Citizens Bank of Canada Responds to Competitive Threat

Case Type: business competition, competitive response.
Consulting Firm: Capital One first round full time job interview.
Industry Coverage: banking; financial services.

Case Interview Question #01207: Your client Citizens Bank of Canada is a Canadian mid-market retail bank specializing in loans to small industrial businesses. Headquartered in Vancouver, British Columbia, the bank operates six branches, one each in Calgary, Vancouver, Ottawa, Montreal, Edmonton, and Toronto.

The niche market of industrial loans in Canada has been seen as too small for the big banks and thus the client has not seen significant competition. Recently, However, a new financial services startup company named Element Financial Inc. has entered this niche market with a unique business model. Your client Citizens Bank of Canada wants to know how they should respond the competition.

Note: This industry uses return on equity (ROE) as the key metric of success.

Possible Answers:

1. Case Overview & Suggested Framework

This “competitive response” type of case tests how a candidate can solve two related problems: first, they need to get a sense of the industry to identify how the new entrant will affect it. Second, they need to come up with a strategy as to how they can reduce the impact on their business.

For the first part, the candidate should look to understand exactly how the retail banking model works by taking deposits and making loans as well as the new business model used by Element Financial.

For the second part, they should look at both offering the same service at a lower price and offering high-quality services that will command a price premium.

2. Information Gathering

Additional Information: only give to candidates if requested

* Client’s business model follows standard retail bank model: they take deposits from the public (which they pay interest on) and make loans (that they earn interest on) and earn a profit based on the spread between what they can loan at and what they pay on deposits.
* Element Financial raises funds from institutional investors and adds heavy leverage to make loans and as a result does not take deposits from the public.
* Equipment loans are seen as a niche market as it requires experience in valuing specialized industrial equipment — many of the client’s employees are former engineers for industrial firms.
* Customers value low interest rates and loans structured around the specific characteristics of their industry — IE. oil and gas companies have no cash until they drill and then have high cash flows, so they prefer to be able to defer interest payments until they hit oil.
* Market for industrial loans is $5 billion in Canada and is growing at 5% annually.
* Market for retail deposits in Canada is $800 billion and is growing at 1% annually.
* Our client has a 50% market share in industrial loans and a 0.25% market share in retail deposits.
* Average interest rate on industrial loans is 4% and on retail deposits is 1.5%.
* Our client faces $20 million in fixed costs, Element Financial faces $10 million in fixed costs.
* Element Financial raises $200 million in equity, which they loan out at 5 times leverage.
* Assume our client’s only assets and liabilities are loans and deposits.

3. Detailed Analysis

I. Part 1

First, the candidate should find the current profitability of the client.

Since they have a 50% market share in industrial loans, they have $5B * 50% = $2.5 billion in industrial loans, which is their asset. At 4% annual interest, they earn $2.5B * 4% = $100 million per year in revenues.

They also have a 0.25% market share in retail deposits, which is $800B * 0.25% = $2 billion in deposit liabilities. At 1.5% annual interest, they have to pay $2B * 1.5% = $30 million in interest on deposits.

Finally they have $20 million in fixed costs, giving $100M – $30M – $20M = $50 million in annual profits.

At this point, they should remember that return on equity (ROE) is the key metric used in this industry. Since the client has $2.5 billion in assets and $2 billion in liabilities, they must have $500 million in equity, which gives ROE of $50M / $500M = 10%.

Element Financial will have $200 million in equity and will lend this out at 5 times leverage for $1 billion in assets. At the same 4% interest rate, they will earn $1B *4% = $40 million in revenues.

Element Financial has $10 million in fixed costs, thus earning $40M – $10M = $30 million in profits and an ROE of $30M / $200M = 15%.

The candidate should notice something important about Element Financial’s competitive threat — since they don’t take deposits from the public, they can steal some of the client’s industrial loans without needing to also take on the deposits.

Additional Information:
* Let the candidate assume that we lose $1 billion in assets to Element Financial.

Client’s new revenues = $1.5 billion * 4% = $60 million, which gives $60M – $30M – $20M = $10 million in profits, which is a $10M / $500M = 2% ROE.

ii. Part 2

Now the candidate should look for ways to reduce the impact of Element Financial’s entry into industrial loan business. There are three things they should propose:

(1) Reduce amount of deposits since less is needed to support loans, this will cut costs and raise profits.

(2) Lower interest rate charged on loans to entice customers to stay. Have them calculate the impact of 1% interest rate reduction on client and on competitor Element Financial -> the client is more susceptible to interest rate declines.

(3) Offer higher quality service through:
– specialized loan terms
– stronger client relations
– new products to cross-sell
– full range of commercial banking services, etc.

The candidate should conclude (1) and (3) are the best strategies given client’s sensitivity to interest rates and industry experience.

4. Conclusion & Recommendation

Ask the candidate to summarize his/her findings and make a final recommendation to the client.

Sample Recommendation:

* Element Financial could pose a significant risk to our client as they could take as much as $1 billion of our earning assets, which cuts our ROE to from 10% to 2%.

* To reduce this competitive threat, we should look to offer specialized loan terms as our staffing of engineers gives us deeper industry knowledge. In addition, these custom products may command a higher interest rate than a standard loan.

* Second, the client should expand their offering to a full range of commercial banking services for this sector, such as operating lines of credit, insurance and advisory, which will prevent Element Financial from taking away our business.