Early in our discussions with many financial institutions, we have some version of this exchange.
FI: “Can you show us how you change the hurdle rates?”
Us: “Actually, we don’t use hurdle rates. We think you should use targets instead.”
Sometimes it feels like we can actually hear the eyes roll over the phone. We know exactly what they’re thinking. “Yeah, whatever, that’s just semantics from the pricing nerds.” But this is far more than just semantics. In fact, this subtle change in mindset actually has a transformative effect on decision making and performance.
The Case Against Hurdles
Let’s start by talking about why we don’t use hurdles. It’s a long list, so we’ll summarize it.
Hurdle rates are, by definition, the absolute lowest return the bank will accept on a deal. Is this really the number you want driving all of the pricing decisions in your bank? If you have a hurdle, it should be treated as a state secret that requires security clearance. Publishing them, or worse, using them as the guidepost on your pricing system, results in two substantial problems.
First, if this is truly a hurdle rate, you take all flexibility (and common sense) away from your relationship managers (RMs). We recently saw an instance in which an RM was working on a deal for one of the bank’s most profitable customers and, due to competitive offers, was a few basis points short of meeting the hurdle rate. Those few basis points translated to about $200 per year, but since it didn’t meet the hurdle, the RM couldn’t meet the critical terms.
As we all know, deals are rarely priced in a vacuum. The competing bank started cross-selling, and pretty soon the entire relationship was at stake. Nearly $250,000 of annual profits were at stake because of refusal to bend a few basis points on one deal.
That scenario is exactly why the term “pricing model” has been banned in the PrecisionLender offices. When you think of your tool as a “model,” you treat “hurdle rates” as the gospel. That removes all ability for experienced RMs to negotiate deals within the context of very complex and unique circumstances.
Even if your bank is not as dogmatic about hurdle rates, there is still a second major issue. If you aim at the hurdle rate on all of your deals, guess what? That’s exactly what you’ll get on the majority of them.
The chart below, sent to us by a client, summarizes the monthly results from their old hurdle-based pricing tool. Can you guess what the hurdle rate was?
Since a hurdle is a minimum return that will be accepted, it generally has to be set well below current market rates. Otherwise, volume will dry up completely. However, once that low hurdle has been set, it acts as a magnet for ALL of your production, drawing each deal as close to that hurdle as the RM can possible get it. Get a couple of banks in a market to start doing this and you can imagine the results.
Set Your Sights Higher Than “Acceptable”
If hurdle rates aren’t the answer, then what should we be using? We believe wholeheartedly in using profitability targets. We are measuring the same thing (risk adjusted return on capital¹), but the mindset is completely different.
Targets are not set as the bare minimum that will be accepted. Instead, they are just as advertised: the target at which we are aiming. Ideally, we will find the current market level for a specific loan type, and then set the target slightly above that. This ensures both that we are competitive in the local market, and that we are also pushing RMs to stretch every deal just a little. We’ll ask for a couple more basis points, or perhaps a little more collateral, a slightly shorter term, or for another account or two. Trying to reach those targets will make us incrementally better deal by deal. On the typical bank volume, that soon translates to big dollars.
The bank we referenced above is small (about $2 billion in assets), and is booking about $100 million per month in loans. Those couple of basis points translate to nearly $250,000 per year in additional interest income.
The diagram below shows the relative difference between hurdle rates and targets.
Stretching Requires Flexibility
Targets should be a bit of a stretch, just above what the competitors are likely offering. But they should also be paired with significantly more flexibility.
First, we want to give RMs lots of options on how they can reach those targets. Again, this is not just about rate, but all deal terms that will move the needle in terms of risk and profit. Second, there will inevitably be times when the right business decision is to book a deal below the target. Maybe the deal is for an existing customer that is highly profitable, or maybe it’s the “foot in the door” for a growing prospect that will pay off down the road.
Whatever the reason, banks must trust their RMs. Commercial loans are complex, and each has nuances that cannot be easily captured in one profitability metric. That context and judgement is WHY RMs are well paid; it is their job to not just build relationships, but to structure each new deal in a way that makes sense for both the customer and the bank. Using concrete hurdle rates restricts that flexibility, and does so with the added pain of lower returns.
You Want to Steer, Not Stand Still
Finally, targets also translate much better as a portfolio construction tool. Hurdle rates are typically static, and reflect the pain threshold for booking any individual deal. Targets, though, can be much more dynamic, and reflect the bank’s current appetite for that particular deal type in that specific market.
If the bank wants to aggressively grow a specific asset type, or wants to gain market share in a new location, targets can be lowered to generate more volume. Conversely, if the bank is nearing concentration limits, or for risk reasons simply has less of an appetite for another deal type or market, targets can be raised. You are effectively limiting the “shelf space” for that type of deal, and only taking the very best – the ones that will meet those higher targets.
In this way, your pricing targets become the steering mechanism for your entire portfolio. Targets can be actively managed as the needs and goals of the balance sheet change, and RMs can always see clearly how their current pipeline fits in the bigger picture.
So, yes, insisting on saying “targets” instead of “hurdles” is a bit of semantics from the pricing nerds. But this subtle change in phrasing and approach can have a massive impact at both the RM and bank level, and we believe it’s worth being a stickler on it.
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¹ For the mathematically inclined, this is actually shorthand. What we are really measuring is annualized risk adjusted return on risk adjusted capital, subject to regulatory minimums. That’s a mouthful (and a calculator full), which is why we use the abbreviated description.
