Monday, December 19, 2016

Wells Fargo's 2016 Woes

Wells Fargo is still big, profitable and well-capitalized, but 2016 had a rough ending.
Board members and senior managers likely can't wait for 2016 to go away at Wells Fargo.

Heretofore, the bank had been often described as the best-managed, the best-run bank among the top global banks. Whenever someone published a list of big banks with the highest ROE's (to measure returns on capital and general performance), Wells Fargo with its 12% returns over the past few years roamed the top. Whenever someone published the credit ratings of big banks, Wells Fargo with its AA-ish rating roamed the top.

Part of its industry respect, its reputation for shrewd management and its results were due to its escaping financial-crisis debacles of trading losses, insufficient capital, and mortgage-securities wipe-outs. It wasn't plundered by billions in mortgage settlements to government bodies.  Part of it was its business model--expansive in all corners of the country, fairly basic:  accept deposits and use them primarily to fund a large, varied, diverse portfolio of consumer and corporate loans.  Sprinkle in a little global activity and a representative investment-banking unit.

Furthermore, its success was because it resisted (somewhat) the temptation to propel itself to the top among major investment banks (mergers, acquisitions, and underwriting) and major securities and trading dealers. It participated in these arenas, but it didn't aspire to compete head-on with Goldman Sachs or Deutsche Bank. 

Then came the retail-bank scandal in late 2016, which smashed the bank's reputation almost to bits and led to the ouster of its CEO John Stumpf in October.  The scandal, as everybody knows, is tied to the bank's strategy to sell phantom bank accounts and other unnecessary services to thousands of retail customers. The bank paid a government penalty, dismissed lower-level employees involved, and continues to address the fall-out from these disclosures.

Such scandalous retail practice was likely its way of responding to pressures to sustain performance. Banks nowadays boost their returns not from highly leveraged, moderately risky loan and trading portfolios.  The strategy calls for controlling costs and generating fee income, steps that have negligible capital requirements and balance-sheet impact.

Now just as it felt it was rescuing itself from the reputation blues, the year winds down and the Federal Reserve and FDIC announced the bank had failed its most recent "living will" test (Recovery and Resolution regulation).  That's the regulatory exercise regulators command banks take seriously, although it addresses a hypothetical scenario. The Dodd-Frank-related requirement stipulates banks must show how they would unwind their businesses and liquidate their balance sheets in stress without being a detriment to the financial system. 

JPMorgan Chase led the short list of banks that fell short on this test last year.  At Wells Fargo, at a time when the bank desperately needs to assure retail and corporate accounts its culture is evolving and convince everybody in sight it has cleansed itself of the scandal, a bank regulator slaps its wrist with a failing grade.  For the second time.

With ample capital (almost $200 billion in equity), strong risk management, and a footprint in households and corporates coast to coast, the bank is in no danger of failing.  It has a net-revenue base of over $80 billion.  Its net earnings top $20 billion annually.

It may likely suffer a hiccup or two in income over the next few quarters, as it addresses lingering issues from the scandal.  (Some customers will likely review their relationships or choose not to funnel similar amounts of business.  They, too, must respond to stakeholders about their ties to the bank.) But Wells Fargo's balance sheet is sturdy, and the franchise entrenched. 

Regulators suggest the bank should take more than a passing interest in trying to pass the "living will" test. They insist if the bank's financial condition is, in fact, declining quickly, if it needed to unwind, dis-aggregate or sell off assets to pay down depositors, lenders and debt-holders, all it should do is click on the "game plan."  The "game plan" should be detailed, thorough and include all funds flows and entities on the organization chart.

In the same way it criticized JPMorgan last year, regulators have one specific issue, among others. It claims Wells Fargo isn't showing adequately how it would funnel cash from affiliates or subsidiaries to the holding company to pay down debt-holders. 

That process is less smooth than JPMorgan and Wells Fargo have assumed in these exercises.  That shouldn't be a surprise, since big banks preside over complex, intertwined organizations. Cash or cash-equivalent liquidity residing on a balance sheet in a subsidiary in Singapore shouldn't be counted on immediately to be a source to pay down a debt obligation for the parent company in New York or San Francisco.

Or the $100 million in Singapore might take weeks or months to snake its way legally to New York through a labyrinth of legal companies and tax obligations. And the amount might dwindle to $50-75 million on the way.

"Living will" tests and other stress tests are exams banks like JPMorgan and Wells Fargo with extraordinary amounts of capital and liquidity should be able to pass, as long as they give them proper attention and devote resources (personnel, technology, etc.).  This time, Wells Fargo's "wrist slap" penalty is a restriction on the bank expanding internationally or investing in non-bank activities--something the bank can accept without complaint.  A greater penalty is for its senior management and shareholders to see the bank's name soaring across the financial media in negative headlines.

Whether it's JPMorgan, Wells Fargo or RBS (which failed a stress test recently), a failing grade results in an "uh-oh" moment, a realization that regulators are, in fact, taking these tests seriously, so "we had better give this priority" beyond delegating the tasks to a team of junior associates.

Tracy Williams

See also:

CFN:  Explaining Living Wills, 2016
CFN:  Wells Fargo Sticks to What It Does Best, 2014
CFN:  Another Round of Bank Stress Tests, 2016
CFN:  When Does a Bank Have Enough Capital? 2015
CFN:  The Essence of Corporate Banking, 2010
CFN:  JPMorgan:  Is $13 Billion a Lot of Money? 2013
CFN:  JPMorgan's Dimon's Regulatory Rant, 2012

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