Wells Fargo Vs. The Regulator And How To Profit From It

| About: Wells Fargo (WFC)
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Summary

The FED will likely increase capital requirements for US G-SIB banks during next 2 – 3 years to decrease their ROE, depress their stock price and force a break up.

Wells Fargo will have the most problems to mitigate a capital regulatory tightening cutting RWAs given its conservative US-centric business model.

WFC stock price is not going to go up in the near future. A profitable strategy would be to sell out-of-the-money Wells Fargo CALL Options at 7 months horizon.

The regulator

During 2016 the Federal Reserve will ask the 8 US Global Significantly Important Banks [Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Citi (NYSE:C), Bank of New York Mellon (NYSE:BK), State Street (NYSE:STT), Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS)] to hold more capital in order to fully absorb financial shocks in future crises.

It will do so incorporating the capital surcharge for US G-SIB only designed by the regulator in the framework of the Basel III rules; this extra charge should be phased in by the end of 2018.

It is widely understood that banking regulators consider mega banks a systemic threat to the financial stability of the country and are pushing to break them down. Allegedly FED top officials believe the full opening of the US retail market to interstate competition, started by Bill Clinton in 1996 when the Riele-Neal Interstate Banking Act was passed has been a mistake and, instead of making the whole system safer, could generate even greater risks when the banking system is too much concentrated.

This school of thought is strong in US economic history and the mistrust of conglomerates and the pressure to break them up follows a well-established practice during the XIXth and XXth Century with famous cases such as the breakup of John D. Rockefeller's Standard Oil and the dismembering of ATT&T giving birth to the "Baby Bells".

Chart 1

The Fed does not have legal power to force a breakup of mega banks though, and it seems very unlikely that Congress will pass legislation to this end given the huge lobbying power of US big commercial banks and Wall Street bulge bracket broker - dealers.

But the regulator can force US banks to increase their level of capital and artificially depress their returns on equity and, if not enough capital is raised, ban partially or fully the distribution of dividends and share buybacks.

US mega banks can and probably will fight the FED 's desires but that is going to cost their shareholders a lot of money: the toughening of stress test requirements looks like only the start of a process driven to the breakup of mega-banks: if they do not want to break themselves, the FED will make clear that given regulatory conditions, they should.

In the words of Jerome Powell, governor of the FED:

"I have not reached any conclusion that a particular bank needs to be broken up or anything like that," Mr. Powell said at a banking conference. The point is to "raise capital requirements to the point at which it becomes a question that banks have to ask themselves."

Lower return on equity and artificially depressed stock prices combined with significant value to unlock through a breakup could attract a predator or a pack of predators - activist hedge funds - very willing to "unlock" the value trapped in a now regulatory inefficient structure.

The power of these vigilantes should not be underestimated: it is worth remembering the pressure a group of New York activist hedge funds allegedly exerted on Citigroup to breakup in the early 2010s.

Wells Fargo

Wells Fargo is probably the bank that will have the most problems to mitigate a capital regulatory tightening given its business model: 1) capital consumption is more difficult to reduce in stable and already optimized retail banking operations and 2) the bank has fewer high capital consuming areas that can be restructured on the capital markets side of the financial business (unlike derivatives in the case of JPMorgan or fixed income in the case of Morgan Stanley).

Thus, the profitability of the lender could be more seriously impacted by the restrictive approach of the FED to capital regulation.

As of today Wells Fargo revenues generation power and efficiency are at the top of all American banks.

Wells Fargo NIM is structurally very high. In a sample from 1998 to 2015 Wells Fargo NIM has stayed at an average of 4.59% compared with 2.93% for Bank of America, 2.43% for JPMorgan Chase and 3.58% of a weighted sample of eight regional banks (Fifth Third, M&T, PNC, KeyCorp, SunTrust, Zions, BB&T and Huntington Bankshares).

Chart 2

In terms of ROA (Return on Assets) results are similar, with an average of 2.007% ROA for Wells Fargo compared with 1.08% for JPMorgan Chase, 1.14% for Bank of America and 1.53% for the weighted basket of US regional and supra regional commercial banks.

Return on equity for Wells Fargo has been historically consistently higher than that of its competitors. During the period 2006 - 2015 pre-tax ROE has stood at an average of 18%, compared with peers, with a gap just after the crisis and a consistent number around 16% - 17% afterwards.

The FED does not have the legal power to breakup the bank, but can slowly suffocate its ROE tightening regulatory capital rules and thus forcing Wells Fargo to hold more capital compared with Risk Weighted Assets employed.

This would have an impact on the capital intensive businesses Wells Fargo is conducting - which should be reassessed - and depress stock prices. This situation is likely to happen in the short mid-term.

If we assume Risk Weighted Assets stay at around $1.4tn under standard methodology (See article "Fed Raises Capital Bar Once Again - Is Wells Fargo Most Adversely Affected?") necessary extra capital would be around $28bn.

That would depress 2015 pre-tax ROE from 17% to 15% and structural pre-tax ROE since 2006 from 18% to 14%, without taking into account regulatory arbitrage, exemptions, equity relief, etc.

The hit is significant, but not devastating; what is worrying is the trend: big bank returns are to a significant extent at the mercy of the Regulator, which wants them to break down. Thus, it can safely be assumed pressure on bank balance sheets will continue to rise over future years.

We are still optimistic about US mega banks in the long term: the huge retail banking market in the US, which has been consolidating for 20 years, is still open for cross state M&A activity and will remain so unless new restrictive legislation is passed, something which is very unlikely.

Thus, the key trend developed during last two decades in the US retail banking market from which US mega banks gain market share on a constant basis from regional and supra regional banks due to their superior organization and market power (see article "Band of America: best long in a generation… despite the regulator) is still there.

Furthermore, following a Miskyan vision of the banking boom and bust process lobbyists, regulatory lawyers, compliance officers and more importantly the forgetting process from the last crisis will slowly erode the will of the regulator to press the banks to hold more capital ("Stabilizing an unstable economy", 1986 Hyman Misky); but in the meantime US big retail banks and their stock prices will suffer

The regulator, China and Wells Fargo stock price

Without entering into a detailed analysis of the long term impact of the trend, regulatory pressure should certainly depress Wells Fargo stock price in the short - midterm or at least prevent it from going up.

Banking indexes worldwide have corrected circa 25% from maximums (Stoxx Europe 600 Financials 27%, KBW Nasdaq Banks -12.9%) after the two year bull market from the depths of the financial crisis, but it is not clear they are going to recover soon as a result of increasing macroeconomic improvements in Europe and the US.

Chart 3

Furthermore, high impact events difficult to foresee but with a reasonable probability of occurring could generate a short term negative impact on financial markets combined with a second banking panic. A clear example is the devaluation of the yuan in the context of a worsening Chinese slowdown; this event would likely trigger a chain of competitive devaluations in Asia and would most likely spook financial markets and particularly the banking sector around the world, including Wells Fargo.

Thus, overall the potential for Wells' stock price to go up over the next 12 months looks very low.

Technically, Wells Fargo stock price reached maximums of $56.07 in August 2015 and at that point broke the secular upside trend started at the end of 2011 at $20.75 and fueled by the economic recovery in the US. The midterm downside movement has been accentuated by the early 2016 banks prices crash and regulatory uncertainty; further pressure from negative external events would make this trend worse.

A profitable strategy would be to sell Wells Fargo CALL Option at 7 months horizon - maturity January 2017 - 20% out of the money as a security margin for $0.14 each; with limited risk and low immobilized margin the investor would pocket a lucrative premium in percentage terms.

At the end of the period, the two key variables for this trade to be monitored are 1) evolution of the regulatory conflict between the Fed and Wells Fargo and 2) evolution of the banking indexes in the US and Europe driven by the balance between global fears (China, Brexit, etc.) and macroeconomic recovery.

If risk is still deemed as low, the strategy might be rolled over six or twelve months more. One caveat must be stated: selling options has always a degree of risk. Even if in this trade odds are overwhelmingly in the side of the investor, a low - moderate risk that should be carefully monitored still remains.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.