A Wells Fargo Sanction, a Warning for Its Peers

SMITH BRAIN TRUST – For Wells Fargo, the Fed’s surprisingly stringent sanctions last week undoubtedly come as a bit of a blow. For the rest of the banking industry, more of a warning.

“This is a supervisory slapdown in a major way like I have never seen before,” says Clifford Rossi, professor of the practice and executive-in-residence at the University of Maryland’s Robert H. Smith School of Business. “To tell an entire firm that you cannot grow, because we don’t have confidence that you have your act together from a governance and process standpoint, that’s pretty severe. That’s about as severe as I have ever seen in my time in industry.” 

Late Friday, after the close of Wall Street’s trading day, the Federal Reserve announced it would require the replacement of four of Wells Fargo’s board members and would limit the institution’s total assets, capping them at the bank’s Dec. 31 levels, until its risk and governance are improved. The sanctions come in the wake of Wells Fargo’s fake accounts scandal, in which branch employees across the country opened more than a million checking and credit card accounts for customers without their permission.

“This is unprecedented and that’s what makes it so shocking,” says Rossi, who before coming to the Smith School was a chief risk officer for Citigroup’s Consumer Lending Division. “And it should send chills down the spines of all banks that are out there. This is the Fed saying, ‘We’re watching what boards do. And we are not going to tolerate boards that are inattentive going forward.’”

Since the financial crisis, regulators have stiffened their expectations for boards of directors of financial institutions – requiring an effective or credible challenge to management. “Boards cannot just go along with what management says, simply because they are the supposed subject matter experts,” says Rossi. “They are there really to play devil’s advocate to what management is telling them about either risks that are in front of them.” 

Now, in the wake of the Wells Fargo scandal, Rossi says, it’s likely that the examination staff at the Federal Reserve, OCC and the FDIC are likely to be more vigilant to what’s going on with bank boards, scrutinizing their meeting minutes more closely, and making sure boards are fulfilling their fiduciary responsibilities in ways the industry has not seen before.

Last year, Rossi examined exactly who was on the board risk committees for each of the country’s five largest banks, trying to determine what their qualifications were for the role. Across the five banks at the time, there were 32 boards of director members seated on risk committees. And of those 32, Rossi says, only two had direct risk management experience.

“They’ve got people who are heads of grocery store chains who are sitting on these risk management committees – people who have never managed risk a day in their lives," he says. "And it’s been that way for years.”

Rossi says he can’t understand why regulators have not set a higher standard for members of bank risk management committees, when the risks that financial institutions face, handled poorly, can imperil the economy.

“Having someone who understands risk on these committees makes such a difference,” Rossi says. “They know how to ask the right questions.”

Some prominent lawmakers, including Massachusetts Sen. Elizabeth Warren, have repeatedly raised concerns that the country’s largest banks are too large to be managed effectively and therefore pose too great a risk to the U.S. economy. There’s some validity to the concern, Rossi says.

“Even an excellent CEO can’t know everything that’s happening in an institution that’s so far-flung. It’s too hard to know where all the institutional issues might lie,” Rossi says. 

Financial institutions need strong governance structures in place and ways to sound the alarm about problems, regardless of where they come from. They need a company culture that allows people to voice concerns without fear of retribution. Without that, Rossi says, risks and other problems will remain beneath the surface, metastasizing.

And they must resist the allure of short-termism, the drive among banks and many other publicly traded companies to focus constantly on next quarter’s earnings, even at the expense of more long-term, meaningful objectives and the proper management of risks. “There is this sense on Wall Street that you are only as good as your next quarter’s earnings,” says Rossi. “Investors are ruthless about that.”

The San Francisco-based Wells Fargo is estimating that the work needed to comply with the Fed’s consent order could shave as much as $400 million from its profits this year. 

“The Fed knew this would have an enormous negative impact on the company and yet they still took action, which tells me that they must be very very concerned that this is a company that has some serious board problems,” Rossi says.

Later this year, Wells Fargo is expected to be the subject of a third-party review of its practices and its response to the Fed’s sanctions.

“I can only imagine being on deck at Wells Fargo,” Rossi says. “It must be pandemonium under the surface there. Working there must be very, very tough right now.”