Does the Fed’s relentless grip on Wells Fargo’s balance sheet herald a new compliance regime?

Remedy will likely remain a one-off action

The Federal Reserve’s limit on Wells Fargo’s balance sheet growth – now two and a half years and counting – has caused the bank to reconstitute its corporate governance structure and control functions in an earnest effort to meet the Fed’s conditions for removal. This unusual remedy has sharp teeth. Bloomberg estimated late in August that the $2 trillion asset cap has cost the bank an estimated $4 billion in profits since the Fed imposed it in February 2018. There’s no indication when the cap will be lifted. Caps on asset growth are common against smaller banks that are financially shaky.

The asset cap raises an obvious question: could it evolve into a new way for the banking agencies to compel meaningful changes in compliance and risk management practices in large, complex financial institutions?

To recap, the Fed issued a cease-and-desist order finding that, in light of “pervasive compliance and conduct failures” involving violations of consumer protection laws, Wells Fargo was not meeting its regulatory expectations. The Fed said the firm had pursued a business strategy emphasizing sales and growth without ensuring that senior management had established and maintained an adequate risk management framework. The Fed obviously used the Wells Fargo as exhibit #1 to showcase its 2017 and 2018 guidance for large, complex bank holding companies on board effectiveness and risk management.

The regulatory focus on the bank began in fall 2017 with the disclosure of fraudulent account openings by employees struggling to meet unrealistic sales goals. The Fed’s 2018 order was preceded by a series of somewhat related scandals – in different divisions across the financial conglomerate but mostly involving consumer credit. These included failure to give refunds on insurance policies when customers paid off their auto loans early and charging customers for auto loans they didn’t need. In the Fed’s view, Wells Fargo’s festering problems showed a pervasive, systematic risk management breakdown that merited a draconian remedy. In particular, board members showed little understanding of the gravity of the systemic problem. An asset cap means the bank has to forgo profitable business opportunities, depressing its stock price and fomenting growing anger among its shareholders.

It is useful to call out certain features of the Fed’s action for the precedents they set. The agency sought to ensure its actions would have maximum public impact on the banking industry. First of all, it made these actions very public. Like all such actions, cease-and-desist orders are typically public documents, but the Fed also published two letters of reprimand scolding the former Chairman and CEO for putting sales quotas ahead of risk management capacity and the lead independent director, though aware of compliance issues, for apparently failing to start any serious inquiry into the sales  practices problems or raise the issue with the board. The asset cap was truly without precedent for a bank that was not considered ‘troubled’ in the Fed’s rating system.

The Fed’s remedy also is noteworthy when compared with more traditional remedies such as deferred prosecution agreements. DPAs have had very mixed results in producing a good return on the investment of taxpayer funds. They are always time-stamped with an end date for sign-off by an independent compliance monitor. These settlements are the end product of a highly negotiated process that doesn’t cross a red line for senior management (for both personal and institutional reasons) and that often offers a low-cost resolution for Justice Department attorneys. They are also expensive for the government to investigate, particularly due to the need to show a level of wrongdoing that will pass the hurdle for meaningful settlement negotiations. The banking agencies use similar remedies – cease-and-desist consent agreements with commitments to reform compliance and risk management.

Traditional remedies have been or are being applied to its peer group of systemically important financial institutions. Firms that come close to Wells Fargo’s system-wide deficiencies include Deutsche Bank (for many reasons) and HSBC in its money laundering DPA of 2012. As I have said elsewhere, I predict that the pending DPA with Goldman Sachs for its money laundering in the 1MDB matter will follow the precedent in other large-firm DPAs, with a guilty plea by its Southeast Asian subsidiary and a DPA with Goldman Sachs Group, Inc. Goldman’s risk management deficiencies in detecting and preventing financial crime are not as systematic as they were in the Wells Fargo matter.

Notably, recidivism despite promises to reform conduct has been rampant in the industry. Many of the large banks entered DPAs with the Justice Department only to later engage in wrongdoing in other, similar financial crimes. The path from LIBOR rigging to forex rigging is not a long one.

Asset caps hit home because they interfere directly with senior management’s efforts to meet analysts’ expectations and to move their stock price steadily upward. They cause considerable uncertainty that cannot be easily addressed in earnings calls. In contrast, a DPA fine is a one-time lump sum that puts the matter behind the bank with a contractual end date, enabling management to turn its attention to strategic business plans, constrained only by the market environment.

But the Wells Fargo matter is most likely one-off. The Fed had considerable political leverage in its negotiation on settlement terms in the consent agreement with the bank and felt comfortable including an asset cap in the midst of the deregulatory push by the Trump administration and making public the letters of reprimand to the two senior bank officials. The bank is a particularly egregious example of systematically poor risk management across a number of business lines, reflecting chronic problems in corporate governance and the structure of the control functions. Most significantly, its infractions incurred the populist wrath of Congress. Despite its enormous retail footprint that would serve it well in Washington in normal times, Wells Fargo had no defenders in Congress because of the severity of its violations of customer trust.

Despite all these caveats, as I have noted in a previous blog, the Fed order order bespeaks a more aggressive approach toward the largest banking institutions due to its increasing concern about the largest firms’ ability to manage their diverse business lines within a complex corporate structure. Because they can have such a large impact on our economy and financial system, all types of remedies are worth exploring.

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