Benefits of Improving Pricing

When looking at potential benefits for virtually any project impacting on the
lending process – 90% of all such business cases will include some words along the
lines of: “with this new (insert capability here) we will be able to generate extra
income from ……” - yet rarely do such projects have an explicit pricing strategy
component!
In this case – we are looking at the return from investing explicitly in pricing
capabilities – so the benefits are direct and highly demonstrable.
Let us revisit the “Base Case” example lending portfolio from the earlier InfraRisk
white paper on credit productivity, as detailed below. Note: the same logic from
that paper also applies in that actual values are not significant as our focus is on
the impact, not the specific numbers:

Base Line Example
Capital 1,000,000,000
Assets 10,000,000,000 $10b of Lending assets, against say Capital
of $1b.
NIM 2.50%
Earnings 250,000,000 Typical Net Interest Margin (NIM)
Fee Income (1%) 100,000,000

Expected Loss (EL) to allow for loan loss
EL% 0.50%
experience.
EL$ 50,000,000

Cost to Income 45%
Operating Expense 157,500,000
Tax 30%
Net Profit after Tax (NPAT) and resulting
NPAT 99,750,000 Return on Equity (ROE) are fairly average
ROE 9.975% for this institution.

With the above results, we can provide a notional valuation of this institution “as
is”. There are a number of ways to do this; either by a rule of thumb P/E type
multiple, or a Cost of Equity / Dividend Growth Model as follows:

Beta 0.9
Using a simple Capital Asset Pricing Model to
Market Premium 6.00%
determine a Cost of Equity (Ke). Risk free and
Risk Free 4.00%
Market Premiums.
Ke 9.40%


Dividend Payout 70% Payout/ Growth Assumption to build a Value
Perpetual Growth 3% model based on Dividend / Ke – g, or:

(70% * $99.75m) / (9.975% - 3%)
Calc. Market Cap $1,091,016,000

Or use a simple P/E of say 12
Or use a P/E of 12 $1,197,000,000

For impact analysis, we can look at the Valuation using either of the above
valuation methodologies.
By improving the pricing process – the most observable impacts will be reflected in
two ways:
1. An improved Net Interest Margin (NIM), and
2. An increase in value of Fees.

It can also be said that loan Volumes could increase as a Lender is arguably able to
improve it‟s win rate of new deals, but that is a less „measurable‟ strategy as
there are many other variables that impact. For modelling purposes, we will only
look at improved NIM and Fee income.
Five scenarios have been generated as below. All else remains equal – other than
some modest NIM and Fee value increases that progressively increase towards
scenario 5. Scenario 4 for example sees a 5 bps lift from the base 2.50% to 2.55% in
NIM, and a 5bps lift from 1.00% to 1.05% for Fees.


The impact of modest improvements on both NPAT and, importantly, Valuation is
substantial. A traditional Project NPV type analysis will often focus on the added
income generated only, however it is also important to be cognisant of what a
more profitable strategy means for the value of the lender. The ultimate goal for
Board & Senior Managers – is to improve shareholder value.

Scenario 5

In the case of Scenario 5, a modest 20 bps increase across Margins and Fees has
been modelled. Achieving this from a superior pricing strategy is a very realistic
target across the portfolio. For this $10b portfolio, the business unit that delivers
this increase obtains not only an added $14m of extra income – but it has in fact
created an extra $153m in Shareholder Value!
Coupled with properly aligned Remuneration Incentives that reward long term
value creation as distinct from short term profit – a win win outcome is created.


4. How to Achieve the Benefits

Clearly the benefits from even a modest, incremental increase in income from an
improved pricing strategy are substantial. How to achieve this?
Some of the key differentiators and capabilities needed for delivering effective
pricing strategies include:

4.1 Market Focus
InfraRisk always recommends a market based focus when setting target Margins
and Fees. In some segments, Banks are price makes who have disproportionate
information to their customers
The margins the market is willing to bear will increase with risk (EL). However,
they increase linearly, whilst risk typically increases exponentially. This fact, plus
the fact that Capital will also increase exponentially with risk, results in a non
linear relationship between expected RAROC and risk grades
Customers are price takers and

 they do not have a clear view of their PD, but they do have a view on
Security strength; and
 they do not care about the bank‟s COF and funding risk either, all they
care about is value proposition: what product features they get for what
all up rate
Customers and frontline bankers think in term of margin and not ROE or variations
of ROE; It is much easier to identify mispricing in terms of margin and expected
loss than by mean of ROE.
We can set up a simple numerical example using a generic calculation for
Unexpected Loss that we use as proxy for Capital

√ ( ) ( )

Where C is commonly set to the value of 4 in many banks

If we look at the RAROC for the three Risk Buckets, it is very difficult if not
impossible to detect if there is a mispricing that can be corrected to the bank‟s
advantage: the RAROC progressively decreases where the Capital increases
exponentially.


However, if we look at the margins that are charged for the three risk buckets, we
can see the mispricing immediately.
Although the Margin for Risk Bucket 3 is higher than Risk Bucket 1 as expected, the
margin for Risk Bucket 2 is smaller than that of Risk Bucket 1. So there is an
opportunity to improve the Margin for the second Risk Bucket. This approach as
opposed to calculating the Margin from a target RAROC, is called the market
approach. The RAROC calculated from a market driven margin is used as a
minimum constraint and not as a target
Return on Capital measures such as ROE or RAROC can be used as guidelines or
even constraints, but not necessarily as the primary target. This is a subtle but
important change to typical processes where ROE type measures are often used
more explicitly as targets or a hurdle.
The benefits of adopting such an approach are:
a) Market based targets ensures a focus on deals that are achievable;
b) More integrity and credibility with the Front Line, being the area where
execution of the Pricing approaches is most critical;
c) Leads to a higher overall portfolio return; and
d) Ensures a more consistent logic and intuition around increasing price for
increasing risk.
Lenders have a huge information disparity advantage over borrowers. Capturing
and using that information is typically not well executed. The following chart
illustrates how market data obtained from Pricing systems can be used to identify
opportunities – or in the case below – mis pricing as per grade 6.

The distributions show the range of returns being achieved for a given Risk Bucket
(ideally, based on Expected Loss). Grades 1 and 2 show strong returns being
obtained, particularly relative to grades 5 and 6 and the applicable risk.


What is also apparent is that the distribution of returns for some grades exhibit a
wide range of outcomes, which if not managed can introduce volatility to a
Lender‟s returns – and this in turn will have an adverse affect on the cost of
capital and ultimately shareholder value.

4.2 Systems & Methodology
To execute a successful pricing strategy – a lender needs solid capabilities in both
systems and methodologies. These two components must compliment each other,
as a strong capability in one area without the other will be ineffective.
Using the above Market based return analytics as an example, without sound
systems in place it is very difficult (and probably an extensive manual exercise) to
generate such insights into sectors where pricing irregularites are observed, or
where the volatility of returns is high.
Similarly, no matter how well designed and informative the systems – without a
suitable methodology in place, the ability to leverage such information is limited.

The Value Tree as shown above illustrates how the different aspects of a bank‟s
operations come together to generate Shareholder Value – and it is important to
ensure that any Pricing methodologies reflect these in totality. This is an area
where methodologies and systems must also converge – as integration in systems of
the above components is as important as integrating methodologies!


4.3 Facility vs Portfolio Returns
When looking at setting pricing strategy, it is important to be mindful of the
different behavioural perspectives that drive decision making. One is at the
facility / relationship level where the Lender and Borrowers negotiate.
The Lender‟s Relationship Manager undertakes a credit analysis and considers the
Borrowers chance of defaulting, as well as the impact of that default as mitigated
by collateral and structuring – and can intuitively understand relative riskiness.
There is also an understanding that longer term deals need added return for both
funding and credit risk migration.
The Borrower will intuitively know that collateral has an effect on transaction risk
for the Lender, and more sophisticated borrowers may also have a general idea of
their relative riskiness, albeit this may well differ from the Lenders view!!
At the point of transaction negotiation, the Relationship Manager and the Borrower
will negotiate on margins and fees within the context of their own views. Some
allowance for term and relationship will of course make a marginal difference.
However – the other key driver of returns that the Borrower will certainly have no
consideration for, and the Relationship Manager is likely to have little visibility on
– is the value of the transaction in context of the Lender‟s portfolio.
In the Value Tree framework above, this is reflected by the Unexpected Loss
component that determines the level of Capital Employed by the Lender.

Neither Relationship Managers nor Borrowers will have any consideration for the
impact a portfolio factor like this will have on assessing the transaction – but
Senior Management of the Lender must.
Such understanding could be based on an intuition around concentration risk in a
particular segment – say Commercial Property, or it could be based on a more
sophisticated insight driven by an economic capital model that estimates capital
requirements taking account of portfolio composition and the diversifying effect of
different exposures based on their correlation to the portfolio.
How does this get reflected at the transaction level, at the point of negotiation?
Senior Management can use Pricing strategy to help shape and optimise their
portfolio – but only if they have the tools and systems to promote the right
behaviours in the Relationship Manager at the time of origination.


5. Conclusion

Achieving a better Pricing capability is one of the highest impact actions a Lender
can undertake to improve it‟s profitability and increase Shareholder Value.
In many cases, this can be readily achieved from systematising what may already
be an effective – but ad hoc and subjective – capability to deliver marginal
strategy refinement and ensure consistency and longevity in any such practice as
personnel change within the institution.
For those Lenders making more significant enhancements to their Pricing
capabilities, further benefits are achievable by the ability to manage pricing
strategy that optimises returns based on market and portfolio conditions – both
being factors that will be increasingly dynamic over time.

About IR
InfraRisk is a thought leader in the Commercial Credit space founded on the
principles of integrating Risk and Return in an efficient framework. Our expertise
is assisting Commercial and Corporate lenders to process credit applications more
accurately, efficiently and focused on improving risk adjusted profit and
shareholder value. InfraRisk offers domain knowledge and integrated solutions
built specifically for demanding banking environment.
To explore more about InfraRisk, visit our interactive website, request access to
our Premium Content or request a demonstration. Further information about
InfraRisk can be viewed at www.infrarisk.com/about.html

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Telephone: +61 3 9602 3396
Fax: +61 3 9867 7750
Email: info@infrarisk.com


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