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Wells Fargo likely to focus on regulatory relationships, not growth, in 2017

Wells Fargo & Co. had a rough second half of 2016, as a scandal led to regulatory sanctions, the resignation of its chief executive and, most recently, a rejected living will. Industry observers say the developments pose risks for 2017 and will force management to prioritize the bank's relationship with regulators over its growth initiatives.

'Crisis of confidence'

The bank is facing a "crisis of confidence" with its customer base and regulators, and it is "losing on both sides," said FBR & Co. analyst Bob Ramsey. The bank must repair its relationship with regulators, who have increased scrutiny in recent months, at the same time it tries to rebuild trust with existing and potential customers.

Wells continues to experience consequences stemming from the revelation that for years, front-line staff at Wells Fargo Bank NA opened millions of unauthorized accounts for customers in response to incentives and sales pressure. The scandal cost the bank $185 million in fines and caused long-time chairman and CEO John Stumpf to step down. Wells Fargo abandoned its sales goals, but the fallout continues. The OCC altered its settlement agreement and imposed greater scrutiny on the bank; it subsequently assigned Wells a 'needs to improve' Community Reinvestment Act rating. Regulators including the SEC, FINRA and the Department of Justice and business partners like Prudential Financial Inc. also began their own investigations.

Heading into the new year, the investment community is questioning whether Wells can show it is implementing cultural change and effectively rebuilding trust.

"It's more about implementing changes around sales goals and how the company operates, and ensuring that that is well-executed," said Piper Jaffray analyst Kevin Barker. "Implementing cultural changes within any organization is difficult and often leads to bumps in the road."

For its part, Wells Fargo said in a statement that it is committed to having a "supportive, caring, and ethical environment for team members" and that the unauthorized accounts were "inconsistent" with its values and culture.

"We regret and take full responsibility for the incidents in which customers received a product they did not request," the bank stated.

Living will setback

After months of losses, Wells Fargo shares rebounded in the wake of Donald Trump's surprise win in the U.S. presidential election in November — perhaps a sign of investor expectations for regulatory rollback under the new administration. But Wells faced another setback in mid-December, as regulators failed the bank's second attempt at a living will.

As a result, the bank faces restrictions on its international and nonbank businesses, which is where senior officials said they had concerns, and must resubmit by the end of the first quarter of 2017. If it has not resolved the issues by that submission, regulators could limit the size of Wells' nonbank and broker/dealer assets to what they were at the end of the third quarter of 2016; if it cannot remedy them within two years, regulators could consult the Financial Stability Oversight Council and require Wells to divest assets or operations.

In a statement, Wells Fargo said it took feedback from its 2015 submission "very seriously," creating a program office dedicated to its resolution and committing "significant" additional resources. The bank said it was "disappointed" with the agencies' determinations but is committed to "strengthening and enhancing" its resolution process.

"We believe we will be able to address the concerns raised today in the March 2017 revised submission," the bank said in the statement.

Several analysts believe the sanctions and living will rejection will not have a material impact on Wells, though these actions could offer clues about how regulators will treat the bank in the future. Keefe Bruyette & Woods analyst Brian Kleinhanzl wrote in a Dec. 13 report that the bank is not as exposed to international markets as its money center peers. Sandler O'Neill & Partners analyst Scott Siefers called the news "an unfortunate surprise" but said he does not expect the bank to be involved in any meaningful nonbank deals in the meantime, in a report dated Dec. 14. Still, these sanctions are "a bit of [uncharted] territory" based on the lack of similar limitations on other companies.

"The harder part is determining from the outside what regulators would consider sufficient remedies to the perceived shortfalls in [Wells Fargo's] living will," he wrote. "For now, it is definitely a negative that regulators have imposed some restrictions on the company's flexibility."

Some analysts believe the rejection of the second living will could also have implications for the company's 2017 submission under the Comprehensive Capital Analysis and Review. The two will be submitted around the same time, Barker said.

"Ultimately, it increases the risk of a qualitative failure in 2017 CCAR," he said. "If you have several instances where a bank is under regulatory scrutiny or the regulators have issues with the way it is managed, whether it's the account scandal or the ability to submit a viable living will, it increases the chances where they could be constrained."

It may take the bank three years to fully recover its credibility with the public and regulators, FBR's Ramsey said; he, too, agreed that passing the qualitative section of CCAR is now a risk for the bank.

"We believe they're going to continue to get dinged on sanctions but we don't know if any will be really material. But it's going to be a constant headline risk for them, [rather] than a bottom-line risk," he said. "By the same token, you have a management team that has to deal with regulators to fix their problems rather than trying to grow the bank."