The price is right

Banks are embracing the concept of pricing optimization like never before. But what is fuelling this rush and what sort of ROI is achievable? In order to get a better perspective on these issues, FST sat down with Dr. Robert L. Phillips, founder, Chief Science Officer and VP of Product Management at Nomis Solutions.

FST. What is pricing optimization and why is it getting so much attention lately?
RP. Pricing optimization is enabling bank executives to use pricing as a tactical tool to meet their corporate objectives and to become more customer-centric in their decision making. It also enables a much more efficient and effective pricing process. Banks that are using pricing optimization technology are gaining valuable insights about how customer preferences impact portfolio performance. Armed with these insights, they are better tailoring the rates and terms for each customer, channel, and product combination. These banks also have the ability to fine tune segmentation to further cater to the specific needs of their customers. The benefits include the ability to acquire and retain more profitable customers, increase profits and market share by 10-20 percent and support compliance efforts.

FST. The use of pricing and revenue optimization is standard in industries such as the airlines, hospitality and retail. Why is this approach gaining popularity in financial services now? What is different about financial services?
RP. There are a number of factors that have combined to spark the significant adoption of price optimization in banks. Fundamentally, banks want to grow and be more profitable. They have spent the last decade cutting costs and weeding inefficiencies out of their processes and there is only so much more that they can “wring out” from cost cutting. Furthermore, the opportunities to grow by merger and acquisition are rapidly disappearing. Banks increasingly realize they need to shift their mindset to organic profit-generation and revenue-growth and the quickest and most substantial way to do this is by using pricing optimization.

Technologically, banks are equipped to do this now. Over the last decade, banks have invested in IT systems to better capture and store vast amounts of customer data. Also, banking customers are more educated about their options and spend time comparison shopping before choosing a banking product. This intensifies the competition and places more pressure on banks to be strategic and insightful about what customers’ value about their products and their brand.

Banking culture is accustomed to using analytical approaches to inform and drive decisions. However, price optimization solutions providers were not focused on financial services. Now, there are financial services-specific solutions. Banking executives are rightfully much more interested in adopting a solution that has been specifically designed for the industry rather than taking a solution that was developed for say, airlines or retail, and trying to adapt that solution to their unique business needs.

What is most unique about financial services price optimization is that unlike in airlines and retail, every credit or deposit transaction implies a long-term relationship with a customer. Take for example a home equity loan. Even after the customer qualifies, the lender approves the loan and the customer books it, there is built-in uncertainty and risk of whether or not the customer will repay early or default.

So, really there are two key components to a pricing optimization solution for this industry. The solution must provide an understanding of customer preferences and enable the bank executive to use those insights to make better pricing decisions. Also, it must balance this insight with the risks involved. It must understand how pricing impacts risk and use this information when generating price recommendations.

FST. Which banking products are suited to this approach?
RP. Pricing optimization can be applied effectively to a wide variety of products, not only in retail bank but on the commercial side too. However, the early adopters appear to be primarily in consumer credit, particularly in auto finance, home equity lending, and personal lending. We are also seeing increasing interest in mortgages, credit cards and deposits. In addition, some banks are thinking about how they can use price optimization across multiple lines of business to gain even more benefits. Ultimately, I think that in five to ten years we’ll see banks using this across all of their retail banking products.

FST. How have prices for lending products been determined in the past?
RP. There is currently no standard pricing process across banks or finance companies. Pricing has been treated as more of an art than a science, which is one reason why there is so much opportunity for improvement.

Most banks don’t use any “purist approach” to pricing today. Instead, many different groups may have their hands in setting rates and it is often hard to determine how or why an individual rate was set. Usually, some combination of cost-based thinking such as risk-based pricing and competitive comparison are used to set rate sheet rates. Then, depending upon the company and the industry, these rates may be overridden in the field in response to specific customers. Ultimately, it is often difficult to determine exactly what reasoning was used to set a particular rate.

Contrary to what most people believe there is a lot of price variation in the market today. Some banks are using pricing optimization technology to better understand how to tailor pricing to ensure they are better catering to their customers needs and outsmarting the competition.

FST. What stops banks from developing this type of solution in-house?
RP. Some try. And, like any other application, finance companies considering pricing optimization face a “build-versus-buy” decision. However, most lack the experience in using the specialized statistical approaches that we use to extract price-sensitivity information from historical data. Also, developing the optimization capabilities to determine the best prices given complex business rules is a challenge. Finally, to deliver sustainable improvement, pricing optimization needs to be embedded in a software package that enables efficient user interactions and continually updates itself over time. I don’t understand why most banks would want to expend the additional cost, take the additional time, and especially take on additional risk when proven solutions are available externally.

FST: Are their any other benefits that bank executives should be aware of?
RP. Yes, we didn’t talk about how pricing optimization helps support compliance.There are three big areas where price optimization supports compliance. We conducted a training session with the Office of the Comptroller of the Currency (OCC) to explain the impact of pricing optimization technology. When done correctly, pricing optimization supports compliance by providing transparency into the pricing process. I believe that a clear and documented pricing process is a major step toward demonstrating compliance.

Second, pricing optimization enables historic pricing decisions to be audited to do show that no prohibited factors were used in pricing a loan or a line. Finally, price optimization enables banks to quantify the impact of price on customer’s propensity to pre-pay, be delinquent or default. This enables lenders to calculate and incorporate these factors into their pricing decisions and ensure that sufficient capital is being booked against the lending decisions

FST. What kind of ROI can executives expect from this type of initiative?
RP. Price optimization enables banks to increase profits and market share by 10-20 percent. For example, in one instance, by using the Nomis Price Optimizer, our lending customer achieved a 15 percent increase in profits and 13 percent increase in market share. Another customer achieved a 22 percent increase in market share and a 4 percent increase in profits. These benefits were achieved by optimizing prices within the current pricing structures. More gains could come from refined product and customer segmentation – for example, by adding additional credit score bands or pricing by loan term.

While the results I described are real, tangible benefits, they just scratch the surface of what’s possible by using pricing optimization solutions. Bank executives gain valuable process improvements and insights about their customers and their products which enables them to make better investments and better pricing decisions. By using a pricing optimization solution, bank executives are setting themselves up for long-term and ongoing improvements to their financial results by acquiring new customers, retaining existing customers and adding profits and expanding their market share.

“Banks increasingly realize they need to shift their mindset to organic profit-generation and revenue-growth and the quickest and most substantial way to do this is by using pricing optimization.”

Dr. Robert L. Phillips is responsible for ensuring that Nomis Solutions' algorithms, methodologies, and statistical estimation approaches are best-in-class and generate the highest level of value to customers. In addition, he leads the technical vision and execution of the Nomis Price Optimizer Suite. Dr. Phillips founded Nomis Solutions in 2002 to help financial services firms use pricing analytics, optimization, and execution to improve profits and market share. He is author of the award-winning book, Pricing and Revenue Optimization.