Even as the rules of the Frank Dodd Act are being negotiated and rewritten, there is another "too big to fail" legislation in draft. According to reports, Senators Brown and Vitter may introduce a bill that will require U.S. banks to have 10% equity capital with a 5% surcharge for banks having more than $400 billion in assets. While both lawmakers said that their intention was not to break up the banks but to force market discipline, they admit that that the country's biggest banks like Wells Fargo (NYSE:WFC), JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) will have to make some structural changes.
In this article I try to look into the impact of the proposed capital rules on large banks in general and Wells Fargo in particular.
Impact of the proposed new capital adequacy rules
When the proposed bill talks about capital adequacy it implies total tangible equity as percentage (10% or 15% as the case may be) of assets, grossed up for derivatives and unfunded commitments.
According to a Goldman Sachs research report, this means that U.S. banks would require $1.1 trillion worth of fresh equity. The U.S. global systemically important financial institutions (G-Sifi or banks or financial institutions whose failure might trigger a financial crisis) would need to more than double their equity, while other banks would have to increase it by 33%. This could be even more as total assets increase as the proposal is for grossing up derivatives and unfunded commitment.
The report estimates the total amount of fresh equity required by the biggest banks to be in the range of $908 billion, which it says would mean a 5% reduction in return on equity and 25% reduction in lending capacity.
Large banks could think of separating their different segments in order to reduce the amount of fresh equity to be inducted. However, this may prove to be more difficult than it sounds. The five biggest U.S. banks, all have multiple segments with more than $400 billion (the asset threshold for 10% adequacy).
If different pieces of banks are separated, it would not only increase cost of money but also reduce earnings diversity, making banks more volatile.
No benefit from breaking up
Wells Fargo has three operating segments. Two out of the three segments have assets more than the threshold limit - Community/Retail Banking ($794 billion) and Wholesale/Commercial Banking ($489 billion). If spun off, only Wealth Management segment of the bank with assets worth $172 billion would fall under the $400 billion cap.
The bank has assets worth $1.46 trillion and total common equity (TCE)/asset ratio of 7.9%. If the bank chooses to remain a single entity and has to achieve 15% TCE/asset ratio of 15%, it will be required to increase its capital 1.9 times. On the other, if it chooses to break itself up into three separate entities, it will have to increase capital by 14.4% or 1.8 times. That is not much of difference in the larger scheme of things.
The current TCE/asset ratio of JPMorgan Chase is 6.1% and if it breaks into five different entities, it requires increasing its equity 2.3 times and 2.4 times if it chooses to carry on as a single unit. For Bank of America, the difference is slightly bigger - 2 times if it breaks up into 6 pieces and 2.3 times if it does not - primarily because four out of its six segments have assets below $400 billion.
But may still have to spin off segments
The outcome of new legislation cannot be predicted. The bill faces opposition in the Senate Banking Committee on the grounds that work on the Frank Dodd needs to be finished first. However, if it does get through, banks may have no option but to separate their segments.
The bill is expected to allow maximum time of 5 years for banks to build the required equity. If the banks choose to build that organically, it would take 12 years at their current level of earnings. On the other hand, if they choose to raise fresh equity, they may find it difficult if investors see returns falling below cost of capital.
With breaking into existing segments not expected to make any big difference to the amount of fresh equity to be raised, the G-Sifi banks may have to break up into more segments to be able to get below the $400 billion threshold.
Wells Fargo & Company - going ahead regardless of new capital rules
Mindless of the new development and what may transpire in future, Wells Fargo is going ahead with its expansion plans. Last week, Reuters reported that Wells Fargo was in talks with Germany's second largest lender, Commerzbank, for buying its UK property loans business. While Wells Fargo is interested only in the performing property loans of the German bank, Lone Star, a distressed debt and equity investor, is eyeing the non-performing loans.
Wells Fargo was among those banks that were scrutinized very thoroughly during the subprime crisis. It goes to the bank's credit that despite past history, it announced that it was expanding its mortgage originating operations despite predictions of 16% decline and competitors like JPMorgan Chase pulling back and cutting jobs. If nothing else, this shows the bank's management's resolve that it has left the past behind.
Wells Fargo's initiative of smaller 1,000 square foot "neighborhood bank format" is also an interesting concept. Intended for person to person banking service, these new banking stores with digital age, paperless, wireless technology and large screen ATMs, this "boutique banking" is a good step in the right direction.
Wells Fargo is the largest U.S. mortgage originator. It beat market estimates of Q1 2013 EPS by $0.05 or 5.75%. Revenue was marginally higher as compared to the Q4 2012 - $21.3 billion from $21.9 billion. Net income was up 22% year-on-year and 2% quarter-on-quarter. Net interest income remained practically unchanged and the $144 million decrease was primarily due to this quarter having two days less as compared to the Q4 2012.
Wells Fargo's trailing twelve month return on equity (ROE) is 13.07%. For Q1 2013, it reported an ROE of 13.59%. It is this that is likely to be affected if the capital adequacy norms are changed as proposed by the Brown-Vetter legislation.
During the earnings call, Wells Fargo CEO John Stumpf admitted that the environment was not ideal for earnings growth - Frank Dodd rules are being negotiated and rewritten and a decline is expected in what is the bank's major business (mortgage originator) operator.
In as far as the Brown-Vitter legislation is concerned, it may prove to be a blessing in disguise. If a breakup is forced on banks, which seems to the major motive of the proposed legislation, it will amount to unlocking hidden value. These factors make me suggest a cautious approach when it comes to investing in Wells Fargo.