Richard Davis is the chairman and soon-to-retire CEO of U.S. Bancorp (NYSE:USB), the most profitable big bank in the United States. It remains to be seen what Davis will do in retirement -- he's only 59 -- but he's purportedly being considered for a position on the Federal Reserve's board of governors. As you'll see by reading through my interview with Davis, which was edited for organization and flow, his insights on the industry are invaluable.
John Maxfield: What did you learn as CEO of U.S. Bancorp that you didn't know before?
Richard Davis: The economy couldn't have been more different when I took over in December 2006. The world was absolutely spectacular. We were coming to the end of a 13-year run on the market. The economy was fantastic. It was the holidays. Everybody thought things were terrific and no one saw a bubble anywhere.
I realized that this company had been playing to its strengths as an efficient company, but efficiency wasn't the way into the future. So as the world was wonderful and robust, I also knew that we'd have to move the bank more into an offensive position than a defensive one and start earning our stripes as an offensive company. But then the bottom fell out and the financial crisis struck, which required that we stay on the defensive to help protect our clients and customers.
So for me it's about the importance of pivoting between strategies when something unexpected happens. In our case, we went back to the old tenets that had kept us safe, and slowly but surely over the last nine years we've moved the company toward an offensive position, which is where we're at today.
Maxfield: When did you know the financial crisis would be so severe?
Davis: When the first money fund broke the buck. That was unprecedented. It had never happened in the history of the world. It wasn't housing. It wasn't mortgage banking. Those were dominoes that fell. But it really was the implied fact that the markets had built up a bubble in secondary, tertiary, and beyond-tertiary monetary instruments.
Because it was money fund-driven, and because we're in the business of managing money as a large bank, we realized quickly that we would be in the path of the crisis. Within days of that, we also realized that we didn't have many of the issues that caused the crisis, which meant that we would be safe from the most significant sources of damage like subprime lending, air-bubble mortgages, and investments built on bubbles. So for quite some time we were quietly celebrating that we wouldn't have to spend time picking up the pieces.
We realized sometime after that the market was responding with great favor to our company. Our stock started to strengthen. We did well even among the strongest banks. And the market's behavior said to us: "We liked you before, but we like you even more in these tough times." This gave us permission to move forward while everybody else was picking up the pieces. It's like we were running a race and you dropped something and had to go back and pick it up.
Maxfield: How did U.S. Bancorp avoid the worst excesses that caused the crisis?
Davis: We didn't stay out of those things because we knew they were bad. We shouldn't take credit for saying that we sat around in 2005 and 2006 and realized that subprime lending would be such a big problem and that there was a bubble in the housing market.
The reason we did well was because we never got away from our basic model, which is to do things that are sustainable and repeatable. So when subprime came along, I'm sure there was a meeting where I asked my team "What do you think?" and they probably said "We just don't think it's sustainable."
One consistent theme between my predecessor and my role is the board of directors. The board hasn't changed. It has an operating philosophy that the bank would always do things that were sustainable. I created the phrase "CPR": consistent, predictable, repeatable. This is code for "We're not going to take a flyer, we're not going to take excessive risk, and we don't do things that only make sense in the near term."
I don't want to give our shareholders a run-up for a quarter or two only to say later that "We just took advantage of a bubble but can't keep it up because it isn't sustainable." That's bad shareholder form. If you stick to your model in good times and bad, it means you don't get greedy when things look too good to be true and you don't get shortsighted when things get tough.
Maxfield: How has U.S. Bancorp gotten such a low efficiency ratio?
Davis: There was a large bank CEO a few years ago that called to talk about the efficiency ratio because he wanted to break through a long-standing high number. He was coming at it like everyone else does, by focusing on the numerator in the efficiency ratio -- expenses. But efficiency isn't about expenses; it's about revenue. He who has the lowest efficiency ratio also often has the biggest revenue, which is in the denominator. A bank needs to look at what it does, and get into businesses where it can be better than everyone else, or where it has skills that no one else has, or where it can outperform its own history.
So the first reason our efficiency ratio is low is because our revenue is better -- which is because our mix of businesses is better. We have the payments business and the corporate trust business, both of which are outsized relative to the composition of our revenue. We've got scale in them. Neither requires capital, so you don't have to put any money against loans or deposits. And the cost of entry is prohibitively high. So they've got all the benefits.
The second thing is that we do have discipline around expenses, but we never use that word. We talk about investments. Everything is about the return on investment. We don't cut off expenses or capital expenditures if they have a good return. But you can't spend money if you don't know what you're going to get for it. If you have a capital expenditure and it's going to be more than $100,000, it has to come before a committee. Small expenditures can sneak up on you. You amortize them, and all of a sudden you've got this huge depreciation cost from small incremental capital items that were done because they didn't impair earnings at the time.
Our expenses have been growing quite a bit. Our revenue is supposed to grow faster. So we have failed the market over the last six quarters because our revenue has not outpaced our expenses. But to our credit, we didn't cut back on expenses to equal the governor of revenue in the near term. If we did that, we'd struggle in the future. So we took a hit from the analysts and said we'd be slightly negative operating leverage. We're doing that because we don't want to stop spending money on important investments.
Maxfield: How important are U.S. Bancorp's debt ratings to its success?
Davis: Let me walk you through our constituencies. The main ones are our customers, shareholders, employees, analysts, regulators, and the ratings agencies.
I start there because the ratings agencies are probably the most important constituency to us. We want to protect their favor and their belief that our reputation deserves the highest debt rating of any bank in the country, which we have right now and have had for a long time. They trust us because they're insiders. If they came in today, we can show them everything that's happening. We can show them our profit plan. We can show them what happened last quarter. We can predict our earnings for the next 90 days. We can show them all our capital expenditures. I can tell them every single thing that I tell Andy Cecere, who takes over as CEO in April.
Every other outside constituency only knows what's happened in hindsight; they know nothing about the future. When a ratings agency goes and meets with Delta, American, United, and Southwest, it is already aware of their current performance. So ratings agencies instead go in to ask questions about the future that only management knows the answers to. Ratings agencies can never disclose this, but they give the highest grade to not only the company doing well now, but also to the one they think is positioned to do better in the future.
So when we sit down with the ratings agencies, we're all about the future. We try to make sure that we retain the respect they've given us -- that they like our future better than anyone else. Not like an analyst who knows our current day better than anyone else. If I talk to the analyst community about my loan growth -- the higher the loan growth, the higher the share price. In the same scenario, the ratings agencies will come in and say, "I'm a little worried about your loan growth. Why is it so high? I'm worried that you're taking on too much risk. Show me your underwriting. Have you made any changes?" Typically, the ratings agencies are worried if we outperform everybody else because they want to ensure that it's sustainable, like I do. It's the complete reverse conversation you have with the analyst community.
That's how we get the highest rating, then we protect it like crazy because anyone in the C-suite of a large company that went through 2008-09 will tell you that they never paid much attention to the quality of the banks they partnered with -- but they do now. When you wake up one day and National City is gone. Wachovia is gone. Washington Mutual is gone. And you're the CFO of a Fortune 100 company and you have part of your line of credit extended there and you're thinking "What do I care? I've got their money." But then the terms change and all of a sudden the new owner can kick them out. So the rating itself matters much more now than it did 10 years ago because people understand that it has value and that it's created by people who are supposed to be experts and are looking into the future.
Maxfield: What impact does U.S. Bancorp's debt rating have on its cost of funds?
Davis: It gives us the ability to go into the market and raise debt at a remarkably low level.
Just the other day we were in the market for $1 billion and paid LIBOR plus 35 or 40 basis points. Another bank would have paid anywhere from 40 to 80 basis points more. So, think of that: Two banks. Both in the same business going after the same loan customer. And I have $1 billion that I get at an average of 60 basis points cheaper than they get. I can take that and use all of it and price the top AAA customer better than they can. I can take half of it, give 30 basis points to the bank, 30 basis points to the customer. But I've got 60 basis points to play with. It's like a head start on every single deal.
We can do that because we have the financial numbers. There's no one that can beat us. Because we have the highest debt ratings, we get the lowest cost of funds. And we only go after the top AAA customers, which helps us avoid quality issues in our portfolio that come from stretching on underwriting or rates. But if our operating model wasn't sustainable and repeatable enough to satisfy the rating agencies that are trained to look for that, then we'd lose the high rating and the advantage on the cost of funds.
Our debt rating is the most credible thing we have to offer Wall Street. No matter what you put up against it, having the highest debt rating and using it to your advantage to get the best quality customers, no one can poke a hole in that argument.
Maxfield: What explains your stock's high valuation?
Davis: It's high because we have a great mix of business and because we have the best debt ratings in the industry. But it stays high because we haven't surprised anybody or let anyone down.
Imagine how concerned we were to announce last year that we would go negative operating leverage. We didn't know how that'd go over with analysts, because higher provisions reduce earnings. But the fact that revenue isn't growing as fast as expenses because of low interest rates doesn't mean that we should suffocate the future of innovation, the future of investment, the future of branch technology. I remember crossing my fingers and wondering if they were going to take us to task. And while they didn't love it, they bought it and they believed it because we've never said something we didn't then do.
We simply manage for the long, long, long term and run the risk of being a little less interesting to day traders but a lot more interesting to people like Warren Buffett.