Don’t base loan and deposit pricing decisions on what your competitors are doing, warns Thomas Farin, president of Farin & Associates.
That’s because “if there’s an idiot in your area, you become an idiot, too,” Farin told attendees of Credit Union Reality Check 2013 in Atlantic City, N.J.
Instead, Farin suggests six lessons to keep in mind when pricing loans and deposits:
1. Know that pricing models are used primarily to separate well-priced loans and deposits from those that are poorly priced, based on rates in a competitive market.
“Well-priced loans are often found where demand exceeds supply, and the best-priced products are often found outside the box,” Farin says.
2. Choose the best way to look at profitability. “Probability is the most important tool right now because most of you have excess liquidity,” Farin says.
Other important measures of profitability include valuation, which is important if you’re going to sell; return on equity (ROE), which is best used when capital and funding are scarce; and return on assets, which measures profitability in the context of balance sheet when ROE isn’t an issue.
3. Understand principal and interest cash flows. “The contract doesn’t define cash flows,” says Farin. “Behavior defines cash flows and is something you can measure.”
4. Use marginal yield and cost as decision tools. Average yield and cost are the most common decision tools, but they fail to consider the effect of pricing actions on existing volume, Farin says.
Marginal cost is a better decision tool, but is rarely used.
5. Understand members’ behaviors. “Make sure you’re using survey data effectively,” Farin advises. “Break products into sectors and subsectors, and compare your pricing to [that of] competitors on sector and subsector levels.”
6. Use segmentation strategies to reduce funding costs and improve loan yields.
“Pay up for rate-sensitive deposits without paying up for deposits that aren’t rate-sensitive deposits,” he says. “Reduce rates on new loan volume without lowering rates on existing loan volume.”
Credit Union Reality Check 2013 ends today.