UNIT 18

Objectives

PRICING OF BANK PRODUCTS AND SERVICES

Pricing of Bank Products and Services

The main objectives of this unit are to:

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provide an overall understanding on pricing issues in Banking Industry; identify the inputs required for taking a pricing decision; explain different methods of pricing.

Structure
18.1 18.2 18.3 18.4 18.5 18.6 18.7 18.8 18.9 18.10 Introduction Pricing in Banking Context Objectives of Pricing Inputs needed for Pricing Methods of Pricing Pricing Strategies Summary Key Words Self-Assessment Questions Further Readings

18.1 INTRODUCTION
Business units all over the world sell products and offer services to customers with an objective of making profit. Profit depends on the ability of the business units in fixing the price at a level, which recovers cost while achieving customers satisfaction. Profit can also be expressed as a function of price, cost and quantity sold where quantity sold or market share achieved is a reflection of customers satisfaction. It is easier to assess the relationship between cost and profit because any savings in cost will either improve profit, when the firm fails to pass on the savings to customers, or retain the level of profit. On the other hand, the relationship between price and profit is complex. There is no assurance that an increase in price leads to increase in profit. Often an increase in price affects customers satisfaction and reduces the volume of sales, which in turn negatively affects the profit. Pricing is thus a complex but an important decision for managers to make. It also assumes strategic importance for many firms because a wrong pricing may affect the business success despite the fact that the firm is making good products and has good distribution network. Customer satisfaction depends on several things and pricing in many products and services is an important factor that influences customer satisfaction. Pricing decision is important for banks for two reasons. Firstly, banks like many other firms produce financial products and offer wide variety of services. Often, banks use common set of resources to deliver several products and services and hence getting reliable cost information is critical in pricing. Secondly, the level of competition has gone up significantly during the last few years particularly after the establishment of several private sector banks. Many of the new entrants are aggressively pricing the products and services to capture a market share for their survival and in that process

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force others to follow an aggressive pricing. The success of a Banking Company today not only lies on its ability to develop products and services that are in demand and developing a distribution network to deliver these products and services to the customers but also on offering such products and services at a competitive price.

18.2

PRICING IN BANKING CONTEXT

For manufactured products, price normally means money exchanged in return for receiving goods. Similarly, in many service industries also, price has a clear meaning. It is again the money exchanged in return of getting a service. For example, if your bank hires a broker to buy Government Bonds, the brokerage you have paid is the price for the broking service. Similarly, when you pay maintenance or warranty fee to your computer dealer, it is the price for the services rendered to you. In Banking Industry too, there are services, where there is no confusion on the term relating to price. For instance, if your bank issues a Demand Draft or opens a Letter of Credit, it collects commission or service charges and it is the price for those services. However, in other areas of banking operation like borrowing and lending, there may be some difficulties in defining the price. It requires an understanding of basic operations of banking. In a typical manufacturing or service unit, the business unit fixes the price for the products or services it offers to the customers. In a banking industry, the primary business activity is borrowing and lending. Banks create financial products and sell them in both borrowing and lending activities. When these financial products are sold, pricing becomes critical for this primary activity. For example, when a bank develops a new fixed deposit scheme with certain specific features, like a television manufacturer comes with a model, it has to decide the interest rate to be offered to the investors of the particular deposit scheme. Here, interest rate is the price for the product. Though interest rates that banks pay on deposits are an expense, there is an element of pricing because the interest rates affect the demand for such deposits. Similarly, when a bank sells a loan product like car loan or housing loan, it combines certain features like floating rate of interest or no-collateral, then it has to fix an interest rate to be charged for the scheme. Here again interest charged is the price for the loan scheme. The process of deciding price for a manufactured product and fixing interest rate for the deposit or loan are same. Bank has to consider the cost associated with the product and customers willingness to pay the price in setting the price. Like in manufactured products, price (here interest rate) influences the customers decision to invest or borrow money from the Bank. Today Banks come out with several products by combing features that cater to particular segments of the customers. There are two reasons for this new trend. Firstly, the new private sector banks and existing foreign banks have become aggressive in their marketing to create a good customer base. It would be difficult to operate a Banking Organization without a good and growing customer base because of asset and liability mismatch. For example, if a bank collects 6 months deposits but lend the money for 1 year, it has to attract a new investor at the end of 6 months to repay the amount deposited by the first investor. Further, a good customer base is essential because profitability of banks directly depends on the extent of financial leverage. This is more critical when the interest rate spread has become very narrow because of competition. Secondly, the developments in personal banking require banks to continuously develop new products to attract new clients. While it may take some time for other companies to copy a new product of a manufacturing company, the lead-time required for competitor to come with similar product and often with better features is very small in banking industry.

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There is no big difference between a manufacturing company and a Bank in terms of developing a new product. The process is by and large same. It requires an understanding of customers need, develop a product with suitable features, identify the cost associated with the new product and finally assess the ability of the customer to pay the price before launching the product. Banks need to continuously innovate new products and resort to financial engineering to retain the existing customers and attract new customers. As noted earlier, the success of a product depends on its ability to generate required customers satisfaction and price along with other features of product is a critical input. Apart from interest rates, price includes monthly maintenance charges (e.g. locker fee), transaction or item charges, minimum balance requirement, commissions and service fees. While few of these prices are directly paid by the customers for availing the services, a few others are indirectly collected. For example, banks allow cheque book facility for savings bank account against a minimum balance. Lower interest paid on such minimum balance is the price charged for selling the product. In other words, borrowers, lenders and other service users are all customers of banks because of their financial intermediary role. Banks produce products or services and sell them at a price. In fixing prices of multiple products, banks need to balance the demand for different products. Any wrong pricing in one segment will push up the demand for the products while pulling down the demand for another product leading to serious assetliability mismatch. Since banks commit certain types of resources, such wrong pricing will also affect the utilisation of resources. For instance, if a bank provides certain spaces of branch for safety lockers but fixes a high price, it may lead to underutilisation of resources. Thus, banks need to follow a balanced approach in pricing of various products.

Pricing of Bank Products and Services

18.3

OBJECTIVES OF PRICING

Price is a function of demand and supply. It means market forces determine the price and hence there is a little role for the producers in pricing the product. Though prices of commodities like vegetables and metals are determined in that fashion, in several products and services, the producer initiates in fixing the price. For instance, a firm that manufactures computers fixes a price based on its own estimation of demand at various price levels such that it achieves a maximum profit. Similarly, in banking services, banks fix the price for issuing demand drafts based on its own estimation of cost associated with the preparation and accounting of demand draft and expected return from such services. In the above two examples, the firms are using an objective of recovering the cost while maximising profit in fixing the prices. Firms pursue several objectives both financial and non-financial in pricing the products. Firms also fix the prices to achieve certain strategic as well as operational objectives. Some of the important pricing objectives are listed below: Survival: Business units typically pursue several objectives simultaneously for different time horizon. For many firms, particularly those operating in a competitive market, survival is the short-term objective. This objective may be for the entire business units or for a particular new product. Here the firm targets a minimum sale for the business or one line of product or service. It develops a pricing structure to achieve the target sales. It doesnt mean that the firm will fix a lower price always to ensure survival. In certain situation, the firm may even increase the price if the cost has gone up during this period. In other words, if the firm fails to increase the price, its survival will be questionable. The important issue is the price during this phase is not aimed to make profit or capture market but mainly to cover the cost and sustain the business. It also doesnt mean that the firm will pursue this objective of pricing forever.

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Profit: Business units exist to maximise the profit. Profit equation shows that the quantity sold, cost and the price are three important elements of profit. If other things remain constant, profit can be maximised by fixing higher price. Often, price affects other elements of profit equation. An increase in price reduces the demand and may also increase the cost if some fixed cost is present in the cost structure. On the other hand, a price reduction may increase demand and thus reduce product cost but there is no guarantee that increased volume and cost saving together is more than revenue loss. It requires a careful analysis of profit function (or equation) to identify the price which maximise the profit. The equation will be complex if we include promotional policies, which in turn affect cost (negatively) as well as demand (positively). Return on Investments (ROI): It is possible for a firm to make profit but may fail to achieve the required rate of return on investments. The profit objective fails to recognise the amount invested in generating profit. The pricing objective based on ROI is to fix a price, which ensures required or targeted ROI. In banking context, when a bank introduces a new product like loan scheme or service and commits funds or resources, the bank has to carefully assess the impact of price on volume and cost and return on investments. An example will be useful to understand why ROI is better than profit in certain conditions. Suppose a bank commits Rs. 100 cr, to a new scheme. It expects a volume of Rs. 500 cr. on the new business but has to incur a cost of Rs. 20 cr. to earn Rs. 500 cr. business. If ROI is 20%, then the bank has to generate an income of Rs. 40 cr. to recover the cost as well as return on investments. It is not adequate for the bank to generate an income of Rs. 25 or Rs. 30 cr. from the new business though the bank gets a profit on an income above Rs. 20 cr. Profit is essential and it should be at least equal to return on investments. Market Share: If a bank pursues leadership objective in one or more segments of business or determined to achieve certain percentage of market share, then it has to set a price to achieve desired market share. It may also require periodical adjustment of prices to maintain the market leadership whenever competitor is trying to capture a part of market share or whenever market share declines from the desired level. Pricing will be dynamic and even powers can be given to certain levels to negotiate and fix the price. Many foreign banks often launch special schemes by offering huge cut in their fees to a group of individuals. Cash Flow: Cash flow objective is to an extent related to market share objective. Here the firm aims to generate more volume and generate cash flows from the new business. It is possible to generate more profit with increased turnover. Though in many business segments of banks, it means higher transaction cost and typically in lending business banks would prefer long-term relationship subject to other issues like credit rating, etc. However, in certain types of businesses like securitaisation banks would like to pursue an objective of large volume. Here banks initially lend but sell the same in the market and use the cash flow for fresh lending. At the end of every cycle (sale), the bank gets a profit. The bank is no more a lending institution on this issue but rather specialises in processing loan application. Status quo: Here the firm doesnt want to grow but rather wants to maintain the present level of standing in the business. Normally, this stage is achieved after intense competition and capturing certain market share. With stable business volumes, the bank will pursue other objectives like offering value addition, etc.

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Activity 1 1) Consider any one of the financial products (deposits or loan schemes like housing loan) or services of your bank and compare the price offered or charged by your bank with other banks. Do you think that your banks rates are competitive with others in the market? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 2) Consider one more financial product or service of your bank. What is your assessment on banks objective in pricing decision? Do you observe that any other bank follow a different pricing objective for the same product? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ......................................................................................................................

Pricing of Bank Products and Services

18.4

INPUTS NEEDED FOR PRICING

In the previous two sections, we discussed pricing in banking context and objectives of pricing. From these two sections, it would be clear that pricing in banking context is to an extent different from that of regular pricing because everyone who deals with a bank is customer to the bank and pricing means fixing deposits and lending rates. Similarly, pricing also depends on the objective of pricing and often banks pursue more than one objective. Pricing in general is complex if objectives work opposite to each other. It is more complex in banking industry because of special features of pricing. Once pricing objective is clear and determined, it is necessary to collect certain basic inputs required for pricing decision. Four important inputs namely demand for the product or service, cost associated with offering the product or service, competitors price and regulations relating to pricing, if any, are useful at this stage.

i) Demand Analysis
It is relatively easy to develop a product or come out with a new service. The real business issue is selling the product or service to the customers. You would have seen that several products are withdrawn after their launch because of the firms inability to sell the product. Thus, the first stage of any new product development or service is to ascertain the demand for them in the market. In fact, many large firms and banks use a team approach in new product development. The team typically consists of executives drawn from different departments like R&D, production, purchase, marketing, finance/costing, etc. The marketing department is expected to perform demand analysis of the product and the team is expected to use the same in developing new product or service. Product or service features and demand for the product or service at different price levels are two important inputs that are useful for those who are designing new product or service. The team uses an approach called target costing that matches product features, cost, price and demand to design a product that satisfies the customers to a reasonable extent while its price and volume cover the cost and profit. An example will be useful at this stage to understand the need for proper demand analysis. For instance your bank is interested to offer internet banking. How do you go about in designing this service? It requires an investment in computer hardware and software but it depends on features to be added and the number of

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prospective users in the near future with some allowance for expansion. Thus, investments depend on potential demand for the product. Demand in turn depends on fee to be charged for such services either directly in the form of collecting fees or indirectly by requiring to customer to have a minimum deposit of certain value. Without this basic information, it would be difficult to decide on pricing structure for the new service. Elasticity of Demand: In many products and services, price negatively affects the demand. We need to understand two more relationships. Price positively affects profit and demand negatively affects costs because of fixed cost. Thus, a change in price affects demand, cost and profit. Thus, we normally get a complex and non-linear relationship between price and profit. While profit and cost are internal issues, the relationship between price and demand is critical in setting the price. Price elasticity of demand determines the impact of changes in price on demand for the product or service. In basic courses on economics, you could have studied two types of pricedemand relationships. The demand for the product is said to be elastic if demand reacts quickly when there is a change in the price. On the other hand, there are products, whose demand reacts slowly to the changes in the price. The demand for these products is inelastic. Figure 18.1 illustrates elasticity and inelasticity concepts.

400
Volume Volume

400 300 200 100 1 2 3 4 1 2 3 4

300 200 100

Price (a) Elastic Demand

Price (b) Inelastic Demand

Figure 18.1: Demand Curves

Demand for a product is typically elastic if there is a scope for substitution and in a situation when customers can easily switch over to alternative products. It is also necessary that customers have complete information on alternative products and price difference is large and important variable in decision making. Many banking products may not qualify to the above tests. It is true that volume of deposits may fall significantly if the bank offers lower rate for term deposits compared to other banks. On the other hand, if there is a general decline in the interest rate in the market and all banks cut down interest rates, it will have less impact on volume of deposits. On the other hand, an existing customer may not switch over to a new bank because the other bank charges a lower interest rate of few basic points. For example, many foreign banks advertise asking existing customers of housing loans of other institutions to them to get lower interest rate but not many customers have switched over to the new banks. Of course, higher interest rates even a few basic points affect future business but banks may demonstrate many invisible benefits like speedier disposal of loan application, improved service efficiency, lower margin requirement, etc. Many banks overcome the problem of price elasticity of demand by bunching of banking products or services. For example, many banks offer free demand draft facility for certain high net worth customers. Most common customers rarely use demand draft facility (how many demand drafts you have drawn during the last three
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years?) but still the free offer attracts customers. Actually, the bank may be factoring the cost in the basic service by requiring customers to have higher minimum balance. Sometimes banks may charge lower interest rate but higher processing fees or vice versa and it is difficult for many nave customers to assess the two offers having different processing fees and interest rates. A few banks offer free insurance benefit to the customers of credit card but they charge twice the amount as yearly fee. Liberal credit limit is another attraction that these banks offer to reduce the negative impact of higher fee for their credit cards. Another reason for many banking products being less elastic is low cost of services. Further even in cases where the cost is fairly high, they are less frequently used. For example, many banks charges fee if the customers use ATM outside the city and the fee may vary bank to bank. Since the fee is small and transaction based and such transactions are taken place once in a while, no customer is going to change the bank account to a new bank because the other bank charges a lower fee. Typically, customer changes bank account once in a five to eight years and most of the time it is on account of shifting the place of residence or office. Customers look into convenience, reputation of the bank and quality of service in deciding to have a relationship with the bank and price becomes secondary in many of the banking products. Estimating Price Elasticity: An understanding of price elasticity is critical for pricing decision because it reflects customers satisfaction. However, it is not easy to get a precise demand curve as shown in Figure 18.1. The firm has to undertake a market research involving primary and secondary data to develop such demand curves. It is possible to collect some details from customers by administering a questionnaire. The respondents may find it difficult to answer if the questionnaire asks a direct question on how many units they will buy at different prices or how they will react to the price increase. Further customers always will tend to resist any increase in price though they may still buy the same quantity at higher price. The point is that the questionnaire has to be carefully designed to get the required information to draw demand curve. Instead of asking a direct question on how price sensitive the customer is, it is desirable to come out alternative pricing schemes with a request to evaluate them. It is also possible to collect information required for forming demand curve through interaction with the select customers. Since pricing is a sensitive issue, there are limitations in getting a reliable primary data through the above methods. Further in banking industry, we have noted earlier that demand is not always elastic. Thus, it is better to use secondary data in addition to primary data for pricing decision. Banks can use its own records to collect necessary information on the relationship between price and demand. For instance, the bank know from its historical database on how customers react to changes in deposit interest rates by looking into last three or four occasions when bank changed the interest rates. It is also possible to know from the published records that how similar changes have affected the competitor banks. The details can be collected at two levels industry-level impact and banklevel impact. Another possibility is to introduce the new product in one or two regions and examine the customers reaction before launching the product in other parts of the country or globe. Citibank N.A. introduced ATM-based savings bank account (brand named Suvidha) in select cites. Though the minimum balance is more than the balance required in domestic banks but it is much below to the balance required by some other foreign and private sector banks. The idea is before introducing the product to other parts of the country, the bank wants to evaluate the success of the product at current price and terms.

Pricing of Bank Products and Services

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Activity 2 1) List down the products and services of your bank and one more with which you are familiar that offers a few products and services other than your bank. For each of these products and services, guess price elasticity of demand. Briefly discuss why the products and services demand is elastic or inelastic? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 2) If you are working for a branch or through the help of a friend working in a branch, find out and analyze why some of the account holders have closed their account during the last one-month or quarter? Is it on account of logistics or some other reasons? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ......................................................................................................................

ii) Cost Analysis

Though cost information is less critical in todays competitive environment, where market sets the price, it is highly useful for two reasons. One, it will be useful to decide whether the firm has to produce the goods or offer the service. Two, it can plan for producing or offering the product or service within the target price by adopting target costing principle. Cost information will also be useful to develop a pricing structure if the market price is above the cost. For example, different banks charge different amounts for issuing credit cards. Some banks charge higher admission fee but lower renewal fee whereas others charge less or no admission fee but higher amount for yearly fees. Since many banks outsource the activities relating to marketing and processing of application, it is not difficult to assess the cost of processing. If the bank uses in-house facility to process the application forms, it needs to work out the costing, which may be higher in view of differences in salary structure. This cost information is vital to price the product competitively and attract more customers. In many service industries including banking, costing system is poorly organised. Banks can easily find out the cost of funds (cost of capital) and normally add few basic points (400 to 600 basic points) to fix lending rates. However, the cost is not restricted to this direct cost. There are several indirect costs that banks incur in the operations of borrowing, lending and providing other services. Often, many cost items are common to several activities or products of banks. Thus, it is difficult to collect the cost data (particularly non-interest cost) relating to the activities unless there is a good costing system. Conventional costing system focuses less emphasis on indirect cost and normally treats the indirect cost as period cost. Thus, there is little effort in analysing and controlling such indirect costs. In Banking and several other industries, such indirect costs are a major part of non-interest cost structure. In many cases, these costs do not vary with period but they vary with activities. Further recent literature in costing also emphases the need for a detailed analysis of indirect costs and as much as possible convert them into traceable direct costs. Thus, banks need to adopt Activity Based Costing (ABC) to get better and reliable cost information of the services offered by them.

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Activity Based Costing: The philosophy of ABC is fairly simple. It believes organisations exist to deliver value to their customers and in that process perform a large number of activities. In other words, organisation is merely a pool of activities performed by men and machines. For example, consider your bank branch and you will see the purpose of its existence is to provide a large number of services to your customers. You and your colleague are there to perform the activities relating to delivery of services to customers. Your bank would use a few machines like computers, printers, etc., to perform these services. ABC requires the organisation to list activities being performed inside the organisation. Once the list of activities is ready, then the resources (men, material and machines) used to perform the activities are also listed. Costing of activities become easier once these two details are available. Suppose, to find the cost of preparing a demand draft or passing a cheque or withdrawal slip for cash payment, the bank need to identify activities associated with these services and time taken. Since cost per activity is already available, time and cost are multiplied for each activity. The total cost of all activity is direct cost of delivering the service to customers. Though adopting ABC cant eliminate indirect cost, its value will be much smaller under ABC. You have an option of allocating indirect cost to services or simply recover them profit by suitably adjusting the profit margin. The cost drawn from ABC is more accurate and reliable than cost drawn from conventional costing system. ABC serves better to any decisions including pricing, which use cost figures. Further ABC supports several strategic management issues. Target costing, a strategic management tool is relevant for discussion under pricing. Target Costing: In a competitive market, firms have little role in pricing. For example, it is not possible for a bank to charge two times of fee charged by other banks to prepare a demand draft or issuing L/C or guarantee. Similarly, banks cant charge an interest rate more than other banks and if they try to do it, all good accounts will move to a new bank and all bad accounts will come to the bank. The pricing issue before the bank is actually costing issue - the ability of the bank to deliver the product or service within the target price. Under this situation, top management will fix a target cost by deducting margin required from the expected price and require the target costing team to find out the ways to deliver the product and services within the target cost. Typically, target cost is multi-disciplinary team, which first list the activities being performed to deliver the service. It also considers other costs like material (if any) to build existing cost structure. Then it critically examines the need for each activity and the level of efficiency in performing the activities. Experience shows that the team often finds a few activities are redundant or not adding any value to the customers. In your own bank, you could have observed several activities are not adding any value. These redundant activities enter into the system for two reasons. One, it is on account of internal control systems, which require counter checking the activities done by your colleague. Two, people continue to perform the activities even after making some changes in the system. Often, a manager wants a particular report for which a new register might have been created but the activity continues even after the transfer of the manager and the new manager is not at all looking into the report! The team carefully examines all the activities including internal control related activities for their need and then identifies critical activities. If ABC is in place, it can easily ascertain the cost. However, there is no guarantee that the cost after eliminating non-value added activities is less than target cost. If the cost is more, then the team examines the efficiency level of the staff and machines performing the activities and if necessary identify training needs as well as replacement of machines. The team can also identify non-critical activities that can be outsourced to cut down the cost. Thus, target costing technique is quiet useful in pricing decision. Fixed, variable and total cost: If the firm decided to use cost for pricing decision or the situation allows the firm to use cost-based pricing decision, then the bank needs to be clear on what cost figures have to be used for such pricing decision. There are two

Pricing of Bank Products and Services

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broad classifications of cost, namely, variable cost and fixed cost. Variable cost varies with the level of activity or product produced. In banking industry, interest expense is a variable cost. Fixed cost is cost that remain constant irrespective of activity level of the bank. Rent, depreciation, etc., are examples of fixed cost. What about employee cost, which is the second dominant cost after interest? Is it a fixed cost or variable cost? Traditionally, labour cost is considered as a variable cost but today it is difficult to follow hire and fire policy in countries like India particularly in an organised industry like banking. Actually, it is a semi-fixed cost because banks employ certain number of people based on the demand for the services. Though variation in demand will not change the cost in the short-run, one can expect that the bank can transfer the excess staff or take additional staff if there is a major change in the demand for the service. It is better to consider employee cost as variable because there is a tendency on the part of managers to give up any exercise to control fixed cost. By considering employee cost as variable cost, there is at least a benefit of monitoring the output, which in turn will control the cost. After determining the variable and fixed costs, banks need to decide the cost to be considered for pricing decision. Conventional costing principle suggests that variable or marginal costing is relevant for decision-making including pricing decision and fixed costs are expected to be covered by the volume. Though the above principle is good for operational decisions, many authors of new costing system have started questioning this approach of not considering fixed cost for decision making. In a large organisation, particularly one with multi-product or service, it is difficult to monitor whether margin fixed was adequate to cover the fixed costs through volumes. Thus, the supporters of new costing system like Shank and Govindarajan strongly require the decision-makers to consider full cost in pricing and other decisions. Full costing system is suitable for long-term pricing but one should not use this cost for adjusting the price quiet frequently in response to the changes in volume. An example will be useful to understand the pitfalls in changing price when you use full cost. Assume that the fixed cost associated with your banks car loan department is Rs. 10 lakhs per year and you expect about 10000 application per year. Assume the variable cost associated with the processing is Rs. 200. Based on the full costing, you have initially designed a processing fee of Rs. 300 per application. However at the end of one quarter, you realised that the bank is not likely to get more than 2000 application for the year. Suppose you change the price to Rs.700 based on revised full cost. It will further affect the number of loan applications. While there is nothing wrong in using full cost figure to initially set the price, it is not good to use the full cost figure to change the price quiet frequently. In the above case, the cost went up mainly because of the under-utilisation of resources and banks cant expect their customers to subsidise the banks inefficiency. Activity 3 1) Consider two activities of your banks, which are different to an extent. For example, consider issuing demand draft and processing a trade loan. List down the activities involved in performing each of the activities and staff and equipment used (with their time consumed) to complete the activities. Take the cases, which are not having any complication for this exercise. Find the cost of performing these two activities and compare with the commission and processing fee charged. ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ......................................................................................................................

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2)

Is it possible to justify the DD fee and processing fee for loan charged as a percentage of DD or loan value? Is cost of performing these activities linear to the value? What is the pricing principle banks use for charging these services? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ......................................................................................................................

Pricing of Bank Products and Services

iii) Cost Analysis of the Competitors

The activities and operations in the Banking industry are highly standardised. However, profits of different banks differ significantly even after adjusting the losses arising out of non-performing assets. The reason for such difference is wide variation in cost structure of competing banks. For example, an analysis of cost structure of Indian and Foreign Banks given in Table 18.1 shows a wide variation in Salary and other employee cost and other operating expenses. While employee cost of Indusind Bank for the year ending 2000 was Rs. 1.57 per Rs. 100 earnings, Syndicate Bank has reported an employee cost of Rs. 25.07 per Rs. 100 of earnings. Employee cost of Foreign and New Private Sector Banks is very low compared to PSU and other old private sector banks because of high level of automation and outsourcing by the former. Other operating costs and depreciation values also show a wide variation. Though some of the old private sector banks and PSU banks have scored better on these cost items, it may not offer any competitive advantage for them particularly when the market grows. Competitor cost analysis is significant not only for pricing but also for product development. For instance, instead of each of the PSU banks trying to come up with their own credit cards, they can consider an alternative in the form of floating a joint venture exclusively for this purpose and market the products through their distribution networks. Due to low level of automation and high employee cost, the product may not be viable on a stand-alone basis for many of these banks if they offer the product on their own. On the other hand, the new joint venture can go for high automation and also extensively outsource the services like marketing and processing of credit card applications. Competitor cost analysis also provides some idea on setting the price of a new product or services. By setting a price close to competitors cost, if the banks cost is still below the price, it is possible to prevent competitors to enter into the segment at least in the near future. The analysis is also useful to the target cost team, which indirectly helps the management to derive a right price. In pricing decision, it is essential to understand or forecast the competitors reaction when the bank changes the price. In a competitive industry like banking, if a bank reduces the charges, other banks will follow suit. Unlike consumable products and consumer durable items, it is not possible for the industry to influence the demand through price. In other words, the demand curve may be elastic at bank level but often in many products, it is inelastic at market (industry) level. Under this situation, the competitor banks will also cut the price to retain their market share. In this process, the whole industry will suffer with reduced profit and more importantly, the bank, which initiated the price war is not likely to get any benefit. Thus, it is essential for the bank to understand the product, where they can cut the price to increase the demand. If the bank has a definite cost advantage on certain products over the competitors, then the bank can fix a lower price to garner more volume. In other words, pricing decision cannot be taken without a cost analysis of competitors in the market.

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iv) Regulations relating to Pricing

Sometimes regulations may have a bearing on pricing of banking products and services. In many countries, particularly before the deregulation of interest rates, the Central Bank prescribes interest rate that can be offered on the deposits. Similarly, there may be ceiling on interest rates charged in general or specific type of loans or customers. The objective of pricing control is to prevent exploitation on the one hand and also ensure viability of banking operations. You may recall how many financing companies in the Southern parts of India have failed during the last few years when they were offering huge interest rates for deposits. Since deregulation, the consumer watchdog groups of the U.S. have taken on a more visible role in monitoring the pricing of bank services. They were able to bring down the interest rates on credit card loans when many banks were not reducing the rates even after a general decline in the interest rates. Banks are also prevented to form a cartel and fix a uniform price for their charges and any such move will attract antitrust regulations.

18.5

METHODS OF PRICING

As discussed earlier, pricing decision is a complex one. In many cases, where competition is high, banks cannot decide on price but rather accept the same set by the market (competitors). Wherever, banks have a role to decide on price, the following methods are available to set the price for the products or services. Cost-plus Pricing: The simplest method of cost-based pricing is called cost-plus pricing. Under this pricing, cost of the product or service is determined and profit is added with the cost to set the price. Normally, the firm or bank uses full cost for the purpose of pricing. Two issues are critical when a bank adopts this pricing method. One, the cost figure should be reliable and should not carry any error in costing to the price. If the cost figure is not correct, the bank may end up either with overcharging or under-charging the customers and the impact of both on the bottom line is same (negative). Two, the market it serves should be ready to accept such kind of pricing. It may be feasible if the product is new to the market and it will take some time for competitors to come out with similar products. Unfortunately, the lead time between the first entrant and second and subsequent entrant in financial services industry is very narrow and it is difficult to enjoy any monopoly even for a short period. Variable Cost Pricing: Variable cost is, sometimes, preferred if there is a difficulty in allocating common costs or such allocation is not reliable. Variable costs are costs that are directly traceable to product or service and hence the scope for any error is little. Another reason for using variable cost is to maximise the contribution through increased volume and such increased contribution is expected to cover fixed cost and offer higher profit. An important problem with this approach is the margin added with the variable cost may not be adequate to cover the fixed cost even with increased volume unless there is a clear policy laid down for this purpose. There is a chance that managers-in-charge for the product bring down the margin in order to achieve higher volume. Another possible drawback is failure of volume increasing when the product or service demand is not elastic. Break-even Pricing: Break-even price, which covers both variable and fixed costs, is useful during the initial period of product launch. When the product is new, it may not be possible for the bank to achieve full capacity. Suppose the capacity used is 60%. If the bank sets the price at the break-even price, it may not generate profit as long as the capacity utilisation is 60%. If the capacity utilisation exceeds 60% over a period of time, then the bank starts earning profit.

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Rate of Return Pricing: Under cost-plus pricing, there is no fixed definition for the margin. It can be an absolute Rupee value or a percentage on cost. Rate of return pricing eliminates ambiguity on profit margin. The profit margin expressed as a percentage of cost is computed as follows: Percentage mark-up = [capital employed/total annual cost] ROCE This pricing ensures the bank earns the required return on capital employed, which is ultimately used to evaluate financial success of the business. The following example illustrates this pricing model. Suppose a bank allocates Rs. 100 cr. for education loans. The average cost of borrowing (deposits) shows a figure of 9%, which means the yearly outflow of interest is Rs. 9 cr. Suppose the bank established a department for processing the application at a one-time cost of Rs. 10 (building, computer, etc.). In addition the bank incurs an annual expenditure of Rs. 3 cr. If the bank aims a pretax ROCE of 15%, the percentage mark-up is 12.5% [(10/12) 15%]. Suppose a borrower borrows Rs. 1 lakh, the total cost of the borrowing and interest to be charged are as follows: Interest Cost Other Cost Total Cost Add: Profit Margin 12.5% Total Interest to be charged Rs. 9000 3000 12000 1500 13500 or 13.5%

Pricing of Bank Products and Services

Though the method is more scientific, it faces two problems against widespread adoption. One, it is difficult to follow the logic particularly in banking industry. For example, if the user treats Rs. 100 cr. also capital employed, the mark-up will give a wrong value. Two, if the capital employed changes from period to period due to depreciation policy, it may require a revision in price.

18.6

PRICING STRATEGIES

Pricing of products takes into several considerations. Three principal concerns before the bank while setting the price are: a) b) c) getting the product accepted by the customers, maintaining strength in the market in the face of competition, and creating profit.

Though it may not be possible to achieve maximum points under each of the above, banks try to balance the benefit by following a pricing strategy that suits the particular condition. The following few strategies are available before the banks. Skimming Pricing: If the product or service is new, then the bank can follow the strategy if there is a great need for the product in the market. Here, the bank sets a high price and tries to maximise the profit even if it is not able to achieve a large volume. The ideal candidate for such pricing is that the product should command very low price elasticity, customers are less price-sensitive and creating an image for the product. It is also suitable during the test market. While it is possible to understand the demand for the product based on response at such a high price, it can also prevent in getting competitors interest. Competitors would be typically interested in fast moving products. Penetration Pricing: It is opposite of skimming. The objective before the bank in opting this strategy is capturing as much market as possible. Many banks use this pricing while entering into the market with a new product or entering into the existing

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Special Issues

market for the first time. Suppose your bank has no credit card product. If you decide to enter into the product, you have two alternatives. One, fix the same charges as others in the market. However, it will take longer time for your bank to get adequate customers unless your bank shows certain distinctive merits like better customer service. On the other hand, if you offer low entry price or no price for existing customers of your bank, it is possible to capture reasonable number of customers without much effort. Of course, there is a revenue loss but the bank has to evaluate the revenue loss with long-term gain. It should be noted that in products like credit cards, customers are not likely to shift the product every year and there is a fair chance of many renewing the card by paying normal fee demanded by other banks. In addition to entry level strategy, this pricing strategy is useful when the demand for the product is price sensitive, cost reduction is possible with large volume and elite market is absent. Perceived Value Pricing: Under this strategy, pricing is based on perceived value for the product or service. For example, internet banking or even ATM banking saves considerable time to customers. Time may be a value to certain type of customers but it need not be a value to all types of customers. For those, who perceive time has a value, the bank may charge a fee that equals to the value of time saved for such internet banking. The difficulty is giving monetary value for time but one can make an attempt. Suppose, a customer on an average spends about one-hour in a bank for each month, internet banking has saved this time to the customers. What is the value of such a time? A survey may be useful to understand value attached by the elite customers for saving one hour per month. Sometimes, customers may be willing to pay for the brand value particularly, if the entry norms are very high for such product. Relationship Pricing: Under this pricing strategy, the bank may group a bunch of products or services and offer a special price for the entire range of products. Alternatively, for customers of particular category, the bank may offer special price like higher interest rate for fixed deposit or lower processing fee, etc. For example, Citibank N.A. comes out with several new products and offer the same at a better price for existing customers. If the service of the bank is good, customers would be willing to buy the products or services particularly when the fee is lower than fee charged to others. Here, the bank wants to strengthen the relationship with the existing customers. Behaviour Modification Pricing: This pricing strategy is adopted to change the behaviour of customers and thereby save some costs to the bank. For example, many foreign and private sector banks encourage the customers to use ATM by charging a fee if they visit the branch for any transaction. It can also be called as negative pricing because customers have to pay more if they fails to modify their behaviour. Another example is charging a fee for issuing cheque leaves beyond certain number for the savings bank holder. Activity 4 Suppose your bank has decided to offer cash collection services under which you will give immediate credit to your account holder when cash is deposited in any of the branches of your bank and on the next day when cheque is deposited in any branches of your bank. How do you price the service? What principles will you use in pricing such new services? ................................................................................................................................... ................................................................................................................................... ................................................................................................................................... ...................................................................................................................................

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18.7

SUMMARY

Pricing of Bank Products and Services

Banks sell variety of financial products and services to customers. The success of bank depends on its ability to achieve customers satisfaction while selling a product or service at a price that brings profit to bank. Pricing is at the centre of business success. It should be low enough to attain maximum customers satisfaction and also high enough to maximise the profit. If a price is increased or if the price charged is high, it may affect customers satisfaction and thus affects product demand. On the other hand, if the price is low, it may lead to more volume but affects profit. Pricing decision is thus essentially balancing these two opposite effects of price. The process begins with understanding the price elasticity of the product. In banking industry, not all products or services have high level of price elasticity. Thus, fixing a lower price or reducing the existing price is not a long-term solution. In the process of pricing decision, banks may discover ways to retain the price and profit by either improving the quality of service or cutting down cost. In addition to elasticity of demand, pricing decision requires three other important inputs namely cost of providing product or service, an analysis of competitors cost and regulation relating to pricing, if any. Since elasticity is not very high in many products of bank, a reliable cost figure will be much useful in following cost-based pricing. Activity based costing is very useful for banking industry in this context. An understanding of competitors cost is useful for two reasons. Firstly, it can be used to fix a price at a level where the competitor finds it difficult to cut down the price. Secondly, it is useful to benchmark the internal costs with the competitors and find ways to cut down the cost while retaining the competitors price. Target costing will be useful in this context. There are several methods of cost-based pricing. It ranges from simple cost-plus pricing to sophisticated ROI pricing. Pricing also depends on the product and conditions in the market. Depending on the nature of product and conditions in the market, banks follow several pricing strategies like skimming pricing, penetration pricing, perceived-value pricing, relationship pricing and behaviour modification pricing. In a competitive market, pricing decision will be often a short-term decision to achieve certain objectives like capturing market or developing relationship. In the long run, banks may have to adopt market determined pricing to survive or cut down the cost considerably to take its own pricing decision below the market price. Thus, banks need to be aggressive in managing costs as costs have a role in their pricing decisions.

18.8

KEY WORDS

Activity Based Costing: New method of costing under which activities of an organisation are identified and cost for performing each of the activities are measured. Behaviour Modification Pricing: Pricing is done with an objective of modifying the customers behaviour and normally resorted to discourage certain facilities that will add cost to the bank. Because of this negative feature, it is also called as negative pricing. Break-even Pricing: Price is fixed such that the revenue is equal to total cost. Competitor Cost Analysis: A technique through which the firm builds and analyses the cost structure of products and services of competitors. Cost-plus Pricing: Products or services are priced by adding a profit or profit margin with the cost of producing products or performing services.

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Special Issues

Penetration Pricing: Price is fixed as much low as possible to get desired market share. Profit is secondary and hence this will be a short-term strategy to get a place in the market. Perceived Value Pricing: Pricing is based on perceived value for the product or service and suitable when the product or service is unique and new in several ways. Price Elasticity of Demand: Price elasticity of demand determines the impact of changes in price on demand for the product or service. Rate of Return Pricing: In addition to cost of products and services, investments made to produce the products or services are considered for pricing. Price is fixed such that it offers a profit that is equal to return on investments. Relationship Pricing: Banks offer special price for its products or services to certain customers. Pricing is often done for group of products or services bunched together or charged at a different price lower to the market price for customers who have more than one type of accounts (relationship) with the bank. Skimming Pricing: Price is fixed at a high level to get maximum profit. Pricing objective is to skim as much profit as possible when there is a demand for the product or service. It is a suitable pricing strategy when the product or service is new and demand is not price elastic. Target Costing: A strategic cost management tool, which helps management to produce a product or offer a service within a target cost. Target cost is derived by deducting the desired profit margin from target price. Variable Cost Pricing: In pricing decision, variable cost alone is considered. Fixed cost relating to products or services is ignored and is expected to be covered through volume.

18.9
1. 2. 3. 4. 5. 6.

SELF-ASSESSMENT QUESTIONS

Explain the pricing issue in the context of Banking industry particularly on borrowing and lending. Why do you think that price elasticity of demand for banking products and services differ between various products and services? Name and discuss a few factors that affect the elasticity of demand for banking products and services. What is the role of cost and competitor cost analysis in pricing? Illustrate a few cases, where you feel such analysis is essential for pricing decision. Is bunching of products or services confuse the banking customers? Are there any chance that you loose some of the customers due to this kind of pricing? What are the different kinds of pricing methods available for pricing of banking products and services? Give one example (products or services) for each of these methods. Illustrate two real life banking products where you can apply skimming pricing strategy. Give another two examples where you can apply penetrating pricing strategy. Justify why not the bank use penetrating pricing strategy instead of skimming and vice versa. Under what condition, the bank should consider a price revision. What is the potential consequence for initiating pricing war when the product is not price elastic at the industry level but price elastic at individual banks level?

7.

8. 9.

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10. What is the potential consequence for initiating pricing war when the product is price elastic at the industry level as well as at individual banks level?

18.10

FURTHER READINGS

Pricing of Bank Products and Services

Pezzullo, Mary Ann, 1998, Marketing Financial Services, American Bankers Association: Washington D.C. (Reprinted by Macmillan India Ltd. Delhi for The Indian Institute of Bankers, Mumbai). Kotler, Philip,1997, Marketing Management, Printice-Hall of India: New Delhi. Peter S. Rose & James W. Kolari, 1995, Financial Institutions: Understanding and Managing Financial Services, Richard D. Irwin: Chicago. Meir Kohn, 1994, Financial Institutions and Markets, McGraw-Hill Inc.: New York. Gabor, Andre, 1977, Pricing Principles and practices, Heinemann: London. Moebs, Michael G and Moebs, Eva, 1986, Pricing of Financial Services, Dow JonesIrwin: Homewood. Guiltinan, Joseph P., 1980, Pricing Bank Services: A Planning Approach, American Bankers Association: Washington D.C.
Table 18.1: Cost per Rs. 100 earnings of sample of Indian and foreign Banks Salary & other Cost 1.57 2.13 2.23 2.53 2.70 2.96 3.47 5.66 6.03 8.19 8.68 9.30 9.66 9.66 11.44 14.49 15.64 15.82 16.05 16.45 16.45 17.17 17.41 17.46 17.46 17.64 18.81 19.57 20.11 21.03 21.27 21.55 23.49 23.62 23.79 25.07 Other Expenses 8.44 9.12 7.86 12.58 6.73 8.47 8.80 18.25 11.98 13.42 5.82 6.09 5.72 5.89 8.73 6.23 6.18 5.07 5.17 4.59 5.66 5.84 5.92 5.66 7.18 5.38 6.06 6.94 5.05 5.56 6.92 4.11 5.48 4.89 5.28 5.15 Provision & Losses 24.01 5.20 12.18 7.26 7.02 1.37 7.20 4.64 8.75 3.19 6.29 7.00 6.47 7.55 5.64 9.28 6.36 9.33 4.92 7.17 9.52 7.79 10.36 5.57 11.18 6.30 8.97 8.93 4.95 4.68 6.67 4.16 8.82 7.02 5.99 2.08 Depreciation 2.84 8.31 5.16 4.63 2.00 1.74 2.47 2.80 3.29 2.58 1.56 1.12 1.19 5.44 1.64 0.94 0.91 0.78 0.83 0.82 0.98 1.16 1.38 1.39 0.85 0.82 1.43 1.75 0.73 0.96 1.50 0.30 0.79 0.63 0.76 0.68

Bank Indusind Bank Centurion Bank GTB Bank of Punjab U T I Bank I D B I Bank I C I C I Bank Citibank N A. H D F C Bank HSBC OBC J&K Bank Corporation Bank Vysya Bank Grindlays Bank SB of Hyderabad Bank of Baroda SB of Patiala Andhra Bank SB of Travancore Dena Bank UBI Canara Bank SBI Allahabad Bank SB of Saurashtra Bank of India SB of Indore PNB IOB Vijaya Bank UBI SB of Mysore UCO Bank CBI Syndicate Bank

Interest 64.50 71.40 62.42 61.72 68.64 69.86 64.20 45.16 46.48 52.29 65.49 61.94 62.43 67.85 46.89 56.26 61.17 52.06 63.80 65.81 66.43 66.16 62.49 59.54 60.94 56.26 64.83 54.59 60.84 66.52 63.15 71.73 54.64 66.48 60.55 61.37

Tax 0.81 1.84 4.97 2.78 4.85 3.64 2.58 12.34 9.29 11.95 2.25 5.95 5.74 0.02 14.38 7.03 4.19 8.44 4.98 2.16 1.39 0.60 2.21 4.44 1.29 3.07 1.45 3.74 2.11 0.90 0.30 0.00 4.08 0.72 1.16 0.97

Pat 2.17 2.00 5.18 8.50 8.06 11.96 11.28 11.15 14.18 8.38 9.91 8.60 8.79 3.59 11.28 5.77 5.55 8.50 4.25 3.00 0.43 1.28 0.23 5.94 1.10 10.53 1.55 4.48 6.21 0.35 0.19 1.85 2.70 3.36 2.47 4.68

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