Successful Credit Union Loan Pricing Considers Value and Risk

An increasing number of banks and credit unions have recently started to explore the concept of willingness-to-pay or customer price sensitivity in their pricing. The advantages are obvious: if prices are differentiated not only on the basis of risk and cost but also on the individual willingness-to-pay of customers, the potential for additional interest and noninterest income can be huge. Typically, such initiatives create an additional 5 to 25 basis-point margin. However, the specific positioning of credit unions with their clear commitment to members’ overall financial well being makes this an interesting topic. A credit union’s pricing must be fair from the members’ point of view, and at the same time, ensure that an optimal price is charged for the value and convenience the credit union delivers.That inherent challenge may be the main reason why, compared to many banks, most credit unions still lack structured pricing guidelines and models to consistently and fairly match the rates and fees they are charging for their products to their members’ willingness-to-pay.Simon-Kucher & Partners’ recent projects have led us to a structured and pragmatic approach to the implementation of value-based pricing in lending for credit unions, allowing for the reduction of gut feel in rate adjustments, while still keeping the pricing process simple, consistent and manageable.Step 1: Identify the factors that influence members’ willingness-to-pay to create different pricing segments.The first step to shifting from a purely cost and risk-oriented rate setting approach to the integration of value-based practices is understanding the structure of willingness-to-pay. In other words, which characteristics of a deal, a member or a loan product influence willingness-to-pay most and therefore the member’s elasticity to rate changes?Usually, we find three main categories of drivers of willingness-to-pay:Member typology. There are a number of member characteristics that influence value perception. Size, activity (industry for commercial loans), age (time in business) and many other traditional, and often already captured factors, help categorize the member portfolio into several sub-groups with different degrees of willingness-to-pay.Product. Even though many loans today are commodities, there are a significant amount of features, like prepayment possibilities, deferred payment loan programs, and others that impact the value perception and thus the willingness-to-pay of the member. A credit union should differentiate rates accordingly.Competitive intensity. Be it at a local level or at the regional level, the intensity of competition certainly has a significant influence on the differentiation of target rates and how much discounting is optimal. A measurement of this competitive intensity and its translation into different target rates and sales allowances enables for the better positioning of the initial offer relationship managers make and to improve the enforcement of more equitable rates.This structure of willingness-to-pay is typical for what we have observed in many projects for banks and credit unions. However, some of these drivers may be less relevant for specific credit unions, markets, or lending areas, while others can also significantly impact pricing patterns, especially for niche products.The only way to determine your credit unions’ pricing segments, which are based on the dimensions of willingness-to-pay previously identified, is to analyze your data, examine past negotiations and, ideally, survey your members. The identification of such pricing segments and the definition of guidelines and processes for differentiating rates along these segments will facilitate the provision of clear guidance for relationship managers on where to apply specific target rates and discounts. This will result in the effective matching of loan rates to member value perceptions, improved pricing consistency and a fair evaluation of relationship managers serving similar markets.Step 2: Measure price elasticity to quantify your ability to profitably change your pricing.Defining a clear price target for each segment is the first important step to grow profitably through pricing.Here, knowing the price elasticities for each of the individual member segments is an essential piece of information needed to understand how members will truly react to rate changes.Elasticities for lending products differ a great deal due to the variety of loan types and members. Using industry average elasticities to define pricing strategies will not work because each credit union has a specific value proposition, offered through a specific brand and in specific local markets.Only a detailed measurement of elasticities for the credit union’s key customer segments and for each product will enable true, value-based price differentiation. As an example: changing rates will indeed have a very different impact on margins if member elasticity is -1 (losing 5% of new loans when increasing standard rates by 5%: from 400 to 420 bps) or an elasticity of -2 (losing 10% of new loans when increasing standard rates by 5%).Several methods, from pragmatic internal workshops to member surveys based on indirect questioning techniques, can be used to measure elasticities, but their common objective is to understand the details of your members’ willingness-to-pay both quantitatively and qualitatively.Step 3: Supporting your value-based pricing approach with customized optimization models.Once pricing segments have been identified and their elasticities measured, rates must be optimized according to the credit union’s specific pricing goals (volume growth targets, income and profitability targets or others). Any pricing decision involves a trade-off between these objectives. An evaluation of reactions to and effects of rate changes is thus helpful to understand the impact on each performance metric, before deciding to change rates. With the help of customized optimization models, cost, risk and margin/risk-adjusted return on capital targets can be combined with information on willingness-to-pay to optimize rates holistically and continuously.The good thing about a downturn is that it creates a sense of urgency. Initiatives that appeared optional immediately seem essential. In that respect, the addition of value-based pricing to current cost and risk-oriented practices is becoming a top priority for credit unions to ensure long-term financial health, and thus the ability to serve their members for many years to come.