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Risk-based pricing is not a new concept, but it is necessary when discussing affordability and profitability. Setting different prices for customers with different risk profiles works to a degree since it equalizes margins, but an increase in price may reduce business volume. The question is, by how much? Pricing based solely on risk does not address this issue, but to maximize profitability the business needs to understand the price elasticity of customer demand.
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Regain confidence with pricing optimization
Danna Gurbaxani Experian
Craig Wilson Experian
#vision2014
2 © 2014 Experian Information Solutions, Inc. All rights reserved. Experian Public.
Lending challenges
Evolution of pricing
The basics of pricing optimization
Benefits and Experian’s pricing solutions
Next steps and conclusions
Agenda
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Lending challenges
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Political and regulatory threats to long-term revenue
Ability to adapt to changing regulation
Pressure on non-interest income
► Card Act regulations impacting non-interest income
Political pressure on usage of financial products
► Public statements challenging financials of credit cards and need for consumer transparency
Lending challenges
Political and regulatory
uncertainty
Growth in a saturated
market Loan performance
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Methods to increase approval rates and to sustain growth trends
New pockets of opportunity for growth (near prime segments)
Saturated market
► Maximizing lending opportunities with existing customers
Near prime segments
► New methods to extend potential customer base
Lending challenges
Political and regulatory
uncertainty
Growth in a saturated
market Loan performance
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Exceptionally low delinquency rates and bad rates
Responsible growth: Balance of revenue growth and loan performance
Loan performance
► Number of debtors is not increasing
► Loan amounts are increasing
Lending challenges
Political and regulatory
uncertainty
Growth in a saturated
market Loan performance
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Implications for pricing
Political and
regulatory
uncertainty
Reduce dependency on non-interest income
Pricing techniques to maximize income potential in constrained regulatory environment
Flexible approach to pricing to accommodate new regulation !
Growth in a
saturated market
Identify higher risk pockets of opportunity but price accordingly
Grow profits through efficient pricing in times of difficult volume growth
!
Loan performance
Responsible growth: Grow volumes without increasing risk exposure
Understand near prime customers and price to off-set increased risk
!
Conclusions
Need for flexible pricing techniques due to uncertain regulatory changes
Need for efficient pricing to drive sustained growth
Need for smart pricing for responsible growth !
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Evolution of pricing
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Evolution of pricing Increasing analytical sophistication
One price Product-
based pricing
Relationship-
based pricing
Risk-
based pricing
Pricing
optimization
Price structure
One-size-fits-all
price
Product rate
sheet
Differentiation by
product features
Product rate
sheet with
specified
discounts
Computed price
by customer or
risk segment
Optimized price
by customer
Pricing decisions
Competition driven
Price floors by
portfolio risk
Competition driven
Price floors by
product-level risk
Limited
segmentation
Broker/dealer
discounts
Customer status
Product bundling
Risk-adjusted
return hurdles
Customer-level
or segment-
level
Builds on risk-
based pricing
Predictive
analytics
Optimised
customer-level
decisions
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Risk-based Pricing
A: Higher prices for higher-risk
customers
Lower prices for lower-risk
customers
Can be integrated with Basel
capital allocation initiatives
Q: Difference between Risk-based Pricing and pricing optimization?
Price variation
– different
prices by risk
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Implications for customers and performance
Price and risk Risk performance vs. market pricing
Market price
Risk
Low risk customers are
over-charged: Damages
volumes and relationships
High risk customers are
under-charged or not served:
Unprofitable, subsidized by low
risk customers
Price
Risk
based pricing
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Pricing optimization
Price levels –
Right price for
each customer
or segment
A: Strategic use of pricing to
better manage performance
Pricing for performance
(profits, volume)
Pricing for control (regulatory
constraints)
Q: Difference between Risk-based Pricing and pricing optimization?
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The basics of pricing
optimization
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Optimization to set the right prices In one sentence
Maximize your business goals (such as EVA, risk-adjusted profit, origination volumes)
By determining the best decision for each customer or segment (such as which APR, fees, margin above index)
Based on the forecasts of your underlying data and predictive models (such as RAROC, take-up rate models, loss models)
While satisfying the constraints of your business (such as eligibility, capital availability, channel capacity)
Optimization enables you to:
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Demand-side:
Willingness to buy
Price
Vo
lum
e
Supply-side:
Willingness to sell
Price
Pro
fit
Unified view of
pricing
What are the trade-offs
between volume, profit
(and other KPI’s) as
price changes?
Volume
Pro
fit
The fundamental principles of pricing: Understanding supply and demand
How do costs and profitability change
as price changes?
How many customers will we
acquire/retain as price changes?
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Demand-side:
Willingness to borrow
Price
Vo
lum
e
Supply-side:
Willingness to lend
Price
Pro
fit
Unified view of
pricing
Volume
Pro
fit
Supply and demand The basics applied to retail lending
What is the expected take-up rate for
each loan/customer as price changes?
What is the risk-adjusted return for
each loan/customer as price changes?
What are the trade-offs
between volume, profit
(and other KPI’s) as
price changes?
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Understanding willingness-to-lend Breaking down the problem
Revenue
Interest income
Fees
Other revenues
Adjustments
+
+
+ / -
Cost
Cost of funds
Operating costs
Expected losses
Cost of
economic capital
+
+
+
Economic profit = revenue – cost
Expected losses
Cost of
economic capital
Both are a
function of risk
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Decomposing RAROC
Refining the framework Risk-adjusted return on capital
How much profit can
we make (in $ / £ /€)?
How efficiently do we
make the profit relative
to the capital we must
put aside?
Economic
profit
Economic
capital
RAROC
From BII A-IRB
approach or VaR
model
Risk adjusted
return on risk
adjusted
capital
Revenue Costs
=
–
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Price-sensitivity at origination (example modelling structure)
Understanding willingness-to-buy Measuring consumers’ price-sensitivity
Acquisition funnel
Market size (macroeconomic conditions and rates)
Market share (headline rates and lending policy)
x
Approval rates (lending criteria)
x
Product selection (x-product rates, macro conditions)
x
Expected
originations =
Take Up (offered rate)
x Greatest driver of
price-sensitivity at
origination
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From insights to execution Estimating the impact of pricing decisions
Customer A Customer B Customer C Customer D
For each set of rates,
we can add the model
predictions to estimate
the overall profit,
volumes and other
KPI’s (risk, etc) Total volume
To
tal p
rofit
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From insights to execution Estimating the impact of pricing decisions
Customer A Customer B Customer C Customer D
Unified view of
pricing
Evaluating all the
different rate
combinations predicts
the possible outcomes
Total Volume
To
tal P
rofit
Efficient frontier
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If the bank has unlimited capital and no operational constraints, then price to maximize expected return for each customer
Reality is more complex with many constraints on pricing and acceptable growth
Pricing theory vs. reality Understanding constraints
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Types of constraints
Eligibility
► Who is eligible for the loan?
Capital availability
► How much total capital do I have available?
► How much capital do I have available by product or other grouping?
Competition
► Do I want to keep my prices within a window of competitors’ prices?
Pricing theory vs. reality Understanding constraints
Capital
availability
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Solution space
Types of constraints
Controlled growth
► Do I want to control the composition of my growth?
► By term, risk, geography or other attributes?
KPI targets
► Do I have multiple goals I need to achieve?
► Market share and profit? Risk and return?
Pricing theory vs. reality Understanding constraints
KPI
targets
Capital
availability
Controlled growth
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Benefits and
Experian’s pricing
solutions
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Implications for pricing
Political and
regulatory
uncertainty
Flexible approach to adapt to changing regulation
Financial benefits to off-set threats to long-term revenue
Increases of 33% in profit, >100% in EVA and RAROC
Growth in a
saturated market
Increase amount booked through higher approval rates and
take-up rates
4% increase in amount booked
Loan performance
Grow responsibly
Increase profits and volumes while controlling for risk
Reductions of 8% - 18% in bad rates
Conclusions
Flexible pricing techniques due to regulatory changes
Efficient pricing to drive sustained growth
Smart pricing to grow volumes without growing risk
Challenges Benefits of pricing optimization
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Experian’s modular approach The four building blocks
Technology
Optimization solutions
► Marketswitch® for
individual-level decisions
► Strategy Tree Optimization
for segment/tree-level decisions
Delivered as service or as a
software product
Technology
Consulting
RAROC and profit model
consulting
Industry consulting (e.g.,
regulation trends, risk-based
pricing adoption study)
Optimization consulting
Consulting
Data
Data
Data readiness assessment and
recommendations
Partner with third-party ETL
vendors for data
transformation efforts
Analytics
Analytics
Custom model development
► Take-up models, demand
estimation models,
cannibalization models
► Profit model assumptions
(loss forecasting, etc)
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Next steps and
conclusions
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Multi-phase approach Perfection is not a pre-requisite to optimization
Phase I:
Proof-of-concept
Benefit
Com
ple
xity Phase II:
Implementation
Phase III:
Increased sophistication
Illustration Only
Limited scope and easy to
implement
First generation models and
data (existing or proxy models)
Develop additional models
Increase scope
Refine operational
processes
Transition to real-time (as
appropriate)
Additional scope, models,
decision points
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Conclusions
Pricing at the
root of
challenges
Regulation: Need flexible approach to pricing
Growth opportunities: Identify pockets of opportunity
Loan performance: Responsible growth
Risk-based
Pricing vs.
Pricing
optimization
Risk-based Pricing: Price variation - Differentiated pricing by risk
Price optimization: Price levels – Right price for each customer or segment
Pricing
optimization =
supply and
demand
Supply: Understand your willingness to lend
Demand: Understand your customers’ willingness to borrow
Proven results: 33% profit increase, 18% bad debt reduction,
100%+ EVA and RAROC improvement
Modular
approach
Four components: Data, Analytics, Technology, Consulting
Phased: Perfection is not a prerequisite, start simple with PoC
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