InfraRisk Pty Ltd. P: +61 3 9602 3396 #203a, 757 Bourke Street F: +61 3 9867 7750 ...
Table of Contents1. Executive Summary 12. Current Practic...
1. Executive SummaryPricing is one of the most critical activities undertaken by Lenders, yet often theability to a...
2. Current Practices & ChallengesFor clarity, it is important to define what we mean by pricing: ...
3. Benefits of Improving PricingWhen looking at potential benefits for virtually any project impacting on thelending...
Dividend Payout 70% Payout/ Growth Assumption to build a Value Perpetual Growth 3% ...
The impact of modest improvements on both NPAT and, importantly, Valuation issubstantial. A traditional Project NPV type a...
4. How to Achieve the BenefitsClearly the benefits from even a modest, incremental increase in income from animprove...
However, if we look at the margins that are charged for the three risk buckets, wecan see the mispricing immediately.Altho...
What is also apparent is that the distribution of returns for some grades exhibit awide range of outcomes, which if not ma...
4.3 Facility vs Portfolio ReturnsWhen looking at setting pricing strategy, it is important to be mindful of thediffere...
5. ConclusionAchieving a better Pricing capability is one of the highest impact actions a Lendercan undertake to i...
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Pricing strategy impacts

Model for determining impact of loan pricing on bank shareholder value.
Published on: Mar 4, 2016
Published in: Economy & Finance      
Source: www.slideshare.net


Transcripts - Pricing strategy impacts

  • 1. InfraRisk Pty Ltd. P: +61 3 9602 3396 #203a, 757 Bourke Street F: +61 3 9867 7750 Docklands VIC 3008 E: info@infrarisk.comWhite PaperPricing Framework Impact for Non Retail LendersQuantifying the BenefitSeries 1.11st Quarter, 2011
  • 2. Table of Contents1. Executive Summary 12. Current Practices & Challenges 23. Benefits of Improving Pricing 34. How to Achieve the Benefits 65. Conclusion 10ConfidentialNo part of this document may be reproduced or transmitted in any form or by anymeans electronic or mechanical, for any purpose, without the express writtenpermission of InfraRisk Pty Ltd.InfraRisk ContactAny questions or requests for clarification or additional information should beaddressed 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
  • 3. 1. Executive SummaryPricing is one of the most critical activities undertaken by Lenders, yet often theability to apply Pricing strategy is restrained by current practices that may nothave evolved to support the increasingly dynamic environments for credit.Lenders will have different competitive advantages depending on thecharacteristics of the markets they operate in – and the need to maximise theseand react to changed circumstances is increasing.Fortunately, the benefits achievable from implementing a pricing framework thatenables strategy to be better executed – are substantial.In this paper we demonstrate that for a modestly sized $10b Non Retail loanportfolio, 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 deliverrequires both methodologies and systems to work in harmony. Some of the keyobjectives 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 areadily achievable proposition. The raw materials to do this – being the experienceand intuition of the Lender along with current market environment factors – arereadily found in most institutions – and with a little effort, they can be used togreat competitive advantage.Pricing Framework Impact Page 1 of 10 © InfraRisk Pty Ltd
  • 4. 2. Current Practices & ChallengesFor 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 notnecessarily 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 (andsome on 4!) such as inconsistency, operational risk from errors, and outdatedinformation – the more significant impacts from not having a sound pricingframework 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.Pricing Framework Impact Page 2 of 10 © InfraRisk Pty Ltd
  • 5. 3. Benefits of Improving PricingWhen looking at potential benefits for virtually any project impacting on thelending process – 90% of all such business cases will include some words along thelines of: “with this new (insert capability here) we will be able to generate extraincome from ……” - yet rarely do such projects have an explicit pricing strategycomponent!In this case – we are looking at the return from investing explicitly in pricingcapabilities – so the benefits are direct and highly demonstrable.Let us revisit the “Base Case” example lending portfolio from the earlier InfraRiskwhite paper on credit productivity, as detailed below. Note: the same logic fromthat paper also applies in that actual values are not significant as our focus is onthe 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 “asis”. There are a number of ways to do this; either by a rule of thumb P/E typemultiple, 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%Pricing Framework Impact Page 3 of 10 © InfraRisk Pty Ltd
  • 6. 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 $1,197,000,000For impact analysis, we can look at the Valuation using either of the abovevaluation methodologies.By improving the pricing process – the most observable impacts will be reflected intwo 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 toimprove it‟s win rate of new deals, but that is a less „measurable‟ strategy asthere are many other variables that impact. For modelling purposes, we will onlylook at improved NIM and Fee income.Five scenarios have been generated as below. All else remains equal – other thansome modest NIM and Fee value increases that progressively increase towardsscenario 5. Scenario 4 for example sees a 5 bps lift from the base 2.50% to 2.55% inNIM, and a 5bps lift from 1.00% to 1.05% for Fees.Pricing Framework Impact Page 4 of 10 © InfraRisk Pty Ltd
  • 7. The impact of modest improvements on both NPAT and, importantly, Valuation issubstantial. A traditional Project NPV type analysis will often focus on the addedincome generated only, however it is also important to be cognisant of what amore profitable strategy means for the value of the lender. The ultimate goal forBoard & Senior Managers – is to improve shareholder value. Scenario 5In the case of Scenario 5, a modest 20 bps increase across Margins and Fees hasbeen modelled. Achieving this from a superior pricing strategy is a very realistictarget across the portfolio. For this $10b portfolio, the business unit that deliversthis increase obtains not only an added $14m of extra income – but it has in factcreated an extra $153m in Shareholder Value!Coupled with properly aligned Remuneration Incentives that reward long termvalue creation as distinct from short term profit – a win win outcome is created.Pricing Framework Impact Page 5 of 10 © InfraRisk Pty Ltd
  • 8. 4. How to Achieve the BenefitsClearly the benefits from even a modest, incremental increase in income from animproved pricing strategy are substantial. How to achieve this?Some of the key differentiators and capabilities needed for delivering effectivepricing strategies include: 4.1 Market FocusInfraRisk always recommends a market based focus when setting target Marginsand Fees. In some segments, Banks are price makes who have disproportionateinformation to their customersThe margins the market is willing to bear will increase with risk (EL). However,they increase linearly, whilst risk typically increases exponentially. This fact, plusthe fact that Capital will also increase exponentially with risk, results in a nonlinear relationship between expected RAROC and risk gradesCustomers 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 rateCustomers and frontline bankers think in term of margin and not ROE or variationsof ROE; It is much easier to identify mispricing in terms of margin and expectedloss than by mean of ROE.We can set up a simple numerical example using a generic calculation forUnexpected Loss that we use as proxy for Capital √ ( ) ( )Where C is commonly set to the value of 4 in many banksIf we look at the RAROC for the three Risk Buckets, it is very difficult if notimpossible to detect if there is a mispricing that can be corrected to the bank‟sadvantage: the RAROC progressively decreases where the Capital increasesexponentially.Pricing Framework Impact Page 6 of 10 © InfraRisk Pty Ltd
  • 9. However, if we look at the margins that are charged for the three risk buckets, wecan see the mispricing immediately.Although the Margin for Risk Bucket 3 is higher than Risk Bucket 1 as expected, themargin for Risk Bucket 2 is smaller than that of Risk Bucket 1. So there is anopportunity to improve the Margin for the second Risk Bucket. This approach asopposed to calculating the Margin from a target RAROC, is called the marketapproach. The RAROC calculated from a market driven margin is used as aminimum constraint and not as a targetReturn on Capital measures such as ROE or RAROC can be used as guidelines oreven constraints, but not necessarily as the primary target. This is a subtle butimportant change to typical processes where ROE type measures are often usedmore 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. Capturingand using that information is typically not well executed. The following chartillustrates how market data obtained from Pricing systems can be used to identifyopportunities – 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 beingobtained, particularly relative to grades 5 and 6 and the applicable risk.Pricing Framework Impact Page 7 of 10 © InfraRisk Pty Ltd
  • 10. What is also apparent is that the distribution of returns for some grades exhibit awide range of outcomes, which if not managed can introduce volatility to aLender‟s returns – and this in turn will have an adverse affect on the cost ofcapital and ultimately shareholder value. 4.2 Systems & MethodologyTo execute a successful pricing strategy – a lender needs solid capabilities in bothsystems 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 soundsystems in place it is very difficult (and probably an extensive manual exercise) togenerate such insights into sectors where pricing irregularites are observed, orwhere the volatility of returns is high.Similarly, no matter how well designed and informative the systems – without asuitable 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‟soperations come together to generate Shareholder Value – and it is important toensure that any Pricing methodologies reflect these in totality. This is an areawhere methodologies and systems must also converge – as integration in systems ofthe above components is as important as integrating methodologies!Pricing Framework Impact Page 8 of 10 © InfraRisk Pty Ltd
  • 11. 4.3 Facility vs Portfolio ReturnsWhen looking at setting pricing strategy, it is important to be mindful of thedifferent behavioural perspectives that drive decision making. One is at thefacility / relationship level where the Lender and Borrowers negotiate.The Lender‟s Relationship Manager undertakes a credit analysis and considers theBorrowers chance of defaulting, as well as the impact of that default as mitigatedby collateral and structuring – and can intuitively understand relative riskiness.There is also an understanding that longer term deals need added return for bothfunding and credit risk migration.The Borrower will intuitively know that collateral has an effect on transaction riskfor the Lender, and more sophisticated borrowers may also have a general idea oftheir relative riskiness, albeit this may well differ from the Lenders view!!At the point of transaction negotiation, the Relationship Manager and the Borrowerwill negotiate on margins and fees within the context of their own views. Someallowance for term and relationship will of course make a marginal difference.However – the other key driver of returns that the Borrower will certainly have noconsideration 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 Losscomponent that determines the level of Capital Employed by the Lender.Neither Relationship Managers nor Borrowers will have any consideration for theimpact a portfolio factor like this will have on assessing the transaction – butSenior Management of the Lender must.Such understanding could be based on an intuition around concentration risk in aparticular segment – say Commercial Property, or it could be based on a moresophisticated insight driven by an economic capital model that estimates capitalrequirements taking account of portfolio composition and the diversifying effect ofdifferent 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 theirportfolio – but only if they have the tools and systems to promote the rightbehaviours in the Relationship Manager at the time of origination.Pricing Framework Impact Page 9 of 10 © InfraRisk Pty Ltd
  • 12. 5. ConclusionAchieving a better Pricing capability is one of the highest impact actions a Lendercan undertake to improve it‟s profitability and increase Shareholder Value.In many cases, this can be readily achieved from systematising what may alreadybe an effective – but ad hoc and subjective – capability to deliver marginalstrategy refinement and ensure consistency and longevity in any such practice aspersonnel change within the institution.For those Lenders making more significant enhancements to their Pricingcapabilities, further benefits are achievable by the ability to manage pricingstrategy that optimises returns based on market and portfolio conditions – bothbeing factors that will be increasingly dynamic over time.About IRInfraRisk is a thought leader in the Commercial Credit space founded on theprinciples of integrating Risk and Return in an efficient framework. Our expertiseis assisting Commercial and Corporate lenders to process credit applications moreaccurately, efficiently and focused on improving risk adjusted profit andshareholder value. InfraRisk offers domain knowledge and integrated solutionsbuilt specifically for demanding banking environment.To explore more about InfraRisk, visit our interactive website, request access toour Premium Content or request a demonstration. Further information aboutInfraRisk can be viewed at www.infrarisk.com/about.htmlInfraRisk Assessment EvaluationPlease call or email for a complete description of the InfraRisk AssessmentEvaluation and what information, resources and Associates from the Bank wouldneed to be involved. Telephone: +61 3 9602 3396 Fax: +61 3 9867 7750 Email: info@infrarisk.comPricing Framework Impact Page 10 of 10 © InfraRisk Pty Ltd

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