Even the nation's biggest banks are struggling to compete on a level playing field against U.S. Bancorp (NYSE:USB). The main sources of the $422 billion bank's competitive advantage are its size, low cost operations, and debt rating.
1. Lower capital requirement
Not all banks are created equal when it comes to the amount of capital they must hold to satisfy regulators. Eight of the nation's biggest banks get the short end of the stick in particular. These "global systematically important banks" must reserve 1% to 4.5% more capital relative to their risk-weighted assets than U.S. Bancorp does.
When the Federal Reserve released these rules last year, JPMorgan Chase's (NYSE:JPM) G-SIB surcharge topped the list at 4.5% -- though it has since purportedly dropped to 3.5%. That was followed by Citigroup (NYSE:C) at 3.5%, Bank of America (NYSE:BAC) at 3%, and Wells Fargo (NYSE:WFC) at 2%.
The impact on profitability from the G-SIB surcharge is substantial. Every additional percentage point in capital that a bank must reserve against its assets translates roughly into a decline of 1 percentage point in return on equity -- this holds true only in the leverage range in which most banks operate. So if Bank A and Bank B both earn 1% on their assets, but Bank A can leverage its equity by a factor of 10 versus Bank B's 9, then Bank A will generate a 10% return on equity compared to Bank B's 9.1%.
This is one reason that U.S. Bancorp earns a higher net income relative to its equity than its too big to fail peers. It reported a 14% return on average common equity in 2015. This compared to Wells Fargo's 12.7% and JPMorgan Chase's 11%, both of which are extraordinary firms. It's also why U.S. Bancorp's stock trades for a higher multiple to book value than any other big bank, as its superior profitability can be expected to translate into higher shareholder returns over the long run.
2. Cost advantage
"When you're in a commodity business, the only way to thrive is to be a low-cost producer," wrote Duff McDonald in his biography of JPMorgan Chase CEO Jamie Dimon. "And when you're selling money, you're in a commodity business."
This is sewn into the fabric of U.S. Bancorp's DNA. "Being a low-cost provider gives one a tremendous strategic advantage," former CEO Jerry Grundhofer told Bank Director magazine's Jack Milligan 16 years ago. "It allows you to deal with challenges, be competitive on the asset and liability sides of the balance sheet, and take care of customers."
Warren Buffett has said the same about the insurance industry, which is analogous to banking for these purposes:
The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.
This is why the efficiency ratio is arguably the most important metric that an ordinary investor can use to compare banks. It's calculated by dividing a bank's noninterest expenses by its net revenue. A low ratio is better than a high ratio because it means that a bank's operating expenses consume less of its revenue. This leaves more to distribute to shareholders, repurchase stock, and fund growth.
U.S. Bancorp is the most efficient bank in its peer group. Its efficiency ratio last year was 53.8%. Meanwhile, the notoriously efficient Wells Fargo's came in at 57.8% while JPMorgan Chase's was 63%. "If our efficiency ratio rose to our peer group average, our return on equity would fall from 14% down to below 9%," U.S. Bancorp's CEO Richard Davis told me.
3. Debt rating
A bank's debt rating serves as a unique competitive advantage because it weighs on costs. But while the efficiency ratio reflects operating expenses, debt ratings impact the cost of funds -- that is, how much it costs a bank to borrow money.
A low debt rating has a particularly pernicious impact on long-term debt. I once estimated that Bank of America's comparatively low debt rating equated to $2 billion more in annual interest expense from long-term debt relative to Wells Fargo. That's a lot when you consider that Bank of America earned only $15.9 billion last year -- and that was its best performance in almost a decade.
U.S. Bancorp understands this completely. It also understands that the cost advantage gained from a high debt rating can be used to compete more aggressively on loan terms and thereby acquire market share from competitors. As Davis noted on the bank's third-quarter conference call:
[Our best in class debt ratings] allow us to benefit from pricing. And again, this is an audience that understands this, but if we're going to the markets and we can receive 5-year money at a 40 to 60 basis point benefit from our peer group, that's 5 years we get to price things better by 40% to 60% -- basis points and/or at least take half of it and put it into price. We only deal with high-quality customers, so we're not using it for subprime or near-prime purposes. We're using it for the best customers to win them and keep them, but we're unabashed about saying that we'll use pricing as a tool at this moment in time.
This is a powerful advantage for a bank that prides itself not just on efficiency, but even more so on its ability to generate positive operating leverage, which stems from growing revenue faster than expenses.
The net result of these three competitive advantages is that U.S. Bancorp appears primed to outperform every other bank in its peer group over the foreseeable future. This could change, but there's no reason to think that it will change for the worse so long as its current group of executives remain at the helm.