The Federal Reserve's Extraordinary Wells Fargo Growth Restriction
Summary
- In an unprecedented action, the Federal Reserve will limit Wells Fargo's asset growth until the bank sufficiently changes its management culture and risk control procedures.
- Wells Fargo estimates this may end up reducing its earnings by $300-400 million this upcoming year, although how long the Federal Reserve's order will last remains uncertain.
- The Federal Reserve also is requiring that 4 members of the 16 member board be replaced. The bank's shares fell almost 7% in post-market trading on the news.
- The sanctions are in response to Wells Fargo's inability to properly fix its internal culture and practices over the past few years amid multiple consumer abuse scandals that have repeatedly come up.
- While temporarily restrictive, the sanctions may result in Wells Fargo getting the turnaround it needs to finally get out the fake accounts mess that's been dragging it down over the years.
The growth restriction implemented by the Federal Reserve on Wells Fargo (NYSE:WFC) will likely moderately restrict the bank's profits for the immediate future, yet may preserve the bank's long-term growth and stability once its systematic internal problems have been cleaned up.
After years of dealing with the fallout and seemingly unending turmoil from the fake accounts scandal, Wells Fargo may now finally have the concluding note it needs to have a fresh start and begin on the path to long-term growth once again.
However, risks remain, particularly if Wells Fargo does not comply properly with the Federal Reserve's plan and thereby continues the drudgery it's been in for the past few years.
An Unusual Sanction: Asset Growth Restriction
On Friday, Janet Yellen's last move as Federal Reserve Chair was to oversee the implementation of quite significant and restrictive sanctions against Wells Fargo for its "widespread consumer abuses and compliance breakdowns." The sanctions will require the bank to replace 3 of its current 16-member board by April, along with replacing an additional member by the end of the year.
However, even more notably, the Federal Reserve has required each member of the board of directors to sign a cease and desist order affirming that the bank's total asset size would not grow any bigger than it was at the end of 2017.
The growth restriction is historically unprecedented and has never been implemented in the history of Federal Reserve banking governance. The restriction will remain in place until "governance and risk management" improves to the Federal Reserve's liking.
Given the bank's diversified asset base and the Federal Reserve's statement that "current activities" such as accepting deposits and issuing loans would not be halted, it is unclear exactly what the specific details of the asset restriction would be.
Nonetheless, Wells Fargo has estimated the sanctions could likely cost the bank between $300 and $400 million in otherwise-expected profit this year. To put that into perspective, based on the bank's Q4 2017 earnings, it earned a total of $22.183 billion during the year and closed the year with assets of $1.935 trillion.
As of the moment, Wells Fargo has announced the likely compliance plan will be to reduce commercial non-operational deposits and trading assets. Furthermore, its announced plan includes seemingly significant changes to management, in preparation for the first 60-day review which may determine how long the asset restriction lasts.
While the news was announced after the close of the trading day on Friday, shares did end up tumbling from their close of $64.07 to a low of $59.61 (-$4.46, -6.96%), before ending post-market at $60.09 (-$3.98, -6.21%).
(Source: Google Finance)
This was already after a rough day for stocks overall in which the overall S&P 500 fell by 2.12%, and Wells Fargo fell during the trading day by 2.20%, from $65.51 to $64.07.
The End Of A Long Saga For Wells Fargo?
It looks like this sanction may be the end of Wells Fargo's long and seemingly ending circling in response to the fake accounts scandal that has been slowly revealed over the course of the past two years.
While financial services institutions often face sanctions from regulators over improper activities, usually these are one-and-done as the financial institutions come to settlements with regulators, take responsibility, and put a halt to the activity that is violating consumer protection compliance or regulatory rules and standards.
In Wells Fargo's situation this initially seemed so, as in response to the initial revelation of the fake accounts scandal the bank was fined a total of over $185 million by regulators, quickly fired over 5,000 employees, replaced then-CEO John Strumpf, and gave refunds to affected mortgage customers in October 2017 over a different scandal.
However, at each stage, it was like pulling out teeth. The bank faced intense public criticism for simply firing the lower-level employees, who were encouraged to fulfill the sales quotas that allowed for the fake accounts scandal rather than looking at the internal management culture and structure.
Furthermore, more scandals soon came up from everything regarding car insurance, life insurance, and mortgage refinancing to veterans. When Wells Fargo CEO Tim Sloan came onto Capitol Hill in late 2017 to testify, and seemingly without taking full responsibility for the management problems that created the mess, he and Wells Fargo faced bipartisan condemnation.
With foreshadowing from President Trump's tweet in December that Wells Fargo would face "severe" penalties, it looks like the 3-0-1 vote by the Federal Reserve leadership to implement the sanctions was bipartisan, as both Janet Yellen and incoming Fed Chair Jerome Powell voted for the order.
It is worth noting that the asset restriction, while unprecedented, is good for Wells Fargo on several fronts.
The first is that the asset restriction is damaging to Wells Fargo, but not devastatingly so. The loss of $300-400 million in net income this year may hurt the share price in the short time, but Wells Fargo's overall earnings were still over $22 billion in 2017. The bank will still be able to use its 2017 assets to generate earnings, albeit with growth limited.
The restriction also may not last too long, depending on how fast Wells Fargo is able to bring its management culture and risk control procedures in line with the Federal Reserve's demands. If it can do so quickly, the order may be lifted quite quickly and result in the expected cost of the restriction being reduced further.
The other major benefit for Wells Fargo from this order is that it may finally put an end to the immense reputation and brand damage that the bank has suffered, to a significant effect on its asset and earnings growth, from the fake accounts scandal and the associated other scandals of recent years.
If Wells Fargo is able to finally break free of these scandals clouding consumer trust in the bank as well as keeping a constant cloud of regulatory risk over the bank's operations, it may finally be able to grow in line with its other peer institutions once again.
On the other hand, there is also a chance that its long tit-for-tat with regulators and the public may continue and drag out this scandal. While it appears this latest Federal Reserve action is harsh enough to spur real change in Wells Fargo's governance, the risk of the bank further deflecting, and thus continuing brand and earnings damage, isn't negligible.
Conclusion
The Federal Reserve sanctions may finally be the conclusion and turnaround Wells Fargo needs to put its scandalous past two years behind itself. While it remains uncertain how fast the bank will be able to comply with the Federal Reserve's risk and management culture demands, if it does then Wells Fargo likely will be able to have the clean new beginning it needs to begin restoring trust with consumers and growing again.
This article was written by
Analyst’s Disclosure: I am/we are long KBE. 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.
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