A Closer Look At The Impact Of The Fed’s Decision To Curtail Wells Fargo’s Growth

by Trefis Team
Wells Fargo & Co.
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Late last week the Federal Reserve passed an enforcement order against Wells Fargo prohibiting the banking giant from growing any larger until it has satisfactorily resolved all its internal governance issues. The unprecedented order by the Fed seeks to expedite the pace at which Wells Fargo fixes its internal control structure which failed to prevent major sales malpractices by some of its employees over a period of several years. The Fed’s action triggered a sharp sell-off in the bank’s shares – resulting in its share price tanking 13%.

While the enforcement order is definitely bad news for the bank, as it will have a material impact on earnings in the near future, we believe that the bank’s shares are now a bit oversold. In our opinion, Wells Fargo investors stand to benefit on two fronts from the Fed’s tough stance: firstly, the bank will now work on an accelerated timeline to put this nagging issue to rest once and for all; and secondly, the bank will very likely increase share repurchases over the next few months as a means to reduce its cash balance while also benefiting from the low share price.

We expect Wells Fargo to fulfill the Fed’s requirements over the course of the next six months – allowing it to get the enforcement order terminated by the end of the year. The bank will, however, lose up to $400 million in profits over this period. Taking all this into account, we believe that a price estimate of $65 for Wells Fargo’s shares is appropriate. Our price estimate is now nearly 15% ahead of the current market price.

What The Fed Wants Wells Fargo To Do, And Why

Wells Fargo – the third largest U.S. bank in terms of total assets – has been under fire from investors as well as regulators since September 2016, when it was revealed that its employees fraudulently opened millions of accounts. Since then, internal investigations by the bank unearthed other improper practices by some employees, including making unsuitable mortgage modifications, selling unwanted auto insurance, improperly charging fees for locking in mortgage rates, and adding chargeable add-ons to accounts without the customers’ permission.

With several U.S. regulators investigating Wells Fargo’s wrongdoings at the state and federal level, the Fed’s recent enforcement action is an attempt to contain the risk to customers from unsound control policies at the bank. The Fed expect Wells Fargo to:

  • Replace three board members in the next two months and a fourth one by the end of 2018
  • Submit a written plan within two months detailing how the bank intends to improve the effectiveness of its board to oversee and govern the bank
  • Submit a written plan to improve its compliance and operational risk management program
  • Conduct two independent reviews of the efficacy and sustainability of its submitted plans later
  • Maintain its average quarterly asset balance at $1.95 trillion till it successfully completes implementing these plans and obtains the Fed’s clearance to grow its balance sheet again.

What This Means For Wells Fargo’s Financial Metrics In 2018

Wells Fargo’s biggest challenge over coming months will be to ensure that it is able to accommodate growth in core loans and deposits without letting its balance sheet swell in size. The required efforts to manage its balance sheet at current levels is expected to cost the bank between $300-$400 million in profits this year.

We capture the financial implication of the enforcement order on Wells Fargo in detail as a part of our Interactive Model for the bank. A summary of our analysis is shown below:

  • The bank will mitigate the impact of a larger loan portfolio on its total asset base by reducing its portfolio of trading assets and short-term investment securities

  • Also, the growth in core consumer deposits for the year will likely have to be balanced by liquidation of non-commercial deposits and deposits from financial institutions

  • The pressure on interest-earning assets will weigh on the bank’s net interest income – although gains from the Fed’s ongoing rate hike will help the overall figure grow compared to 2017

  • Additionally, specific fee-based revenue streams that are directly linked to balance sheet items (like deposit- and loan-related fees) will see muted growth over the year

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