Fed should force Wells Fargo into being a simpler bank

Earlier this month, Wells Fargo’s primary regulator testified that the bank has not yet cleaned up its act. Appearing before the Senate Banking Committee, Comptroller Joseph Otting asserted that regulators “are not comfortable with” Wells Fargo’s lackluster efforts to fix its innumerable problems.

Wells Fargo has repeatedly demonstrated its inability to oversee its traditional banking businesses, with scandals ranging from its retail deposit accounts to consumer lending. Why, then, do regulators continue to permit the company to engage in even more complex nonbanking activities?

Historically, bank holding companies have been limited to taking deposits, making loans and engaging in closely related activities, such as investment advising and asset management. In the Gramm-Leach-Bliley Act of 1999, however, Congress authorized a new subset of firms — called financial holding companies — to engage in an expanded range of financial activities. These privileges include investment banking, insurance underwriting and merchant banking.

To qualify as an FHC, a firm must meet heightened regulatory standards. Specifically, the company itself and all its bank subsidiaries must be both well capitalized and well managed. Thus, only companies with high capital ratios and satisfactory management and composite Camels ratings can become and remain FHCs. These standards ensure that only strong, well-run firms engage in potentially risky financial activities.

In the two decades since Gramm-Leach-Bliley, all of the largest U.S. financial conglomerates have become FHCs. Even Wells Fargo, with its traditional focus on plain-vanilla banking, expanded into nonbanking activities. For example, Wells Fargo now operates a sizable investment bank that has been designated as a primary dealer by the Federal Reserve Bank of New York.

Despite the prevalence of FHCs, the Fed has failed to ensure that these firms continue to maintain the requisite safety-and-soundness standards. By law, when an FHC ceases to be well capitalized or well managed, it has 180 days to correct its deficiencies. After that, the Fed may revoke the company’s FHC status, requiring the firm to cease its nonbanking activities or divest its subsidiary banks.

The Federal Reserve, however, has never publicly rescinded a firm’s FHC status. Instead, the Fed typically orders a noncompliant FHC to execute a “section 4(m) agreement,” in which the company commits to correct its deficiencies within a certain time frame. These confidential 4(m) agreements, however, can be rolled over indefinitely. In the meantime, noncompliant FHCs may continue to engage in financial activities.

Wells Fargo no longer satisfies the well-managed requirement to remain an FHC. A bank’s Camels rating is typically treated as confidential supervisory information. However, The Wall Street Journal recently reported that Wells Fargo’s management rating was downgraded to “needs improvement” in mid-2017. Comptroller Otting’s comments to the Senate Banking Committee indicate that the bank has not improved its risk management oversight or corporate culture since then.

It is therefore time for the Fed to revoke Wells Fargo’s FHC status. If Wells Fargo cannot safely manage its traditional banking businesses, how can we expect it to oversee its more complex activities?

Terminating the FHC status of Wells Fargo and other chronically noncompliant firms would have several significant benefits. For example, forcing noncompliant FHCs to divest their nonbanking operations would decrease the financial stability risks posed by these poorly managed financial conglomerates. In addition, by exercising its authority to break up noncompliant FHCs, the Fed would increase other FHCs’ incentives to remain well capitalized and well managed.

Withdrawing Wells Fargo’s FHC status is all the more important because past enforcement actions against the firm have proven ineffective. Earlier this year, the Fed famously restricted Wells Fargo’s asset size to no more than $1.95 trillion. Although touted as a significant sanction, the penalty has had a negligible effect on the bank. Indeed, Wells Fargo executives estimated that the asset cap would reduce after-tax net income by just $100 million. Earlier this month, Wells Fargo reported $6 billion in third-quarter net income despite the cap. And the bank is planning to return a record amount to its shareholders through dividends and share repurchases.

Nor will other enforcement mechanisms sufficiently penalize Wells Fargo and its leadership. The directors who were discharged in connection with the Federal Reserve’s consent order have found soft landing spots at other firms. And, for whatever reason, no individuals have been prosecuted for Wells Fargo’s fraudulent conduct.

To appropriately penalize Wells Fargo, therefore, the Fed should revoke its FHC status. Without FHC privileges, Wells Fargo would be forced to spin off or sell its investment bank and other nonbanking activities that account for approximately 15% of its revenues. Divesting these operations would allow Wells Fargo to focus on fixing its persistent problems in its core retail bank business. Wells Fargo could divest its nonbanking operations with limited market disruption, just as other financial conglomerates have spun off sizable segments in response to market forces.

In sum, Wells Fargo has consistently failed to meet the heightened regulatory standards necessary to engage in the full panoply of complex financial activities. The Fed should ensure that it no longer enjoys that privilege.