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The blessing and curse of YoY

Every three months Canadian Retail Banking executives scurry to prepare for the quarterly analyst call where they explain the year over year (YoY) growth - or lack of it - in key metrics such as Revenue, Net income, and Lending balances. 

The ideal outcome for a Canadian Retail Bank is to have stable growth that is slightly above market. It signals stability, implies solid risk management and creates the expectation of continued growth. 

However, striving for stable growth is not necessarily optimal from a pure financial theory perspective. 

Consider two hypothetical executives - Nikhil and Sophia - who each run a Canadian Retail Bank with annual Revenue of $5Bn. Simultaneously they come up with a new idea that could create a new Revenue stream of $300M. For example, this new idea could be repricing a large line of credit book using a new sophisticated risk score or it could be a new lending policy that allows easier (but low risk) lending to new immigrants in Vancouver. For simplicity, assume the market expects 5% annual Revenue growth and both executives will achieve this rate without the new idea.

Nikhil optimizes for NPV and takes the full $300M in year one. His Revenue growth rate in year one is 11% - well above market. However, as soon as he hits year 2 his growth plummets to 4.7%. Barring another new idea, his growth rate will be below market indefinitely. The worst case for Nikhil is that the market doesn’t believe his phenomenal 11% growth in year 1 and suspects that he took excessive risk. They punish the stock price for this, and then continue to do so in the next years as his growth comes in under market. To boot, the Regulator decides to do a thorough audit of his operations. 

Sophia is shrewd and decides to deliberately delay the implementation of the new idea. She spreads the growth over five years by activating only one fifth of the new Revenue stream each year. She now manages to grow by around 6% for the next five years, nicely beating the market, but not by too much to cause suspicion. Nobody asks “Is this real?” Rather, analysts applaud her bank for delivering consistent market beating performance for five solid years. 

The irony is that Nikhil’s bank had an additional $300M of capital from day one that they could use for further growth or acquisitions. In addition, they actually made more money out of the same idea, assuming the discount rate is greater than zero. If Nikhil was running a PE portfolio company or simply a small business, he would be a hero. Running a large Retail Bank, he doesn’t look so good.  

The following two headlines in the Globe and Mail reporting on the 2019 Q2 results of the banks, triggered this insight piece: 

  • Slow loan growth, higher provisions eat into CIBC quarterly profit as big-bank results kick off

  • RBC and TD Bank top estimates for quarterly profits, powered by loan growth 

It’s true that the YoY loan growth of CIBC in Q2 was -0.4% while RBC had growth of 3.8%. However, if we consider the 5 year CAGR, CIBC is at 6.1% while RBC is at 3.9%. (The big 5 had an average of 4.1%.) 

Put differently, CIBC added $62Bn to its loan book while RBC added $58Bn in the last five years - and CIBC had a significantly smaller base from which to grow, and presumably a smaller sales force. 

CIBC got more loans earlier, which sounds like a good thing from a capital perspective. However, over this time the CIBC YoY growth rate fluctuated between 11.3% and -0.4% while RBC’s lending growth rates were much more stable, between 3.4% and 4.7%.    

The bottom line? In a world of asymmetrical information, a steady growth rate is a powerful signal of health, and something to consider when you have your next big idea. Maybe you don’t maximize for NPV - as wrong as that may feel.

Martin Nel