Kohl Strategic Pricing Framework
Introduction:
In today’s dynamic financial environment, pricing is no longer just a function of covering costs, it's a
strategic tool for long-term sustainability and capital growth. This paper introduces the Kohl Strategic
Pricing Framework, which uses a Risk-Adjusted Return on Assets (RAROA) methodology to align product
pricing with profitability, risk, and institutional mission.
At the heart of this approach is Return on Assets (ROA), a foundational metric that ensures pricing not
only covers costs but also supports capital retention or expansion. This document outlines how ROA is
calculated, how major risks and operational costs are incorporated, and how the framework drives
disciplined, value-oriented pricing for loans and deposits.
Step 1: Determining the Target Return on Assets (ROA)
The Baseline ROA
ROA should first be calculated to at least maintain the current capital ratio as the institution grows. This
is done by multiplying the desired capital ratio by the asset growth rate. This ensures capital grows
proportionally with assets, preventing capital dilution from poor pricing decisions.
For Credit Unions:
The baseline ROA serves as the optimal return needed to avoid overpricing or underpricing. Any surplus
is returned to members, aligning pricing with cooperative principles.
For Banks:
In addition to maintaining capital ratios, banks must factor in target dividend payouts and tax effects.
These requirements mean the ROA must be calculated on an after-tax basis. The resulting ROA can then
be converted into Risk-Adjusted Return on Capital (RAROC) by dividing it by the institution’s capital.
While RAROC enhances capital efficiency, excessive optimization may reduce the institution's margin for
error and increase risk exposure.
Step 2: Incorporating Key Risks and Operational Costs
Liquidity and Interest Rate Risk (LIRR):
Despite its significance, LIRR is omitted from pricing by nearly 80% of institutions. FTP (Funds Transfer
Pricing) has long been the preferred method for incorporating LIRR, though interest rate stability over
the past decade led many institutions to deprioritize it. With the return of rate volatility, institutions
using FTP are better positioned to manage funding and liquidity risk.
Credit Risk:
A core component of any pricing model, credit risk accounts for the possibility of borrower default. Its
inclusion ensures pricing reflects the true cost of extending credit.
Operational Costs:
Precise pricing depends on accurate attribution of origination and servicing costs. As roughly 75% of
operational expenses stem from labor, activity-based costing rooted in employee time allocation is
essential. Inaccurate assumptions here undermine the validity of the entire pricing model.
Step 3: Pricing Loans and Deposits
Loan Pricing:
RAROA defines a minimum acceptable loan rate, one that fully covers the ROA target, LIRR, credit risk,
and operational costs.
Deposit Pricing:
RAROA similarly sets a maximum deposit rate that balances the need to attract funds with institutional
profitability. Paying more than this maximum sacrifices value for the institution’s stakeholders.
Governance and Strategic Alignment
Centralized Oversight:
RAROA implementation requires centralized control. The CFO is uniquely positioned to oversee pricing,
especially regarding LIRR. Just as credit risk oversight is independent of the lending team, profitability
measurement must reside outside of product groups to avoid bias and ensure comprehensive risk
inclusion.
Pricing Flexibility:
While product teams retain flexibility to set rates above the minimum for loans or below the maximum
for deposits, deviations outside these parameters should require executive approval. This ensures pricing
decisions remain aligned with long-term strategy.
Discipline vs. Market Following:
Too often, institutions fall into the habit of matching competitors' pricing without understanding the
underlying economics. This "price following" may seem safe but often leads to mispriced risk, capital
erosion, or missed earnings targets. By contrast, pricing discipline—rooted in ROA, risk, and cost—
ensures that the institution is pricing according to its actual financial and strategic position. It transforms
pricing from reactive to proactive, reinforcing long-term value over short-term wins.
Incentive Alignment:
Compensation structures should reward adherence to RAROA or RAROC goals. Tying bonuses to these metrics shifts focus from volume-based targets to value creation—ensuring that lending and deposit-gathering efforts benefit the institution as a whole.
Summary
The Kohl Strategic Pricing Framework leverages the RAROA methodology to deliver a disciplined, risk-
aware approach to product pricing. It begins by establishing a target ROA to preserve capital, adjusts for risks including LIRR and credit loss, and incorporates precise operational costs to arrive at minimum and maximum pricing thresholds.
More than a formula, RAROA fosters accountability, centralized oversight, and strategic alignment. It ensures the entire institution is united around value creation—not just growth in loan or deposit volume.
In today’s volatile environment, this framework offers financial institutions a resilient path toward sustainable profitability.