Why pricing strategies matter

FST’s Leslie Knudson speaks with Lars Tonnesen, SVP of Pricing Strategy at Wachovia, about the all-important notion of pricing within the financial industry, as he reveals his insights around pricing pressures, trends and technologies.

Time and time again, pricing keeps making its influence known. In just the first week of October, Wal-Mart has upped the ante for retailers by already slashing prices for the holiday season, putting pressure on its competitors and setting the stage for holiday price wars.

With consumer spending facing a tepid outlook against the backdrop of the failing housing market, the credit slump and rising fuel costs – early and severe price cuts could seriously damage retailers’ margins and thus many are predicted to take a less aggressive pricing stance.

More recent fanfare in the pricing world comes from Apple’s decision to drop the price on its recently debuted iPhone by $200 after just 68 days on the market – a move that has elicited cries of price discrimination from customers and an apology from Steve Jobs.

With Wal-Mart’s early discounts sending chills to other retailers and the iPhone price cut garnering frowns from loyal customers, it all comes back to one resounding theme: pricing matters. A lot.

Such incidents reassert pricing’s sensitive nature and its ever-increasing importance in overall company strategies – with its strong link to both consumer and competitor reaction, not to mention its direct impact on the bottom line. As pricing continues to move closer to the forefront of companies’ focus, a strategic approach to pricing has proven to be a huge win for companies.

The financial pricing scene
The financial industry is well familiar with the impact of pricing. While it varies from institution to institution, a number of techniques are transforming the overall pricing process today in the industry.

The emergence of risk-based pricing has largely impacted the name of the game when it comes to pricing techniques. “In the old days, you would walk into a branch and you would try to get a loan and the rate for that loan could vary based on what the bank knew about you,” Tonnesen reflects. “But what has happened is the development of Bureau scores – it’s become more of a mathematical equation if you will as to what your risk profile looks like and the likelihood of default.”

As risk-based pricing has become commonplace in the industry, banks have started using more sophisticated techniques to determine the risk profiles of customers. “More has started happening under the umbrella of risk-based pricing, and most banks have something along those lines today,” Tonnesen acknowledges. “We’re seeing more activity around some of the techniques that retailers have used for years, and there’s more energy around understanding and experimenting with the various quantitative solutions to optimize pricing.”

One of the techniques that Tonnesen predicts will gain momentum in the industry is more differentiation on pricing, particularly in the context of channels. An example of such pricing differentiation would be pricing the internet channel versus the branch channels. Rather than simply pricing per product, price would vary for customers who shop online and those who desire the service and delivery offered through the branch system.

“The way that I think we’ll be looking at this in the future is that you will price based on what is it that those people in those channels are willing to pay for that service you’re providing,” Tonnesen explains. “As an example, Wachovia gets recognition for customer service; we have a very wide distribution net and that’s what customers like from us. That’s expensive to deliver but if customers are willing to pay for that and if that’s our competitive advantage rather than the price then you will see that throughout the pricing we have in the branches.”

Tonnesen foresees the practice of price differentiation among unique channels growing in the future, as customers expect a higher level of service through certain channels. “I know of only one or two banks that actually differentiate on the internet versus the branch pricing today but I think in the future there will be more differentiation depending on channel. Customers need to recognize that they have to pay a little extra if they want what comes with a more expensive service channel.”

In addition to channels, other attributes inherently factor into pricing, such as brand and the type of customer a specific brand attracts. Wachovia wouldn’t necessarily offer the lowest price of any internet channel since their brand carries some weight and allows them to price higher for its degree of recognition. “It’s also a matter of what type of customers you are attracting with your brand and then trying to optimize the pricing for those types of individuals,” Tonnesen adds.

Such analysis trends are helping organizations move towards the ever-elusive relationship-based pricing – the so-called Holy Grail of pricing within financial services. “As we get better at understanding how customers value our products and the combination of products that we can put together, I think we’ll get better at pricing across our various products,” Tonnesen says. “So really it’s pricing relative to the value that you’re providing to the customers, and finding that right price point where customers look for a single product but also are willing to trust you with more than just one product.”

Pricing optimization technologies
For an industry that has spent a significant amount of analytical time on understanding risk profiles, quantitative techniques are nothing new.

Yet while quantitative optimization tools may seem like good end-all solutions, Tonnesen urges not to lose sight of each organization’s decision path and not immediately jump on the solution bandwagon. “When you’re talking about pricing optimization, I think a lot of vendors would jump directly to these elaborate quantitative optimization routines. For those who have not already gone out to some of the low hanging fruits, there are plenty of opportunities within optimization before you even have to go to the elaborate technical solutions.”

Despite the advancement and availability of pricing optimization tools today, Wachovia is not quite ready to lean completely on automation. “We should never get away from the base adjustment that we also have from the knowledge that we have. I don’t think that the models yet have proved strong enough to completely be so automated that you don’t have some adjustment overlay on some of the decisions that come out of the pricing.”

While models may indicate that a certain space presents a monetary opportunity, it doesn’t necessarily mean it’s the right move. Ultimately, each organization’s pricing strategy should fit into the overarching business strategy. Defining objectives – whether it’s to obtain the highest revenue or to optimize market share – will help to define where an organization should position itself in the marketplace.

First defining objectives will then help to decide how to best use price optimization tools. “You can use these tools to find out the best price you can provide if your objective is growth or the best price if your objective is revenue,” Tonnesen says. “How we’ve been approaching it is first you set your strategy and then you use some of these tools to optimize against those strategies. If you made a decision that you’re not really comfortable in a particular lending space yet the model tells you there is an opportunity there, you may want to think twice before you execute against that.”

Another aspect that organizations should consider before employing models is that most models were designed for an economically stable environment. In today’s rocky environment – taking into account the turmoil in the sliding credit market and housing market – models need to be adjusted for use in time periods of such turbulence.

Today Wachovia is not quite ready to rely solely on facts and quantitative tools, and still prefers to impart their own judgment. For example, Wachovia still has overrides so while automated scoring may decline an application for a loan, Wachovia employees still have the ability to evaluate someone’s credit score and override the decision based on additional information.

Down the road Wachovia is likely to be a bigger fan of automated tools like modeling. “At this point it’s more something that helps us make better decisions but it doesn’t make all the decisions for us,” Tonnesen admits. “We are not 100 percent dependent upon automated solutions in our decision-making. We’ll still have our judgment. Eventually as we trust these techniques more, we will probably also rely on them more – maybe eventually down the road they will be fully integrated into our front line decision-making so that we sort of customize the price that comes out.”

While Wachovia is taking its time in adapting to the use of automated solutions, it hasn’t lost sight of the positives behind using such tools. For individual level decisions in a lending environment, the tools help to maintain a level of consistency. “The fact that we can well document how we make the decision that one loan is seven percent versus 6.5; these tools can help us make sure that there isn’t bias in the decision we’re making,” Tonnesen acknowledges. “The more they are made based on quantitative things, the less judgment there is in it and thus the less bias you have in it as well.”

The future of pricing
In the next three to five years, pricing optimization should continue to see an uptick in the industry as vendor efforts mature and gain momentum.

The industry has already seen much more vendor activity in recent years, with vendors emerging who are solely focused on solutions for banking and financial services. “It seems that the vendors focusing on the credit space have the most traction, and probably within that it would be indirect lending and home equity predominantly that we’ll see experimentation around these solutions,” Tonnesen says.

While only a handful of institutions have fully implemented the solutions, more are testing and experimenting, and are expected to adopt solutions in the near future. “More and more banks are getting interested in exploring these kinds of techniques,” Tonnesen says. “We are seeing more and more vendors helping to provide solutions and these vendors are gaining experience. The projections that we have is that most banks will have adopted some sort of quantitative pricing solution within maybe the next five to ten years.”

Tonnesen is optimistic about the vendor landscape and the deepening of their offerings to help organizations prioritize pricing as a focus area. “As these vendors are getting better and learning more, they will probably have some more off-the-shelf solutions. A lot of work still has to happen and many of the solutions are still very single product focused. The next evolution will try to leverage the relationship into these models and perhaps even as far as transaction level information – so how these customers are using the branch could impact potentially how we ought to price them.”

Today there is a much greater focus on pricing as organizations have begun to recognize the value of pricing when done right. “Pricing in many organizations has been buried; it’s sort of been a secondary focus area for another department and we’re now seeing a shift that more focus is being put on pricing because there really is a lot to be gained by doing it right. At the end of the day you’re pricing to what is right for the customer. If customers are not willing to take your price then they’re going to go somewhere else, so the marketplace is getting very transparent.”