As we have written in the past, we strongly favour U.S. mid-cap banks – i.e., those with assets under $100 bln. These 200+ banks are growing (much) faster than their large-cap peers, are generally more rate sensitive, and are merging. And crucially, they have less regulatory risk.
Up until recently, the epicentre of regulatory risk among the mega-caps has been banks with global investment banking operations (i.e., in the U.S., C, JPM, BAC, MS, and GS and in Europe, BARC.LN, DBK.GY, CSGN.VX, and UBS.VX). Which brings us to Wells Fargo (WFC), long considered one of the best large-cap banks in the world. The market appeared to have the mistaken belief that its consumer focused strategy translated into materially lower regulatory risk than its more capital markets focused peers.
However, the bank’s recent scandals surrounding its cross-selling practices appear to be very serious, arguably making the bank more vulnerable given the much wider array of possible litigants. Unique among the non-universal banks, WFC is a national bank, which means it can be sued by up to fifty Attorneys General (many of whom likely want to eventually run for Governor). In addition, with the politically-charged environment in the U.S., there is a risk that the bank may be fined by the Department of Justice. This does not even deal with the response of its primary regulator – the Federal Reserve.
The two most important risks facing WFC have the potential to be hugely significant, but are not quantifiable. First, it is not known what the impact on capital will be from potential litigation from a myriad of plaintiffs, many of which are governments or government agencies. It is reasonable to expect the bank to incur massive and multiple fines, rising litigation reserves, and even implications for the stress tests (i.e., lower capital return assumptions). Second, and even more ominous, fourteen U.S. Senators recently called on the Department of Justice to open a criminal investigation into the bank’s activities, which if it happened, would have an exceptionally negative impact on investor sentiment.
In our view, the latter risk arguably makes WFC un-investable, for now.
To emphasize the ever-expanding regulatory risks, in just the last week, the State Treasurer of California announced it was suspending business with the bank. In Illinois, the Chicago City Counsel announced it was suspending business with the company. The Illinois State Treasurer reportedly suspended $30 bln of state investment activity with the bank. Senator Sherrod Brown is pushing a bill to make it easier for customers to sue the bank (i.e., to supersede arbitration). If this passed, the bank would be vulnerable to class action lawsuits from hundreds of thousands, if not millions of customers, including those in states where jury settlements can be very high. The U.S. Department of Labor vowed to investigate the bank’s employment policies “top to bottom” and has even created a webpage to ensure that current and former WFC employees are aware of worker protection laws. And ominously, the Democratic nominee for President pledged to hold the bank “accountable”.
Where to go from here?
It is possible the bank’s highly material but unquantifiable litigation and regulatory risks could persist for years. Moreover, with literally hundreds of publicly traded banks in the U.S., a substantial number of which have greater earnings growth and – obviously – lower regulatory risk than WFC, we just don’t see a compelling rationale to invest in the bank. That said, it is also possible that the issue passes with minimal impact on the bank’s capital position, as it uses its huge pre-tax quarterly earnings base to build litigation reserves to absorb potential fines over an extended period of time (although in the past, it has seemed as if regulators scale the fine to match the size of the bank). However, we do not believe this is the highest probability outcome.
As we discussed in our Insight Four Largest U.S. Banks See Earnings Decline 9% Y/Y in a Tough Operating Environment (While Mid-Caps’ Earnings Rise 9%), the U.S. mega-banks (including WFC) are experiencing mediocre, if not negative EPS growth. At this time, we see no compelling reasons to invest significant capital in the thirteen largest U.S. banks, namely the three universals (C, BAC, and JPM) and the ten largest regional banks (including WFC, USB, PNC and RF). In the meantime, we will watch future developments facing WFC with great interest.