A process for achieving harmony in pricing decisions.
Clearly and consistently navigating the route to optimized future balance sheets and income statements is the responsibility of a credit union’s asset/liability committee. ALCO meetings can be some of the most dynamic and participatory events in the credit union when a practical, efficient, and effective process is used to create harmony and execution in optimizing ALCO loan and deposit pricing decisions.
Pricing managers recognize that pricing impacts revenue in two ways. Higher sales price—such as a loan rate—increases the revenue on realized business, while making the sale more difficult. Lower sales price tends to increase the likelihood of the sale, while reducing the profitability of any sale achieved. This conundrum often causes discouragement for those without an effective framework to anticipate and properly deal with it. High-performance pricing managers recognize the environment and have learned how and where to make optimizing pricing adjustments. We share their process here.
Recognizing that price is a major factor in both volume and interest spreads and that the combination of volume and interest spread produces profits, it’s easy to conclude that price is ultimately a primary determining factor of profit. The harder part to understand and apply is that some price increases cause a related increase in performance, while other price increases actually decrease performance.
For example, a credit union’s ALCO could decide to raise loan rates. It’s always profitable to increase the price of a loan if nothing else changes as a result. But member behavior in response to an increase in loan rates—such as deciding to go elsewhere for the loan or deciding not to take a loan—could reduce the credit union’s revenue and overall profitability.
When teaching pricing, I like to simplify the process so my students can understand the meat of the decision and not get confused (or deterred from making a decision) by all the moving parts. To get them warmed up to the process, I show them a simple table, like the one below. And I remind them that the ALCO can do four things: It can increase loan rates, decrease loan rates, increase deposit rates, or decrease deposit rates.
Optimal Loan and Deposit Pricing Decision Matrix
From working examples, it can be clearly demonstrated that excessively high spreads are detrimental to performance because they make it difficult for credit unions to attract members and tend to attract only those with lesser credit quality. Excessive high spreads unnecessarily restrict the volume of profitable business and keep us from optimal financial results.
Likewise, ultra-high liquidity is also detrimental, because it represents untapped opportunity for serving more members and growing the balance sheet and income statement.
With those ideas in hand, we consider an extreme case—the corners of the graphic, where liquidity and spread are either very high or very low. At these extreme positions on the chart, only one thing can be done to improve both spread and liquidity at the same time. You can see what action is indicated by each position marked in the graphic below.
Optimal Loan and Deposit Pricing Decision Matrix
But of course credit unions don’t regularly operate in an extreme case. So we talk about how to apply the graphic and methodology to market situations. Naturally, this process begins with an assessment of the situation, done at your credit union by the members of the ALCO. They should plot on the chart their general assessment of the state and trend of the credit union’s relative interest spread and liquidity position.
If they find that they’re in the middle of the top right quadrant of the graphic, they might test the impact of lowering loan rates. But if they find the credit union is off to the right, but neither at top or bottom, they might lower both loan and deposit rates. If they are lowered together, spread is maintained and the CU will move from high liquidity to more normal liquidity.
With these perspectives, we can weigh the relative impact of the “good” and “bad” on interest spreads and volumes. This means that, for example when lowering loan rates to grow loans, given the right situation, the “bad” associated with lower interest spreads can be more than offset by the greater “good” associated with growing the volume of business and serving more members. However, as the organization continues to experience lower and lower spreads, at some point the “bad” of lower interest spreads overwhelms the “good” associated with growing the volume of business and serving more members.
In all, the benefits of pricing adjustments are clearly situational and this approach equips and empowers managers to engage the situation. We can determine the proper direction of pricing adjustments only after we correctly assess our current liquidity and interest spread positions using a chart like the one above.
By creating clarity of the required decisions based on first determining the interest spread and liquidity situation, the ALCO need only debate the relative position and momentum of these factors and then let the process drive the appropriate optimal decision. From the resulting mutual assessments, senior management is generally well-informed and united in the appropriateness of the resulting ALCO pricing initiative(s). The transparency and collaborative nature of this process produces many benefits:
- sets the expectations of a dynamic on-going process;
- transforms ALCO into a collaborative decision-making body;
- incorporates objective and subjective information to define the current situation and momentum;
- uses fundamentally sound analyses to determine what direction and velocity is needed;
- reduces resistance as it provides a method for talking about outliers; and
- develops a united awareness and effort, unleashing the team’s collective energy and potential.
Neil Stanley is CEO/founder of The CorePoint, an Omaha, Neb., firm offering a web-based retail deposit pricing and sales platform and performance analytics.