U.S. Bancorp (USB) Q3 2016 Earnings Report, Transcript and Summary

Welcome to U.S. Bancorp's Third Quarter 2016 Earnings Conference Call. Following a review of the results by Richard Davis, Chairman and Chief Executive Officer; and Terry Dolan, U.S. Bancorp's Vice Chairman and Chief Financial Officer, there will be a formal question-and-answer session. [Operator Instructions]. I will now turn the conference call over to Jen Thompson of Investor Relations for U.S. Bancorp.

Thank you, Melissa and good morning to everyone who has joined our call. Richard Davis, Terry Dolan Andy Cecere and Bill Parker are here with me today to review U.S. Bancorp's third quarter results and to answer your questions. Richard and Terry will be referencing a slide presentation during their prepared remarks. A copy of the slide presentation as well as our earnings release and supplemental analyst schedules are available on our website at USBank.com. I'd like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on page 2 of today's presentation and our press release and in our Form 10-K and subsequent reports on file with the SEC. I'll now turn the call over to Richard.

Thanks, Jen. Good morning, everybody and thanks for joining our call. I'd like to begin our review of U.S. Bank's results with a summary of the quarter's highlights on page 3 of the presentation. U.S. Bancorp reported net income of $1.5 billion for the third quarter of 2016 or a record $0.84 per diluted common share. I'm very pleased with the third quarter results. Industry-leading profitability was supported by solid loan and deposit growth and broad-based core revenue growth. As a reminder, our prior quarter results included notable items including a Visa gain of $180 million in noninterest income and $150 million related to litigation accruals and a charitable contribution in noninterest expense. There were no notable items to report in the third quarter. So for the remainder of this call, we will discuss the results on a core basis excluding the notable second quarter items I just described, as this is how we believe the investment community looks at our results. Slide 4 provides you with a five-quarter history of our profitability metrics which continue to be among the best in the industry. In the third quarter, our return on average common equity was 13.5% and our efficiency ratio was 54.5%. Turning to slide 5, the Company reported total net revenue of $5.4 billion in the third quarter. Excluding notable items in the second quarter of 2016, this represents an increase of 2.3% on a linked quarter basis. Our revenue growth was primarily driven by loan growth of 1.1% and strength in a number of our fee-based businesses, including mortgage banking and Payment Services. The industry continues to face headwinds from the low rate environment and a flatter yield curve. This quarter, our net interest margin was also impacted by higher levels of cash balances due to the strong deposit inflows. However, despite our lower net interest margin, which declined by 4 basis points to 2.98%, in line with expectations, we reported net interest income growth both sequentially and on a year-over-year basis. Credit quality was stable in the third quarter as expected. Both nonperforming assets and net charge-offs decreased modestly compared with the prior linked quarter. Before turning to Terry, I'll provide you with an outlook for the fourth quarter. Currently, we expect average loans to continue to grow in the range of 1% to 1.5% sequentially. While mortgage loan growth is expected to slow in line with industrywide tapering of refinancing activity and due to seasonality, we look for a rebound in commercial loan growth in the fourth quarter and expect strength in consumer loans to continue. Given the current shape of the yield curve, we expect that the net interest margin will decline a couple of basis points. However, we expect net interest income will increase on a linked quarter basis, principally driven by growth in earning assets. We look for somewhat lower mortgage revenue in the fourth quarter, in line with an expectation of lower refinancing activity. We expect expenses to grow 2.5% on a linked quarter basis, primarily driven by seasonally higher expenses including tax credit amortization costs related to our community development business. And finally, given the underlying mix and quality of the overall portfolio, we expect credit quality to remain relatively stable and we expect the provision to increase in line with loan growth. Terry will now provide you with more details about our third quarter results.

Thanks, Richard. I'll start on slide 6 which highlights our loan and deposit growth. Average total loans outstanding grew 1.1% on a linked quarter basis and increased 7.6% compared with the third quarter of 2015. Excluding the retail card portfolio acquisitions completed in the second half of last year and student loans that were reclassified to held-for-investment in the third quarter of 2015, loans grew by 6.4% compared to the prior year. In the third quarter, the year-over-year increase in average loans outstanding was led by strong growth in average total commercial loans of 9.0% and strong growth in average total residential mortgage loans of 8.6%. Consumer loan growth was broad-based, led by credit card loans and other retail loans. Specifically, credit card loans grew 5.9%, excluding the retail card acquisition; and other retail loans grew 5.2%, excluding the student loans. Home equity loans grew 2.4% on a year-over-year basis, with growth primarily sourced from our branch network. On a linked quarter basis, our average loan growth was 1.1%, in line with our expectations. Credit card loans grew 2.4%; residential mortgage loans grew 1.4%; home equity loans were up 0.5%; and other retail loans were up 2.7%. Total average deposits increased by more than $28 billion or 10% compared with the third quarter of 2015 and were up 3.6% on a linked quarter basis. On a year-over-year basis, the trend reflected strong growth of 11.9% in our low-cost deposits, which includes our non-interest-bearing deposits and our interest-bearing savings deposits. This strong core deposit growth more than offset the runoff in higher-cost time deposits. Turning to slide 7, credit quality remained relatively stable in the third quarter. Third quarter net charge-offs increased by $23 million or 7.9% compared with the prior year, but decreased by $2 million compared with the second quarter of 2016. Net charge-offs as a percentage of average loans were 46 basis points in the third quarter, unchanged from the prior year and down from the 48 basis points reported in the linked quarter. Compared with a year ago, nonperforming assets increased $97 million or 6.2%, mostly due to downgrades that occurred in the prior quarters related to energy credit. Linked quarter, nonperforming assets decreased by $8 million or less than 1%, primarily driven mainly from improvements in residential mortgages and other real estate. We continued to add to the allowance for loan losses in the third quarter, in line with loan growth. Slide 8 provides highlights of third quarter results versus comparable periods. Third quarter net income increased by $13 million or 0.9% on a year-over-year basis, net revenue growth was partially offset by higher noninterest expense. As Richard mentioned, results in the prior quarter were impacted by notable items, including a $180 million Visa gain in noninterest income and $150 million in noninterest expenses related to litigation accruals and a charitable contribution. Excluding notable items from the second quarter, net income increased by $2 million or 0.1%, reflecting total net revenue growth of 2.3%, offset by noninterest expense growth of 3.1%. Our efficiency ratio of 54.5% was in line with our guidance of 54% to 54.9%. Turning to slide 9, net interest income on a taxable-equivalent basis increased by $122 million or 4.3% compared with the prior year. Strong average earning asset growth was offset somewhat by the impact of a 6 basis point decline in the net interest margin to 2.98%. The year-over-year decline in the net interest margin primarily reflected increased funding cost, higher average cash balances, and lower rates on securities purchases partially offset by higher rates on new loans. Compared with the second quarter of 2016, taxable-equivalent net interest income increased by $47 million or 1.6%. Growth in average total loans was offset by a 4 basis point decrease in the net interest margin. The linked quarter decline in the margin primarily reflects the impact of higher cash balances which represented 3 out of the 4 basis point decline, as well as lower average rates on securities purchased, offset somewhat by the benefit of higher LIBOR rates on loans during the quarter. Slide 10 highlights trends in noninterest income which increased $119 million or 5.1% year-over-year. The increase was primarily due to growth in mortgage banking revenue, trust and investment management fees, credit and debit card revenue and merchant processing revenue. Mortgage banking revenue increased $90 million or 40.2%, supported by core growth and strong industrywide refinancing activity which drove originations and sales volume. Trust and investment management fees increased $33 million or 10%, reflecting lower money market fee waivers, growth in assets under management and improved equity markets. A $30 million or 11.2% increase in credit and debit card revenue was driven by higher transaction volumes, including the acquired portfolios. Merchant processing revenue increased $12 million or 3%. Excluding the impact of changes in foreign exchange rates, merchant processing revenue increased 5.3% from the prior year. On a linked quarter basis, noninterest income increased $73 million or 3.1%. The increase was principally due to stronger mortgage banking revenue and growth in payment services revenue. Mortgage banking revenue increased $76 million or 31.9% which slightly exceeded our previous guidance range of 20% to 30%. Growth in mortgage banking revenue was driven by higher production volumes, reflecting stronger refinancing activity. Mortgage banking revenue was also supported by a favorable change in the valuation of mortgage servicing rights net of hedging activities. Corporate payment products revenue increased by $9 million or 5.0%. And as a reminder, corporate payment products revenue is seasonally stronger in the third quarter of each year. Merchant processing revenue increased $9 million or 2.2% due to seasonally higher transaction volumes. Excluding the impact of foreign currency changes, merchant processing revenue would have increased by 3.5% sequentially. Commercial product revenue decreased by $19 million or 8.0%, primarily due to higher capital markets volume in the second quarter which in turn reflected market volatility during that quarter. Turning to slide 11, noninterest expense increased $156 million or 5.6% on a year-over-year basis. Compensation expense grew versus the prior year, primarily due to hiring decisions to support business growth and compliance programs, as well as the impact of merit increases and variable compensation tied to production. Professional services increased $12 million or 10.4%, also reflecting costs associated with compliance programs. Technology and communication expense increased $21 million or 9.5%, including the impact of capital investments and costs related to the acquired credit card portfolios. We continue our investment in our brand which is reflected in slightly higher marketing costs from a year ago. On a linked quarter basis, noninterest expense increased $89 million or 3.1%. Compensation expense increased $52 million or 4.1%, due to the impact of one additional day in the quarter and increased staffing. The $23 million increase or 5.1%, in other noninterest expense primarily reflected seasonally higher costs related to investments in tax-advantaged projects and the impact of the FDIC surcharge which began in the third quarter of 2016. Marketing and business development costs decreased $7 million or 6.4% due to the timing of various marketing programs. As Richard mentioned, we expect expenses to grow in the fourth quarter, however at a slower pace than the 3.1% growth that we recorded in the third quarter. Our current expectation is for linked quarter expenses to grow by 2.5% in the fourth quarter. This is primarily due to seasonal expenses, including tax credit amortization costs which we expect will increase on a linked quarter basis approximately $60 million during the fourth quarter. As a reminder, we realize the benefit of these tax credits in our tax rate. The linked quarter decline in preferred dividends was reflective of our fourth quarter 2015 preferred stock issuance which has a semiannual dividend payment. As a result of that issuance, we will have higher quarterly dividends in quarters 2 and 4 of every year, compared with quarters 1 and 3. Turning to slide 12, our capital position remains strong; and in the third quarter we returned 79% of our earnings to shareholders through dividends and share buybacks. We expect to remain in our targeted payout ratio of 60% to 80% going forward. Our common equity Tier 1 capital ratio, estimated using the Basel III Standardized Approach as if fully implemented at September 30, was 9.3% which is well above the 7% Basel III minimum requirement. Our tangible book value per share rose to $18.85 at September 30, representing a 9.6% increase over the same quarter of last year and a 2.1% increase over the prior quarter. I will now turn it back to Richard.

Thanks, Terry. I'm very proud of our record third quarter results. We maintained our industry-leading performance measures and we reported an 18.1% return on tangible common equity in the quarter. Our industry continues to face challenges from the low interest rate environment. However, we remain confident that we can continue to grow revenue even as we prudently manage expenses and strategically invest in our businesses to create value for both our customers and for our shareholders. That concludes our formal remarks. Andy, Terry, Bill and I would be happy to answer any of your questions.

[Operator Instructions]. Your first question is from Matt O'Connor with Deutsche Bank.

This is Ricky Dodds from Matt's team. I've got a quick question on C&I loan growth. It's a little weaker than we expected and I was wondering if you could provide us any color on what's driving the slowdown at USB?

Yes. I'll go first, Ricky and I'll turn it over to Andy. As we’ve said, I think, at our Investor Day five weeks ago, we think quarter 3 represents a pause in C&I lending, meaning that it was strong in quarter 2 and we expect it to recover in quarter 4, in part based on what we believe is the vagaries of quarter 3 where we had some of the Brexit activities moved things up into quarter 2 and perhaps some of the uncertainty around election and other things moving things into quarter 4, but we see that returning nonetheless. You'll see that we had a particularly across-the-board performance in most of the corporate space as the slowdown reflected things like higher paydowns, reduction in deal activity. And a healthy capital market condition allowed some borrowers to use the debt markets, although we also captured some of that in our capital markets activity. The rest of the lending, though, on the consumer side, remained strong and in fact got stronger as the year progresses, and we continue to see that progressing into quarter 4 as well. But for a little color around commercial and CRE, maybe we'll have Andy give you that.

So another factor was a little lower utilization rate. We were down maybe 75 basis points from 26 to 25.25 this quarter, and this is reflective of some of the things Richard talked about. Again I think the very strong debt capital markets issuance that we saw in the second quarter and early in the third quarter impacted Bank outstandings, as we talked about. And finally M&A activity which was a driver of strong growth in prior quarters, took a little bit of a pause here in the third quarter, either delayed or deferred to future quarters. So those factors all come into play and that's why we think it was more of a pause and that will come back a little bit as we [indiscernible].

I just might add, it's already October, what is it, 19th? And so we're deep into the fourth quarter, and we have a pretty good idea how the annuities look, so we can see growth certainly over quarter 3. It's how strong it gets in the next couple of weeks; we'll be able to reflect at the next conference.

Your next question is from John McDonald with Bernstein.

I wanted to ask about expenses and efficiency, Richard. Where are you on the ongoing effort to kind of improve productivity and expenses but also keep investing? Is it a goal to try to self-fund your expenses and investments with savings elsewhere? Or is it more about an efficiency ratio mindset?

Yes, so you know, John, we don't measure efficiency ratio. It becomes the result of the fraction of revenues-to-expenses. So the best way to keep it low is to do more revenue which is our number-one goal. Expense-wise, I think we've telegraphed to you all that we appreciate that the higher cost of compliance and actually some of the capital expenditures we've been making in innovation technology continued to bear down on expenses. So I will continue to let expenses grow only to the level that revenue is allowing it under the circumstances that we set forth at the Investor Day which is that we think there will be a couple of nominal rate increases in 2017. With those rate increases, we made a commitment to you all, based on what we can see today to provide slightly positive operating leverage in this environment. We also said, however, if those rates don't materialize, it will be much harder for us to do that. To give you a sense of it, without the rates, a couple of rate increases in the next year, that for us is hundreds of millions of dollars in expenses that we would need to reduce further and I think would probably cut into some of the muscle of the Company's long-term objectives for growth and innovation. So we're not going to make that commitment at this stage, but we'll watch every nickel and dime. I always find a need to pause and remind you guys, to be in the 54%s isn't, like, easy. We don't sit there and we watch every nickel and dime and we have efficiency programs all over the Company. One of the ways we've kept it low is that we continue to get better every day. We take innovation and we let technology make it more efficient for our Company and for our people and therefore better service, but it's not easy. So we do have expense programs all the time, every day and forever. Some of the companies I know that announced efficiency programs, they put names around them, they give you dollar amounts; we don't do that because it's not our style. We also don't need to. But we do watch it every single day. So we will let revenue be the dictate in most cases to how well that efficiency ratio performs. Our goal is to have it continue to be in the mid-50%s and for a while. At that point, we'll measure against a future that I think won't be starved for investment. At the same token, the minute things get better and we have every opportunity to save a dollar, we will do that very thing and give you a better return.

Just on the topic of rates, I was hoping to ask Terry if he could flesh out a little bit of the outlook on the NIM that you gave for next quarter. What are some of the puts and takes, the good guys and bad guys affecting the NIM outlook for next quarter? And if you could include there, what's your guess as to the effect that one Fed rate hike would have on your NIM in the quarter afterwards? Thanks.

Sure. Incorporated into our guidance, we're assuming that the rate hike does occur in the December time frame; and that in and of itself would have a positive impact with respect to margin, probably maybe by a basis point or so. But one of the things that we anticipate, John, is that the cash balances that we saw an increase in, in the third quarter, we think are tied to money market reform. And that is going to have an impact in terms of net interest margin at least probably through the fourth quarter. We anticipate that it's going to be transitory and that those cash balances will start to dissipate as people get more comfortable with money market reform, but when we guide that the net interest margin is going to be down a couple of basis points, the cash balances are going to have an impact on that.

And Terry, just to clarify, the one basis point NIM help, is that for the quarter that -- if it happened in December you would get that help this quarter? And would there be a carrythrough to the next quarter that's a little bigger than that?

Yes.

Yes and yes.

Your next question is from John Pancari with Evercore ISI.

Back to the loan growth topic, thanks for the color that you've given in terms of near term trends; and I hear you in terms of some of the inconsistencies around borrower demand amid the uncertainty right now. How does that play into your expectation for how you're looking at 2017? I know you don't yet have guidance and there for loan growth. But I want to get an idea if you continue to expect improvement coming out of fourth quarter through 2017 and generally expect a higher level of loan growth. Thanks.

The answer is yes. We've been in that range of 1% to 1.5% for a long, long time. Every quarter is different and yet we've found a way to pretty much stay there and I think you can count on that to be a forerunner for the future. When revenue is -- or when growth is strong in retail, it might be stressed in commercial; but this is a really well bifurcated model we have here. We like C&I, we like CRE, we like all consumer categories; but we see actually a little slightly stronger 2017 than 2016 based on nothing more than the fact that the world gets better a little bit, slowly but surely and because we're taking market share. I haven't talked about market share in a number of quarters, because I know it's a hollow category when all banks are doing well and everybody talks about it, but you know, we really are -- $28 billion in deposits in one year, the kind of loan growth we've had consistently, 10% commercial loan growth year-over-year, we're taking market share. And part of that, John, is also a proxy for next year, because we believe that market share momentum not only continues but it gets stronger. When anybody in our environment -- think of the foreign banks or think of other banks that go through any period of stress -- we get the benefit of that. And as long as we continue to be -- if we're not their first customer, we're their first choice after that particular bank they're with, that's going to be a really good way for us to grow the business. So next year it's across-the-board. We expect to be strong in virtually every category. Look at our home equity. We continue to grow home equity and it's not with smoke and mirrors. We do it the old-fashioned way with really good products and really good branch-based products coming out of the branch employees. That's something that is really quite a difference from most of the companies that we compete with. So we can do it across-the-board and we like all the categories. So I think quarter 4 will continue to be in that range. I think next year will be in that range and maybe slightly positive bias to that.

Then separately, I guess this would be a question for you as well, would be around the regulatory side. Since we've been talking about the regulatory expenses that you've been putting in the work, can you give us a related update on the BSA/AML progress and if there's any way to help us with expectations of when that could be resolved? Thanks.

Yes, sure, John. We're deep in the middle of it, so I not only don't have a projection of when we'll leave, if I had it I wouldn't tell you because of the regulators. I haven't made any agreements. So that will take a while; it will definitely be well into next year that we'll get a line of sight on when we can look for an exit of that. In the meantime, it's taken us to a compliance cost level that I had hoped to recover when we got out of the mortgage consent order which we're now long out of. But as it turns out, when the AML Consent Order came in, it's virtually replaced those same costs. So with our growth expectation of reducing expenses, we're unable to do that at this point. But it's also finding its way now into the run rate of the Company. It's also made us a better bank. I don't like Consent Orders and we only have the one and it's frustrating to me. But the fact of the matter is it's a proxy for the expectations of zero tolerance for errors and we've aligned that proxy with everything we do. It takes a little bit of time to adjust to it. It takes a little bit more money to get your first, second and third lines to do amazing levels of oversight and quality assurance. But once and when you've done that and you've put it into your run rate, both in costs and the way you do business, we'll be a better bank for it. So I would like you to think that the AML project has extended itself through the whole Company to improve our compliance capability and therefore fend off any other future areas of shortcomings. And I would say next year we'll be able to give you a better line of sight; but at this stage, we're deep in the middle of it, doing our very best job to satisfy the regulators and to overperform even to our own expectations. And at this point, I'd be hesitant to give you any kind of an exit timetable.

Your next question is from Ken Usdin with Jefferies.

I had a question on the fee side of things. Terry, you mentioned that mortgage would be down in the fourth; and you talked about into the quarter how it would have a nice leap. I'm just wondering. It looked like the gain on sale margin was quite high. I'm calculating 150. Can you walk us through the mix of refi versus purchase and what you're expecting in general for mortgage to do in the fourth quarter?

Sure. If you end up looking at the third quarter versus, for example, the second quarter, just to address your question related to the mix of refinancings, in the second quarter the mix was about 65% to 70% on the purchase side; and the rest of it was refinance, so let's say 35%. It was closer to 45% during the third quarter and we would expect that that refinancing mix will probably decline closer to 40% in the fourth quarter. So it is coming down based upon what we're seeing. You are right that when you end up looking at the mix of where a lot of that refinancing is coming from, it's coming from high-quality product, again primarily sourced -- probably a higher mix through our retail banking system. So when you end up looking at the gain on sale in that margin, we're seeing in the third quarter a better margin than what we had experienced in the past. So the growth that we saw in the third quarter is a mix of higher production as well as higher margin. So you're right on.

Can you help us triangulate that to what kind of delta? You helped us understand the 20% to 30% up in the third; does that roll back off in the fourth or is it somewhere in the middle?

Yes, I would say that it's probably somewhere in the middle, again, simply because of where the production is going to come from. When you have higher levels of production you're able to get better margins and pricing with respect to the product and therefore better margins as a result. But when we end up looking at the fourth quarter, we do expect the margin on production to be starting to taper a little bit, as well as production levels.

A second follow-up, just, Richard, you've made the point about the kind of set-your-clock-to-it seasonality. I was just wondering on the rest of fees generally, do you see just the same type of growth patterns happening as far as the ones that grow and the ones that typically don't? And just your general sense of the ex-mortgage, just fee businesses, any improvements underneath the surface there?

Yes, I'll let Andy answer that, but I want to tell you, Ken, we're a seasonally strong fourth/third quarter Company on revenue, also higher expenses in third and fourth quarter because of the CDC. But that's one of the reasons this can look like a consistent predictable outcome, but it's slightly different each time. Quarter 4 we like a lot for fees and I'll have Andy give you some color around that.

Right. The quarter 3 is the strongest quarter for corporate payments and then it tapers off a little bit. If you look at merchant and credit card issuing, I would expect a continued level of growth that you saw this quarter, the same-store sales in that 2%-plus, total revenue in that 3% to 5% like you saw this quarter. So I would see that same expectation, other than corporate payments which does tend to go down in the fourth quarter because third quarter is the strongest given the government activity. Trust fees will be a bit of a function of what the market is doing. We had a strong quarter this quarter with both strong market activity as well as good core growth. I would expect that to continue. And then Terry made reference to money market reform. We did see quite a shift in our balances also. Our primary funds went down in the neighborhood of $6 billion given money market reform; but our government bonds went up almost $9 billion. So how that settles out will also be impacted with fees here in the fourth quarter.

Your next question is from Erika Najarian with Bank of America.

Just a follow-up question on John's line of questioning, if I look at the 6% year-over-year increase in expenses in both 2Q and 3Q, Richard, could you help us break it down in terms of how much of that could be attributed to higher compliance costs and risk management costs and how much of that could be attributed to costs to invest for innovation?

Yes. The breakdown is it's both. Let's start with just year-over-year running the Company this size. Your merit increases alone, say they are 3%, 3%-plus and our total expenses are half compensation. That's 1.5% right there. Number two, I want to make it clear we're spending a lot more in our CapEx in innovation and technology. Gosh, five years ago this Company was at a $400 million, $500 million max annual investment in CapEx; this year, it's going to be between $800 million and $1 billion and our run rate is probably going to be more like $750 million to $800 million. That's good because it's appropriately -- because we're now more of a technology Company than we used to be. And given our payments leadership, we should be making those kinds of investments which of course will yield value down the line. So that's another piece of it. What's left then is the compensation costs and the overall just running the Company better and spending money on things that we didn't used to spend money on. Like quality assurance which isn't related to the compliance, that's just doing the job better. And making sure our people are paid fairly. The compensation is entire; it's employee benefits and it's the way we treat the employees and making sure that the culture itself is strong across all categories. And sometimes we have to spend money to make sure that the brand is protected, that the employees feel safe, that the work environment is good. And we're investing in all of those things, too. So compliance is a piece of it, Erika. That 6% is a number I don't want to see over the long course of time. I'd like it to come down to over a course of time more like a 3% to 5%, because I do think you have to spend money on investments. But that's a little bit high and compliance is probably the delta on that, that 1% to 2% delta that I want to bring down over time in these most current periods. So it's probably a third of it, but it's also a part that won't sustain over the course of a long period of time because once we get it right we'll get the benefits of that.

And just a follow-up question, in terms of Governor Tarullo's speech, it sounds like given that your binding constraint will be the capital conservation buffer. That shouldn't make any difference in terms of how you think about capital planning at your size or the need to scale up to your asset base in order to deal with a higher capital requirement. Am I thinking about that correctly?

Yes, so let me take a stab at it and then Andy can add to it. When you end up looking at Tarullo's comments and then the impact to U.S. Bank, we don't really see that it's going to have a significant impact to either our capital distribution plan or the requirements that we have with respect to the minimum requirement. That is because of the fact when you end up looking at the capital depletion that occurs during the stress-testing process that capital depletion for U.S. Bank, given our risk profile, is lower than the 2.5% buffer that is already incorporated into it. So we think that our minimum requirement from a regulatory perspective is going to continue to be at that 7%. We don't see that technology changing a lot. Impact to peers? Probably the smaller peers, simply because of the fact that they don't have to deal with some of the qualitative aspects I think will be net positive to them. But we don't see a big change to it. So Andy?

And because of that, Terry, our current binding constraint is the standardized ratio under the base case and it will continue to be up.

Your next question is from Marty Mosby with Vining Sparks.

You talked a little bit about the shift that was coming in because of the money market change. But deposit growth just continues to outpace loan growth. 10% over the last year for you all is just incredible at this part of the cycle. So why is this? The deposits keep flooding back into the bank balance sheets. Where is the primary source of all that coming from, because it's across-the-board for most banks?

Marty, I think one of the principal reasons and both Terry and myself referenced it -- is money market reform. We saw ourselves about a $6 billion decline, some of it going to governments. But the industry saw about $0.5 trillion move out of prime obligation or prime funds. Some of that's moved into bank balance sheets and I think some of that will move back once the investment policies and so forth are adjusted to allow for floating NAV. But that is one of the key factors. I think the other factor is some of the movement between and among banks. Again, given ratings and some of the stresses that are occurring, we're getting a lot of deposits that are flowing to us from some of the non-U.S. banks and that has also been helpful.

The other thing, when you look at the mortgage servicing, this was an interesting quarter for mortgage because you had the production go up with refis, but you also had rates trickle up at the back end of the quarter. So your valuation on servicing was actually positive as well. That happens occasionally but not typical. When you look at the about $25 million that you had positive in valuation, but you also had prepayments that were coming through, so your actual cash flow increased the other adjustments of servicing value, how do you look at the net of those two things going forward in the impact to the mortgage banking fees in fourth quarter and then into next year?

Yes, Marty, I think when we end up, at least with respect to fourth quarter -- because it's a little hard to look beyond that -- but when we end up looking at looking at the fourth quarter relative to the MSR hedge, we would expect that to taper a little bit as well. That would be another reason why we would expect the mortgage banking revenue to decline somewhat during the quarter.

But the other changes would also taper down, so that big negative you had there would be less negative as you moved into the next quarter as well.

That's fair.

Your next question is from Mike Mayo with CLSA.

First, a follow-up from Investor Day, I wasn't sure about your appetite for bank acquisitions after that day. In other words, once you get the regulatory side resolved, are you willing to look a little bit more or not?

Yes, sure. You can go back to, gosh, any of the 40 earnings calls I've had where we would remind you that we will more gladly double down in the 25 retail markets in states that we're in than to go into a new market where we would have lower pricing power and lower brand value. So think the Chicago deal a couple years ago, where we doubled down in Chicago. Think the New Mexico transaction; we moved in as number-three bank overnight. Those kind of opportunities will continue to be attractive to us. The idea of moving into a new market that we don't currently have a position in would have to be remarkably attractive and it would have to be at a pretty high market position to get our attention. So the good news is, despite the fact that we haven't got the ability to do that right now, there's nothing out there that we wish we could have had and the timing is working out pretty well. But when that opportunity is back, you can well count on us looking in-market for sizable deals that are worth disrupting the momentum of the Company -- but in markets where we're already present.

Then a separate question. Your last comment at Investor Day, maybe I can call it the Richard Davis soliloquy.

Well, I don't know. Now what? Me and the 10-year bond? What is it now?

Well, you go, look, banking has this remarkably noble opportunity to change the world; there's no other business I can think of. We don't feed people or fly people or give them medication; we get behind their possibilities. And it goes on a little bit more. And just the disconnect between that statement talking about the noble opportunity of banking and the tarnish the banking industry has now, due to some issues around cross-selling and--

Sure.

I'm just looking for some additional perspective from you. What are you doing to ensure this doesn't happen at U.S. Bancorp? And, more generally, when you do make a mistake and you say there's a guarantee, what do you do to fulfill that guarantee?

I just want to start out by saying, we've looked at this whole topic as industry and individual bank. Many years ago at a financial services roundtable, we made an effort to consider a nationwide brand reputation and rebuilding after the downturn and discovered very quickly that the American population wasn't ready for that. The bank industry sadly doesn't speak yet as one voice and even to date still doesn't. But we did agree that each of us could do a much better job of satisfying our own customers and building our own brand and eventually the totality of that would be the way to rebuild. I think, sadly, we're not where we'd like to be, but that's the way to do it. So each bank needs to stand very strongly on its own and do what's right by its customers. And if one bank falls away from that, then it's just one bank; it's not an industry. So we'll figure out a way to tell that story better. In our Company, it's where you start that matters the most in terms of sales culture. And it's not even sales culture, it's culture. Just underline the word culture. Sales practice is part of that; the way you incentivize people is part of that; the way you handle your customers. So answering your last question first, the guarantee is to always stand behind what you promise, overperform if you've made a mistake, atone and apologize, fix what's wrong and then figure out how that applies to the next possible action that could otherwise become a problem later. I've long talked about bankers going from baggage handlers to pilots in the same company. In fact, as of this morning baggage handlers now have to be more like pilots, if you follow the news out of the White House. But we believe that same thing is the case. I think as an industry we have to be much better at handling every individual transaction uniquely and honestly and genuinely. And when we make mistakes, get it right, fix it and apply it to the next things. You know me, Mike. I've been with you as long as anybody on this call and we've never even use the word cross-sell. I don't even know what the cross-sell is at this Bank. Honest to God, I've never, ever looked at that number. I would guess it's between two and four because nobody wants -- any part of their lifecycle needs more than probably two or four services at one time from a bank. But we don't measure that. We don't set quotas. What we instead do is ask our employees to make sure people know what we have so that as their lifecycle change needs and if we're their trusted partner they'll ask us for it. What that means is people buy our products; we don't sell them. As long as we have something they want and it's for services rendered and fees benefited, we'll be happy to provide that. I want to make sure it's clear, though, for this industry, selling is not bad. It's not bad anywhere, as long as you're selling to people's needs and you're making it clear what advantages you have to provide them at the time that they want them. So, yes, it's tough on the industry. But it still always go back to people love their banker, they like their bank, because they made those choices. They don't so much like the industry. We're sadly years away from getting that right. But if every bank and every banker does a better job, despite what happens on occasion in one location or another, we've got a fighting chance to bring this thing back. And I'll close the soliloquy with the fact that this has all been accomplished under a very negative economic environment. One of the reasons banks were possible 10 years ago, notwithstanding the downturn, was when times are good banks are doing more positive things. People are healthier. The economy is moving more quickly. People want us and need us and we can say yes more often. When the world gets a little bit better, we can just say yes more often; we're more popular and we're more effective. When times are tough, actually we move on to defense and we're there to protect people from things that could get them in harm's way. That's a less attractive position. People don't like to watch defensive games either, because it's low-scoring. At the end of the day, at the very end, it really does matter. So I do think it's a noble occupation. I'm very proud of what we do and very proud of the people that do it across this country. It's one of the most important things that we have in America and it's what makes us unique. And by the way, it's the only place where you can get leverage. $1 of deposits at a good bank is worth $7 in loans and that is an amazing way to grow an economy. So I'm going to still be in the camp of it will get there one day, but one bank at a time. We can control it on that basis and we're doing our best here to do that.

Your next question is from Kevin Barker with Piper Jaffray.

I just wanted to follow-up on some of the comments you made about mortgage banking. In particular, you're mentioning the increase in refi activity. I would assume that the refi activity would tend to be more retail originations versus correspondent. So you probably had a positive mix shift this quarter. Was that a dramatic impact on the number and the gain on sale margin? And going forward, do you expect that mix shift to change as well?

It was a little bit more retail. And just generally speaking, the gain on sale margins on refinancings are higher than purchases, so that was also a factor. As Terry mentioned, we would expect the refinancing component to go down in the fourth quarter as well as the overall volume. If you look at just the last few years, historically in a normal environment fourth quarter activity is down 10% to 15% because it's just fourth quarter; and new purchases particularly are down. So I would expect that same trend. And we will update you at further conferences during the quarter to give you an update what we're seeing, because it's also very dependent upon rates, particularly at that level of the yield curve which is quite an impact to activity for the fourth quarter.

We're also seeing in the servicing market the market for MSRs softening and so the yields on those assets are going up. Are you seeing an opportunity to get better margins in the correspondent market and that support your overall gain on sale margin? And are you potentially participating in the purchase of MSRs?

We're not going to participate in the purchase of MSRs. We're in the correspondent market. It depends on the geography and the type of loan. I would say some of it is very competitive in terms of pricing and some of it a little less competitive. So it depends on the mix.

Your next question is from Brian Foran with Autonomous.

Maybe on the auto business, I realize it's not a huge part of your loan book; between the loans and leases maybe 9% or so of the book. But it's been a source of growth. You outlined a couple years ago some ambitions for market share improvement which you seem to have achieved. I wonder if you could just talk about further appetite for growth both in loans and leases. And then in terms of the credit quality, you had the comment in the release about lower residual gains. The appendix does show delinquencies rising, albeit from pristine levels. Is the performance you're seeing in line with what you had penciled out when you wanted to grow this book? Or is there a deterioration happening? Or how should we think about that?

Brian, this is Andy, I'll answer those questions. First of all, the volume continues to be strong. It's a function of our dealer partnerships and the technology investments that we've made in the business. It's a good mix of lease as well as purchase. I would expect us to continue to have partnerships expand and continue to see strong growth. I'd also mention that we do not do any subprime activity in this business and we in fact have very conservative credit standards both in terms of term as well as the credit quality underneath it. So it is a high-quality portfolio and I'm very comfortable with the credit. One phenomenon that is occurring in the marketplace is residual values are coming down a bit. That's a function of dealer incentives going up which makes the comparison of new versus used favor the new. That means that the gain on sale is still positive, but might have been somewhere in the $1000 range, it's closer to $600 or $700. You'll see that phenomenon occur through our fee income category. Again I want to highlight it's still positive; it's just less positive.

Maybe one follow-up, and just to get the spirit of the question right, it's not to pin down basis points and the efficiency ratio, but just to make sure it's the right base. For 2016, it sounds like efficiency will be a little higher; the ratio will be a little higher in 4Q. And then I'm assuming we're using the adjusted 2Q number. So as we think about slightly positive operating leverage with a couple rate hikes or maybe flat without, is the base 55%? Basically 55%?

Okay, so you are trying to get the basis points. Look, this year it's going to look back, it's going to be in the mid-54%s. If we can deliver positive operating leverage -- and I said slightly -- then it stays in the mid-54%s. If we're unable to do that, it floats into 55%. Doesn't go above the mid-50%s and it doesn't go down to 51%. Until the world starts to give us a more robust both interest rate trajectory, mostly a steeper yield curve and/or just a stronger economy -- pick any of the three and pick all of the three -- things start to take off. So I'm going to say it as just much -- and expense is much of what you see this year, it's much of what you'll see next year. It's not going to move a lot one way or the other for better or for worse. But I will tell you it's the revenue that we're going to try to hope we can pull down even further into in 2017 and keep growing this thing like we do every year. We had record EPS this year. It's not just because we had a decent buyback but because we have good underlying loan quality and good underwriting and really decent revenue. So we're going to keep delivering that, Brian. And I would just expect it to be fairly consistent with what you see this year.

Your next question is from Matt Burnell with Wells Fargo.

It's actually Jason Harbes on Matt's team. Most of my questions have been asked and answered, but maybe I'll just ask a question on the card business. You've seen really nice momentum there this year. It looks like a lot of that is on the back of a Fidelity portfolio acquisition late last year. One thing that caught my eye was the net charge-off ratio was unusually low both sequentially and year-over-year. Is that primarily a function of the higher quality of that Fidelity book? Because I'm looking at the reported level compared to your normalized through-the-cycle target of 4.65% and it's quite a bit below. So just any comments around how your credit card business is going would be much appreciated.

This is Andy again. Yes, that is the key difference; the Fidelity portfolio is slightly higher quality. Our card portfolio is very high quality, but the downturn that you see in that charge-off level of delinquencies is a function of the higher-quality Fidelity portfolio.

Maybe just a bigger-picture question on the expense outlook for next year, this year it looks like you're going to come in a bit above the 3% to 5% target. A lot of that seems like it's related to some of the remediation activities that you are undertaking. But as we think about 2017, would it be realistic to think you might actually come in more towards the low end, as those costs or issues are resolved?

Yes, Jason, one of the things that we've talked about when you think about the compliance programs -- and it ties into some of the things that Richard talked about with respect to AML and BSA -- we'll continue to work on that probably through next year. Last quarter we said that the compliance costs were peaking in the second quarter, but we also said that we really don't see them declining significantly, at least not through 2017. In other words, I would think about it more as it's kind of plateauing and it's going to stay at that level at least for some period of time until we get through some of these compliance issues. So if you're thinking about the 2017 time frame, that's the way that I would think about it.

Your final question is from Nancy Bush with NAB Research.

Good morning, Richard. How are you?

I'm good. I was wondering where you were.

Still here in Georgia.

Well, you were on the Morgan Stanley call; I know you love them more.

Yes. Yes, you could have brought up the -- you opened the door with mentioning election and Brexit and some other things. But I'm just more curious about your view of the regulatory scene right now. It seems everybody is focusing on Tarullo's latest speech or what a Fed governor is saying and we're losing sight of the forest for the trees. So can you just give me your impression of the overall regulatory scene? And do you expect it to change markedly one way or the other depending on the outcome of the election?

First of all, I think -- and I said this at our Investor Day. I think if we're a nine-inning game, we're probably in the eighth inning. We know most of the conditions. We know the condition on the field. We know the umpires. We know the fan attitude. We know the weather. We know the ball speed. There's not a lot here new. And there will be some adjustments to the election, but as you know, most of these positions are not tied directly to the election or directly to the President's term. They have different term timetables; and think the FDIC and the OCC to name two. So I think the philosophies and the general sense of what regulation looks like for banks is pretty well set. I think we understand most of those rules and what we're dealing with now is nuances, why certain speeches make so much attention, because we're trying to read tea leaves and figure out if they changed anything systemic. I don't think there's anything major to change. I also think a new President which is undoubtedly going to happen, has a slight variation one way or the other. I won't talk about which one I think does which, but one gets a little more uncertain and causes us to stand back a little bit and wait to see how things settle. The other one is a lot more of the same and probably, whether we like it or not, is something we can manage because it's the devil we know. Either way, I don't see any circumstances where bank regulation gets easier or lightens. I don't see a significant place where it gets any tougher or gets a lot stronger. I do think there's going to be a need for us to particularly respond to this current issue on culture and doing the right thing and that makes sense to me and that's a place that we'll welcome that oversight. In fact, maybe to the earlier question, if banks are proven for the most part to be doing really the right things the right way, that might be a very positive catalyst for the American people. Because they now know that we're stronger; they know we're safer. They don't know that we intend to be good with that. And if we can prove that over the course of the next couple years, especially as the economy might get better at the same time, I think we're in a pretty good place. But for this bank, there's not a lot -- we don't spend a lot of energy trying to figure out what's going to happen next. We have relationship with regulators both local and national that we know and trust. And for us it's part of doing business and I think it's a normal course of running the bank. We don't fret about it and we don't try to predict anything.

Well, on this issue of culture, how do you see that coming to the fore? Is that going to become a special -- does that get built into the DFAST? How do you see that happening?

Yes, that's a good question. That's too early to know. I do know and I believe it's known, that the OCC is conducting a horizontal review, first and foremost starting immediately on unauthorized new accounts. They are doing that horizontally. I don't know how far it's going but it's the first of -- look at more things like incentive practices and then will be, I think, eventually culture. We're thinking of it as culture and we always have from the very beginning. But I think, Nancy, that will find its way probably through more likely the OCC under the doctrine that they have as they oversee the banks. And then the Fed for the Fed banks will find their own way to approach it. I don't necessarily see it going into a CCAR stress test environment at this early stage. I see it being more of a pattern and practice for the CAMEL ratings and the overall valuation of management and board oversight. So for me I think it's just another nuance and we keep getting different things. It's a spotlight on a stage, right? Everything is on the stage, but you can only see the stuff the spotlight is on. It's just going to move across and now find something in the form of culture. I think we're all going to need to put better words around what we do. I think we're going to have to prove what we do. And I think we're going to have to show sustainability to good practices and that does require us to do a lot more record-keeping, a lot more auditing, a lot more quality assurance. I would say it's actually a pretty good thing, because most banks do it very, very well. And I think we're going to find out that that's an area of strength that we can showcase, that banks haven't been able to really put their finger on until now. Unfortunately, it takes a blemish to bring out the issues, but I think you'll be -- the American people will be quite pleased with what they find.

Okay. One other regulatory issue, the fact that the EU seems to be backing away from Basel, do you think that will change anything? Does that make any difference? Do we not go to Basel IV? What do you think the impact of that is?

I don't predict that one as well, because I do think this one does matter a lot in who's in a position. I think Dan Tarullo's been our best guiding voice on this particular topic, both on what volatile means to the United States banks and what it means in relationship to the global circumstances. As long as he's in position I don't think it goes away and I think he continues to argue the position that America's banks need to be at the highest, best, strongest, position first and foremost -- but in an environment where all the banks have to account for the same general level of oversight. If Dan were to change positions, I think that will have a meaningful impact on whether or not the position of the domestic banks in relation to the international banks remains the same or not. But I think there's a general sense across the world that everyone wants all the banks to be stronger. They're looking for a governing doctrine. Basel seems to be the one that allows everybody to think most banks across the world have generally the same minimum oversight; and we're all getting there at different speeds. So I think it's probably still the best proxy and I don't think it changes greatly. I think the verbiage of a speech or a general sentiment that things aren't going to be adopted or things are going to be changed is just that, it's a small nuance. I think we're all going to stay within the confines of a general Basel oversight created out of the institutions across the country that have a voice and then America being probably the loudest.

I will now turn the call back over for closing remarks.

Thank you for listening to this review of our third quarter results. Please contact us if you have any follow-up questions.

Thanks, everybody.