Pricing and Revenue Optimization

By Phillips, Robert; Rohde, Frank | The RMA Journal, February 2006 | Go to article overview

Pricing and Revenue Optimization


Phillips, Robert, Rohde, Frank, The RMA Journal


This article is based on a chapter of the book Pricing and Revenue Optimization by Robert Phillips, who contends that profit-based pricing is relatively new to the financial services industry; after explaining its success in other industries, he provides 10 key elements of a successful profit-based loan-pricing model.

Many lenders consider risk-based pricing to be the ultimate in pricing sophistication. There is no question that identifying higher-risk customers and charging them higher rates to compensate for higher losses is a sensible (and profitable) idea. However, risk-based pricing does not incorporate one of the key elements required to maximize financial return--customer price sensitivity.

Understanding and using customer price sensitivity in setting prices is a highly developed science in many industries. The key to maximizing profitability through pricing in all industries is to trade off the increased profit per transaction at higher prices with the reduced penetration at the higher prices. This trade-off needs to be made for each combination of customer segment, product, and channel and updated continually as market conditions and cost-of-funds change. This is the discipline of profit-based pricing.

Analytical approaches--for estimating customer price response for different products by different micro-market segments and for using this information to optimize prices--have been used successfully in such industries as retail, hotels, and telecommunications for many years. Hotels understand that late-booking customers who want to book a room only for Tuesday night are likely to be business travelers who are relatively price insensitive, while early-booking customers for weekend nights are more likely to be leisure travelers who are more price sensitive. By setting and adjusting rates using these insights, sophisticated hoteliers are able to extract significantly greater profit from the same fixed stock of rooms. Sophisticated retailers track customer demand and price-sensitivity across their stores, adjusting discounts and promotions to target more price-sensitive groups of customers only as needed to move merchandise. Deep discounts are not wasted on customers who are more than willing to buy at higher prices but are targeted specifically to the most price-sensitive buyers in the market.

Application to Financial Services

While profit-based pricing has been immensely successful across many industries, lenders are only now starting to use profit-based pricing to set and update APRs offered to various customers for different products. Successful lenders have recognized that there are many characteristics of consumer lending that require specialized approaches and algorithms. Simply put, pricing consumer loans is not the same as pricing capri pants, groceries, or hotel rooms.

* The profitability of a consumer loan is a complex function of the term of loan, the APR, the amount borrowed, and the propensity of a particular customer to repay early or to default.

* Adverse selection means that increasing the APR for a particular credit offering will tend to reduce the average quality of applicants for that product. Adverse selection has no analog in other industries, and ignoring adverse selection was a shortcoming of some initial attempts to apply retail-based pricing optimization approaches to financial services.

* Banks are subject to both voluntary and regulatory constraints on rate levels, including fair lending laws, which need to be taken into account.

Nonlinear profitability functions, complex customer behavior, adverse selection, and regulatory constraints work together to make optimal consumer credit pricing more complex than retail or airline pricing.

However, banks have at least one advantage over retailers when it comes to pricing. Lenders typically have extensive information on failed sales--customers who were approved for a credit product but decided not to take it. …

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