Academic journal article ABA Banking Journal

Product Pricing Risk

Academic journal article ABA Banking Journal

Product Pricing Risk

Article excerpt

By Stanley D. Smith, Ph.D., and Larry A. Frieder, Ph.D. Dr. Smith holds the SunTrust Chair of Banking at the University of Central Florida. Dr. Frieder is the Eminent Bank Scholar Chair Professor of Financial Services at Florida A&M University.

Small movements in product pricing can have a major impact on profits.

A simple procedure can help quantify the risk

Former First Chicago executive Robin Foote wrote some months ago in the Journal of Retail Banking Services that the bank "learned that we earned an adequate return on only about one-third of our customers and that a handful of highly profitable customers in effect subsidized services for the rest of the households."

Perhaps the most troubling point about her comment is that First Chicago may be an exception in having such a high percentage of its customers profitable. Numerous other banks have alluded to earning 110% to 140% of their profits from 15% to 30% of their customers, which suggests that the well-known 80/20 rule may be optimistic for many banks. Moreover, Foote argued that cross-customer subsidies are among the biggest threats to banking today. Clearly, the industry's current understanding of customer behavior and profitability is inadequate.

There are several challenges involved in addressing this dilemma. In general, banks must collect and analyze much more information about customer behavior and preferences. Such information would facilitate the design of value propositions-tailored product/pricing packages and delivery channels for individuals or segments of customers-that would assure a higher percentage of profitable customers. Questions about revenue potential, cost/resource utilization, product design, delivery approaches, branching, and pricing would be addressed in the development of the value propositions.

While many banks are presently active building central data warehouses as an initial step to address the customer profitability dilemma, a significant part of the customer profit and risk equation remains dangerously neglected-product-pricing risk.

As multiproduct firms operating in numerous different product markets, banks face many different types of risk. Models that measure credit, interest rate, and foreign exchange risks have become Increasingly common and sophisticated in banks over the years. Yet, to date, little attention has been given to the measurement of product-pricing risk in evaluating the franchise value and/or risk of a financial institution.

Bank managers sometimes argue that their products are unique in some way; however, customers often view the same products as commodities. Thus, a key factor in the pricing of a product is the question of whether it is a commodity or is in some way differentiated. Commodities compete strictly on the basis of the lowest or best price. Differentiation indicates that customers perceive some characteristic of a product to be different from similar products. The difference may allow the producer of the product to charge a higher price based on that difference.

Differentiation can take many forms, one being service. The vast majority of banks compete on the basis of service, however, which implies that it plays a smaller role in differentiation. Some products may be bundled into a package that is more appealing--for example, packages of checking, savings, credit cards, and safe deposit boxes. Other products may result from alliances, such as cards linked to frequent flyer programs. Large, rate-sensitive products--home mortgages, large deposits, auto loans--may be better marketed as individual products.

What is the impact of product differentiation? Increasing competition should drive nondifferentiated pricing differences to zero. The risk associated with a product is shown in the equation on this page.

In other words, to the extent your product has a higher price than the lowest market price, then increasing competition should drive that difference to zero and decrease your profit margins, and thus, your franchise value. …

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