Saturday, September 17, 2016

The harder they fall

The revelation that Wells Fargo employees had opened millions of accounts without the knowledge of their customers has come like thunder in a bright blue sky.

Here was the most respected of the big US banks seemingly behaving as the reviled Wall Streeters, after it had touted its plain vanilla business and earned Warren Buffett’s confidence and admiration[1]!

Of course, not everybody cried, as Congressional critics were quick to point out that they had been right all along: big banks were out to trick their customers rather than serve them, and their staff would stop at nothing to earn fat bonuses.  It also provided a timely boost to the controversial Consumer Financial Protection Bureau which uncovered the problem.

Still, the bank has given them ample ammunition:

-         The scope of the fraud, close to two million accounts and credit cards,
-         That some 5,300 employees and managers were fired, hardly “a few isolated bad apples”,
-         That the leader of the unit where the shenanigans had taken place chose that time to retire with US$125 million in stocks, options and retirement benefits, a large chunk of which had been accumulated during her stewardship of the consumer banking unit,
-         Finally, that the bank CEO squarely blamed employees but didn’t name any high ranking executives among those responsible and was vague as to his own accountability.

At the same time, it should be noted that the actual financial damage inflicted on the bank customers was light: some 14,000 accounts incurred an average of US$28 each, and, in total, US$5 million was refunded which works out to less than US$5 per client[2].  This explains why, by today’s standards, the fine was a very modest US$185 million.

Nevertheless, I expect that the final cost to the bank will be much higher.

To begin with, the bad publicity will bite all the more so that Wells Fargo had such a good reputation.  Negative sentiment will weigh on the stock price.

The bank will need to spend hundreds of millions on better internal controls and training.  The decision-making will likely be slowed down as transactions will need to go through lengthier and slower approval processes.  Risk taking will probably diminish, and with it profits as staff will be wary of making career-ending decisions.

This scandal will likely take a bigger toll on top management than we have seen to-date.  Let’s face it, when thousands of employees feel so pressured to reach their goals that they resort to fraud, either (1) they were poorly trained and/or of uncommonly bad character, or (2) the top down pressure was so intense and widespread that it was no accident.  Either way, management is at fault.

Having worked for a large bank, I for one believe that corporate culture determines how business is conducted; it is critical in guiding managers’ and employees’ behavior and decision making.  In this instance, and from anecdotic evidence, I believe that there was a corporate cultural problem.  Setting the appropriate culture IS the responsibility of top management, under the supervision of the board of directors.

A key Wells Fargo strategy toward growth and profitability has also been called into question: the much advertised effort to deepen and broaden the relationship with customers by selling them ever more products.  Yet in recent years, while the goal had been set at 8, they had plateaued just north of 6.  If 6 rather than 8 is the effective ceiling, how will the bank make up for this setback, especially since cross-selling will be under closer scrutiny?

Some have compared this crisis to the JP Morgan “London Whale”.  JPM was punished much more harshly, even though its victims were its own shareholders rather than its customers.  With its “fortress balance sheet”, JPM recovered relatively quickly although it is likely that its future profitability suffered because of rising compliance expenses and lower risk tolerance.

Wells Fargo has in my view a bigger problem: besides incurring greater compliance expenses and dialing back risk-taking, it faces a greater strategic challenge and it may suffer from upheaval in its top management ranks.

For all these reasons, I wouldn’t be surprised if its stock price were to drift down toward book value, i.e. US$36 vs. US$47 today, reflecting a loss of premium valuation and lower future earnings.

Although it is no excuse, I think that the current financial context of quasi-zero interest rates keeps exerting ever stronger pressure on banks’ net interest margins, and Wells Fargo is the latest but by no means last victim.




[1]  Buffett’s Berkshire Hathaway owns 9.7% of Wells Fargo, a stake worth US$21 billion.
[2]  In the absence of further details, such average number is difficult to interpret.  My own hunch is that some customers were charged fees of about US$30 while others incurred no charges.

No comments:

Post a Comment