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Richard Davis' Twin Pillars of Prudent and Profitable Banking

By John Maxfield - Updated Jan 26, 2018 at 3:44PM

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The CEO of the nation’s most profitable big bank shares his philosophy on banking.

The cover of U.S. Bancorp's (USB -0.06%) 2009 annual report shows a paper airplane gliding peacefully through the air on a mildly cloudy day. There's no hint whatsoever that it had been the second worst year for banks since the Great Depression -- the worst being the year before. Yet the image perfectly captured where the bank was at that moment in its history. "During 2009, U.S. Bancorp continued to create momentum and position the company for long-term growth and profitability," wrote CEO Richard Davis in his shareholder letter that year. "We protected our franchise and benefited from a flight to quality."

Davis was referring to the fact that 2009 had been the second year in a row that U.S. Bancorp's deposits grew by a double-digit percentage -- a trend that would continue for three more years. Companies and individuals flooded the conservative bank with money after watching hundreds of its peers collapse during and after the financial crisis. The net result is that while most banks emerged from the turmoil bruised and battered -- if at all -- U.S. Bancorp gained from it. The downturn accelerated the annual growth rate of its book value per share, widened its lead over other banks in terms of profitability, and left the $446 billion bank with the best debt ratings in the industry.

U.S. Bancorp Chairman and CEO Richard Davis.

U.S. Bancorp Chairman and CEO Richard Davis. Image source: U.S. Bancorp.

It took a village to accomplish all of this, but Davis has been its chief for the past decade. The genial 59-year-old executive first entered U.S. Bancorp's orbit in 1993 by joining Star Banc Corporation, the second-largest bank in Cincinnati at the time. Through acquisitions over the next 13 years, Star Banc inherited the U.S. Bancorp name and evolved into one of the country's leading regional banks. It then consolidated its position after Davis became CEO in 2006, emerging as the top regional bank in the United States by both asset size and profitability.

Stirred by Davis' rapidly approaching retirement -- he'll step down at the bank's shareholder meeting this month -- I spoke with him about his, and therefore U.S. Bancorp's, philosophy on banking (here's the transcript). His approach is multifaceted, but it coalesces around two points. The first is that U.S. Bancorp prioritizes its relationship with the ratings agencies, helping to explain the bank's industry-leading debt ratings. The second is that U.S. Bancorp's notoriously low efficiency ratio isn't driven by expenses, as most people tend to assume, but instead by revenue. In short, based on my interpretation of his approach, these are Davis' twin pillars of prudent and profitable banking.

Pillar No. 1: Getting and keeping high debt ratings

A conversation with Davis about U.S. Bancorp's coveted debt ratings begins with him explaining the bank's main constituencies: customers, shareholders, employees, analysts, regulators, and ratings agencies. "I start there because the ratings agencies are probably the most important constituency to us," Davis said. "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."

Davis' prioritization of the ratings agencies may seem odd. After all, the CEO of a publicly traded company owes legally mandated fiduciary duties to shareholders, which would seem to make them the most important constituency. Yet the more Davis explained his rationale, the more it made sense. In the first case, as he stressed, ratings agencies are insiders, giving them access to data about U.S. Bancorp's current and future performance that only senior executives ordinarily have:

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 rating 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.

By catering to the interests of the ratings agencies, U.S. Bancorp is thus simultaneously serving the interests of its shareholders -- who tend to be long-term, value-oriented investors like Berkshire Hathaway, which owns 5% of the bank's stock. Both groups prefer consistent, predictable, and repeatable results over unsustainable surges in revenue and profit. "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," Davis said. "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."

It's important to appreciate, as well, that gaining and maintaining the ratings agencies' favor gives U.S. Bancorp a potent competitive advantage. "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," Davis said. "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."

The data bears this out. Starting in 2008, U.S. Bancorp experienced five consecutive years of double-digit deposit growth. The inflow was catalyzed by acquisitions of failed banks from the FDIC, but its driving force was the flight to safety Davis cited in the bank's 2009 annual report -- the one with a paper airplane on the cover. In this way, U.S. Bancorp's high debt rating served as a magnet for customers and clients who, as Davis wrote in his shareholder letter that year, "sought the strength and stability of an organization operating on sound and prudent principles."

On top of this, U.S. Bancorp's high debt rating enables it to borrow money from institutional investors at a lower rate than all but a handful of its peers -- PNC Financial being the sole exception among large regional banks. This is an enviable advantage in an industry defined by leverage. "It gives us the ability to go into the market and raise debt at a remarkably low level," Davis said:

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 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.

A high debt rating also reduces U.S. Bancorp's incentive to take unnecessary risk. It does so by lowering the bank's cost of funds. To Davis' point, this allows U.S. Bancorp to out-compete its peers on loan terms and rates for the top AAA customers. This minimizes quality issues that may otherwise come from stretching on underwriting. This is why Davis could boast eight years ago 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."

The one downside to U.S. Bancorp's prioritization of the ratings agencies is that it can conflict with the interests of other constituencies -- especially analysts. Davis emphasized this point multiple times. Analysts are focused on short-term results, which often puts them at odds with the ratings agencies, who are focused on long-term stability and profitability:

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.

This is where trust comes in, which is why Davis begins his 2016 shareholder letter with that very word -- the first sentence is literally "Trust." A bank's constituencies can conflict, he told me, but so long as they trust its executives, the bank will have the flexibility it needs to make difficult decisions:

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.

Pillar No. 2: Drive efficiency through revenue

The second of Davis' twin pillars of prudent and profitable banking revolves around efficiency -- though, as with his prioritization of constituencies, he comes at it in a unique way. To illustrate this point, he began our conversation on the topic with a short story.

A few years ago, the CEO of a large bank called Davis. The CEO was new to the job and wanted to break through his bank's long-standing high efficiency ratio -- the percent of revenue consumed by operating expenses. He had come to the right place. U.S. Bancorp has long been one of the most efficient banks in the country. Its efficiency ratio in 2016 was 55% compared with its peer group average of 62%. But the problem was that the CEO was looking at efficiency all wrong. "He was coming at it like everyone else does, by focusing on the numerator in the efficiency ratio -- expenses," Davis said. "But efficiency isn't about expenses; it's about revenue."

The instinct when someone hears the word "efficiency" is to think about cost-cutting. Yet if you chart the relationship between expenses and efficiency ratios at the nation's biggest banks, there's no discernible relationship. Conversely, if you chart the relationship between big bank revenues and efficiency ratios, the correlation is apparent to the naked eye. "He who has the lowest efficiency ratio also often has the biggest revenue," Davis said. He would know: U.S. Bancorp generates more revenue than all but three other big banks on a size-adjusted basis. Its revenue as a percent of assets last year was 35 basis points higher than the average of its peer group. That equates to a $1.6 billion subsidy that most of its peers don't get.

Davis' focus on revenue to drive efficiency is an invaluable insight, but executing on it is easier said than done. This isn't because it's hard for a bank to grow revenue per se. It isn't. All a bank has to do is lower its credit standards and increase its loan volume by lending to people and businesses that other lenders may deny or demand usurious interest rates from. But this is risky because a higher percentage of these borrowers will default. What's hard, then, is boosting revenue responsibly -- or, according to Davis' CPR framework, in a consistent, predictable, and repeatable manner.

To do so, Davis believes that a bank must seek out "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." U.S. Bancorp has found two such niches. "We have the payments business and the corporate trust business, both of which are outsized relative to the composition of our revenue," Davis said. "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 closed. So they've got all the benefits."

Another piece to Davis' perspective on efficiency is to view expenses and capital expenditures as investments. "We do have discipline around expenses, but we never use that word. We talk about investments. Everything is about the return on investment," Davis explained. "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." This perspective is especially important right now, given that the challenging revenue environment brought on by ultralow interest rates doesn't negate the need for a bank to continue innovating and investing in its business.

Nevertheless, ratcheting up expenses and capital expenditures at a faster rate than revenue, even when appropriate, presents the same challenge Davis faced for prioritizing the ratings agencies. Namely, the strategy can run afoul of other constituencies, and analysts in particular -- which, again, underscores the ever-present importance of trust.

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.

The common denominator of trust

Given the central role that trust plays in both of Davis' twin pillars of prudent and profitable banking, it's only appropriate that his final letter to U.S. Bancorp's shareholders revolved around it. "Times have changed. The essence of the relationship between bankers and customers, however, has not: do the right thing and re-earn their trust today," Davis wrote earlier this year.

I'll be the first to admit that this can easily come across as vacuous corporate jargon. What CEO wouldn't say that trust is important? In U.S. Bancorp's case, however, there's substance behind the semantics. "Grounded in ethics and integrity, our one U.S. Bank philosophy drives our focus on achieving a strong financial performance," Davis went on to write. Indeed, perhaps more than anything else, it's been trust among its constituencies that has fueled U.S. Bancorp's ascent to the pinnacle of the bank industry. 

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