Desperate times call for desperate measures.  When put in the context of product pricing, I couldn’t disagree more with this statement.  Famed Nobel Prize-winning economist Milton Friedman (bear with me, I do not intend to debate the merits of Friedman v. Keynesian economics and which is to blame for the current financial systems meltdown — that’s a whole other post, written by someone other than me) once argued that irrational traders could not sustain long-term influence on financial markets, because their foolishness would inevitably lead them to failure. 

That’s great and all, but what happens in the short-term? 

The daily roller coaster ride that is our stock market, where prices and valuations dip and rise at the drop of a hat, certainly is not always the result of clear-headed rational thinking.  The message communicated to investors has traditionally been that they need not worry if they’re in it for the long haul, because everything should eventually work itself out.  As Friedman might say, we just have to wait for these irrational traders to fail and get out of the game, allowing saneness and logical thinking to win out.  In other words, those who avoid the desperate measures will end up in better shape in the long-run.  Typical tortoise and hare stuff.

I mention this because it reminds me of how product pricing decisions can have such a profound impact on your bottom line.  Pricing decisions that you make today have a direct effect on what your institution will look like years down the road.  Unfortunately, for some struggling institutions, it may even mean the difference between survival and failure.  This applies to both loan and deposit pricing, but I’ll focus on the deposit side for now.  During times when your institution is desperate to grow deposit balances, it’s easy to turn to aggressive pricing to achieve your growth goals.  The problem, of course, is that your profitability goals end up getting sacrificed.  We want the best of both worlds, which is where a rational, or scientific, pricing strategy comes into play. 

An astute pricing strategy will no doubt be a high priority for institutions in 2009, as the industry braces for the insurance premium hikes that threaten to diminish earnings even further.  In response to this, we have been approached by a number of institutions looking for ideas to help lower their cost of funds.  In each case, our strategic consulting group has had great success in working with these institutions to help design a system such as the one described in this article.  While RFG can help you cultivate the many intricacies involved in implementing such an approach, the underlying idea is actually rather simple.  Your rate decisions fall into one of two categories: Standard pricing or Specials pricing.  

With Standard pricing, the objective is to set your rates at or below what you have to pay for the funds in the wholesale market, while taking into account your marginal costs.  Participants in our CEO Strategies Group program are familiar with our concept of measuring the opportunity cost, or what we often refer to as the transfer price.  Let’s take a look at a one-year certificate of deposit as an example.  Think of the current FHLBB advance rate for one-year money as the wholesale value.  The other piece of information you will need to gather is your marginal and fully allocated annual expense on a CD account.  I’ll use these figures for our example:

As the table above illustrates, we’re simply computing the marginal and fully allocated dollar costs to a percentage, based on the average balance we expect.  You then arrive at the maximum rate you could pay to cover the costs, by subtracting that cost percentage from the wholesale value of the money (the corresponding FHLBB advance rate).  So the maximum rate that you would want to pay while still covering your marginal costs is 1.24% (Zone B – Acceptable Pricing).  Better yet, if you do not exceed 0.89%, you would cover the fully allocated costs as well (Zone A – Optimal Pricing).  Typically, pricing on your standard product menu should fall into Zone A or Zone B.  Pricing in these zones are driven by profitability and targeted to non-rate sensitive consumers.

Zone C would then represent your Specials pricing.  When you enter this pricing territory, you realize that you are no longer covering the direct or indirect costs of the product.  This would be a conscious decision to make if you need to rapidly generate deposit growth, or feel that you need to close the rate gap with some of your competitors.  But a key point to consider is that you don’t just give away your money in Zone C.  Consumers generally understand and accept that in order to be rewarded with a higher rate, they will typically be required to take additional action or meet specific requirements.  For example, you may require additional account relationships in order to grant the higher yield, or a higher minimum balance.  In order to obtain a special rate on a high rate Money Market Account, you could require both a higher minimum balance and a checking account with direct deposit.  Or add another layer to this by also requiring the customer to pay at least two bills a month online.  So even though you’ll be paying more on the MMA, in return you’re getting an active checking account with regular bill-pay usage.  The possibilities are endless, and the relationship combinations are a great way to increase adoption of other channels and services like online banking and e-statements. 

For term products like our CD example above, you may pay the higher competitive rate initially, but have it renew into a standard price CD thereafter, unless the account holder takes action and yet again seeks a specially priced product.  For example, you could offer a specially priced 7-month CD that automatically renews into a 6-month standard CD, or an 11-month special CD that renews into a standard 12-month.  As more accounts renew into the standard price option, your cost of funds is significantly reduced over the long term.  If your institution has tried this strategy in the past, what percentage of the accounts ended up just renewing into the standard product?  We’ve heard from some institutions that 40 percent or more simply renew into the standard priced product, so it’s certainly worth trying and tracking your results to see if it pays off.

These strategies allow you to remain competitive on price, when you need to, but also give you the chance to make up some of the margin decline through other channels.  The “when you need to” caveat is important, because it may not always be necessary to have products or pricing in Zone C, or at least not as many.  Think of Zone A and Zone B as your standard product menu, which is basically permanent.  On the other hand, Zone C specials can come and go as competitive pressures change, or as the demand for funding grows or diminishes.

Now more than ever, keeping your cost of funds in check will help you weather the current storm, and recoup some of the additional expenses being thrust upon the industry in the form of increased insurance premiums.  Based on some modeling that we have done, we reckon that more than 30 percent of the premiums can be offset through some subtle deposit pricing and mix changes.  While I’m certain (ok, hopeful) that your current rates are determined by doing more than just peaking your head out the window and looking at the latest CD banner for the bank across the street, there is likely some room to refine your strategy even further by taking a more scientific approach.  We’ll be discussing this topic further during a complimentary Web conference on April 30 (visit http://registration.raddon.com/step4.asp?2587 to register for this event), or give us a call and we can work with you on some of the complexities involved in navigating these waters.

It’s understood that you can’t make pricing decisions in a vacuum, and it is important to balance the competitor pressures with a systematic approach.  But if the last few years have taught us anything, it’s that it’s not always rational to try and constantly keep up with the Joneses.  If you take a look at the famous Jones house down the street from you now, there’s a good chance that it has been foreclosed on due to all that irrational spending that was once the cause of so much envy!  Likewise in our industry, look at the predicament that some institutions find themselves in as a result of following the “leaders” into the sub-prime lending debacle.  Similar to Friedman’s take on irrational traders, those financial institutions acting and pricing irrationally will eventually price themselves to nonexistence.  If sound economic theory doesn’t support the idea of irrational behavior, then why should your institution?  Viva la tortoise!

Need new ideas, recommendations or solutions for product pricing and design?

Contact RFG to learn more about our Consulting Solutions Group.  Call 800.827.3500 or email

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