Fed's stinging Wells rebuke puts all banks on notice

The Federal Reserve on Friday slapped Wells Fargo with an unprecedented enforcement action — one of the harshest it has ever handed down — but the message it sent went far beyond a single institution.

The order bars the nearly $2 trillion-asset bank, the third biggest in the U.S., from growing any larger, though Fed officials and the bank itself were quick to clarify that it could still take deposits and make loans. In a concurrent decision by Wells’ board of directors, three members of the Wells board will be replaced by April and a fourth will be replaced by the end of the year. (Neither the bank nor the Fed would reveal which board members were leaving.)

Reaction to the news was swift and severe. Wells’ share price dropped more than 6% in after-hours trading, and Sen. Elizabeth Warren, D-Mass., praised the recently departed Fed Chair Janet Yellen for removing members of the bank’s board of directors in response to its phony-accounts scandal, which came to light in 2016.

“For months, I have repeatedly pressed Janet Yellen to hold Wells Fargo accountable for its fake-accounts scam and push out responsible board members,” Warren said. “Today she did it — in her last act as Fed chair. Fines alone will never rein in fraudulent behavior at the big banks and by pushing out board members at Wells Fargo, Chair Yellen sends a strong message.”

The Fed’s order does not require any members of Wells Fargo’s board of directors to be removed, nor did Yellen or the Fed take credit for their ouster.

But the announcement sent ripples through the financial regulatory world, signaling a new era at the Fed and continuing trouble for Wells and other big banks.

"The Fed’s actions were likely meant to serve as a warning to other banks just as much as they were meant to discipline Wells," said Brian Tayan, a researcher with the corporate governance research initiative at Stanford Graduate School of Business. "Severe actions are likely to get a lot of bank board members’ attention, and it looks like they succeeded."

Here are some key takeaways from the order:

No federal regulator has ever restricted a bank from growing before, but in the case of Wells Fargo, the Fed was clearly willing to give it a try.

The order requires the firm to develop and submit a plan to the Federal Reserve Bank of San Francisco and the Fed board’s Division of Supervision and Regulation within 60 days that addresses a panoply of managerial and risk-control problems identified by the Fed.

The problems are related — but not limited to — the bank’s cross-selling scandal and questions about its insurance sales practices, according to a Fed official, and the requirements of the order are meant to ensure that the bank has a better hold of its compliance and management before it gets any bigger.

The Fed said in its order that Wells “shall not … take any action that would cause the average of [its] total consolidated assets … to exceed the total consolidated assets reported as of Dec. 31, 2017.” That effectively bars any future acquisition, but could also apply to any number of actions the bank may have been considering as part of its overall business strategy.

And the requirements that the order imposes are daunting — or at the very least time-consuming — for Wells to comply with. Those restrictions will be in place until the firm submits written plans to comply with its various managerial shortcomings to the San Francisco Fed and the Fed Board.

Both the regional Fed bank and the board’s Office of Supervision must be notified in writing that those plans are acceptable. Wells then has to implement those plans “to the satisfaction of the Reserve Bank, with the concurrence of the Director of the Division of Supervision and Regulation” and then must be notified in writing by both that “all of the above conditions have been met.”

And finally, if Wells does “not make progress satisfactory to the Board of Governors” in addressing the problems cited in the order, “the Board of Governors may impose additional restrictions or limits, or take other action as permitted under applicable law.”

Tayan, the researcher at Stanford, said that the order suggests that the Fed intends to keep the bank under its microscope much longer than the institution might have anticipated, and that time may be far more uncomfortable than it thought.

"The big takeaway for banks is that regulatory scrutiny of their behavior has the potential to extend much longer in time than they might realize,” Tayan said. “It looked like Wells was digging out of their problems, but regulators are signaling that they want to keep a tight leash on management and boards until problems have been thoroughly rectified.”

Tayan added that the order will probably be taken as a lesson to other banks as well.

“They are truly holding board members accountable for management misbehavior,” Tayan said. “The likely outcome is that boards will press management much more actively for information about potential violations in their organizations, and most likely also hold them to higher standards. Self-preservation is a powerful motivator.”

Despite its ongoing reputational troubles, Wells Fargo last year recorded net income of $22.2 billion, a number surpassed only by JPMorgan Chase among U.S. banks.

The bank said Friday that it expects its 2018 net income to fall by $300 million-$400 million as a result of the consent order — equivalent to 1.3%-1.8% of last year’s total. That’s a significant hit.

Shares in the company fell by 6.2% in after-hours trading, following a broad sell-off of the stock market earlier in the day.

“It will be interesting to see what happens on Monday morning,” said Nancy Bush, an analyst at NAB Research, who heard the news at dinner.

Bush said the Fed’s action against Wells Fargo is harsher than any penalty against a big bank that she can remember during 35 years covering the industry.

“This is much more draconian than anything I can remember,” she said. “So it’s shocking.”

Bush expressed particular concern about the asset cap that is imposed by the consent order. At the end of 2017, Wells had total assets of $1.95 trillion. It will have to stay at that level until it satisfies the Fed’s concerns regarding the company’s governance and risk management controls.

The asset cap will remain in place until at least the fourth quarter of this year. Just how much the cap will crimp the bank’s growth is unclear. In 2016, Wells Fargo grew its total assets by just $21 billion. The previous year, the bank’s assets rose by $143 billion.

On a conference call late Friday, Wells CEO Tim Sloan said that the bank plans to manage its balance sheet by reducing its volume of certain commercial deposits, trading assets and short-term investments.

Combined, the categories of assets that the bank said could be reduced total around $530 billion. They do not include any consumer deposits.

“The takeaway here is that we have meaningful levers we can pull within the cap and still grow loans and deposits with relatively modest balance sheet impact,” Sloan said.

Concurrent to the consent order, Wells will also replace three current board members by April and a fourth by the end of the year.

Nine of the company’s 16 directors have joined since 2015. Two directors whose tenures began earlier, Enrique Hernandez and Federico Pena, received less than 55% support from Wells Fargo shareholders at the company’s annual meeting in April.

It makes sense to bring fresh blood onto the bank’s board, said Charles Elson, a professor of finance and corporate governance at the University of Delaware who is also a Wells Fargo shareholder.

“These folks were overseeing the bank when the problematic activities occurred, and there has to be some consequences for problematic oversight,” Elson said.

But Elson took issue with the asset cap, saying that it imposes additional pain on him and other shareholders.

“Ultimately it’s the shareholders who were harmed by the actions of management,” he said.