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Payments Advocate
BY KENNETH CLINE
U.S. Bancorp CEO Richard Davis says payments is integral to his company's future.
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SYNOPSIS | U.S. Bancorp acquired its payments operations in a merger and only gradually recognized the value of this array of businesses, according to CEO Richard Davis. But now that payments has become more high profile in banking, with the transition from paper- to electronic-based processing, the company is continuing to expand in payments as a relatively low-cost method of deploying its capital and diversifying its earnings stream. Davis is particularly bullish on untapped growth in corporate payments and expanding U.S. Bank's payment operations in Europe.
Sometimes it pays to be lucky, as U.S. Bancorp discovered following a merger that left it with a robust array of payments businesses.
CEO Richard K. Davis says he and other top executives took a while to recognize the value of what they had — the merger of U.S. Bank and Firstar Corp. in 2001 had been predicated on building retail strength. But once they began focusing on payments, they understood that these businesses provided an excellent place to invest relatively low-cost capital and diversify the bank's earnings stream.
Today, U.S. Bank is one of the rare banks below mega-bank status that can claim to be a major player in payments, with top 10 status in merchant acquiring, credit and debit card issuing and ATM processing. As Davis makes clear in the following interview, he fully intends to build on that base, particularly in corporate payments and in overseas markets, such as Europe and Canada.
And why not? Based on U.S. Bank's experience with payments so far, he says, "I already know we're not going to fail at it, and I already know that scale is working for us."
Q: When it comes to payments, U.S. Bancorp has taken a bit of a contrarian stance in that you're heavily involved in an area that many peers have abandoned, because of thin margins and lack of scale. What made U.S. Bank decide to stay in payments, and what was the strategic rationale for that?
Davis: When we merged U.S. Bancorp and Firstar Corp. in 2001, we noticed an opportunity to leverage the scale we gained from the transaction. I definitely mean "noticed an opportunity." We didn't conduct the due diligence on payments per se; we didn't merge the companies on that basis. But shortly after the merger, we realized that between these two companies we had an amazing collection of payment capabilities. We realized we could have scale beyond our asset size, which is now $217 billion, sixth largest in the nation.
Now it's probably more important today to be in payments because our customers started saying, "Payments are going to be important to me." Moving money around, knowing where it is, knowing how to maximize it — those things started to matter to the customers. It's always good to be lucky.
Q: But what about the argument that payments is a low-margin, commodity-type business?
Davis: It actually takes a very low cost of capital to maintain payment businesses and processing businesses. One of the reasons that those businesses have higher earnings multiples is that they're not balance-sheet businesses. You don't have to take a majority of your shareholder equity and put it into reserves for loans that may never be paid back. The payments business has a different financial risk/reward profile.
It also responds to financial markets in a different way. For example, when fuel prices are down, people say we should have a good holiday season. That's great news for our payment business, because we get paid, in some cases, for outstanding balances. But, when Wal-Mart comes out and said it had the softest same store sales since 2000, that can also affect payment volumes and therefore our earnings stream.
I like that, because investors typically like diversity of revenue streams and, therefore, earnings. They give you credit over time for a steady and stable earnings projection. That's what we're counting on.
Q: And this year provides a particularly good example of the benefits of that diversity, correct?
Davis: Yes. In the third quarter of 2006, year-over-year, our net interest income was down 7%, but our fee income was up 11%. If we had not taken these actions five or six years ago, moving into the payments space, we would have been more reliant on spread income and much less reliant on fees.
We also think that the payment business has a great deal of untapped growth, because there are still a number of consumers and businesses that aren't using payment products. Additionally, moving into Canada and Europe with our payment businesses affords us a different, if not an improved, near-term growth curve that we wouldn't get by focusing only domestically.
It's a change for this company, though, because we've always been known as a core domestic bank. After all, that's intrinsic to our name. Now, we find ourselves evaluating some international markets in order to offer some of our payment capabilities because, frankly, those foreign markets are ahead of what some of the domestic markets offer.
Q: Your payment businesses include merchant acquiring, ATM processing, debit card processing, credit card processing, etc. Looking ahead, say the next few years, where is the growth coming from? Where is the "sweet spot" in that array of payments operations?
Davis: Corporate payments probably represents the sweetest spot, because there are many commercial customers who have yet to appreciate how they can leverage their money. It's very important that our customers get exposed to that.
Because we've chosen to spend our extra capital and energy on the payments side, we've also started to diverge from our peers in terms of commercial/corporate banking. When we visit a customer, we can say, "I've got some new payment capabilities I want to share with you." It's an advantage, because if I'm going to work my way into earning a relationship for the traditional loan or deposit, or cash management product, I have more to offer.
Consider some of our peers. They diverted their additional energies into more mortgage or insurance, and those are great product sets. We offer them too. But I don't think those products afford your calling team as much differentiation from peers as being able to get into the space called payments.
Q: Do you offer your frontline employees incentives to sell payments products?
Davis: We're changing our incentive plans to give credit for cross-selling payment products based on the richness of the overall relationship.
To back up a bit, this company has never, unlike some of our peers, tracked cross-sell as a measure of performance. But we do measure cross-sell as a retrospective view of customer quality, the quality of the overall relationship. We don't care if someone sells one product or 20 products during a customer contact. But if a relationship is deeper, based on tenure, average value and number of products used, we will make the translation that this customer is more likely to be a long-time supporter of our company and provide incentives based on that.
The problem we have now is we hire a lot of employees from other banks who don't have payments expertise. So, to provide them with an incentive to sell payments products, we are "over paying" in the beginning stages for payment business. While we're not over paying to the point of losing money on it, we're emphasizing payments for a while in this company to make sure it doesn't get overlooked.
It's easy to talk about this story now because we've been in it long enough. I already know we're not going to fail at it, and I already know that scale is working for us. If you look at our M&A activity, almost all of our time and energy has been spent in the payments, trust and processing businesses. For example, NOVA Information Systems, our merchant processing company, bought First Horizon National Corp.'s merchant processing business last March for $433 million.
I'll mention that our corporate trust business and the attached processing business is no less impressive. That's the other place we've been spending our energy. At the end of the third quarter, we ranked number one in the municipal trust and structured finance businesses. You don't get headlines for that, but it's a very good scale business.
We're spending our capital in different places, and the capital story is the same for other processing businesses as it is for payments. We're not using the balance sheet, for the most part, to make those investments.
Q: But you still have an interest in expanding your retail bank, right?
Davis: While we are not intent on buying other large banking companies — that's not one of our near-term goals — we do want a deeper franchise presence in our current 24-state footprint regarding traditional banking products and services. Our strategy is to look at smaller acquisitions that fill in geographic areas where we have lesser presence, such as our recent acquisition of Vail Banks, Inc. in Colorado, where we extended our presence on the Western Slope region, and most recently in Montana, where we acquired United Financial Corp. and nearly doubled our presence in that state.
Q: Let's go back to international. You've done a lot in Europe, which a lot of U.S. payments operators stay away from because of the fragmented, multi-country market. Where do you find your opportunity in Europe?
Davis: First of all, it's primarily the merchant acquiring business, not card issuing. That's an important distinction; we're not issuing cards or taking on debt from international clients. That would be banking, and we're not doing that. Our growth is in merchant processing, and merchant acquiring. We've invested heavily in that space by acquiring the merchant acquiring businesses from banks in Ireland, Norway, the U.K. and Poland, for example.
When we do these partnerships with foreign banks, we typically purchase the merchant portfolio and then we get a multi-year referral stream from them. They still want to offer the product, but they just don't want to run the business anymore. They don't have the scale or the interest in making the continuing capital investment needed to stay competitive.
Let's go back to the States for a minute. NOVA is the merchant acquirer for 14 of the top 35 banks. There are people in major banks in the country today driving about doing their calling efforts and they're selling merchant services through NOVA, a subsidiary of U.S. Bancorp. That business is important enough for them that they're willing to accept a bifurcated model, where we partner with them for payments expertise. They leverage our scale and we help make them successful.
We also think there's a lot of value on the research and development side of it. We're not Procter & Gamble or Microsoft, but we do spend quite a bit of energy on innovation, which has to come from scale. Because otherwise, you're going to be better off being a quick follower.
In Europe, when we do a partnership with Bank of Ireland or Banco Santander, it's the same thing we do here with the major banks, where we function as their private-label provider of merchant acquiring services. No one has a problem with that, which is terrific. I might add that when we acquired NOVA, we worried that a lot of the banks would leave NOVA because a bank owned it. Not a single one of them left.
Q: Some executives in your company had previously been quoted as saying 2008 might be the year U.S. Bank ventured into Asia Pacific. Are you now adopting a more cautionary outlook?
Davis: We are now more cautionary. All we know about the Pacific Rim is it's growing. What you're not exactly sure about is in what category, i.e., what is growing and how that's relevant to you. We're not going to take bets on something we don't know.
We didn't get into Europe on our own either. Every step was a partnership. So what you'll see in Asia is that our ventures will come about as a byproduct of a partnership with somebody who wants to learn and work with us, or wants to sell their merchant acquiring business with the referral trailer that comes along.
Q: When you appear at BAI's TransPay Conference & Expo, you'll probably be asked to comment on some of the major issues roiling the payments world right now, like the transition from paper to electronic processing. What's the long-term goal that banks should be working toward in payments processing?
Davis: I think the primary challenge facing banks right now is how to innovate and grow beyond their balance sheet business.
Innovation comes from being able to move money for customers and optimize that movement. We have chosen to innovate and invest in payments and our other fee-based businesses, which we see as emerging markets. There is a great deal of customer interest in these businesses, which gives us the opportunity to talk about the full spectrum of products we have to offer.
Q: And what role does imaging technology play in that scenario?
Davis: Let's call it "paperless exchange."
As banks, we are going to have to protect our long-standing position in the payments stream. Our role in payments has always been as an authenticator and validator. We can authenticate that X is who he says he is and we can validate that the money X says he has is in his account. And if neither one turns out to be true, we will guarantee to you, as the merchant, or you, as the other holder in due course, that we will make good on that mistake.
When we come to images, the issue for us is: where does the image originate? What is the image you pay on? And who is the holder in due course, i.e., responsible for something that goes wrong?
Imagine if payments become image-based and become intra-moment. Then, all of the sudden, what happens to float? Where is the overdraft? What role do banks have? Banks will have to collaborate and work together to understand the changing environment or we run the risk of someone else mapping a new course for us.
Q: Another hot issue in payments right now is contactless cards. Where do you think the U.S. market is moving in terms of that product?
Davis: I think it's in its infant stages.
I was at a bank event at an NFL game last October where we had 26 people demonstrating contactless cards as a preview of a pilot that we were about to launch in that market. I was standing there watching people try it. The general thought seemed to be, "This is cool, but I still have to use my card. Instead of giving it to somebody, or swiping it myself, I'm just kind of getting it near something." And the question that came up more than once was, "If my purse or my pocket gets too close, will it debit me or charge me for something?"
It isn't like contactless cards change your life. It's just a different approach. It's kind of like the mini card that came out a few years ago: clever, cool, fun. I think the contactless card is probably nothing more than a proxy for other innovative things that will come up.
When you can look into my eyes and take my retina print and all of a sudden debit my account and I don't have to lift a finger — that will truly be an innovation. But we're not there yet.
Q: Health Savings Accounts (HSAs) represent another payments-related innovation. A lot of people see it as an engine of growth on the retail side, but everyone acknowledges the bureaucracy involved in interfacing with the insurance companies, employers and customers. Your view?
Davis: We're big proponents of HSAs, as much because of our trust business as because of our payments operation. I don't know of a better product that overlaps those two businesses. HSAs have our name written all over them.
But employers and consumers need to adopt it first. It will be rather like the adoption of IRA accounts, which started slowly. HSAs will hit their stride, but it will be because employers have created partnerships with financial service providers and are directing their employees to use the solution they've developed.
I don't even think it will be a political hot topic. I think it will be simply a matter of adoption rates by consumers, who will take their time until their employers make it more pertinent to them, more relevant to them and, in some cases, more non-negotiable.
Q: There's a lot of talk in the industry about using reward programs to spur the growth of debit cards (see "Debit Cards on the Offensive"). U.S. Bancorp has been active in this arena. What's the next step for rewards programs?
Davis: We were one of the first to reward customers for debit purchases. We started out with a debit card reward program called "Checking That Pays" nearly 10 years ago. It is a cash-back program that has grown into a full suite of rewards including cash, miles or merchandise. We will still offer rewards, but it's no longer a novelty.
We're moving things to another level with the assistance of Richard C. Hartnack, vice chairman of consumer banking, who came over from Union Bank of California two years ago to run our retail operation. That next level will be rewarding customers for the value of the relationships they have with the bank. For example, a customer comes into the office and says, "I want a car loan from you." For the first time in the history of this bank, we'll actually be able to spin the screen around to the customer and show him all the business he has with us. We will show him how much we value that business with a point system and offer either interest rate deductions on the car loan, Cabela's gift certificates, Northwest Airlines tickets, or whatever.
If the customer has business with other institutions, such as credit card or mortgage, we'll value that too and offer points for moving the business over to us for additional discounts and benefits.
We tested this in a variety of branches in several of our markets. For the first time in my memory, the employees, en masse, said, "I like this program. I'm finally giving something to my customers that they may want. I'm actually getting their attention and giving them some quid pro quo."
Many times, customers don't do anything when they receive this information, but it's now in their mind that, if I do more with this company, there's going to be more coming to me
So, my point is, rewards will move from credit card, to debit card, to entire holistic relationships, and that is, in my mind, the next generation of rewards: a value-based proposition that people see as different and distinctive.
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