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Right pricing is continuous pricing

Mar 17, 2015

Banks have often been criticized on the lack of transparency in their pricing. Hidden fees, fine prints in terms and conditions and other unpleasant surprises are sadly too common. Beyond these mishaps, another oddity transpires: the lack of pricing logic and fine-graininess.

A common example is mortgages. The conditions on your loan will depend on a series of variables, including the current interest rate environment, the bank’s need for liquidity, the loan-to-value ratio, your credit rating or your customer lifetime value. This series of variables ultimately boils down to two factors: the profitability of the loan/customer and the overall risk the bank is taking.

Therefore, all other things being equal, the shorter the loan, the better the rate should be. Indeed, the shorter the loan the less risk for the bank. Yet, this is not what we see in practice: if you get a 20-year loan at 3%, the same loan for 17 years is still at 3%. Only when you decrease the duration of the loan to, say, 15 years, can you finally get a better rate.

Similar thresholds exist for the other variables, such as for the amount of the loan or the loan-to-value ratio. Why is there a discontinuity in borrowing rates at the 80% loan-to-value ratio?

Right pricing is continuous pricingThese kind of arbitrary thresholds not only fail to accurately reflect the underlying business logic, but they can confuse or exasperate customers. After all, if you take a shorter loan or borrow a lesser amount, you’d expect the rate to change accordingly and in a continuous way, instead of changing by discrete steps at large intervals.

Most likely, the simplistic logic and models currently used are inherited from a time when automation and computing power were limited. In this age of continuous technological innovation, revisiting long-time business practices is a good starting point to adapt to customers’ changing expectations.

In a previous article, I discussed the need to differentiate around core products such as savings accounts, for example by providing interests on a much more frequent basis. Having a logically and continuously varying pricing policy is another clear way to differentiate and bring value to the customer.

 

David Andrieux, PhD


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