U.S. Bancorp (USB) CEO Andy Cecere Presents at Bernstein Strategic Decisions Conference (Transcript)

U.S. Bancorp (NYSE:USB) Bernstein Strategic Decisions Conference May 28, 2020 1:00 PM ET

Company Participants

Andy Cecere - Chief Executive Officer

Terry Dolan - Chief Financial Officer

Conference Call Participants

John McDonald - Autonomous

John McDonald

Great. Good afternoon everyone. We're very happy to have U.S. Bancorp up next. Joining us today is Andy Cecere, CEO; along with Terry Dolan, Chief Financial Officer. A few housekeeping reminders, please participate in our Q&A via pigeon hole. [Operator Instructions]

So, with that, thank you both Andy and Terry for joining us today and being consistent supporters of the conference.

Andy Cecere

Thanks John.

Question-and-Answer Session

Q - John McDonald

Andy -- I thought we'd open up Andy with kind of a big picture question. U.S. Bank was well-positioned going into the great financial crisis both to its PPNR generation and a conservative credit culture. How do you feel today about how the bank enters challenging times as we go into this kind of COVID pandemic situation?

Andy Cecere

Great. Thanks John and thanks for hosting this conference in this very different way but I think it's highly effective and it's certainly timely. You're right. If you think about the last crisis 2009 through 2011 or so, I think we came out of that actually stronger than we went in. And that's for a couple of reasons that still exist.

We -- the financial discipline that we have our strong credit culture and certainly our mix of business is a key component of that. We have this great diversity of businesses that earn revenue from the balance sheet as well as fees and that combination of those businesses really are important at times that are challenging like they are today.

So, I would say as we come back now to today 10 years later, those three strengths still exist, but we have a couple of other things too. Number one, certainly from an industry standpoint and I'm sure you've heard this from others banks are much better positioned and really in a position to help customers both consumer as well as commercial, stronger capital, stronger liquidity, and I think that's true across the board.

U.S. Bank specifically as you know we spent the last many years building out our compliance and risk management systems. So, I think those are even stronger than they were they're more efficient, they're more effective, and they're more technology-driven. And probably the most important change is our digital capabilities.

So, if you think about 10 years ago, we did not have any of the digital capabilities we have had through this crisis. And even the last two years what we built is so important as customer behaviors have changed. They want to interact with the bank has changed. How we communicate.

So, those digital capabilities are also important. Really right now that offer a huge opportunity to connect in different ways. So, I talk about that business mix. It's a challenging time for margin as well as payments, but our mortgage business, our capital markets business is probably as strong as it's ever been. So, having that diversity of revenue is really important to help us navigate and I'm confident we'll get through this as well.

John McDonald

Great. Well, that's a good overview. Let's dig in a bit. We've got a lot going on in the industry. So, let's dive into some of the trends that you're seeing. On the commercial side Andy there's really three major unusual items going on right now. I think that are occupying banks time and their balance sheet. So, let's discuss what you're seeing in terms of PPP, line draws, and then maybe the Fed's main street funds as that starts getting started off?

Andy Cecere

Sounds good. I'll start with PPP and I'm going to ask Terry then to talk about the others. So, from a PPP perspective, John, it's been a terrific team effort across the bank. We've done about $7 billion in loan activity, about 88,000 loans. Our average loan size is about just under $80,000. So, it's been a great team effort.

We continue to see activity. We're getting about 1,000 apps a day to continue to flow through our process. Industries that we're serving include; restaurants, small businesses, salons, real-estate agents and the like. And it is across our entire footprint principally customers, but also a number of non customers. So it's been a very successful program. And what we're waiting for now is additional clarity on the forgiveness and pre-payment rules, which I'm sure will come in the next few days if not weeks. And then Terry, maybe you can talk about some of the trends we're seeing?

Terry Dolan

Yes. So maybe the last question around the Main Street Lending Program. You know, that is very much in the early stages. We spent a lot of time being ready to be able to handle that in whichever way our customers need us to be able to work with them. So --we're up and ready as that program rolls out.

With respect to trends as we talked about at the end of the first quarter, we saw some significant line draws about $22 billion in the last 15 days that occurred in the first quarter. And in early April, we continued to see some line draws and the pace of it slowed pretty significantly as we got further into April. And today with the capital markets opening up, we are now starting to see many of those customers starting to pay down those lines. Most of those lines were really defensive in nature high-quality investment grade. They were really drawing down in order to be able to support the commercial paper business or their commercial paper issuance and all sorts of things.

The other thing, I think, we're seeing with that is strength with respect to the capital markets business, which I know Andy mentioned a little bit, but a lot of that liquidity being -- or the line draws was being put back into their deposit accounts. So we saw the line draws, but we also saw some significant deposit inflows during that time frame.

John McDonald

Terry, any sizing of the paydowns you saw? Yesterday we had Bank of America say about half of the draws from the first quarter had paid down already. Any perspective on relative sizing there?

Terry Dolan

Yes. For us it hasn't been quite that strong. It's probably in that 30% range. And it really kind of peaked I would say toward the latter half of April.

John McDonald

How about kind of the everyday normal course of business? What would you say the sentiment of the commercial customers is? And what kind of trends are you seeing in terms of maybe what you call normal loan demand if there is on that front?

Terry Dolan

Yes. So I would -- generally if you kind of look at customer sentiment, it really kind of depends upon the industry that Corporate America is dealing with. So there are -- as we know there are some significant impacts with respect to the airline industry travel, hospitality those sorts of things. And I think they're adapting. They're starting to make changes to their business model and operations in order to be able to get back and get their business kind of up and running again, but they're still very much in the early stages.

You know, there are some industries that are doing very well. I mean if you think about the grocery food industry, utilities all sorts of things that you would expect to do reasonably well in this sort of, environment. I think are generally pretty optimistic in what they are seeing happening within their particular businesses. And when you end up looking at just kind of loan growth the -- I think when we look at the second quarter I think we're going to see nice loan growth that's going to occur. Part of it is going to be driven by the PPP program. Part of it is going to be driven by the line draws that we saw early in the quarter. And then some of it is just natural in some of those industries that we've been talking about.

John McDonald

Okay. Let's switch over to the consumer side a bit. What are you seeing in terms of consumer forbearance and trends? Maybe give us a sense of deferral activity size and whether it's slowed a bit.

Andy Cecere

So I'll take that one John. So on the consumer side, about 7% to 7.5% of our mortgage activity in installment loans are in forbearance, between 1.5% and 2% of our card activity and about 11% is small business. And I will say that the forbearance particularly in the mortgage side has slowed significantly. So a lot of that came on mid-April through the early part of May. The last few weeks it slowed up here a bit.

What's also interesting is about 30% of those customers, although they're in forbearance, they're still actively paying on their loans. So they sought the – they seek the forbearance activity but then they're still paying. So – but it's stabilized a fair bit in the last few weeks

John McDonald

What about cards as well? Has that slowed Andy, maybe not as much as mortgage but also slowed?

Andy Cecere

It's slow but not as much as mortgage just exactly right. So again about 1.5%, 2% and slowing but still a little higher than the mortgage activity

John McDonald

And what have you guys been doing in terms of tightening of credit standards and underwriting practices just as we go through uncertain times here?

Andy Cecere

Yes. We've always been a prime and super prime lender. So we made a couple of small adjustments around the edges but one of the benefits of being in that consistent sort of box you don't have to change a lot because we're always focused on the highest credit quality. So a few tweaks around the edge has been nothing major.

John McDonald

And what kind of trends in consumer lending balances have you're seeing? We'll talk about payments later but I assume the card balances is slowed. We've seen paydowns in ATM [ph], a card following the payments down. And maybe you could also comment in terms of other consumer products like mortgage and auto for you.

Andy Cecere

Yes, it has slowed a bit. As you said, the card spend is down, therefore balances are down. Auto is also slowing a bit some of the turbulent you're seen in the auto industry for a while there. There were actually very few sales activity occurring because of the dealers closes those down.

So those have started to come back a bit and there's some stability we're seeing even on the ones that are coming off-lease in terms of auction activity has stabilized a fair bit. And then home equity has always been relatively slow. We're continuing to book home equity but it's not material at all. And mortgage is strong. The mortgage activity both on and off-balance sheet is as strong as it's ever been.

John McDonald

Terry, maybe I can ask...

Terry Dolan

I was just going to add on the credit card side, the consumer spend being lower is obviously impacting those balances but the revolve rate is offsetting that to some extent and it should help in terms of net interest income. So when we think about that for the second quarter. That will be a little bit of an offset to what Andy talked about.

John McDonald

Terry maybe we can shift to that net interest income discussion, just maybe broadly, how you think about managing interest rate exposure in this challenging low-rate environment? And then maybe you could give us some thoughts about the NII trajectory a lot of moving parts with PPP and other things going on? So you could talk to some of those puts and takes

Terry Dolan

Yes. There are a number of puts and takes. And as we're kind of in this environment we certainly believe that this is kind of a low-rate environment for a longer sort of time frame. And of course, the yield curve has flattened. It's come up a little bit on the 10-year treasury. But generally, it's pretty flat.

Usually in that environment, you start to see banks become more asset sensitive just because of the mix of their business, et cetera. And that's happening to us as well. The – I think the challenges are when you think about net interest margin in particular, we're maintaining a lot of liquidity on the balance sheet.

Recently we've been kind of targeting that $40 billion range. And that's going to have an impact with respect to net interest margin. But in terms of how we end up kind of managing through and some of the things that are going to drive net interest income is just loan growth that's on the balance sheet continuing to work deposit prices down as we think about the current environment with a lot of excess deposits.

And then to the extent that we have that liquidity from the deposit inflows, working the investment portfolio and maybe more of a little bit of a barbell-shape sort of an environment or a structure in order to be able to get some yields while continuing to maintain that liquidity. So those are different things that we're certainly looking at and doing.

When we think about the second quarter in terms of net interest income, we believe that it's going to be relatively stable to the first quarter. And that is kind of a function of the loan growth that we saw at the end of the first quarter and continuing into the second quarter being offset by margin compression, that's going to take place in the second quarter. That's going to happen across the industry.

And the big drivers behind that really relate to the yield curve. And what has happened, a lot of the change in the yield curve was happening later in the first quarter. So, you're going to see the full effect of that in the second quarter, and then we've been maintaining a lot of liquidity.

It's likely that the net interest margin for us, just because of maintaining higher levels of liquidity, is going to be in that 15 basis point sort of range. So while net interest margin is going to be down fairly significantly, I think, in the second quarter, it's going to be offset by the low the loan growth that we experienced and net interest income should be relatively stable in the first quarter.

John McDonald

Okay. That's helpful. And the PPP dynamics, do you expect that to play out over the next few quarters, second, third quarter predominantly?

Terry Dolan

Yeah. I mean it will be principally I think in the third quarter and the fourth quarter in terms of the impact of it. A lot of that came on the balance sheet throughout the second quarter. So, there's going to be a little bit of a benefit in terms of net interest income, that's going to happen in the second quarter, maybe a little bit of compression related to net interest margin. So I think in the second quarter, it's kind of there's puts and takes associated with it, but more of the benefit occurring in the third, fourth quarter.

John McDonald

And I know you don't look out too far in terms of predicting net interest income. But as you just think about the balance of this year and into next year, if we have a flat rate environment continuing, low flat environment continuing. Do you hope you can grow net interest income with the balance sheet? And kind of the rate effects start to neutralize and the comps get easier. Is that the low?

Terry Dolan

Yeah. I mean the expectation that we have as we kind of look out into the second half of the year is that net interest margin will be relatively flat to the second quarter. So you're going to see the compression in the second quarter, net at being relatively flat from there.

So the growth in net interest income is going to be driven by the balance sheet growth in terms of earning assets whether that's in the investment portfolio or loans during the third fourth quarter. That's kind of how we're thinking about it and how we're modeling it and forecasting at this particular point in time.

John McDonald

Okay. Understood, that's helpful. Maybe shift gears, we could talk about payments, give us an update on volume trends and whether you're seeing some improvement in May relative to what we're seeing in late March and early April when you last spoke on the first quarter earnings call?

Andy Cecere

Yeah. I'll start and then I'm going to ask Terry maybe to give some details. So John, you referred to the first quarter earnings call. At that time, we thought merchant was going to be down about 50% to 60% in the second quarter and extend through most of the year. We thought commercial payments would be down 25% to 30%, and card retail payments down 30% to 40%.

I'll tell you at the highest level, things are better in the second quarter than we thought, and continue improving in the month of May. So I think basically the spend activity is starting to increase as people are starting to open up again. And maybe Terry, you can give some of the specifics and details.

Terry Dolan

Yes. So let me break it down by the various areas within the payment space. So merchant processing at the end of the first quarter, as Andy said we saw the consumer spend down 50% to 60% kind of in that range. That -- and especially in particular industries that's kind of come back nicely. Today in May, the decline on a year-over-year basis is in that 30% to 35%, 40% range.

So we've seen a little bit of improvement. And as we think about the second half of the year, we would expect that to continue to improve as stay at home orders subside and states start to open up and people have the opportunity to be able to go and spend.

On the retail payments side of the equation, I really want to break that down between two different components. First is on the debit card side of the equation. At the end of the first quarter, debit card spend was down 20% to 30%. But if you end up looking at where it is today, it is really flat to up about 5%. So we've seen a nice recovery with respect to debit spend.

It's on the credit -- that's on the credit card side of the equation in terms of the spend, again that was down kind of in that 30% to 40%. Today it's a little stronger roughly 18% to 20% down on a year-over-year basis. So it's rebounded a bit. And as we think about the second half of the year, we expect it to be to continue to strengthen again as people start to normalize in the -- with respect to the stay at home orders and the states opening up.

So I think there's good trends as we second quarter being better than what we had expected. And as we think about third and fourth quarter the trend has been positive.

John McDonald

Great. And just to clarify Terry when you say today is that kind of May those updates on the -- credit month of May?

Terry Dolan

It's really the first -- last two or three weeks of May that sort of time frame as you're starting to see states open up.

John McDonald

Yes. You took some expenses for the future delivery risk. You called it in merchant in the first quarter. Do these improving trends make you feel good about what you took and maybe you took too much there? Or any color you could provide there?

Terry Dolan

Yes. The charge that we ended up taking is really building a reserve related to future delivery. And just -- if you kind of step back really what that represents the bulk of that is in the airline industry. Where they have from -- in terms of their sales and their cash flows and future tickets has really subsided and they're not flying.

And so, the customers are not able to use those flights. And so, the merchant acquirer is always kind of what I would say the last backstop from a consumer standpoint to the extent that the consumer is not able to recover it from the airline.

Real risk though John is, if the airline is not flying anymore on a permanent basis when they start to open up and they start to fly, the exposure that we have will start to come down. And that's fully our expectation. So as they go into bankruptcy or whatever might be the case, that's really not as big of an issue or a risk because in bankruptcy as long as they're flying, it's helpful.

When we think about the second quarter, I believe that we'll continue to build that reserve a bit, but it will be significantly less than what we had to build in the first quarter. And we'll feel by the end of the second quarter we will have ring-fenced that exposure pretty well.

John McDonald

Okay.

Terry Dolan

The other component that we talked about with respect to expenses that we talked about was just some of the other COVID related costs. And so if you think about premium pay that we implemented for our employees that are frontline, as well as things like PPE and just technology costs in terms of being able to get people to be able to work from home that is -- we took some expense in the first quarter. That's likely to be a little bit larger in the second quarter, but then that will pretty much dissipate when we get into third and fourth quarter. So we really feel like second quarter is kind of the high-water mark associated with those other COVID related costs.

John McDonald

Those are about $100 million in the first quarter?

Andy Cecere

Yes.

Terry Dolan

Well, the total COVID related cost was about $100 million in the first quarter of which about $80 million of it was related to the future delivery liability that we established. And again, that future delivery charge will come down pretty significantly in the second quarter. And then we feel like we've ring-fenced.

What is likely to go up a little bit is the premium pace simply, because we implemented it in March and it will be really in place for the entire quarter, most of the quarter in second quarter. That's the reason.

John McDonald

Okay. So back to payments more strategic. You've done some acquisitions in the merchant processing side talech and Sage Pay. How are those helping USB increase its share of online processing, which is really important obviously with e-commerce continuing to grow rapidly?

Andy Cecere

So John, both of those are very focused exactly on e-commerce omni-channel, talech and small business. And it's exactly what is important in this environment right now. So glad we made those acquisitions. We're trying to really encompass them into our overall product offering, doing a great job on that. And right now we're sitting at about -- just about 30% of our activity in merchant is e-commerce-related activities.

John McDonald

And is that improved at all? I mean, it's been early on the acquisitions, but any traction there? Is that helping?

Andy Cecere

Yes, the acquisitions were really the last two pieces, but we've been investing in e-commerce capabilities for a couple of years. So that it's been a steady line improvement and we would continue to expect it to move in that direction particularly in this new environment where digital is all the more important, as you think about the way we interact and the way spend occurs.

John McDonald

Do you know where that number was a couple of years ago, Andy, just to kind of get a sense of?

Andy Cecere

It was -- if it's 30% today, it was a few years ago, it was below 10%.

John McDonald

Okay. Terry, any other comments, you talked about payments what about other fee businesses. You've already mentioned capital markets and mortgage. Any more detail in terms of other fee businesses or details you wanted to share on those two-line items?

Terry Dolan

Yes. Generally, the other fee categories, I think are going to be relatively stable. They're not quite as impacted by some of the consumer spend issues that we see in the payment space, et cetera.

I do think that with some of our relief programs related to customers, the deposit service charges might have a little bit of pressure, but I don't think it's anything that's really significant. And then the mortgage banking business both, because of the investment that we have made, the digital capabilities just the level of refinancing. We're able to handle the capacity that the incremental volume has kind of thrown at us, and we've been able to deal with that very well. And I think the second quarter is going to be another strong quarter with respect to the mortgage business.

And then on the fixed income side of the equation, again, I think, it's going to be a really nice strong quarter for us. Things opened up pretty early in April and it's been going gangbusters. We've had a lot of a lot of bond issuance that has been taking place in the capital markets space. And a lot of that is on the investment-grade side of the equation, which is one of our sweet spot. So we feel pretty good about that too.

John McDonald

That's still a relatively small piece of your overall fee income, but growing? The fixed income?

Terry Dolan

Yes, the fixed -- yes, absolutely, the fixed income I want to say it's around $300 million, $400 million today in terms of the fixed income business, but it's been a business that's been very nice. It's one of those businesses that we ended up getting into during the last crisis. One of the reasons for that is it enables us to be able to complement our large corporate and our commercial banking customers that want to be able to access the capital markets.

And when you're seeing pay-downs occurring on the loan side of the equation we're able to offset some of that revenue pressure through the fixed income side of the equation.

So, I think that that's -- it's been a great business for us. It's growing well. And the second quarter is going to be a nice quarter for them.

John McDonald

Okay. Andy maybe you could talk a little bit about how you're thinking about managing expenses in this kind of environment both near-term and as you think about your investments over the next year or two?

Andy Cecere

Right. So, first of all, given the revenue that the industry is facing as well as U.S. Bancorp, we're being very prudent around expenses. Some of the basic blocking and tackling like T&E and activities that can reduce spend we've done that. We put that in place.

I think importantly a lot of the digital investments we've made are starting to pay dividends right now. And if you think about customer behavior changes so we saw a significant increase in digital transaction offset by a significant decrease in volumes of digital -- of transaction activity in the branch and the same with sales.

Sales are down significantly in the branch, but up a lot in terms of what's occurring from a digital fashion. So, you have anywhere between 17% to 35% increases in digital activity occurring that used to occur in the branch. And all of that saves expense and we're going to continue to invest in that. It's also a function of what's happening in terms of consumer behaviors to the extent they can do it in a digital fashion in their own home; we're going to choose to do that.

So, those investments not only pay off in terms of customer interaction and acquisition, but in terms of expenses. So, John about a year and a half ago, two years ago, we talked about targeting 10% to 15% closure of our branch footprint to our locations. And I would expect we would accelerate and probably do more of that given the behavior changes have occurred and those digital investments that we've made.

John McDonald

Any sense Andy that you'd want to share about how that all kind of nets out this year between extra COVID expenses? Some more culling that you can do in terms of how we should think about expenses relative to last year or a growth rate or anything like that for us to help in the modeling?

Andy Cecere

Well, excluding some of those COVID expenses that we talked about that Terry articulated both the merchant reserve which again is going to come down. We're really focusing on match expenses very tightly sort of in that flattish range and that's our focus.

John McDonald

Okay, great. Well, 27 minutes we haven't talked about credit quality yet. So, I guess we should over to that. There's a few questions out there investors have. Maybe from a high-level perspective, what's the challenge of operating with the new CECL accounting framework?

At the same time, you've got a shifting economic environment and you've got a lot of forbearance that is changing the dynamics around what you'd usually measure on delinquencies and NPAs. Maybe just talk about that and how you're managing those dynamics?

Terry Dolan

John I'll take that and then Andy can add to it. But you're spot on in the sense that there is a lot of uncertainty and there's a lot of difficulty in terms of being able to forecast out what the impact of the COVID environment is going to be both in terms of the depth of the unemployment as an example or the change that we would see in unemployment but also how long in duration with respect to COVID, how quickly businesses get back to work, et cetera. So, there's just a lot of things that you're trying to take into the calculus when you go through that. At the end of the first quarter, there was – it was developing pretty rapidly. And when you end up thinking about, how much the expectations around unemployment have changed between the end of March and even today and it's been pretty significant.

When we were looking at the reserving in the first quarter, we kind of had expected unemployment to be kind of in the high-single digits. And clearly, as we get into the second quarter it's going to be in the mid to high teens for the second quarter. And then where it goes from there is kind of hard to know.

And then you throw in the – what sort of benefit are you going to get in terms of the stimulus packages? When does that start to take effect? And how long does that last? And so you can imagine, there's just a lot of different moving parts with respect to how you come up with the estimate associated with. And that's what creates the difficulty associated with it.

When we think about the – maybe at a broad level, fundamentally it comes down to what sort of economic losses you have. CECL is the accounting aspect with respect to trying to understand that. And it tends to front-end load it, but it's – what sort of economic losses do you actually experience? And we feel like, we're in a good a relative position in the industry as we can be. I mean, we are prime super prime sort of lender.

On the consumer side of the equation our corporate business is generally investment grade, high investment-grade sort of customers and that sort of thing. So, when you end up looking at, whether it's on the consumer or on the commercial or corporate side of the equation, we feel like we're going to perform very well in terms of actual losses that end up taking place.

When we think about the second quarter, which I know people are trying to understand, clearly, our expectation is that unemployment is going to be pretty significant in the second quarter and then starting to dissipate or moderate as we go through the rest of the year and into 2021.

So our expectation is that, the reserve builds in the second quarter by the industry as well as U.S. Bank is going to be pretty significant. And then where it goes from there, I do think at least right now based upon our modeling that that's kind of the high watermark. But some of those other uncertainties that I talked about in terms of the duration how long it takes for unemployment to start coming down, stimulus impacts et cetera is going to influence whether or not there are – there's more reserve builds in the third and fourth quarter. But that's kind of hard to know at this particular point in time. We have a little bit of a wait and see. Andy, what would you add to that from a credit perspective?

Andy Cecere

I think that's right. It is a – it's a scenario, where you have to plan a number of different scenarios, determine the probabilities across those scenarios and then come up with an answer. And that answer can vary quite a bit. But I do think as we sit here today versus where we were on March 31st, I think for us and for I think most the expectation is unemployment is going to be a little higher than we thought two months ago. And the extent to the duration of the recovery will take a little longer. And those two things will drive to additional reserve build.

John McDonald

Yeah. Some banks have spoke this week have pointed to the first quarter reserve build as a guide for the ballpark of where the second quarter ends up. Is it too early for that? I mean, on one hand I look at what you guys did you had a very conservative looking CECL day one. And then the second quarter maybe came in a little lighter on the provision but your overall reserves look good relative to peers. Is there a benchmark we can point to the CECL day one or your second quarter reserve build that you're thinking of as a ballpark? Too early? Any thoughts there you can give?

Andy Cecere

Yeah. Well, it's a little bit too early. But again, if you just look at unemployment and unemployment is a big driver of actual economic losses that you experience. If we – if the industry, for example, was assuming 8% to 9% unemployment at the end of the first quarter and it's going to be in that 15% to 17% or that mid to high teens. You should expect that the reserve builds in the second quarter is going to be kind of a magnitude of that.

And of course, again the challenge with CECL is that everybody makes different assumptions about every one of the factors that I just talked about. So -- but to me that is kind of one way of thinking about what the second quarter is going to look like relative to the first at least for us.

John McDonald

Okay. And in terms of the kind of, heavily COVID -- you gave some disclosure on your first quarter earnings of your exposure to those sectors. Anything you're seeing surprises you? Industries that show more stress than you thought or less than you might have expected? In terms of commercial credit?

Terry Dolan

Yes. Yes. I mean, obviously, on the commercial side of the equation at the end of the first quarter we talked about higher risk or at risk sort of industries. And that represented about 10% to 11% of the overall portfolio. So in terms of the size of those at risk industries, we feel like it's manageable as we go through this particular cycle. And then when you think about the investment-grade quality of those particular customers we don't do a lot of leverage lending and never have. If you think about our commercial real estate portfolio for the last two or three years we've been talking about the fact that we have been downsizing and being very prudent with respect to underwriting.

So we -- while there's going to be stress with respect to commercial real estate I think, on a relative basis we feel like we're in a pretty good position as it relates to commercial real estate lending as well. I don't think that there's any areas or industries that we have been surprised by. I think we now need to kind of see how it plays out relative to those industries being able to get back to business.

And I think one of the things that's been interesting to watch is that businesses are being very creative in terms of how they are adapting to this environment whether it's work from home or whether it's using plexiglass to create barriers between their customers and them in terms of sales and all sorts of things. So -- but we do need to see it kind of play out a bit. Andy anything that you would add to that?

Andy Cecere

I think that's right. The only thing that surprises. Commercial we meet on credit every week as you might imagine. Commercial real estate is actually holding up better than I would have thought. You know, it might be a little early in the process thus far. But it's holding up a little bit better than what I thought personally, but I think it's -- it will come as we expected over time.

John McDonald

Okay. Let's shift gears again and talk about capital and dividends and maybe a little bit on M&A. Andy just when you think about DFAST, CCAR coming up in a couple of weeks. Do you have a sense of how the Fed will be adding a COVID overlay and kind of testing for the current environment in addition to the scenarios that you previously laid out?

Andy Cecere

I don't have a clear sense of it. But, I think we're all waiting for exactly what the outcome will be John. But my understanding is there will be a COVID overlay that will impact the ultimate results and the ratio is how and what it is? I don't know. I don't know. What I do know is that under our modeling and we've talked about the different scenarios.

One thing I will tell you, Terry and his team have been running a number of different scenarios because as you can imagine, I don't think are things changing quickly, but they're also changing dramatically. So we're running bookends to make sure we understand what potential is.

And under those scenarios given our -- if you think about last year over $10 billion of PPNR in the first quarter a run rate of about $10 billion, we generate a lot of profits as we talked about that business mix. We ended the quarter -- first quarter at 9% CET1 as we talked about our capital ratio targets between 8.5% and 9%. So under the scenarios that we've developed, we continue to believe that we have the earnings power and the capital ratio to continue to pay the dividend at current level even under some of those very stressful scenarios.

John McDonald

And do you see any risk if the Fed requires some banks or all banks to do it from a messaging standpoint or incongruous with the banks are strong messaging. Would you worry about that?

Andy Cecere

I do think banks are strong. And one of the great things the Fed has done over the years together with the banks has developed a good process. And we have -- the CCAR is a good process. It develops a stressful scenario. It says, can you survive in that scenario? Can you continue to distribute capital? And it's worked. And it's worked not only from the extent of the paying capital, but building capital across the industry. So my hope is that we continue to utilize that process that we've built. Overlays may occur to inform us and I think that's appropriate given this environment. But I think we should let the process work, which is why I think we're doing.

John McDonald

Okay. In terms of other...

Terry Dolan

And John, I was just going to say as a reminder, we've gone through many stress tests on years. And because of our business mix, because of the diversification that we have, our PPNR has performed very well even under stressful environments. And part of that is what we're seeing play out in this particular situation. But our credit losses that might deplete capital through the stress environment also performs very well. And again, that kind of comes back to the underwriting practices that we file risk management activities that we have followed over the course of the year.

We've oftentimes talked about the fact that you can't wait until it's upon you in order to adjust credits you are booking two years ago is what's going to play out now and we've always performed well in those stress tests in terms of the amount of capital depletion that occurs. And so our expectation as we see the economic losses flow through in the form of net charge-offs that we're going to perform well again in this environment relative to our peer group.

John McDonald

And in the terms of other uses of capital, one thing you've done recently, you announced the alliance with State Farm. Maybe Andy you talk about the strategic rationale there? And how that's going so far?

Andy Cecere

Yes. I think it's going to be a terrific alliance. We're planning to close out it in the second half of the year as you know. And literally what it allows us to do is to distribute our banking products through 19,000 agents that State Farm has across the country. So it's the best of both. We are really good at banking. We're really good at digital. State Farm has terrific relationships with their customers. And to the fact that we can effectively distribute banking products through this broadening distribution platform, it fits in right into all the things we're focused on which is broadening distribution, digital capabilities and acquiring customers.

John McDonald

Great. And Andy on the broader question of M&A, it's come up a bit recently with PNC's decision to sell BlackRock and their expression of interest in potentially distressed acquisitions. Just remind us of U.S. banks position on M&A. You've been very conservative. And how maybe this changes as things get tough environment versus the last couple of years where again you haven't done too much in terms of traditional bank M&A?

Andy Cecere

Right. So first of all at this point in the cycle, there's a fair bit of uncertainty in terms of projections as we've talked about already. So it makes M&A a little bit more complicated for sure. That's number one. Secondly, we talked about the digital component of what we're doing and how that activity that was in a branch is migrating towards digital. So you need to think about not so much acquiring a footprint or branches but acquiring customers.

And as we've talked about in the past, we would want to do something that was material that would extend our distribution or our customer base in a material way and to our capabilities. And that is still the way we're thinking about it. So if opportunities present themselves, we'll take a look at it. But I will tell you, given where we are in the cycle, I think it would be – we would look at it with a very careful eye because there is a lot of uncertainty right now.

John McDonald

Okay. Fair enough. I've got a few more questions – a few more minutes. One of the questions Andy, we're asking all the CEOs, across all the industries, speaking at the conference. It's really as you think through the other side of this pandemic, what do you think the impact of what we've gone through might be on the banking industry? And how might it change the way U.S. bank invests and maybe approaches expenses over time?

Andy Cecere

Yes. So, John, we talked about this at our Investor Day about a year ago over – a little less than a year ago but we talked about the fact that the way customers are interacting with banks is changing. And I think this pandemic has accelerated that behavior will change in a fairly substantial way.

So as I talked about the ability to not only do-it-yourself, EIY, which is just a big topic at our Investor Day. But do it together or do it with me co-browsing, co-consulting is going to be more important. The physical footprint is going to be less critical on a go-forward basis. The way people interact and their job is going to be different.

We went from having under 10% of our employees at home to over 75% now. So that's also going to be a different component because I think on the return, a lot of those employee positions may remain at home. So the work environment will change, the interaction with customers will change. I think it fits our model in terms of understanding the digital investments that are important and that has been a focus for us for the last couple of years.

And then lastly, I will say, the whole risk management, component of this and credit underwriting is going to continue to be so important for the next couple of years as we sort of regain and get back to normal. But until we do having good disciplines around that will be critically important.

John McDonald

Yes. And you think it will accelerate the shrinkage of the size of branches, the number of branches and maybe even your corporate real estate that you occupy as a big financial institution?

Andy Cecere

I do. And I talked about the fact that we had thought about 10% to 15% branch footprint reduction and I think it will be higher than that. I think what we found is that customers are two things. They're willing to do more on their own or from the – from a digital device or a home.

Or secondly, they're willing to travel a little further. So I think we turned this concept of a digital-first branch-light as we enter new markets. I think we're going to start to migrate that way across most of our markets.

John McDonald

We've got two questions. I want to just sneak in from the audience here.

Q – Unidentified Analyst

Terry just a follow-up on the payments, I may have missed it too. Did you cover the commercial payments and any trends within the corporate and the government split there? Can you just remind us what you're seeing in the update on the commercial payments and maybe that's split within that business?

Terry Dolan

Yeah. So, if you think about the commercial payment side of the equation, it was down 25%, 30%. We've actually seen it, where it's at today is probably similar to that maybe even slightly lower. It's principally driven on the governments -- for two reasons. One is you have the commercial T&E spend. And the fact that businesses are basically looking at all discretionary spend and just kind of pulling back on that.

But then, also on the government side, at least during the COVID situation, there hasn't been a lot of things like Troop movement and those sorts of things, and a lot of our government spend is really tied to Defense spending and activities associated with that. So, I would say, it's similar today, relative to what we saw at the end of the first quarter.

But our expectation is that, again as, some of the restrictions around COVID start to loosen up, we're going to start to see more government spend coming into the equation. And the overall revenue growth should start to get a little bit better than what we saw in the first quarter.

John McDonald

Okay. And then there's a final question I'll ask here, just a follow-up on lending spreads. If you're seeing improvement in lending spreads, on new originations. And have you been successful you and other banks maybe putting in LIBOR floors, on new originations?

Terry Dolan

Yeah. So, with respect to the LIBOR floors, we've always had some level of LIBOR floors in our contracts. And that has been kind of a practice for us for a long time. Certainly in the marketplace credit spreads have widened. We've -- like many of the others have been able to take advantage of that.

That is one of those things that will help from a net interest income perspective, as we continue to move forward. But that is really on the new business as you said, as opposed to the overall portfolio. But credit spreads are widening, we're seeing the opportunity to be able to take advantage of that. And it's really both, it's on the corporate side of the equation, but it's also in areas like auto lending et cetera.

John McDonald

Okay. Well with that, we are running up against the time. And I want to thank Andy and Terry for their insightful and candid comments. There's also the presences fall. I encourage everyone to fill that out. Andy and Terry will give you guys the results of what we get there. Thank you again for participating. We really appreciate it.

Terry Dolan

Thanks John. Thanks for having us.

Andy Cecere

Thank you very much.

John McDonald

Okay. Have a great day. Thanks.