Wells Fargo’s banking recipe

By: Shyam Pattabiraman

The US bank operates on the principle of focusing on core banking activities rather that fee-related and trading activities.

Wells Fargo is one of the few banks that was able to keep its head above water during the mortgage crisis that took down many of the others in the US. This is surprising, given that it is one of the largest mortgage lenders (home loans) in the US.

Of course, it is easy to lay the credit in the lap of the US Government which forced large banks such as Wells Fargo to compulsorily accept financial aid to bolster their balance-sheets.

But people in the banking circle know that Wells Fargo would have survived even without the Government’s largesse. Today, Wells Fargo is one of the most valuable banks (by market cap) in the US and probably one of the safest too.

During the height of the financial crisis in the US, John Stumpf, CEO of Wells Fargo, made a pertinent comment. He said: “It’s interesting that the industry (banking) has invented new ways to lose money when the old ways seemed to work just fine”.

His statement, albeit funny, highlights a few important aspects of banking. First, banking is by nature a risky business; second, it is the job of banks to minimise credit loss in the process of pursuing profits; third, it is safer to stick to the knitting in terms of the business model rather than be too adventurous.

Here are a few insights from Wells Fargo’s success that can be used as a checklist to evaluate any bank.

Traditional business model: At the core, banking is about earning a spread between what it pays to depositors and what it charges borrowers. Of course, there is a whole gamut of fee-related and trading activities that banks indulge in to augment their net interest margins (spreads).

However, these are best viewed as toppings on the cake. Wells Fargo operates on the philosophy that one can’t risk the cake for the topping.

High CASA ratio: Current and savings deposits (CASA) are the cheapest source of funds available to banks. Banks that are able to garner a high proportion of their total funds in the form of CASA, have low cost of funds.

For the same interest income earned, banks that have high CASA ratio incur lower interest expenses and, therefore, earn higher net interest margins (spreads).

This provides them the flexibility to restrict their lending to relatively ‘safer products’ and ‘safer customers’, because, thanks to their low cost of funds, even a reasonable interest income can earn them healthy spreads.

On the other hand, banks with high cost of funds are forced, in some manner, to indulge in riskier lending in search of higher interest income and fees, because that is the only way in which they can compensate for the high cost of funds and still attain healthy spreads. Banks with low cost of funds typically have a CASA ratio in the range of 50 per cent of their total funds.

Low cost-to-income ratio: This can be perceived as the inverse of operating efficiency in banking terms. The ratio is computed as operating costs divided by total income (net interest income or spread + fee income).

Again, similar to the cost of funds argument above, banks with low cost-to-income ratio, have low operating expenditure (that is, branch cost, personnel cost, and so on) and, hence, can translate a larger portion of their income into profit.

The thumb rule in banking is to attain a cost-to-income ratio less than 50 per cent — the lower, the better.

Consumer and small and medium business oriented: On the lending side, banks that provide smaller loans to a larger number of clients are generally better off in terms of diversification and risk mitigation.

Such banks focus on retail customers (individuals) and small and medium businesses (SMB) rather than large corporate, infrastructure finance, and so on.

More products for the right customers: Wells Fargo is predominantly a consumer and SMB bank that develops deep relationships with its customers so that it has a comprehensive view of their financial profile, which it in turn uses to deliver appropriate financial products.

This model reduces cost of delivery by providing multiple products per customer relationship and enabling the bank to grow along with the customer. It also reduces risk by being able to build a business around customers that have displayed good track record.

Low LTV asset-backed lending: Safer banks have a larger portion of their loan portfolio backed by assets, for example, home loans. But merely having underlying assets doesn’t make the loans less risky, especially given that asset bubbles have become so common these days.

What’s also essential is skin in the game for the borrower in the form of down payment (margin) requirement.

This is measured through a LTV ratio — average loan amount to value of underlying assets.

Lower the LTV ratio, more the skin in the game for borrowers and safer the loan portfolio. Average LTV of more than 80 per cent is typically a risky play.

Beware of sub-prime: Sub-prime loans generally indicate higher risk. Of course, they also provide an opportunity for the banks to charge much higher interest rates but many a time the risk ends up subsuming the rewards, like what happened during the US mortgage crisis.

Lower the share of sub-prime loans in the lending portfolio of a bank — the safer it is.

For a bank like Wells Fargo, less than 2 per cent of their current residential mortgage loan servicing portfolio is sub-prime.

Back in India, NBFCs such as Shriram Transport Finance have been able to prove that even the subprime segment can be safe and profitable if handled the right way, but that’s a story for another day.

Minimal proprietary trading: Lastly, banks inevitably have to engage in trading to accommodate investment/transaction activities of customers and execute economic hedging to manage certain balance-sheet risks.

But proprietary trading, where the bank uses its own capital purely for speculation, is the most risky.

While there are few investment banks that make outsize gains from their proprietary desks, when things do not go well, these same activities can produce outsize losses that could potentially pull down the bank.