Competing for business through pricing is a common feature in any trade. Business units of banks often experience losing business opportunities due to price competition from other banks. This often leads to accusations being levelled against the competitor for undermining the trade through unprofessional and unsustainable conduct. Sometimes the bank losing business, resorts to counteract such threats aggravating the situation further.

There is no argument that a customer is entitled to receive a competitive price (interest or fee) for his transaction from any bank. The question one should ask though is whether banks that compete for business ‘at any cost’ are aware that their actions, in the long run, do not really receive the dividends expected and thereby become detrimental to the interests of their many stakeholders of whom the customer is just one.

Profitability of a bank is not a matter of immediate concern to a customer who deals with it. However, it is a matter of high interest to people who deal in that bank’s stock, i.e. Financial Analysts and Portfolio Managers alike. Low profitability also affects a bank’s ability to attract new capital, raise low cost debt or successfully meet balance sheet and credit risks that are inherent in the business. Also, the bank would no longer be able to attract high quality staff for employment and keep pace with investments needed to grow for the future. For these reasons, banks now are no longer assessed on balance sheet growth alone. Instead, returns on capital and assets employed in the business, have now become key performance indicators for banks, word-wide. Over the years, banks in Sri Lanka too are coming under increasing pressure to adopt such profitability measurement standards as key business objectives and to perform in these indicators better than their competitors in the market.

Business competition between banks in the local market mainly pivots on interest charged and paid. That is, interest paid for deposits and interest charged for credit facilities offered by the bank. This is so particularly in Corporate business segment where, relationships are established mainly on agreement reached on rates charged for credit facilities offered by the bank. Fees and commissions, though equally important, are given lesser prominence and is generally relegated to the back stage of negotiations. For this reason, banks are increasingly in the habit of using low interest rates as a major weapon to win business deals, sometimes on the mistaken belief that they could ‘make money’ on such deals by ‘other’ means.

This article attempts to analyze in simple terms, the accuracy of that belief and how banks could in fact use pricing as a business tool, not only to win business but also to maintain market leadership in profitability and balance sheet health. In order to appreciate issues in a ‘real life’ environment, published data from 04 local commercial banks are used throughout in this article.

Interest income and interest cost are the two largest segments in a bank’s revenue accounts and therefore the matrix of its ultimate profitability. An increase in the net interest income is possible through increasing interest income and reducing cost. However achieving this feat is not that simple because banks are not doing business in isolation and therefore do not enjoy the ability to apply prices at will. The business of banking is a very competitive game, typically in a market like Sri Lanka, which has an arguably over-banked situation. So how could banks make their cost of borrowing low and increase the returns on lending? The answer is not that simple.

There is a running debate in banks as to which business segment in the bank has the dominant effect on its profitability. A clear answer to this question may never be found but perhaps, one could find that from time to time, due to special circumstances the ‘flagship’ status could alternate between deposit or lending or even in fee and commission business. This therefore does not give a ‘right’ to any business unit to dictate their pricing independently or at the expense of another business. As a result, a lending unit cannot reduce rates and expect the borrowing units to supply funds cheaper or a borrowing unit cannot pay high rates for deposits and expect the lending units to charge higher for loans. Each unit should get rewarded at going market rates for products they deal in.

Preferred deposits.

A bank has several borrowing options at its disposal. Most common among them are the retail deposits from customers. Then, there are large ticket corporate borrowings and borrowings from ‘money market’ sources. In addition, some banks resort to enhancing their fund bases through special deposit schemes and long term subordinated debt issues. Therefore the cost of funds of the bank, at a given moment would be the aggregate cost of all these deposits or the cost of that bank’s ‘deposit mix’.

A bank would naturally prefer to have the lowest cost deposits in high proportion in their deposit mix. Therefore, comparing the interest rate only, the order of preference would obviously read as Demand (Current account) deposits followed by Savings and Time (Fixed) deposits. Inter-bank deposits and subordinated debt issues are costly funds and are usually sought by banks for different reasons. Although one prefers to have more ‘low cost’ deposits, there could be a significant hidden cost to attracting these deposits making them costlier that they appear to be.

Depositors at banks, always expect the best interest rates and have no desire to part with funds at low interest rates. In a deposit taking exercise, what really happens is that the customer buys a ‘cash management’ solution offered by the bank that suits his actual or (perhaps) perceived investment plan. These solutions come by way of a set of well structured and time tested deposit products sold by banks. Products such as current accounts and personal savings are very commonly sought cash management products in an inventory of a bank. In order to provide these solutions and attract customers in large numbers, banks itself have to undertake certain investments at substantial cost. The following table (Table A) illustrates a list of customer needs and cash management solutions generally offered by banks, their attractions, costs and benefits to each party concerned.

Table A

In essence, one could trace that various deposit products on offer today have originally evolved as cash management solutions offered by banks to their customers over a period of time and proven successful. They are therefore time tested and have come to stay as mainstream banking products of universal acceptance. Interest paid for the deposit is an important part of that solution. A lower rate could make a customer move away to a competitor unless there is a trade off between the rate and some benefit in the product that the other could not match. Due to this reason, it is observed that there is a general similarity in interest rates paid for each type of deposit product across the market.

A closer look at 04 commercial banks actual deposit mixes (Table B) reveal that no two banks have an identical fund composition, although there may be some similarity in the distribution of deposits among the different products. It is also interesting to note that although some banks are benefited by having a large percentage in low cost funds, as far as the aggregate cost is concerned, there is only marginal difference between one another.

Table B

• Bank A and B are commercial banks with branch networks in excess of 100 branches and Bank C has a 30 branch network.

• Bank D is also a local commercial bank that commenced operations recently and having a 10 branch network.

• Balances are at end 2004 balance sheet and rates given were those published by the Central Bank.

• A uniform rate has been assumed for other borrowings (7.5%), for simplicity, although funds may actually have been borrowed at slightly different rates over the period.

Cost of Funds

The cost of funds raised by a bank using various products therefore is the aggregate cost of all such products. Some banks have an ability to canvass low cost funds more easily than others due to certain advantages they have in providing solutions for customer needs. Therefore, even if there is a similarity in interest rates of each product, the aggregate cost of funds of banks could vary between one another due to concentration of deposits in different products within banks. Any advantage a bank has in low cost funds should essentially contribute to its profit either directly or by leveraging through other business deals. This is because the actual cost of these funds should also include the opportunity cost of any infrastructure investments made and a premium for liquidity and maturity mismatch risks carried. Instead, some banks appear to use these funds at their historic cost to capture business volumes (and therefore increase risks) which is contrary to the basic “risk – return” matrix of the trade.

Pricing of Loan Assets

Pricing of Loan Assets is much more complicated than pricing deposit products. This is because in granting a loan, the bank assumes certain risks that were not relevant to it when accepting deposits. These risks range from credit risk on the borrower to liquidity and re-pricing risks attached to funding of the loan. Then, there is a need to recover costs associated with running the business and depreciating the investments made.

In a way, pricing a loan is somewhat similar to pricing a product for sale. First, there is the input cost of materials (funds) and the cost of production (overheads), which are definite costs. Thereafter a profit margin for the business, in line with investments made and risks taken (return on equity and risk premium) has to be added on. Failure to include any of these throughputs would make the product cheaper (and therefore easier to sell), but unprofitable to the business in the longer run.

Let us examine in brief, the impact of each of these items in pricing a loan.

(a) Cost of Debt (or Cost of Funds)

Although we found the aggregate cost of the analyzed 04 banks deposits, one should take care in deciding what the Cost of Funds (COF) that should be applied to a loan to be given. This is because to have a perfect match, the amount and the tenor of funds raised need to be identical to the loan granted. Otherwise, the funds earmarked either have to be replaced or re-priced independent of the loan. This in turn would expose the bank to interest rate and liquidity risks. It is rather impossible for a bank to find an exact match between their loans and covering funds at all times and therefore matching of funds has to be done on an aggregate basis using convenient time ‘buckets’ (bands). This task is usually performed using specialized software programs available in the market.

Once the availability of funds for various time periods and their costs are determined, a few more issues need attention.

1. Whether the funds available are sufficient to handle the bank’s expected loan demand.

A bank needs to carefully assess its future funding requirements well in advance, preferably during the annual budgeting process. This would enable it to plan any liquidity needs of the future through the most cost effective method. This is a key responsibility of the banks Asset and Liability Management Committee, the Treasury and the Liability Units. Determination of future funding needs should also take into account the effects of available liquidity positions and blend it with the projected funding to fill the gap to meet the projected loan disbursements. This is the bank’s Funding Plan.

2. How funds available should be valued.

Once the funding plan is in place there are three options available to the bank to price the funding cost of any loan. First, it could use the cost of existing deposits, provided they are sufficient to meet the anticipated demand entirely. Second option would be to ‘blend’ any available funds with new funds, in the event the former is not adequate to meet the outflows in full. The cost of new funds would be at the going market rates. The last option is to cost the entire lending at going market rates, irrespective of whether market funds are used in part or in full.

The decision to price the funds (cost of funds) is perhaps, the most critical aspect in fixing the lending rate due to the following reasons.

Funds available to the bank from deposits raised during an earlier period are ‘historic cost’ funds and their cost may differ from the current market rates. The reason why these funds are now available is because either the bank carried them without having had a matching need or alternatively the projects they were used to fund would have matured by now. In other words, the bank has carried a maturity mismatch in these funds.

Maturity mismatches carry large but invisible risks (and opportunities) and therefore need to be managed appropriately.

This observation brings into light some lessons in using historic costs in pricing bank products, be it loans or deposits.

Therefore a bank’s cost of funds for pricing a loan has to reflect the applicable “market’ rate for the loan tenor even if the actual cost of funds are cheaper. Passing on any low cost fund benefit amounts to giving away the reward due to the bank for running mismatch risks and therefore should be compensated in some other way through the same relationship.

(b). Overhead costs

Running a banking business is very costly. The largest cost components in a bank would be the human resources, depreciation (mainly on account of costly investments in technology) and upkeep of its infrastructure. Although clear statistics are not available, it is generally assumed that the largest cost component would be associated with the resource mobilization efforts of the bank, that is the branch network and support staff to sell and service deposit products offered. As mentioned earlier in this article, banks tend to account for this cost aspect somewhat through pricing but it is difficult to have a 100% recovery of costs through deposit pricing alone. This is because the depositor, as the risk taker in the game, has many other options (such as other competitors and the opportunity to invest in guilt edge securities etc) at his disposal to resist paying any direct overhead costs to the bank, when depositing funds. This leaves the bank with no other alternative, but to charge such cost to other products it deals with, namely loans and fee based products and services.

(c) Allocation of costs.

A bank has to recover its annual overhead expenditure from business every year since they are of recurrent nature. Costs can be directly passed on only to turnover based businesses such as loans, letters of credit, remittances and guarantees. They cannot be charged from foreign exchange contracts or inter- bank operations as they operate in a separate market. A bank can possibly adopt two methods to recover costs through products.

(i) Aggregate turnover based cost recovery.

Under this scenario the bank assumes a certain turnover in related businesses. Thereafter the estimated annual recurrent cost is spread over the turnover to arrive at a ‘cost per transaction’ number. This calculation is usually done in approximation and therefore needs no specialization. The cost so arrived should thereafter be recovered from the turnover of transactions referred to above. Recovery of costs is an important component in pricing since these are actual costs and any failure would immediately affect the bottom line of the bank. If one is to consider these figures for the banks under scrutiny, the transaction cost of each bank would be as follows.

Table C

a. average balance have been extracted from annual reports of 2003

b. Contingencies are assumed to turnover 03 times per year.

c. Overheads costs do not include provisions, write backs or exceptional items.

d. Remittances figure is an approximation, used only to complete the product ‘base.

It is evident from this data that banks with a large branch network (A, B and C) have a relatively higher cost base than a small bank like Bank D. Although banks A, B and D have lower cost funds than Bank C (Table B), if the majority of overhead costs of these banks are counted as deposit mobilization related, their overall Cost of Deposits would exceed that of Bank D.

(ii) Product specific cost allocation.

The cost allocation given in (i) above assumes that the costs are equally incurred in sourcing funds and servicing each product given. However in reality, it is not so. Therefore a bank may decide to charge different cost components to different products. While this determination is complicated, if correctly applied it will give the management a clear picture on the cost attached to each asset and liability product handled, an information that could be leveraged into competitive product pricing.

(d) Cost of capital

Capital employed in the business is the shareholders’ contribution (investment) to the business. This includes the share capital and any surplus profits (reserves) left over in the business. The cost of capital employed in the business is the shareholders’ expected return on his total investment in the business. A shareholder investing in a bank will expect a reasonable return from his investment as the business of banking has significant risks. The shareholder return can therefore be benchmarked to a premium over the risk free rate, which is the average Treasury Bill rate for the year. It is generally assumed that banking business should provide at least a 5% margin over the risk free rate to justify the risks taken in the business. The return on shareholders’ funds (return on equity or ROE) is determined by dividing the banks profit after tax (PAT) by the total shareholder funds (Equity).

Capital requirement (Capital Adequacy)

Capital adequacy is the minimum regulatory requirement of capital a bank should have in relation to its risk weighted assets (loans, advances and commitments). This requirement was originally proposed by the Basle Committee of the International Bank for Settlement as a means of ensuring shareholder participation in the business risk. The current minimum capital requirement has been set as 10% of the total risk weighted assets. This means that as far as regular commercial loans are concerned, the bank should have at least 10% of capital as a part of the loan, the balance being, borrowed funds (debt). While the capital adequacy requirement sets the minimum capital level a bank should have, in reality, banks do have capital in excess of this requirement since capital is required for future business expansion and other investments planned. For this purpose banks usually retain a large part of their annual profits without distributing them to the shareholders in entirety and retained profits have thus become the largest single source of liquidity for most banks.

Although having shareholder funds retained in the business offers comfort to other stakeholders, as a measure of investors’ commitment to the business, it also puts additional pressure on the management of the bank to increase revenue disproportionately. This is because the shareholders return in the business is the residue of the profit, after accounting for all dues, including corporate tax on profits. Therefore the shareholder expectation is a ‘post tax’ item and has to be adjusted upward to a ‘pre-tax’ position when charged to a product as the ‘profit margin’. For example, if a shareholder’s return (ROE) is decided as 13% (i.e. Current Treasury Bill rate + 5%) and if the applicable Corporate tax rate is 30%, the grossed up return expected for the shareholder fund component in the business would be 18.57%.

Because of the high cost of capital, it will be unwise for a bank to have capital very much in excess of the regulatory requirement. It is therefore assumed that on an average, maintaining 12% capital adequacy requirement is a good measure of health, that too equally divided into Tier I (Core capital) and the balance under Tier II (Hybrid Capital). This is because hybrid (Tier II) capital cost is normally priced at a premium over the market rate benchmarks and is therefore substantially cheaper than Tier I. Achieving these capital ratios cannot be done overnight and needs careful planning over a long period. However, as long as the bank maintains a more than required (or ideal) capital structure, that bank’s product pricing has to take into consideration this additional cost to ensure that the expected ROE target is achieved at the end of the financial calendar.

Table D below shows the capital structure of the same banks, its implication on loan pricing and also the benefit of having an optimal capital distribution between Tier I and II.

Table D

Some of the conclusions that can be drawn into by studying the capital structures of banks given in Table E are as follows.

i. Bank A has a very high core capital base which allows it to venture into new investments or grow the balance sheet immediately. While reduction in the core capital through investments would improve the capital mix, business growth would reduce the overhead cost in pricing and attract more business leading into ultimate revenue growth. However since it has an overall ‘excess’ capital structure than statutorily required, it needs to recover a larger capital cost through pricing, than others.

ii. Banks B and C are reasonably above the capital requirement, but if they are to maintain capital adequacy at same level, they would have to raise supplementary capital (Tier II). By doing so they can move into an ideal capital blend and thereby reduce the capital cost in business and improve pricing further, more easily. However immediate business expansion is not possible unless new capital (Tier II) is infused.

iii. Bank D has a bare minimum capital in total. Its Core capital exceeds 90% of its capital base. Business expansion is absolutely not possible unless more capital is infused. Capital base increase can come by way of Tier II.

(d) Risk Premium.

Risk premium attached to a lending operation is the reward expected by the lender on the credit risk of the borrower. It is rather theoretical because the risk is assessed by benchmarking the lender against a set of pre-defined parameters reflecting sound credit qualities of a business. The rationale being that, businesses that are further away from such qualities have a higher default probability than others who are in line with them. Although banks have their own risk assessment capabilities, there is increased tendency towards adopting international risk ratings to lending operations.

Pricing Model

Once you are aware what inputs need to be considered to price a product or service, the cost of these inputs have to be lined up in a logical manner. For example, if the product is a loan the appropriate cost of debt and capital need to be found in accordance with the capital adequacy requirements. These workings are usually performed using ‘pricing models’ by banks. While the same approach is needed to price other ‘credit’ products, such as Letters of Credit or Guarantees, their pricing would not vary at individual transaction level, as they do for loans.

A pricing model is nothing but an assembly line to put in appropriate inputs to price a product for sale. In the case of a loan pricing model, it will give attention to following input components to decide the optimum rate that should be charged from the loan.

Comparison of lending rates based on a pricing model approach.

If one were to apply various components of a loan pricing formula (model) that were relative to the banks under discussion, the price of a loan for a similar risk category and tenor, using their own funds, would be follows.

Above illustration provides an observer with some important points, not only in loan pricing but also on the overall business health of banks concerned. If the banks are listed in “best price” order, they would look as follows:-

(1) Bank D (Bank with a small capital and small branch network)

Bank’s cost of funds are higher since it has to attract high end deposits due to lack of a branch network. However there is a trade-off between high cost deposits and low overheads. Capital cost is lower because capital used barely meets the regulatory standard. Even though pricing is better it needs capital infusion urgently to accommodate more business.

(2) Bank C (Bank with a large branch network, but smaller than bank A and B)

Good cost of funds mix. However overheads are almost similar to the larger two banks although having half of their number of branches. Capital structure restricts high business growth and investments unless Tier II capital is infused to replace core capital used for loan expansion and investments.

(3) Bank A (Bank with the 2nd largest branch network)

Large branch network has helped to reduce cost of funds but is partially offset by high overhead costs. Large core capital base allows business growth as well as investments in other business and technology to improve profitability. Increased business growth could reduce overheads and improve overall loan pricing as well. No new capital infusion is necessary (Tier I or II) to grow.

(4) Bank B (Bank with the largest branch network)

It has not been able to transform the network advantage to lower funds cost. High cost of funds and overhead costs make pricing costly. It may not be able to go for new investments due to limited availability of Tier I capital. Some business expansion is possible but to maintain the present capital adequacy, level Tier II funds need to be infused.

Acid Test

Banks in general are reluctant to admit that they do not look at loan pricing in the aforementioned manner. Some argue that pricing is strictly relationship driven and that they ‘know’ what to charge from whom, while some others maintain that if business is done at low rates they ensure being rewarded through ancillary business from the relationships. Whilst some of these arguments are valid reasons to price loans purposely low, at the end of the day, one should get compensated sufficiently through other income.

Two simple tests can be done to ascertain whether this position is a fact or fiction.

(a) Return on Equity (ROE)

If a bank conducts its lending operations based on a pricing discipline, the bank should end up recording a ROE equivalent to that it planned for in pricing. Any concessions given in view of ancillary business expectations too should finally contribute to the bottom line of the business, in lieu of interest income. Therefore under either scenario the bank should record a ROE at least equivalent to that included in our pricing model illustration (i.e. 13%, which is 5% over the 2003 average 01 year Treasury bill rate).

The 04 banks’ ROE figures adjusted for exceptional Treasury gains in 2003 (so that they reflect return on ordinary banking activities) are as follows:-