Wells Fargo’s New Enforcement Action Pushes Back The Asset Cap Lifting Timeline (Rating Downgrade)

Summary:

• Wells Fargo’s ongoing regulatory issues, including a recent OCC enforcement action, delay the likelihood of the Federal Reserve lifting its $1.95 trillion asset cap.
• The bank’s efforts to modernize risk management systems have not fully satisfied regulators, impacting its ability to expand and improve profitability.
• Wells Fargo’s valuation remains lower than peers due to regulatory scrutiny, with recent developments lowering near-term price estimates to the high $50s.
• Future dividend increases and profitability are tied to lifting the asset cap, which now seems less likely to occur before late 2025 at the soonest, and probably later.

Wells Fargo (NYSE:WFC) issues with federal regulators have and continue to frustrate shareholders. While it had recently appeared as though WFC was getting into the better graces of the agencies, this appearance changed earlier this September after the Office of the Comptroller of the Currency (or “OCC”) entered into a Formal Agreement with Wells Fargo Bank. This issue increases scrutiny on the bank and lowers the probability of the Federal Reserve lifting the $1.95 trillion asset cap it imposed on the bank in 2018.

Last month, I wrote an article where I presumed the asset cap was likely to be lifted in 2025 due to the banks progress, but this new enforcement action by the OCC makes such an occurrence considerably less likely. Therefore, even though the bank does appear to trade at a fair value at risk, near term price estimates should be lowered to reflect this reduced probability of exiting the regulatory purgatory where Wells Fargo has remained stuck since 2018.

Wells Fargo primary challenge over the last half a decade has been to fix its risk management systems and oversight, and to modernize those systems to a level that pleases federal agencies, and especially the Federal Reserve. beyond the asset cap, agencies imposed multiple consent orders upon the bank. Wells Fargo has had to replace its C-suite and spend tens of billions in upgrading its risk management platform in order to obtain better oversight of the practices of its bankers, and had to revamp the policies that resulted in fraudulent account openings, among other actions. It had appeared as though Wells Fargo was close to appeasing the regulators, but this most recent OCC issuance of an enforcement action calls into question the progress the bank has made, as well as the opinion of the regulators.

The OCC’s recent Formal Agreement identified deficiencies relating to the Wells Fargo’s “financial crimes risk management practices and anti-money laundering internal controls in several areas including suspicious activity and currency transaction reporting, customer due diligence, and the bank’s customer identification and beneficial ownership programs.”

The agreement requires the Wells Fargo to take comprehensive corrective actions to enhance its Bank Secrecy Act/Anti-Money Laundering and U.S. sanctions compliance programs. Wells Fargo will be precluded from expanding into new products, services, or geographic markets with a medium or high BSA/AML or OFAC Sanctions inherent risk while developing fixes for the concerns highlighted by the OCC.

This criticism appears somewhat closely related to the pre-existing concerns regarding poor risk management systems and oversight. Further, it is probably the case that the Federal Reserve is unlikely to lift the asset cap in advance of such issues being corrected, or at least while a peer agency is adding scrutiny to the bank.

Due to these ongoing regulatory issues, Wells Fargo trades at a lower valuation than most of its large peer banks, as well as its own historical valuation. Such a discount makes sense, as rebuilding trust with customers and regulators is a costly and long-term process. It had appeared reasonably probable that much of the damage was in the past, and that the bank would soon begin to benefit from the capital expenditures it implemented as part of the process. This is likely still the case, but the OCC’s new Enforcement Action indicates there is probably more road ahead than previously appeared to be the case.

This continuing regulatory scrutiny has caused Wells Fargo to forego various actions that it may have otherwise implemented in efforts to enter new markets, add financial products, or even finance large corporate clients in M&A, as well as development plans. Beyond the asset cap and enforcement actions, banks like Wells Fargo are stress tested by the Federal Reserve and must accept the Fed’s decision on matters such as increasing the dividend.

Wells Fargo had to substantially reduce its dividend due to the scrutiny it faced, and continues to face, as well as the loss to revenue and income the bank’s poor actions had on its business. In 2023 and earlier in 2024, Wells Fargo was able to raise its dividend and annual dividend increases in 2025 and 2026 still appear reasonably possible, absent a significant economic downturn.

Wells Fargo’s capacity to raise its dividend, as well as the level to which it may make future increases, will at least partially depend upon the timing of the Federal Reserve lifting the asset cap. In 2022 and 2023, higher interest rates allowed the bank to generate better net interest margins than it realized in prior years, but that benefit likely already peaked. In fact, Wells Fargo’s net interest income strength may have already peaked in 2023. Going forward, Wells Fargo’s capacity to increase its profitability will more closely become correlated with its capacity to increase its business, which means it will need to get out from under the cap.

In 2020 and 2021, Wells Fargo divested itself of various higher risk portions of its asset portfolio in order to stay under the asset cap. This maneuver made the bank higher quality by de-risking its portfolio. Because of this, its assets were less susceptible to declining valuations in the face of rising interest rates. Moreover, their shorter duration made it easier for Wells Fargo to roll them over into higher yielding short term Treasuries and related high quality paper as rates continued to climb. But when rates are declining, higher yielding assets become more desirable.

The asset cap mandates that the Wells Fargo’s assets remain under $1.95 trillion, and the bank basically hovers just below that level. Because of this, Wells Fargo must refrain from investing in anything that has the potential to increase in value, or it will have to divest it, or something else equal to those gains. As interest rates decline, some of Wells Fargo’s assets are likely to increase, meaning that the bank may have to sell more assets if it cannot get out from under the asset cap during this coming rate cut cycle.

On July 12, 2024, Wells Fargo reported second-quarter EPS of $1.33 per share, compared to $1.25 per share in the second quarter of 2023. Trading revenue was $1.4 billion, which was nearly an all-time high for the bank. Wells Fargo’s return on tangible equity was 13.7 percent, which was below management’s target of 15 percent.

The bank estimates that total 2024 NII may be as much as 9% lower than 2023’s total, which came in at $52.4 billion. It appears reasonably likely that NII is in the middle of a bottoming process, and that Wells Fargo should have the capacity to increase its net interest income in 2025 and 2026. Wells Fargo has had no real capacity to make a significant acquisition since the asset cap was put in place. This has also prevented the bank from being a choice for receiving assets due to FDIC failures, much like JP Morgan (JPM) has been.

Wells Fargo has made significant investments in technology in order to enhance the customer experience, improve efficiency, and develop a state of the art risk management system that will please regulators. Despite these efforts, Wells Fargo continues to get whacked by regulatory scrutiny and in particular due to issues relating to their risk management systems. The OCC enforcement action released earlier this month indicates that Wells Fargo is not as close as it previously appeared to getting out from under the scrutiny of the federal agencies, including the Federal Reserve’s asset cap.

Another major risk is that of potential regulatory changes, which could depend upon political posturing, or follow the failure of a peer bank. Changes to financial regulations can substantially impact the banking business model, or simply cause reduced profitability. While it is hard to imagine Wells Fargo having greater regulatory oversight than it has had over the last several years, it could happen, or the existing oversight could simply continue longer than previously anticipated.

Wells Fargo also must continue to rebuild trust with customers. Where the bank was once viewed as one of the most trustworthy and conservative banks, these recent scandals have changed that perception. Regaining consumer confidence is a long-term challenge that will require a sustained effort. Further revelations of impropriety only delay this process.

Conclusion

The fair value of Wells Fargo shares should be lowered due to the new enforcement action by the OCC, and the likelihood that this action created towards extending the timetable for lifting the asset cap. Wells Fargo previously appeared somewhat likely to finally get out from under the Federal Reserve’s asset cap in 2025, and such a revelation was likely to cause shares to be revalued higher. Due to the recent OCC enforcement action, this timetable appears less probable, and now late 2025 seems like the rosiest of expectations for the asset cap to be lifted, and later than that is becoming increasingly probable.

Since this new enforcement action regarding risk management systems delays the probable timeline for lifting the asset cap, this should result in a lower fair market valuation for Wells Fargo. While it previously appeared as though Wells Fargo shares would soon appreciate to the $60s, this new development lowers that potential valuation target to the high $50s. Though Wells Fargo still appears to present a strong value at risk, it no longer seems probable that the asset cap will be lifted in 2025, and the bank is likely to be susceptible to market volatility in the coming months. Further, Wells Fargo is now likely to provide updated guidance regarding costs associated with fixing its regulatory issues, so as to include measures to address the OCC’s new enforcement action, and this may result in lower income and analyst estimates after reporting its next quarterly earnings in October.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of WFC, JPM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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