Second in a four-part series on creating profitability POWER.

A financial institution swims in a sea of numbers but seldom has a firm grip on the costs required to offer products and services. This is important information to have, as well as knowing the costs for each activity associated with those products.

Such cost allocations have never been easy. For instance, it costs more to pay interest monthly by mailing CD interest checks than it does to compound the interest semiannually. If pricing does not reflect that difference, the ROA will be less.

The Federal Reserve Bank used to provide cost statistics until the late 1990s when it discontinued its functional cost analysis. Even with the lack of industry unit cost guidance, an institution must allocate overhead to its products as well. Allocating overhead helps management develop a clearer understanding of the costs of each product and service. At a very minimum, an institution should have an idea of the variable costs associated with servicing a product line. It would be further prudent to allocate all fixed costs to existing products. Otherwise, these costs become “stockholder expenses.”

Conducting an exercise to allocate overhead based on dollar amounts assigned to product features—such as payment frequency, term, and sources and uses of funds—can provide a pricing matrix that will help establish pricing tiers based on account balances. What’s more, the cost information can ultimately be used in customer profitability models prompting more informed management decisions.

Another element to consider in the pricing of earning assets is the risk of loss. This is most relevant in loan pricing. Many institutions assign a risk weighting to individual loans over a certain size or based on loan type and assign a credit risk charge based on those ratings.

Asset and liability mix also impact pricing results. Generally speaking, an institution operating with higher loan-to-asset ratios can afford to pay more for deposits. Likewise, an institution can afford to be more competitive on certain deposit products if it has fewer maturities in a particular time frame or less total outstanding balances in a product line.

Of markets and customers

Customers have more distribution channels available to them today than at any other point in history. In the past 10 years, the number of financial institution locations has increased 20%. Of course, there are the mortgage bankers, the Internet, and a host of other financial service providers competing for customers' loan and deposit business.

Therefore, an institution must understand the market rate for its core products. The competitive marketplace always ensures that if a financial institution is charging too much for loans or paying too little for deposits, its share of the market will likely dwindle as existing and prospective customers find alternative providers. An institution can do all the math it wants to determine required pricing points, but if its pricing is uncompetitive, its market share will shrink.

In addition, customer relationships are difficult to assign a value to in the pricing process. Customers will generally press for some price concessions in consideration of other relationships they have with an institution. 

Overall, an institution will need to identify sales strategies and operational performance features to make its rates the most competitive in its market.

Finding balance

Pricing is always a key issue for the associates who sell products to customers. The fact is lenders want the lowest rates, and people dealing with depositors want to pay the highest rates. An institution needs the right balance of fee income, strategies to reduce operating costs, and a healthy asset and liability mix to change its required pricing. By pursuing balance, an institution can find a Profit Opportunity Within Every Resource (POWER)!