U.S. Bancorp's Moat Widens

Following a major refinement to our bank economic moat methodology, we've upgraded several banks to a wide economic moat rating, including

Our new methodology includes analysis of regulatory, competitive, political, and economic elements in all 22 countries we cover. These elements support the sustainability of banks' economic returns over time. Our updated analysis for rating financial systems explains why bank moats differ across our global banking coverage despite similar business models or similar profitability. Accordingly, we note that our wide-moat banks are generally contained within high-quality systems such as Australia, Canada, Sweden, and Chile, which score well across the banking system criteria we've developed. Some U.S. banks, like U.S. Bancorp, also earn wide moats despite operating in a weaker system. These banks score well on other factors, including evaluations of a bank's culture, balance sheet, ability to fend off disruption, and ability to generate excess returns.

We see low funding costs as a key advantage for retail and commercial banks. However, we believe switching costs play a key role in a bank's ability to maintain low-cost funding (its cost-advantage-based moat source) and are consequently adding switching costs as a moat source. In addition, we're delving deeper into moat sources for non-interest-earning banking businesses, which can contribute half or more of earnings at complex banks.

Strong Loan Underwriting Is Key Few domestic banks can match the operating performance of U.S. Bancorp since the financial turmoil of 2008-09. The bank's longstanding ability to post excess returns on capital is rooted in its superior credit underwriting, fee generation, strategically beneficial acquisitions, and sound management. As with any high-quality bank, strong loan underwriting is fundamental. At the height of the financial crisis, U.S. Bancorp never incurred a loss from severe credit charge-offs as seen at other institutions. With its well-diversified mix of loans and sound underwriting practices, net charge-offs peaked at just over 2% of loans during the crisis.

U.S. Bancorp has built an imposing slate of fee-based businesses from credit cards, wealth management, and payment processing, which account for approximately half of total revenue. Its payment processing business, which generally carries the payments between consumers and merchants, remains very lucrative, with a large number of merchants under contract. The payment processing business also remains highly scalable, and we expect it to continue its consistent contribution to the bottom line. As a result, the bank's efficiency ratio is exceptionally low--typically in the low 50s. The low interest rate environment has caused this to increase to the mid-50s in recent years, but we expect the efficiency ratio to decline as rates rise in a normalized macroeconomic environment.

Even with a favorable mix of businesses and excess returns on capital, regulators have limited U.S. Bancorp's dividends to about 30%-35% of net income in recent years. However, we expect dividends to increase as U.S. Bancorp demonstrates its ability to generate excess capital. Ideally, the company aims to return 60%-80% of net income to shareholders in the form of dividends or share repurchases. This would be the icing on the cake for U.S. Bancorp, one of the best-run banks we cover.

Cost Advantages and Switching Costs Dig Wide Moat We think U.S. Bancorp has a wide economic moat as it possesses cost advantages along with switching costs for its customers that are consistent with our bank moat framework. In its retail and commercial banking segment, we think U.S. Bancorp has cost advantages through its superior credit, funding, and operating costs.

Over the past 10 years, overall net charge-offs never exceeded 2.4%, even during the financial crisis. Many other U.S. banks experienced net charge-offs nearly double that amount during the crisis. Through an economic cycle, we think U.S. Bancorp and its strong credit culture will remain intact, contributing to low credit costs.

We think bank moats are largely derived from a low-cost deposit base, allowing a bank to effectively compete for quality loans to increase interest income. We believe U.S. Bancorp enjoys a competitive advantage with its funding costs, which are lower than those of aggregate banks insured by the FDIC.

These cost advantages are reinforced by implicit switching costs, which we see as high relative to the benefits of switching. While switching is nominally free, the benefits are often unclear with similar bank products across firms and nominally free checking accounts. Moreover, switching is viewed by customers as troublesome, especially for those who use multiple products from their bank. As a result, retail banking customers tend to move banks only once a decade.

From a systemic standpoint, we believe the United States offers a fair banking environment. Though the quality of regulatory monitoring has become considerably stronger in the past several years, the country still uses a complex and somewhat archaic system of regulation. Furthermore, the banking market is quite fragmented--U.S. Bancorp competes with a variety of regional and community banks as well as large money center institutions. Over the past 50 years, the banking system has achieved returns roughly in line with its cost of capital, which supports our view of the environment as intensely competitive. Our outlook is more positive from a macroeconomic and political standpoint. The U.S. is still the world's leading democracy and maintains the world's reserve currency, both of which contribute to banking stability.

Nonperforming Loan Levels Low and Going Lower We have few concerns about the credit quality in U.S. Bancorp's loan portfolio. Even with competition for high-quality borrowers intensifying, nonperforming loan levels at U.S. Bancorp continue to decline. Net charge-off levels are under 1% of loans, which is low given the size of the bank's credit card portfolio. Capital levels, which cushion the bank for loan losses, also remain strong and continue to improve as the bank is restricted from paying higher dividends. Furthermore, the allowance for loan losses represents more than 275% of nonperforming loans. We think U.S. Bancorp's balance sheet and loan portfolio poses little risk for significant future loan losses or to its continued strong operating performance.

We think U.S. Bancorp is in good financial health, as demonstrated by its low level of nonperforming loans and sufficient loss reserves to cover them. Capital remains decent, with the common equity Tier 1 ratio at 9.2% as of March. Dividends are still restrained by regulators, who have been cautious about allowing larger U.S. banks to pay higher dividends. Even with the severity of the financial crisis, U.S. Bancorp never incurred a net loss during that period. In fact, it is achieving returns well in excess its cost of capital.

U.S. Bancorp's funding is also strong. Deposits constitute 78% of total liabilities and carry an average cost of approximately 17 basis points. The remainder of liabilities (19% of total assets) is primarily composed of long-term and short-term borrowings. Overall liability funding costs are about 43 basis points, which we think is low for a bank of this size.

Stewardship Is Exemplary CEO Richard K. Davis is clearly the dominant influence throughout the company, and we have been pleased with the performance of the bank under his leadership. During Davis' tenure, U.S. Bancorp grew to become the fifth-largest bank in the country, up from the seventh-largest in 2006. It is now located in nearly half the U.S., has gained market share in many of its markets, and came through the worst financial crisis of our generation without realizing a loss in any year. He has helped nurture the company as a community bank operating in many markets while also being a low-cost provider of numerous services and products. As U.S. Bancorp looks to extend its advantages in its businesses, we think it will continue to realize strong returns on equity over the long term. We believe shareholders will be rewarded for Davis' leadership.