Annual reports from 2020 are showing increased Cost of Risk across the banking industry, with signs that the challenges are continuing into 2021. While it may be tempting to blame this trend on the pandemic (with the optimistic view that vaccines will solve the problem), the reality may be quite different.
What could be the underlying reason then–beyond covid? As a matter of fact, the current pandemic crisis has created lasting change in customer behaviors and financial health, jeopardizing the accuracy and validity of banks’ existing methodologies at all levels. This raises other questions such as:
- Are banks comfortable with how well they know their customers?
- Do they really know and understand what is in their lending book, whether it is on the performing or non-performing side?
- Are banks as healthy as their financial reports claim?
With risk at heart
Risk is inherent and at the heart of the banking business. When addressing cost of risk, the bank wants to make sure it is sustainable on the long run. This necessitates an analysis of multiple stages of the loan lifecycle- from incoming risks at loan origination to optimal recovery and collection strategies to limit financial losses without offending valuable customers in the process. Banks need sophisticated strategies to shape their portfolios’ risk profiles without sacrificing profitability.
This is even more critical in situations like the current pandemic – when we expect fewer eligible borrowers and a significant increase in those unable to pay, expanding collections and defaults in the bank’s lending book. At the same time banks must lend more, whether it is coming from governments and central banks eager to support citizens and fuel the economy, or investors looking to grow their ROE.
These pressures are combined with significant headwinds from both competitors and the broader market environment. It is difficult to grow NII with interest rates in the Eurozone at record lows, while the ECB is clearly signaling that these conditions will continue for years to come.
Meanwhile, neobanks and insurers are all threatening to expand their market share with aggressive pricing, efficient client onboarding and native digital customer experience. Banks must fight for every basis point of profit.
Since insurance companies already had a head start in leveraging data to understand their customers, they were less affected by the pandemic and better able to invest in AI and machine learning. Which, in turn, will further increase the gap between insurers and banks, especially those banks that are focusing too much on cost reduction and not enough on their growth and innovation strategy.
Pandemic governance and compliance
As if this was not enough, banks also expect greater scrutiny from internal and external authorities. How did the bank really navigate the pandemic crisis? Did it lend enough? Were prices and commissions fair, compliant and ethical? Do financial reports reflect the true reality of the financial health of the bank? Does the bank have enough reserves?
In addition, the EBA has set a clear tone with its 2020 guidelines for loan originations, as seen in the below extract:
“Banks should bring greater level of sophistication in their pricing methodologies as well as ensure that its pricing framework is well documented and supported by appropriate governance structures (i.e. systems and processes…) For the purposes of pricing and measuring profitability, institutions should consider and account for risk adjusted performance measures in a manner that is proportionate to the size, nature and complexity of the loan and the risk profile of the borrower”.
The urgency of real-time pricing
After risk, comes pricing – as the other main driver of any bank. The institutions’ pricing structure has an impact not only banks’ KPIs, but also balance sheet ratios and the entire credit life cycle. Critically, pricing remains the first reason why consumers say they switch banks.
With the acceleration of the adoption of digital channels, banks must get the right product at the right price to customers immediately – as there will be fewer interactions with the customer to discuss and negotiate prices and contractual terms. KYC becomes the key to success.
Pricing and offers are key components that banks need to optimize to transform their value proposition and better satisfy customer needs. Improving pricing is a relatively low-cost way of increasing revenues and often a much quicker, healthier, and more profitable way to win than a several year cost reduction program for. And by doing pricing right, it is also an excellent gatekeeper to control incoming risks and unprofitable loans on the lending book.
For a quick win and addressing all – Revenues, Risk and Compliance – at the same time banks ought to look at their pricing methods and governance processes.
Best of class pricing
Pricing excellence depends on a combination of analytic techniques and process management. In this exercise, the bank will need to bring greater sophistication to its methodologies and deploy state-of-the-art machine learning tools, with a comprehensive framework that can support governance and auditability throughout the entire end-to-end process to satisfy the EBA guidelines.
The Earnix solution is specifically designed to address these challenges and is fully integrated for customer centricity (KYC/KYB). Being a centralized platform all users – from data scientists, business users to upper management – share the same information and dashboards and can leverage the power of big data to drive analytically-driven strategies.
Earnix is an off-the-shelf, flexible and scalable pricing analytics platform, with a comprehensive framework that supports the end-to-end pricing process, from analytics to execution. Earnix provides an integrated platform, capable of processing data, importing, and managing models, and intuitive business simulations. The platform also enables the user to deploy these optimized prices to the market in real-time.
The 3 pillars of Earnix value proposition
- Performance – Improve revenues, margins and business KPI’s, (i.e. volumes, activity, churn, loyalty, satisfaction etc.)
- KYC by leveraging data and deploying more sophisticated analytics, simulation, and pricing methodologies, based on AI and machine learning techniques. Personalize prices by simulating the portfolio to better control the credit mix under multidimensional constraints, to find the optimal efficient frontier between volumes, margins, and risks,
- KYC and KYB through advance portfolio analytics to confidently launch marketing campaigns and new products at any time,
- Detect and predict x-selling and customer needs for a loan/lease, insurance, etc.,
- Automatically and immediately recommend a personalized offering, with the right product, at the right price, to the right client at the right time, through the right channel.
- Risk management and control
- Loan origination: KYC and lend more without compromising on risk. Through pricing optimization, the bank can control the risk shape and profile of its book, as well as significantly reduce the number of unprofitable loans and leases.
- Credit Risk: By detecting customers under financial stress and proactively offering a rescue package, saving the customer and the bank from loan delinquency,
- Cost of Risk: Know your book and predict UtP customers by leveraging real-time data and analytics to recommend optimal rescue packages that can fit the bank and the customer. Optimize collection recovery strategies, by finding the efficient frontier to maximize profitability of recovery while minimizing losses. And optimizing NPL packages allows the bank to narrow the existing gap between the book value and what debt buyers on the market are willing to pay,
- Operational risks: Systemize, streamline, and automate the bank’s pricing processes, to quickly and confidently deploy prices to the market at any time and frequency. Prevent the painful losses in profits and market share caused by delays in price updates.
- Compliance and auditability
- Designed around regulations for fair lending, dealer commissioning, and risk management i.e. EBA; FCA), Earnix is a fully integrated, centralized, supported, and maintained platform. Its transparency, auditability, and governance features are in place to satisfy regulatory needs. With Earnix every pricing decision can be traced back to its source and with ease at any time.
Sooner, rather than later
As the world re-emerges from a year-long pandemic, banks will need to quickly adapt to the changing consumer landscape with new pricing tools and strategies.
Modern SaaS solutions are easy to integrate with banks’ existing systems and move pricing strategy from a reactive function of market dynamics to a proactive, Enterprise-wide approach to profitability and financial risk modelling and management.
Along with revenue improvement of 6-15% (source Mc Kinsey), analytical pricing can also deepen relationships with valuable clients and drive sales and operational efficiencies throughout the organization.
As liberalization and macroeconomic changes create an inevitable need for increasing sophistication, banks can choose to be reactive or proactive – those that move quickly stand to gain a strategic advantage and rewards over their more passive peers.