Breakingviews: Wells Fargo labors under $100 bln sin discount

Charlie Scharf started his new year’s resolutions early. The Wells Fargo chief executive agreed the bank would pay $3.7 billion to settle with a U.S. consumer finance watchdog at the end of 2022, atoning for years of mistakenly freezing accounts, wrongly repossessing cars and illegally charging customers fees. With a cumulative cost of bad behavior surpassing $100 billion, by Breakingviews calculations, there is a lot of hard work yet to do.

For Scharf, 2023 is crunch time. It has been five years since the U.S. Federal Reserve forbade Wells Fargo from growing its balance sheet beyond $2 trillion until its conduct problems had been resolved to the central bank’s satisfaction. The trigger was the discovery of millions of accounts opened without customers’ consent, but the problems are multitudinous, from mis-selling loan insurance to the use of the lender’s software by foreign banks doing business with sanctioned entities.

Censures and fines, especially of this magnitude, can start to seem like just the cost of doing business for big banks. Investors rarely blink any more by the time they are announced. Wells Fargo shows what happens when misbehavior becomes a feature rather than a bug. It hasn’t helped itself with other examples of how a culture can run amok, from reports of sham job interviews designed to boost diversity numbers to the recent firing of an India-based executive accused of urinating on a fellow airline passenger.

The resolution in December is undeniably progress, however. The San Francisco-based bank will pay $2 billion to customers it short-changed and another $1.7 billion directly to the Consumer Financial Protection Bureau. Scharf said Wells Fargo would book a $3.5 billion charge when it reports earnings, scheduled on Friday. Earnings per share are likely to be 41% below last year’s annual figure, according to RBC Capital Markets. There is more to come: Scharf warned recently that rehabilitation would be slow and costly. An October disclosure itemized 14 separate legal actions.

Tragic number

Serial mischief has cost Wells Fargo investors in three ways. First, there are penalties that show up in what the bank calls “operating losses.” It will have booked $25 billion of them since the beginning of 2017, the first full year after widespread fraudulent habits were uncovered in its consumer bank. Of that sum, it has paid $11.5 billion in fines, according to the Good Jobs First Violation Tracker. That is money diverted from stock buybacks and dividends, or which deprives the bank of earnings to fuel future lending.

Second, there are the expenses Wells Fargo has incurred from its internal deep clean. Those range from “professional services” to extra hires in its compliance and administrative teams. Before the fake-accounts scandal, Wells Fargo used to spend around $50 billion annually on expenses, excluding operating losses. Since then, it has laid out around $16 billion above that baseline. Together with the operating losses, it suggests over $40 billion of pre-tax earnings have been thrown on the bonfire.

Shareholders have suffered the biggest cost, however, in a less straightforward way: the balance sheet restrictions. Wells Fargo’s asset total remains capped until Scharf can convince Fed conduct chief Michael Barr that staff have changed their ways. America’s top six banks as a group, over the past five years, have expanded their balance sheets by one-third. Had Wells Fargo been permitted to keep pace, it might have amassed an additional $650 billion in assets.

The figure represents a heap of lost profit, considering that Wells Fargo consistently generates earnings of about 1% from its assets. At that rate, it suggests $6.5 billion of forgone profit. Since investors have tended to value Wells Fargo at 11 times its forecast year-ahead profit over the last decade, according to Refinitiv, it equates to some $70 billion of market capitalization that the Fed’s financial handcuffs have put out of reach, and takes the total notional cost of Wells Fargo’s misconduct to more than $100 billion.

The silver lining is that Scharf has something big and measurable to aim for in 2023: earning back that 12-digit heap of lost value. A little more than seven years ago, Wells Fargo, Bank of America and JPMorgan were roughly the same size in terms of market cap. At $161 billion, Wells Fargo now sits $110 billion short of Bank of America and a whopping $243 billion below JPMorgan. If Scharf’s to-do list is as bold as what he accomplished at the end of 2022, he might just be able to take advantage of rising interest rates, boost the bank’s lending and start playing catch-up in earnest.