Wells Fargo’s Sales Scandal Is A Bad Look, But Bank Is Well-Positioned Going Forward

by Trefis Team
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Wells Fargo & Co.
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Wells Fargo (NYSE:WFC) stood out in the U.S. banking sector as one of the few banks that emerged stronger from the economic downturn of 2008 – capitalizing on its risk averse, community-focused business model to grow large enough to rival its substantially diversified peers JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Citigroup (NYSE:C). In fact, the other banks have been working on ways to emulate Wells Fargo’s success over recent years – especially by looking for more efficient ways of cross-selling financial products to existing customers like Wells Fargo. This is why investors, and the industry at large, were taken by surprise earlier this month when Wells Fargo revealed that it will pay $185 million in fines to regulators over fraudulent selling practices by some of its employees since 2011. ((Wells Fargo Issues Statement on Agreements Related to Sales Practices, Wells Fargo Press Releases, Sep 8 2016))

With Wells Fargo staring at a large class-action lawsuit from customers, and with its top management taking considerable heat from investors and the U.S. Senate over the malpractices, its share price has fallen by more than 7% in the last two weeks. Another factor that played a role in the share sell-off was the bank’s remedial action to eliminate all product sales goals for its retail banking employees, as this is likely to negatively impact fee-based revenues for the bank going forward. [1]

While the situation will directly cost Wells Fargo millions of dollars in legal and settlement fees, and the bad press has hurt the bank’s reputation, we believe that the bank remains in a strong position going forward. The bank’s shares are currently very oversold, and we maintain our $60 price estimate for Wells Fargo’s stock. This target price is around 30% higher than the current market price.

See our complete analysis of Wells Fargo here

The Cross-Selling Story Isn’t Inherently Wrong; Wells Fargo Just Pushed It Too Hard

Wells Fargo seemed to have its hands on the perfect formula for success in the traditional loans-and-deposits banking industry, as it churned out better returns for investors than any other big bank in the country – even though the low interest rate environment presented considerable headwinds. The key was in Wells Fargo’s ability to grow fee income to counter the impact of falling net interest income on the top line, something that it achieved primarily through cross-selling its products to existing customers.

As it turns out, Wells Fargo promoted the cross-selling culture too aggressively. With compensation for retail bank employees being directly tied to closely monitored sales targets, a sizable employee base resorted to unfair selling practices. An internal analysis by Wells Fargo revealed that between 2011 and 2015, the bank’s employees opened 1.5 million deposit accounts and issued 565,000 credit cards for customers without authorization. [2] Other malpractices included issuing debit cards and generating PINs for customers without informing them, and creating fake email IDs for existing customers to sign them up for additional online banking services.

It should be noted that these malpractices did not have any positive impact on Wells Fargo’s deposit base or card balances, as the unauthorized accounts merely contained funds and balances transferred from legitimate accounts. However, some of these actions did trigger specific deposit-related fees (like overdraft fees and insufficient funds fees), annual fees and also financing/interest fees in the case of some cards. But given that regulators estimate that the total fees wrongly charged to customers were under $5 million, they did not have a material impact on the bank’s deposit and card fee revenues over 2011-15 (which add up to over $41 billion).

The Direct Cost To The Bank From These Misgivings Are Sizable, But Won’t Dent Profits

Wells Fargo’s direct cost from these malpractices can be classified as:

  • Penalties and fines to regulators: As already announced by the bank, total regulatory fines total $185 million. Of this, $100 million will be directed to the Consumer Financial Protection Bureau’s (CFPB’s) Civil Penalty Fund, $35 million will be paid as penalty to the Office of the Comptroller of the Currency (OCC), and $50 million is earmarked for the City and County of Los Angeles. [3] Notably, the bank had already accrued these costs by the end of Q2 2016, so the bank will not incur any additional cost this quarter as a result of this settlement.
  • Customer Redress Costs: The bank will set aside $5 million to pay restitution for all customers affected by the fraud.
  • Other Legal and Settlement Costs: While these expenses are difficult to estimate, the fact that Wells Fargo is being probed by the Department of Justice (DoJ) over these fraudulent practices even as affected consumers work towards a class-action lawsuit makes this the biggest potential direct cost for the bank. In any case, we believe that these costs are unlikely to exceed $300 million.

Wells Fargo is therefore looking at total expenses of no more than half a billion dollars. That represents just about 6% of the bank’s quarterly operating expenses of roughly $8 billion – not something that will hurt the net income figure for any given quarter.

There Will Also Be Some Notable Indirect Costs To Be Incurred

There are indirect costs that Wells Fargo will have to incur as a result of this sales scandal in the near future, though. Firstly, the bank is likely to see a sharp reduction in deposit growth over the next few quarters, as retail banking customers could shift their cash to competitors. Such a scenario was seen in 2012 for rival JPMorgan, when the bank reported losing billions due to the London Whale trading debacle. As the banking industry is all about customer perception, JPMorgan saw its deposit base fall in Q2 2012 – immediately after the announcement.

The issue at Wells Fargo directly affected retail banking customers – unlike JPMorgan where the losses were internal. So, the resulting loss in customer trust is likely to hurt Wells Fargo’s deposit base for a longer duration than what JPMorgan saw in 2012.

Also, the increased scrutiny from regulators and the Senate could result in key management personnel exiting the bank – something that will introduce yet another hurdle in the road for Wells Fargo as it tries to quickly resolve the issue at hand.

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Notes:
  1. Wells Fargo to Eliminate Product Sales Goals for Retail Bankers, Wells Fargo Press Releases, Sep 13 2016 []
  2. Consumer Financial Protection Bureau Fines Wells Fargo $100 Million for Widespread Illegal Practice of Secretly Opening Unauthorized Accounts, CPFB Website, Sep 8 2016 []
  3. ref:3 []
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