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Price and revenue optimization (PRO) software uses analytics to help companies maximize profitability for any targeted level of revenues. PRO utilizes data about buyer behavior to gauge individual customers’ price sensitivity and predict how they will react to prices. It enables users to charge buyers who appear to be less sensitive more than those who appear more price-sensitive. PRO is a significant departure from inward-focused, single-factor pricing strategies such as cost-plus pricing or, in the case of financial services, risk-based pricing (using a borrower’s credit score, for example). Instead it offers a multifaceted customer-centric analytic approach to pricing built on analysis of large sets of data.
Price and revenue optimization is a natural fit for the application of big data analytics. Our benchmark research on challenges in big data shows that three-fourths of companies are addressing more than 10 gigabytes of data per day and 10 percent are deal daily with a terabyte or more. Financial services companies in particular can benefit from big data analytics because their core products are essentially numbers. For them, analytics involves sifting through large data sets to collect characteristics of consumer behavior that will enable them to identify customer segments and quantify their price sensitivity. These complex calculations require software designed for the purpose. Big data analytics software can help users manage more granularly the process of defining offers to customers (and the levels of discretion they allow to account managers and sales people to set prices) as well as the terms and conditions of the transaction. Upon identifying characteristics that influence buyers’ price sensitivity companies then combine the most relevant factors to present a price that will enable them to optimize revenue and profits from those customers.
Nomis Solutions provides PRO software and services to financial services companies, including banks, automobile credit providers and credit card processors. In past years at its annual user conference, the company has focused on the science and technology behind its product, as I’ve noted. Those sessions were useful in providing attendees with a deeper understanding of “the why behind the what” of the applications’ capabilities.
Taking a somewhat different approach this year’s conference focused on the challenges that the financial services industry will need to address over the next several years and how information technology generally – and price and revenue optimization software specifically – can help these institutions address them. Presenters at the Nomis Forum covered three main issues facing financial services businesses:
- Increasing velocity and volatility of interest rates
- Disruptive sources of competition in financial services
- Expanded regulation of financial services businesses.
Those charged with setting prices in financial institutions have been operating in a relatively benign environment for the past few years. Interest rates in many of the developed world economies have remained relatively steady and low in inflation-adjusted terms by historical standards; this simplifies the pricing of loans and credit. The recent environment of low interest rates and low volatility has muted the need for the capabilities found in PRO software, although financial services companies that have deployed PRO have improved their results measurably. However, it’s likely that the interest rate environment will transition to a more dynamic phase within a few years. Technology can enable financial institutions to operate more effectively in that kind of interest rate environment, helping financial services companies be more effective when interest rates begin to rise and fluctuate. It can do so by enabling them to automate analytics and reporting as well as facilitating management of the related data. This makes it easier for a financial institution to adapt fast to a challenging atmosphere and set prices in a way that best matches its strategic objectives (such as to be a market share leader in specific product categories or to maximize returns on risk-weighted assets). Using price and revenue optimization rather than simplistic risk-based pricing can provide a competitive advantage in achieving higher returns on assets and lower costs of capital.
However, such technology may present challenges to established financial services organizations. As it has been in many industries, it is becoming a disruptive force, especially as innovators use the Internet and evolving computing devices to change the competitive landscape. The financial services business is feeling the impact of new approaches to traditional methods. Deposit banks, mortgage companies and other lenders as well as major credit card companies all face challenges from entrepreneurs seeking to supplant established business systems. There are new formulations of finance in areas such as peer-to-peer lending (for example, Lending Club), purely online banking establishments, mobile payments systems (such as Apple Pay) and crypto currencies (Bitcoin). To date these new formulations haven’t achieved significant penetration, but when technology-driven market disrupters arrive, Andy Grove’s cautionary advice – “Only the paranoid survive.” – is worth heeding. The upstarts have attracted substantial amounts of investment capital, giving them parity with established players in terms of a low cost of capital and the ability to keep trying.
In assessing the challenge from disruptive innovators, Nomis founder Robert Phillips insisted that financial services incumbents are not defenseless. They are able to match innovators in matters of convenience and (to some degree) cost, two areas where companies such as Amazon, Netflix and online travel booking services were able to use these aspects to quickly displace well-established companies. Existing financial institutions have been adopting technology by developing it internally or by acquiring technology-enabled disruptors. For example, in the United States the camera-equipped smartphone took advantage of the 2003 law that eliminated the requirement that physical checks must be returned to their makers to enable people to “deposit” checks into their account without having to go to a bank or an ATM. Traditional financial services companies have heavy compliance costs and considerable overhead that give upstarts and advantage, but they also have some advantages of scale.
Philips cited two major areas of competitive differentiation. One favoring new entrants and the established organizations. Incumbents are most vulnerable to disruption because typically they are slower in reacting to customers and ponderous in managing processes. Retail and small business banking is a consumer market, and today consumers in developed countries increasingly want transactions to be fast and hassle-free. On the other hand, incumbents have a wealth of information about their about customers, their assets and their past behavior that they can use to optimize pricing in every aspect of their business as well as to improve their customers’ experiences. Using software to manage rates charged or offered is a way to quickly provide quotes to prospective borrowers and depositors while providing effective controls on how front-line representatives set rates. Upstarts that have less of this information available will have to rely more on risk-based pricing.
Increased regulation since the 2008 financial crisis is another major challenge for financial institutions in the developed world. Its purpose has not just as an attempt to prevent future debacles but, particularly in the United States, to promote fairness. For cultural reasons, demanding different prices from some customers or raising prices during periods of peak demand is a sensitive topic in many developed economies. Tightly regulated financial services companies are more vulnerable to charges that some protected groups are hurt in the price-setting process and therefore subject to fines and demands for restitution. One advantage that companies using PRO software have in defending against charges of unfairness is that it makes the price-setting process transparent and based on objective measures related to their willingness to pay.
Price and revenue optimization is a strategic business technique that has conclusively demonstrated its value in travel and leisure, retail and industrial businesses. It is steadily gaining traction in financial services. Yet from discussions with existing users I find that it is rarely easy to implement from a management and process standpoint. One important reason is that the results of the analysis of customer behavior often defies common sense. The use of big data analytics to assess and quantify the drivers of customer decision-making enables a company to apply a more nuanced view of the often complex factors that influence customer decisions. From this analysis it can segment its prospects more accurately than by using simplistic assumptions (that is, what “everybody knows” to be true). For example, it may not be necessary to offer loyal customers the lowest price. Other inducements may be more important to them and may even be costless to the financial institution or seller – for example, maintaining an ongoing relationship or not having to spend time shopping around. Indeed, one advantage of PRO is that it’s often counter-intuitive and therefore offers strategies unavailable to less well informed competitors. PRO also is an operating methodology so it’s not easy to implement the management and process changes necessary to utilize the technique, especially in larger organizations. Nonetheless, companies that recognize its advantages and put it into practice can obtain a competitive advantage over competitors that aren’t able to overcome institutional inertia.
I recommend that companies, especially those in the financial services industry, explore the benefits of using price and revenue optimization tools. It is worth remembering that technology has long been a driver of innovation and change in financial services. Our research on the use of analytics in banking and financial services shows that financial services companies are looking for analytics that will improve their decision-making and business processes as well as enhance their operational efficiency. They want analytics to enhance their competitiveness and provide a strategic advantage. PRO is a technology-driven technique that can underlie a more intelligent and strategic approach to pricing.
Robert Kugel – SVP Research
The proliferation of chief “something” officer (CxO) titles over the past decades recognizes that there’s value in having a single individual focused on a specific critical problem. A CxO position can be strategic or it can be the ultimate middle management role, with far more responsibilities than authority. Many of those handed such a title find that it’s the latter. This may be because the organization that created the title is unwilling to invest the necessary powers and portfolio of responsibilities to make it strategic – a case of institutional inertia. Or it may be that the individual given the CxO title doesn’t have the skills or temperament to be a “chief” in a strategic sense.
In business, becoming a chief anything means leaving behind most of the hands-on specific skills that made one successful enough to receive the promotion. This is often the hardest requirement, especially for those coming from an administrative or a highly technical part of a business. Take the chief financial officer position. The person who gets that job often was a controller – an individual who must be able to manage the minutiae of a finance organization. Most of the detailed skills required of a great controller are counterproductive for a CFO, who must focus on the big picture, work well with all parts of the business and be the face of the company to bankers and investors. People who can’t leave the details behind are by definition not strategic CFO material. Similarly, the job of the chief information officer ultimately is not about coding, technical knowledge or project management. It’s about understanding and communicating how the most important issues facing the business can be addressed with technology, ensuring that the IT organization understands the needs of the business and delivering value for the money spent on IT.
The same distinction applies to newer C-level titles. For example, since the financial crisis a few years ago, there has been a growing recognition that banks must manage risk more comprehensively. In response, a number of banks have created the position of chief risk officer or, if they already had one, have invested a broader range of responsibilities in that office. Managing risk strategically has gained importance in financial markets as rising capital requirements and increased regulation force banks to structure their asset portfolios and manage their assets more carefully to maximize their return on equity (ROE). In most banks, optimizing risk – getting the highest return at any given level of risk – and managing risk more dynamically over a credit cycle requires a strategic CRO to lead the effort. Even so, in many organizations the office of the CRO doesn’t have the weight it needs to make such a difference. Here are the most important requirements for chief risk officers who want to transform a middle management job into something more strategic.
Approach risk management as if it were a four-dimensional chessboard. Having the proverbial “seat at the table” (a hackneyed business phrase that’s shorthand for being taken seriously by the senior leadership group) means being able to bring something of value to the table. While an appreciation of the overall business and its strategy is necessary as one rises through the ranks, a purely functional position usually doesn’t require an especially deep understanding of the other parts of the business. For a chief risk officer to play more than a titular role, however, he or she must have a solid understanding of all the major operating pieces of the business on both sides of the balance sheet and a knowledge of the industry’s competitive dynamics – three dimensions of the chessboard. This is particularly important because risk is just a constraint, not the sole consideration in decision-making. That is, the role of the CRO is not simply to enforce constraints that minimize risk – it’s about optimizing risk within the context of the corporate strategy. Stiffer capital requirements are a defining characteristic of today’s banking industry, especially in the United States. Optimizing risk is a necessary condition for optimizing return on equity and the long-term success of the bank. Moreover, the role requires thinking ahead several steps and understanding the dynamics of the business – that’s the fourth dimension. A solid grasp of credit and financial market cycles is essential in leading a risk organization. The ability to use past experience to forecast the consequences of even disparate sets of actions makes the risk organization strategic.
Learn another language. Understanding of other parts of the business goes a long way toward being able to work more effectively, and a CRO should be to translate risk jargon into words and concepts that are relevant to specific parts of the business. It works both ways, too. Understanding the objectives, objections and concerns of other executives means being able to grasp the nuances of their questions and comments. It also helps in explaining the thinking behind the trade-offs necessary to optimize a balance sheet to achieve an optimal ROE for the level and structure of the risk. It’s also essential to be able to communicate the essence of risk management to laymen, for example, by distilling the complexities of a black-box risk strategy into an elevator pitch. All risk models are translatable into easy-to-comprehend concepts. A CRO must be able to do this and even develop an institutional shorthand within the organization that everyone understands – the functional equivalent of describing a feature film as “a car-chase buddy movie.”
Assert leadership when it’s needed. Some leaders are born, but everyone else needs to unlearn habits that detract from their effectiveness as a leader. People in risk or compliance roles may have a harder time than others because the basic skills necessary to excel in this area tend to be found in less introspective souls. Those who work in a compliance function can fall into the trap of using “the rules” as a cudgel for wielding power rather than persuading and gaining assent. Joining the senior leadership team, though, transforms the CRO from a simple enforcer to one who works with others to find solutions.
Beyond these three personal and interpersonal requirements, appropriate use of information technology – data and software – is essential to strategic risk management in banks (and other financial services companies). Successfully exploiting the advantages that can be had with advanced IT is fundamental requirement of making the role of a CRO strategic. SuccessfulCROs must weigh the make-or-break information technology issues of mastering data quality and using the right software tools.
Data is the lifeblood of risk management. The credibility of the risk organization is based on accuracy and availability of data. Bad data drives bad decisions and undermines the authority of the risk organization. As data sets proliferate, grow larger and increasingly incorporate external data feeds (not just market data but news and other unstructured data), the challenge increases. The proverbial garbage-in-garbage-out (GIGO) becomes Big GIGO, as I have written. Data quality must be built into all of the systems. Speed in handling data is essential. The pace of transactions in the financial markets and the banking industry continues to increase, and their risk systems must keep up. Our benchmark research shows that financial services has to deal with more sources of data than other industry sectors.
Yet beyond these maxims is the reality that all large financial institutions fall short in their ability to handle data. “You can have your answers fast or you can have them accurate,” is often said in jest, but it reflects the business reality that analyses often are not black-and-white – utterly reliable or completely false. They may have to be based on information that to varying degrees is incomplete, ambiguous, dated or some combination of these three. Adapting to this reality, new tools utilizing advanced analytical techniques can qualify the reliability of a bit of analysis. It’s better to get some assessment and see that it’s 33 percent reliable than to get no answer or – worse – get an answer without qualification. In most cases, it’s better to get an approximate answer now than to wait for an ironclad answer in a day or two. The decision-makers have an idea of the risk they’re taking if they act on the result, or they can take a different approach to look for a way to get an answer that is more reliable.
Software is essential to risk management and optimization. Technology can buy accuracy, speed, visibility and safety. Many banks ought to do more dynamic risk management. Analytical applications using in-memory processing can substantially reduce the time it takes to run even complex models that utilize very large data sets. This not only improves the productivity of risk analysts but it makes scenario analysis and contingency planning more accessible to those outside the risk organization. If you can run a complex, detailed model and immediately get an interactive report (one that enables you to drill back and drill around), you can have a business conversation about its implications and what to do next. If you have to wait hours or days as you might using a spreadsheet, you can’t.
Desktop spreadsheets have their uses, but in risk management the road to hell begins in cell A1. Spreadsheets are the right tool for prototyping and exploratory analysis. They are a poor choice for ongoing risk management modeling and analytics. They are error-prone, lack necessary controls and have limited dimensionality. The dangers of using spreadsheets in managing risk exposure were laid bare by the internal investigation conducted by JP Morgan, which I commented on at the time. There are many alternatives to desktop spreadsheets that are affordable and require limited training. For example, many financial applications for planning and analysis have Excel as their user interface. There are more formal tools, such as a multidimensional spreadsheet, that are relatively easy for risk modelers to use and offer superior performance and control compared to desktop spreadsheets.
Automate and centralize. Information technology delivers speed, efficiency and accuracy when manual tasks are automated. The payoff from automating routine reporting and analytics may seem trivial, but this is usually because people – especially managers – underestimate the amount of time spent as well as the routine errors that creep into manual tasks (especially if they are performed in a desktop spreadsheet). The need for automation and centralization especially applies to regulatory and legal activities, such as affirmations, attestations, signoffs and any other form of documentation. Especially in highly regulated industries such as financial services, there is no strategic value in meeting legal requirements, but there is some in doing so as efficiently as possible and limiting the potential for oversights and errors. Keeping all such documentation in a central repository and eliminating the use of email systems as a transport mechanism and repository for compliance documentation saves time of highly compensated individuals when inevitable audits and investigations occur and limits the possibility that documents cannot be found when needed.
Senior executive sponsorship is also a critical need if the chief risk officer is to be a strategic player. If the CRO has done all of the above, that’s not going to be a problem because the CRO’s objectives and the CEO’s objectives will be largely aligned. True, that’s not always a given. Some organizations will not embrace the notion that managing risk can be strategic. CROs who find themselves in an organization where their aspirations to serve a strategic role are not met should find another one that appreciates the value they can bring to the table.
Robert Kugel – SVP Research