The unbanker

Though he's been a banker for 21 years, Dick Kovacevich still hasn't got the hang of it. He keeps referring to branches as "stores," and thinks companies like McDonalds and Home Depot are good role models. He's CEO of a superregional bank but won't make loans to giant corporations or foreign countries. He keeps talking instead about selling--selling--mutual funds, insurance policies, mortgages, and, oh yes, checking accounts to people in a town called Spearfish.

No, the chairman, president and CEO of Norwest Corp. is not what most people would call a typical banker. He kind of cuts across the grain of conventional thinking in many ways, which may account for why he doesn't like to think of his company as a bank at all, but a financial services company. He can afford to be different because Norwest is not only highly respected among both bankers and the investment community, but highly profitable as well. Third quarter numbers included a return on assets of 1.51% and a return on equity of 22.2%. More to the point, the company's increasing success and gradually rising stock multiple (13.5x as of late November) is a result of its chief's unconventional thinking, not in spite of it.

Kovacevich (pronounced ko-VAH-se-vich), joined the Minneapolis based regional bank in 1986, after a stint of ten years at Citibank, where he had risen to group executive of international consumer operations. Norwest at the time was struggling under a passel of bad loans. Kovacevich and former chairman and CEO Lloyd Johnson set to work straightening things out, which they accomplished in less than two years and began transforming the highly centralized and company into a more diversified company with clear profit centers.

Kovacevich became CEO in 1993 and has spearheaded the company's rapid geographic expansion in banking and rise to the top of both the mortgage origination and servicing worlds. Before becoming a banker (officially at least), Kovacevich worked for General Mills, and its Kenner Products unit. He might have been a professional pitcher if he hadn't injured his pitching arm in his senior year at Stanford.

In addition to being unconventional, Kovacevich is also candid--sometimes blunt--as the following article will demonstrate. He has said in speeches, for example, that "banking is dead." Editor-in-Chief Bill Streeter began his interview with Kovacevich by asking him how that remark differed from a more notorious one about "dinosaurs." The following dialog has been edited for length and, in places, for clarity.

ABABJ: You've said in speeches that "banking is dead." In the context of that remark, would you have agreed with Bill Gates' reputed statement that "banks are dinosaurs?"

RK: "Dinosaur" has the connotation of ancient, not up with the times. My point is more that the changes in customer behavior are causing us to think much broader than the "banking segment." That's very unlike dinosaurs.

We never would have had a banking industry, an insurance industry and an investment banking industry if we simply followed the way that customers wanted us to be. [That structure is] due to laws, regulations, and so on. And since the customers don't want us to behave the way we legislatively are supposed to, we've got to break out of that--that's what I'm saying.

The need that is being satisfied by an annuity, a CD, and a mutual fund is basically the same--a long-term savings vehicle. Today, the customer has to pay for three different distribution systems to deliver these products and then has to figure out which of the three--even though they're similar--may be the best for him. So I asked myself is there an opportunity in offering customers [these products] through one distribution system at one third the cost and helping the customer select which one of them is best for him. If you can offer better service to the customer at a third of the cost, you can make a business out of this.

If you think of yourself [as being] in financial services, you look at things a whole different way [than] if you think of yourself as an insurance company or a bank or a mutual fund. These are only segments; there's only one industry and that's financial services.

ABABJ: To what extent has the failure to pass a major financial modernization law hindered you?

RK: "Hindered" is a good word. It hasn't kept us from pursuing things on the fringe. It has made it difficult for us to pursue those activities, and more costly. But we have figured out through one loophole or another a way to get into most of the fields [we want to be in]. Unfortunately most of our competitors--American Express, Merrill Lynch--are not hindered in that way at all; they can do everything that we can do without any of the restrictions, be they CRA, reserves, etc.

ABABJ: If you had to pick a couple of banking laws for Congress to pass, what would you pick?

RK: In my opinion, we're never going to get the deregulation we want and need, never get the product freedoms we need until we address deposit insurance. There are some legislators saying, "I'm not going to get off your back until you get out of [government's] pocket."

Regulatory reform and product permissions are so critical to this industry that we must address the deposit insurance issue; must get it out of the taxpayers' risk so that we can move forward.

ABABJ: Don't community banks tell you that a lack of FDIC insurance would put them at a disadvantage to big institutions, and that deposits would flow to the big banks?

RK: That's not really the community banks' feeling. They feel, and justifiably so, that it's too-big-to-fail is the issue--that the insurance fund and the government will not let big banks fail. That is unfair. That's why I believe you privatize the fund and [ensure that] the fund does not pay for too-big-to-fail. If Congress or the Treasury wants to [bail out someone] like they did with Chrysler, fine.

I believe if you guarantee what I just said, 90% of the community banks would be in favor of it because of the benefit they would derive from it--deregulation, which is more important to them than it is to us. Also, they'll never pay another nickel into the insurance fund, because it was the use of the fund illegitimately for too-big-to-fail that caused the fund to be drained, not bank failures.

There has not yet been a bank that's too big to fail, in the sense of bringing down the world's financial system. And I believe that it would be very unusual that the Treasury or the Fed would rescue [a bank] if there was no [public] insurance fund.

ABABJ: I haven't heard that come up much as a public policy issue.

RK: There's a very good reason: The regulators don't want it, because now they [would lose] a source of funds, and many politicians don't want it because they love controlling banks--they love using us for their social purposes.

People are coming to the conclusion that every time want something, deposit insurance comes into it. So I think the tide is rising to address it.

ABABJ: How much will consumers care?

RK: There's as much money in mutual funds today as there is in CDs. Consumers have already decided.

ABABJ: Would a prolonged market correction affect that decision?

RK: I think it would. You would see money come back to banks, but over the long term the days are numbered for the franchise of deposit taking. Deposit growth will be far lower than the wealth created by individuals. Just look at the behavior of younger people today. I didn't know what a mutual fund was when I was younger, but all my kids already have as much if not more of their money in a mutual fund than in a bank. The only reason we have as much deposits as we do is because of our older clients.

ABABJ: Are your deposits still growing?

RK: They are. But it's more difficult to grow them and they're not growing nearly as fast as the total of bank deposits mutual funds and money market funds. Our mutual funds and annuities are growing much much faster than our bank deposits.

ABABJ: How does that shift affect funding, both for Norwest and the industry as a whole?

RK: It simply says we'll have to find different sources of funding. One of the easiest ways is securitization. You don't fund your assets you securitize them. And you can securitize almost anything today. Second is that wholesale funding may become more important. By that I'm not just talking Fed funds, but long-term debt and the normal sources of funding that other [nonbank] operations use. If you look at the fact that banks have only about 25% of our customers' assets today, that means 75% is elsewhere. To my knowledge GE Credit, General Motors, and American Express don't have any trouble funding themselves.

ABABJ: That funding is costlier than deposits, though, right?

RK: Well, the thing that we don't know, and which is hard to determine, is what is the cost of our branches--the noninterest costs. We have this fixed cost base and how much do we attribute to a checking account versus a loan versus whatever. So there's somewhat arbitrary costing going on. If bank funding was that much cheaper I think you would have found GE Capitals going to that direction. To me it is not obvious that there's a huge difference there.

ABABJ: But smaller banks wouldn't have access to the same sources of funds as large institutions.

RK: That's certainly a true statement. But you could well have large banks and other institutions helping them securitize assets and/or helping to fund them. If community banks are providing a real function and doing so at a reasonable profit, there will be ways to fund them.

I'm not talking about deposits going away, I'm just saying they're becoming very different than they have been. Small banks will need to do the same things as the big banks: if there is less [deposit growth] they'll have to make it up by selling whatever the customer wants like mutual funds and so forth and it will work itself out--the markets work.

ABABJ: You've said that you don't spend a lot of time at Norwest thinking about the banking industry will look like in the future, rather you rely on being nimble and innovative to meet the change. But don't certain things require a long lead time to get ready for--the Internet, for example?

RK: What you do is test. Rather than trying to figure out how many people are going to be using the Internet ten years from now, we ask, is at least possible that the Internet could be an important vehicle of financial transactions? If the answer to that is yes, then we just dabble and dibble with the Internet till it becomes clear that it's either not going to work or it's going to be big. By testing you determine what technology you're going to need, what are the marketing implications, and what are the lead times if you had to roll this thing out quickly.

You rarely have to be first into a new market, but you can't be 50th either. Oftentimes the second or third into a new market does better than the first does because they have a chance to see and learn. But the main reason we test is because--taking the case of the Internet--we have no idea when [it will be big for banking], and I don't know of anyone who does. My bias is that these kinds of changes generally take longer than the pundits say. But change is inevitable and it's very unlikely you'll be operating your business ten years from now close to how you do today. But I'm not willing to bet my company until I think the odds are in my favor that what I'm betting on is the likely outcome. You find that out by testing.

What we have concentrated on are skills that we believe are going to be needed regardless of what products and services we're going to be offering, and what channels we're going to be using--skills like selling and servicing and managing risk. Whether it was ten years ago, today, or ten years from now, whoever has the best sales force and the most motivated employees is going to be a winner. Whoever knows how to deliver products to customers with excellent service will be a winner. It doesn't do you a lot of good to be very skillful in the delivery of a savings account when the savings account may not exist ten years from now, but it's going to be as important if not more important to be able sell somebody a product that is of a savings nature. Perfect the skill, don't perfect the product.

ABABJ: Your average cross-selling rate is 3.7 products per customer, and you want to get it eight. Isn't that quite a jump?

RK: 3.7 is our average, but for every customer that's been with us five years or more, we're over five products. And already 42% of all our households have six or more products. So the average is brought down by the young stores that haven't gone through the full training. We think eight products isn't as impossible as it looks from 3.7.

On average, a household has about 15 products that we count--checking, CDs, mortgage, credit cards, installment loans, all forms of insurance, mutual funds, brokerage account, annuities. So even if we have eight of them, we only have about half. What's also interesting, and why we think this cross-selling is so important, is that if you take all the customers we have that have both a banking relationship and a mortgage relationship, the average [number of products sold] is six--seven if they have an investment relationship. We call these core relationships--products which if you have them, the propensity to buy an additional product from you is greater than for just any old product. Checking is a core relationship, so is a mortgage, an investment product, and an insurance product.

ABABJ: Do multiple products equal greater profitability?

RK: Yes. If you have two products with us we make on average $22; if you have nine products we make about $352 per household. The reason is very simple: This is a high fixed-cost business, and the incremental revenue from selling an additional product to someone relative to its incremental cost is very, very attractive.

A simple example is, if you have a checking account with me what's the incremental cost of me selling you a statement savings account? Zero. We're already sending you a statement every month, we already know your Social Security number, literally all the profit from that product incrementally goes to the bottom line. This is not rocket science. But what you find is it's very difficult to achieve. And in a way, that's good, because if it were easy to achieve, anybody could do it.

The skill base [to achieve this strategy] has nothing to do with banking. It is closer to what McDonald's and Home Depot and Starbucks do. It's taking a commodity product and differentiating the way you distribute it and executing the same way everywhere, as opposed to selling derivatives or trading or underwriting $200 million loans to Chile. We don't do any of that stuff. We have more in common with retailers than we do with our banking brethren.

ABABJ: In that regard, the removal of Glass-Steagall restrictions probably wouldn't mean that much to you, would it?

RK: Peanuts. The reason we support the removal is that we think it will be beneficial to the money center banks and will help their price/earnings ratios and therefore help our p/e because people still think of us as a bank. But in terms of increasing our profits considerably, it would not be a big deal.

ABABJ: You say, "We're not a bank, we're a financial services company," and yet the market tends to think of you as a bank. Are the multiples of other financial services companies different than banks?

RK: First of all there's really not a financial services company out there--with the possible exception of a Merrill Lynch--that's like us, or like what we're trying to be, which is one of the problems. It's tough for people to value something that they've never seen before, especially if they think they have seen it before.

Second, there are pieces of what we do that do sell higher than [banks]-- our consumer finance company sells higher; so do our investment and insurance companies. That can lead someone to say, "Why don't you split them out and get the value?" We think that is inherently wrong. Let me explain.

There are two reasons why are we pursuing the financial services industry as opposed to a particular segment--an investor reason and a business reason.

The investor reason is that most everything in financial services is a risk-related and/or cyclical business. We don't think you can eliminate risk or cyclicality but you can diversify to reduce it.

Money never goes away. It simply moves from one pocket to another. Mutual funds and cds are probably going to move in opposite directions, for example. Therefore, what you need is a diversified number of businesses to counter both the risk and/or the cyclicality.

There's nothing wrong with the average earnings of banks. That's not why they sell at a discount to the S&P, it's because of the volatility of that earnings stream. The market hates volatility. By diversifying, we think we can significantly reduce if not eliminate the volatility and therefore our p/e ratio should improve. That's why we don't split off our finance company or our mortgage company. That would increase volatility, not reduce it.

The second, business, reason is what we just discussed--that the more products you sell somebody, the more money you make. If you split off 20% of your company, you couldn't have easy transfer pricing and so on, because you'd have to make sure that there's a fair treatment based upon two ownerships and so forth.

Let me give you a reason why this is more important than anything else I've said. If you're in a cyclical business and you've got analysts breathing down your throat and the market isn't conducive to the business you are in, very few people have the guts to pull back and say I'm going to take some negative earnings for a while because this is not a good market. Instead, [most] of us fall over the cliff together singing and dancing.

The point is [with a diversified business mix] we are never forced to continue pursuing a strategy when there's nothing there because we have something else to offset it. When you have a bad mortgage market--high rates, high inflation--that usually means a booming economy, so commercial lending does well. A recession means low rates. Commercial lending is not going to do very well, but what happens to mortgages at this time? So when we have a problem--and I give this in theory now--we will never have the problem times two or the problem times three that is generally true of financial services companies because they're always stretching. Banks get themselves in serious problems not because of normal cyclicality, but because we don't know when to stop. We overreact on the bad side, and then we overreact on the good side.

ABABJ: Norwest was one of about 12 banking companies grandfathered many years ago to sell insurance across the country. With the Barnett Supreme Court decision, others can begin to duplicate that. Is insurance a lucrative business?

RK: We're the largest bank-owned insurance agency in the country and we're the 14th largest insurance agency of any kind. We'll have about $300 million in insurance revenues this year. It's a tough business.

When we look at a customer--commercial or retail--we know a lot about that customer. Take a commercial customer: one of the things we look for to make a loan is, do they have proper insurance? Given that we are already making that analysis, the incremental cost to us to sell them something [additional], is very low. The same thing when we make a mortgage. We require, of course, that they have homeowner's insurance and like them to have credit life. So it's an adjunct to what we already do.

We don't have separate distribution systems [and we aren't] in products we don't already know something about. That is how we have been successful in insurance and why we view it as a good product group.

ABABJ: Banks often feel they can't compete against specialized financial services companies like credit card companies or brokerages because they concentrate on one product niche. Are banks doomed to be niched to death?

RK: Let's just ask some questions. Say we're in Spearfish, S.D.--trust me, there is a Spearfish, S.D. What's the incremental cost to Norwest, of putting a commissioned broker in our existing bank there--assume we have space and we have a communications network in place? Zero--the person is commissioned. So where is the cost advantage that a Fidelity has over us?

Now assume that I can either develop myself or buy from someone else a product line that is as good as what Fidelity or Schwab offer. As a customer in Spearfish, you can talk to some people who work for a company called Fidelity, but only by telephone, or you can talk to a human being who's no more than ten minutes from where you live, in person, by telephone or any other way you want to do it. Same product, similar customer. Who would you rather deal with?

My point is, the Fidelity's of the world don't have [an insurmountable] advantage on the banking industry. Their competitive advantage is that they have focused on something and done it very well. We let them into a market because we didn't have a proper vision of what we were in business to do--we were a bank. As we were busy selling savings accounts and checking accounts and making loans to Chile, they were out saying, "Hey, we've got a new product here called mutual funds," and they grew 15% a year. We weren't trying--and by the way it wasn't legal for us to do it for a while, either. Now that they're established, it's not easy to go to the Fidelity customer in Spearfish and say, "Hey I've got a broker right here." But I think we can still do it.

It's a matter of focus; it's a matter of having the product line. It's my belief that compared to any niche player--on the increment now--we can match their price or beat their price.

To me the issue is not that you start with a competitive disadvantage, but rather can you execute to eliminate any disadvantage you may have. Can you put into your bank an insurance agent or a broker who can perform, and who has at least as good a product, and can you make sure that the customer who needs that service is transferred to that person. Now that is easy to say but very hard to do, but it isn't some inherent advantage someone has over you, and the reward is so huge, if you can figure it out, that it's worth going after.

ABABJ: Is one of keys to selling the customer what they want a need, having a data warehouse or database system?

RK: Very important. The winners of tomorrow will be those who have the richest database and know how to most effectively use that database. Now, one of the advantages of multiple financial services is the richness of the database you have. Think of what you know about that customer if you have eight relationships with him instead of two.

ABABJ: In some ways you are a national brand already, although you don't see the Norwest name as much in the East. Do you feel like you want to become a national brand?

RK: First, we only want to be in banking in about 25 of the states. Second, the mortgage business is almost an indirect business--we go through real estate agents, so having a brand name doesn't make a lot of sense. The finance company also is basically an indirect business. With both of these I mean the initial customer contact is indirect. So I don't see us spending the amount of money necessary to have a national brand image because I don't think it's going to help our businesses that are not banks. But in the places where we have banks we absolutely want to have a brand image. Our goal is to have 50% of our customers in a state say "Norwest" when asked, "Who is the premier financial institution in your state?"

ABABJ: Why wouldn't you put banks in the other 25 states?

RK: Culture is very important to success in banking. By culture I mean that if the customers we deal with in a new geography are similar to the customers we have today, and the bankers are similar, there should be no reason why we can't be successful. Or to state it another way, we think banking in New York City is very different than banking in South Dakota. Why try to have multiple cultures when the difference between us going from Iowa to Missouri is hardly any difference at all, whereas if we went to New York with the image and positioning we have today, it would be a disaster.

ABABJ: Also true of California?

RK: California has two different cultures--northern and southern. Northern California would be just fine [for us], southern California would be a struggle. Even in Texas, we're not really much in Dallas and Houston, but everywhere else. It's difficult to create and nourish one culture, it's impossible to do two or three.

For more of "The unbanker" with additional topics covered by Norwest Corp. CEO Richard Kovacevich that did not appear in the cover story, click here!