The importance of understanding consumer price sensitivity

As the economy recovers, financial institutions will come to the realization that their most important asset is not their “portfolio”, but their ability to persuade customers to do business with them and to manage existing customers more profitably. This means understanding how pricing influences every customer interaction from acquisition to growth to retention. This will be especially important as the interest rate environment changes over the next 18-24 months.

“Financial institutions will come to the realization that their most important asset is not their 'portfolio', but their ability to persuade customers to do business with them and their ability to manage existing customers most profitably”

The ability to tailor prices to micro segments based on the value of price vs. other features will be essential to help banks succeed in an environment of increasing regulation, changing rates, increasing competition and changing consumer preferences.  Pricing optimization technology can help banks understand what customers' value and how much they are willing to pay for each of these components.  A deep understanding of customers' preferences will enable banks to maintain profitability without surrendering market share or revenue in a way that is both fair and consumer-friendly.

Price-sensitivity is the weight that customers place on price relative to other factors such as brand, features, access or advice in making choices. Price-sensitivity varies among customers in predictable and stable ways.  For a particular decision, price-sensitivity will depend on the characteristics of the customer, as well as the product, channel, and relationship with the bank.

The price sensitivity of North American consumers has changed drastically as a result of the recent global recession. From the peak of lending in late 2007 to the over-tightening of credit supply in 2009 and early 2010, there was a parallel move in consumer price sensitivity, as reflected in the Nomis Price Sensitivity Index.  The PSI saw a dramatic drop in price sensitivity from a high of 33 in 2007 to its present value of 6 (NB: at a PSI of 33, a 100 basis points rate increase will result in a drop in demand of 33%, while at a PSI of 6, a 100 basis point rate increase will result in a drop in demand of just 6%.)

When credit was broadly available, consumers were highly sensitive to price both due to awareness that they had other credit alternatives and due to aggressive rate-oriented marketing from lenders. However, as credit markets dried up, consumers' credit options were severely limited and, as a result, their price sensitivity plummeted. How will consumer price-sensitivity change as interest rates rise, regulation changes, and banks return to lending?  Based on the most recent data, Nomis is forecasting a slow but persistent increase of the Price Sensitivity Index through the rest of 2010 and into 2011 in North America.

Increasing price sensitivity makes it imperative for banks to effectively align offers and pricing with customer values in order to acquire new profitable customers while retaining and growing profitable customer relationships.  Today, most banks price by a matrix of risk, product, and channel dimensions.  This approach makes it difficult to understand the impact of price on each individual customer and results in offers misaligned to customers' value for rate vs non-rate factors.  The consequences are lost profit and volume opportunities. 

This is especially true in a recovering economy, where rising interest rates and increased competition will increase consumer price-sensitivity and change product preferences.  Those banks who do not price optimally will face adverse selection as more informed banks cherry-pick desirable customers.  That is, the highest-priced banks in a market segment will experience higher losses than lower-priced competitors, even with similar underwriting policies.  In addition to increasing pressure for attracting new customers, the most profitable customers will be under threat from competition.  Since it is more cost-effective to retain customers than acquire new ones, banks will need to increase focus on their retention strategies to maintain and grow profits.

Regardless of current pricing methods, lenders can quickly and dramatically improve financial results by using the recently introduced price sensitivity score (Nomis Score^TM) that rank-orders the sensitivity of a potential customer to the price of a product/offer and predicts the change in take-up rate with varying APR.  For example, a particular bank in one market may find that customers with lower price sensitivity (eg a Nomis score of 625) will respond to a loan offer of 9.00% APR with a take-up rate of 42%, while those with higher price sensitivity (eg Nomis score of 750) will respond to the same offer with a take-up rate of only 30%.  However, higher price-sensitivity also means greater response to a change in APR.  If the same offer were lowered to 8.50% APR, the take-up of those with a score of 625 would increase from 42% to 46% (a 10% increase), while the take-up of those with the higher score of 750, would increase from 30% to 36% (a 20% increase).

By using a customer-level price sensitivity score, banks can derive the optimal segmentation of customers and prospects and target the right offer to the right segment, providing significant uplift in business results.  For example, the score could be used in marketing campaigns to offer lower rates to those with greater price sensitivity, while increasing rates for those with lower sensitivity.  The result is an increase of the overall response at the same average or higher rate offered.

Scores can also be used to determine different levels of price discretion through a dealer, branch or call center by offering less discretion to those with lower price sensitivity and more discretion for higher sensitivity.  The result is an overall decrease in discretion used, while maximizing take-up rate.

As interest rates rise and competition and regulation increase, price sensitivity scores can provide unique insight into the attitudes and preferences of customers at a micro-segment level.  They provide the ability to personalize offers to retain your most valuable customers and attract new profitable ones by directly addressing their needs. By understanding the incremental contribution of each new prospect, banks can continually refine and improve their targeting and pricing processes, even within dynamic market conditions.