Castro is Dead but Politics Still Reign

by Roy C. Smith

Fidel is dead at 90; Raul still rules. When will things really start to change in Cuba?

Fidel Castro has been a world celebrity since leading his revolutionary army into the City of Havana in 1959 and subsequently ruling the country as a Communist state to the great annoyance of the United States. Under a mantle of “Socialismo,” Fidel improved public education and health care under a 30-year satellite arrangement with the Soviet Union, but left Cuba, once the jewel of the Caribbean, as a totalitarian economic ruin.

Fidel became ill a few years ago and turned power over to his brother, Raul, now 85, who is the less flamboyant and more practical of the two. After the USSR voted itself out of business in 1991, Cuba was left on its own and nearly starved until rescued a second time by another socialist country – Venezuela – which exchanged valuable oil subsidies for the services of Cuban doctors. Now Venezuela is on the verge of collapse, and Raul knows that any future that the Castro’s Cuba may have will depend on economic reforms achieved through a vibrant private sector.

So, Raul undertook several economic reforms even before the announcement of “normalization” of relations by Barack Obama and Raul Castro in December 2014. But the reforms were cautious and limited to the retail sector. No big businesses from abroad would be invited in (with a few exceptions for non-US companies in the hotel and port-management businesses).

Since then two years have passed and not much has happened. 300,000 more American tourists have visited the island, and remittances from Cubans living abroad have increased significantly, but the “Embargo” of US-Cuban commercial activity, constituted by a series of legislative actions beginning in the 1960s, remains in place and Cuba has done little to reform its economic practices to attract the transformational foreign direct investment that it badly needs.

Raul is afraid that if he moves too fast to free things up, Socialismo will be swept away just as Communism was in Russia, Eastern Europe, and China. Indeed, the main argument in the US for repealing the embargo is to effect regime change through economic means that political isolation could not accomplish.

There are those in Cuba who would speed things up, particularly in the agricultural sector (Cuba imports 70% of its food, despite large quantities of arable but uncultivated land), but in industrial sectors also. But as long as Raul breathes, even after he is replaced by a successor in 2018, he will determine the pace of change. Presently it is pretty slow.

And there are those in America who believe Raul is as ruthless and brutal a dictator as Fidel, and resist doing anything that will ease the economic pressure on Cuba that the embargo provides. They say that the regime change they are seeking will occur because of the embargo, and the Castro’s should not be rewarded by repealing it. The Republican majority in Congress has favored retaining the embargo, insisting that it cannot be lifted until Cuba becomes more democratic and agrees to settle claims for property seized after the revolution. Reince Priebus, Mr. Trump’s chief of staff, said after Fidel’s death was reporte, that the President-elect was inclined to reverse Mr. Obama’s Cuban initiatives unless more progress was seen on the Cuban side.

As we are becoming more accustomed to Mr. Trump, we are learning that everything is negotiable. The Deal King has simply announced his opening position, which he expects will lead to some give and take, followed by an announcement of an improved agreement.

But, maybe things will move along anyway. Both sides are under considerable pressure from public opinion to put the past behind and open things up. Cuban can do some of this by encouraging major investments by European or Asian companies not subject to the embargo – there is much to do on many fronts. If this happens, US companies will lobby fiercely for repeal of the embargo so they don’t lose out.

Still the Cuban market is small, Cuba has no money to modernize it, and investors still see plenty of political risk. In the long run, it is hard to know whether the new Cuba will look like Singapore, another island entrepot economy servicing its neighbors, or Puerto Rico, an economy that has never lived up to its golden potential when becoming a US territory (entitled to citizenship) at the same time that Cuba became independent in 1902.

What Will Mr. Trump Do With the Banks?

 

By Roy C. Smith

Based on comments last week by Donald Trump, “dismantling” the Dodd-Frank Act of 2010 will be among the first things attempted. What would that mean?

Trump’s position on banks has never been one to encourage them. He has railed against bailouts and the easy treatment of bankers. He is for breaking up the banks and agreed with Senator Bernie Sanders that the Glass-Steagall Act of 1933, that forced a separation between the banking and securities businesses, should be restored.

But he was never a supporter of Dodd-Frank. It was too much regulation, too complex, too expensive and too stifling of banks’ important role in extending credit to business. The Republican Party Platform that he ran on (and largely dictated) called for Dodd-Frank to be repealed and Glass-Steagall reintroduce

The argument supporting repeal is that Dodd-Frank has proven to be vastly more complex and expensive than expected ($36 billion to date, according to one estimate) and is no longer necessary now that the capital adequacy rules of Basel III have come into effect and the Federal Reserve has developed its stress tests and other rules to tighten its control over the banks.

Large US banks also argue that laws that restrict only US banks, but not foreign banks, injure US banks’ ability to compete globally. Smaller banks argue that they had nothing to do with the crisis, and the many constraints of Dodd-Frank shouldn’t extend to them.

Dodd-Frank would have to be replaced by something – Americans are still angry at the banks and distrustful of them. So why not Glass-Steagall? It was simple (only 37 pages long), inexpensive, and provided for stability and safety of the US banking system for 66 years? A Trumpian “deal” swapping Glass-Steagall for Dodd-Frank, which would also involve breaking up the banks, brilliantly delivers three campaign promises in one stroke.

Could Trump get such a deal through Congress? Probably.

Dodd-Frank passed in 2010 in the Senate by a vote of 59-39; the filibuster rule requiring 60 votes in the Senate was not invoked even though the Republicans strongly opposed it. Today, Republicans have a majority in both houses of Congress that probably would support a swap if asked to do so.

Will Trump do this? Hard to say.

Republican Jeb Hensarling (R, Texas) is chairman of the House Financial Services Committee, and someone who has been mentioned recently as a potential Treasury Secretary. He is an arch foe of Dodd-Frank, and the author last June of an alternative approach which gives banks a choice – they can elect to operate in a much less regulated environment if they have the highest so-called Camel ratings (strength measures by bank supervisors) and maintain equity capital worth at least 10% of total bank assets, a much higher requirement than Basel III.

It is not clear what regulatory regime would apply to those not opting out of it if Dodd-Frank were repealed, or if the option element would be retained. Nor is it clear that large, systemically important banks would be better off under his plan than keeping things as they are.

Also, there is the advice of Paul Atkins to be considered. He is a respected former SEC commissioner and a Trump transition team member for financial regulation. Indications are that he would prefer dismantling over repeal, i.e., amending Dodd-Frank to shed it of its most objectionable parts, but keeping the structure that everyone has been working with for the past six years in place.

This, however, could be a huge undertaking. The 2,300-page law has sixteen “titles” covering a wide variety of regulatory activities that have required the writing of 390 new regulations by the several different federal agencies. These alone have so far produced 22,000 additional pages of new rules, and there are still some yet to come. Opening this can of worms up to piecemeal amendment (and hundreds of lobbyists) would be very messy and time consuming at best. Still, it may be the preferred way experienced officials like Adkins would like to proceed with the issue.

Will they listen to Adkins? Maybe not.

There will be pressure from the political side to just dump Dodd-Frank and start over. That would eliminate the hated (by Republicans) Consumer Financial Protection Bureau, and the Financial Stability Oversight Council, living wills, the Volcker Rule, and many other provisions. It would also make uncertain all the rules written by regulatory agencies under the law, but it would certainly shake things up.

A swap deal will certainly be tempting for Trump’s first bold legislative thump.

How would we cope with the re-imposition of Glass-Steagall?

The law would have to be modernised (e.g., do “securities” include government obligations, tradable bank loans and derivatives?) but it could be done. But, only the largest US banks (five or six) would be affected meaningfully. They would have to spin off their investment banking subsidiaries as they did in the 1930s. Most of the banks would object to this strenuously, but at least two of them, Citigroup and Bank of America, longtime too-big-to-manage underperformers trading well below book value, would be better off breaking up. Neither are likely to do so on their own.

If the banks were to spin off their investment banking units, like Lehman Brothers was spun off from American Express in 1994 after a disastrously unsuccessful merger was finally acknowledged as such, the US investment banking industry would suddenly bounce back to five highly-focused competitors: Newly relaunched Salomon Brothers, Merrill Lynch and JP Morgan units would be competing head-to-head again with Goldman Sachs and Morgan Stanley (shorn of their Bank Holding Company status), and Citibank, Chase Manhattan and Bank of America could go back to competing with Wells Fargo for national commercial and retail banking prominence.

The blunt force of politics is not usually the best way for economic policy to be made, but maybe this time it is.

From eFinancial News, Nov. 15, 2016

A Stunning Result, but Wait and See

By Roy C. Smith

It’s a bigger shock than Brexit. The polls had it totally wrong, with bookmakers giving odds of 83% for a Clinton victory a day before the election. A nationwide wave of unseen Republican support appeared unexpectedly and elected the most negatively regarded and controversial candidate to run for the office in modern times.

The result was not only surprising, it turned out to be worse than any of the so-called elite establishment types regarded as their nightmare scenario: Donald Trump not only becomes president, but Republicans retain their majorities in the House of Representatives and the Senate, giving the new administration legislative powers to pass all sorts of controversial measures promised during the campaign.

Markets will go haywire for a while because of the uncertainties. It is hard to guess where economic policies and outcomes might end up, but as often happens when jolts like this occur, markets overdo it. In fact, as unappealing as Mr. Trump may be to some, his actions could be beneficial to the economy and cause markets to give him another look.

First, Mr. Trump’s domestic economic policies are not too different from those offered by Speaker of the House of Representatives Paul Ryan, whose “Better Way” conservative approach to tax reform and other economic measures are essentially reasonable in a Ronald Reagan sort of way. Such policies, like Reagan’s in 1981, might very well provide the boost the slow-growth economy of the Obama years needs. Senate Democrats may try to force a 60% vote to pass these plans, but popular presidents can often find ways to get the few missing votes they need.

Second, Mr. Trump’s promise to undo much of the Obama era regulation by executive order – which has been considerable in energy, environmental, financial and pharmaceutical sectors -- would be very welcome in business sectors.

Third, Mr. Trump’s approach to trade and immigration may not result in the dire outcomes the campaign has led us to expect. He is likely to force a confrontation with Mexico on issues related to NAFTA and “the Wall” (i.e., the border), and with China on imports, but these will lead to negotiations to gain some improvement in the status quo. Richard Nixon did the same when he imposed a 10% tariff on Japanese imports in 1973 that ended in some voluntary quotas and a victory for American workers. Nixon said that being seen as unpredictable increased his bargaining power. Trump supporters believe his proactive negotiating style learned in the take-no-prisoners New York real estate markets is his true comparative advantage. It’s all about deals; if something doesn’t work, try something else.

Mr. Trump is also likely to get his nomination for the vacant Supreme Court position approved, bringing the court back to nine justices. The list of nominees he has already put forward is not really controversial at all. But, Mr. Trump’s intention to “repeal and replace” the Affordable Care Act (Obamacare) is unlikely to happen soon. There is no replacement plan as yet, and the Act is popular enough to make getting the 60 votes in the Senate unlikely.

Of course there is a lot to worry about with Mr. Trump in the most powerful office in the world, starting with who his advisers will be and whether he will listen to them. He likes powerful personalities like Chris Christie, the New Jersey governor who chairs his transition committee, Rudolf Giuliani, a former mayor of New York, and Newt Gingrich, a former Speaker of the House of Representatives. They were all made in the Trump mold – brash, bullying and confrontational, but they are people who got things done. Though Mr. Trump makes a lot of his own decisions without relying on others very much, these largely have to do with managing his own image and persona. He has learned to delegate the rest of what he has to look after to competent, if low visibility associates.

The list of names he has presented so far as potential cabinet members or senior advisers contains very few individuals (beyond the three mentioned) with experience of high level public service. Up until now, many of those with the necessary skills and experience have been reluctant to be associated with Mr. Trump, but having won, he is in a much better position to attract the talent for his administration that he will need.

In the end, Mr. Trump will be confined by the checks and balances of the American constitution, and the standards of presidential conduct that the American public expects. He has been given an opportunity to serve his country that few ever receive, an opportunity that cannot succeed without public support, which he will have to earn the hard way – by delivering results sufficient to retain the support. He has invoked the insatiable gods of populism to get elected, and will have to satisfy them once in office.

At this point neither we nor the gods know what we have got on our hands. Democracies can produce unexpected leaders when electorates are afraid, unhappy or excited.  Some of those leaders came from backgrounds offering no training for Presidential office at all, including Jimmy Carter, Ronald Reagan, Bill Clinton, George W. Bush and Barack Obama and we survived them. Today, we are giving Donald Trump, the first businessman to be elected president since 1928, a chance to see what he can do. So let’s wait and see.

Skepticism about Business Ethics

By Roy C. Smith

I have just finished teaching a required MBA course on business ethics, called “Professional Responsibility.” During the six-week duration of the course, we had the lingering effects of the Volkswagen, Valeant, and Panama Papers scandals, and a new one from Wells Fargo to discuss.

My approach to teaching this subject is to set aside most of the philosophy and sociology of ethical conduct to focus on the pragmatic aspects of setting and enforcing standards for such conduct in one’s own business for the betterment of all. It’s about how managers such as they will soon be should act in business.

We begin with observations of how varied and selectively applied ethical standards are in today’s society, how competitive pressures from the marketplace encourage continuous testing of their outer limits, and how elected officials and legal systems operate (not always fairly or effectively) to uphold the public’s interest. Today there are more checks and balances affecting corporate actions than at any time in history. On the other hand, tolerance of sloppy ethical conduct in other parts of society, including in the personal histories of our presidential candidates, may be higher than ever.

Against this dual-standard backdrop, my students were divided into groups to select an example of ethical failure in business, and to report on it in depth. Key to their reports is their analysis of why the failure occurred, and what might have been done to prevent it.

Their reports covered different industries: autos, big pharma, banking, and private banking for the wealthy. What they had in common was that the companies involved were large and publicly traded, and their industries were very competitive, global, affected by sometimes contradictory public polices and highly regulated. All of the companies were under considerable pressure from their boards and managers to increase sales, lower costs and, in general, do what was necessary to increase the stock price. The companies the groups studied, they believed, were typical of others in these and other industries.

The groups reported on their incidents based on data available to them from court filings and other public sources. The groups did not discuss their findings with the other groups, yet, their analyses of why the ethical failings occurred were surprisingly similar.

Several pointed to aggressive business models coldly engineered to maximize profits, without much regard to the impact of their actions on public perceptions beyond those of business success.

These business models were executed and reinforced by top management, sometimes (but but not usually) to a point of obsession. Management used compensation and promotion to reward those that went along, and to discipline those who didn’t. In their enthusiasm to succeed under these arrangements, subordinate and middle managers tended to amplify the need for results throughout the organization.

Also our groups believed that internal control systems to detect abuses were inadequate, underfunded or didn’t cover certain key areas of the business. And there was little evidence of any internal training for middle managers on detection and prevention of ethical misconduct before it could occur.

Most of the groups said they believed that dissenting managers would have had little room to change things at Volkswagen, Valeant, Wells Fargo or any of the other dozen or so banks that have recently settled misconduct cases with the US Justice Department for amounts totaling more than $150 billion.

That is a discouraging conclusion, suggesting, among other things, that teaching Professional Responsibility may be a waste of time – what does it matter if you have an ethical sensibility if the big guys don’t want to hear about it?

I understand why the groups concluded as they did, based on the documents and press coverage that they reviewed. And, they may be right in some or all of the cases they studied, but I don’t believe they are right as a general matter. Boards and senior managers of most large corporations want their junior and middle managers to be aware of ethical infractions that could bring serious financial or reputational consequences, and to speak out when they encounter them. If they don’t want to hear from them – as is always true in these discussions -  then the managers should look for another job.

But without a doubt, many large corporations do little to train or equip middle managers with the knowledge, resources or procedures for reporting and defusing ethical misconduct. One of the arguments against big banks that is brought up periodically is that they are “too big to manage.” Either top management loses control of what goes on below, or what goes on is not protected by strong internal controls and middle managers who are rewarded for defensive play as well as offensive.

What the students appear to agree on is that if they had their own businesses, employing, say, a hundred or more people, the task of setting and enforcing ethical standards would be up to them, and they, as owners of the business, would take the task seriously. Of course, this is equally true if the company grows and becomes publicly traded – it still needs its owners (now represented by the board of directors) to take the task seriously.

For many companies this task gets lost in the mix with their other mission of meeting performance standards.  Too many take their boilerplate statements about ethical standards for granted; by now they should have learned from the examples we studied and others that the consequences of losing track of ethical standards can be ruinous. Being in denial about this can be very dangerous.

But, it is also fair to say that examples of ethical failure have to be kept in perspective. Of the approximately 10,000 public companies listed on major stock exchanges around the world, only a very small percentage are involved in examples of ethical failure. And of these, only a very small number are involved in criminal infractions though of course these get most of the attention.  The ethical performance of large corporations is certainly far better than it was 40 years ago when price-fixing, bribery, market rigging and illegal political contributions were not uncommon. Then transparency was less, enforcement weaker and cynicism by top managers greater; today these things are reversed but, like everything else, the price of good behavior is constant vigilance – by middle managers especially.

John Stumpf, RIP

by Roy C. Smith

The Wells Fargo case broke in mid September with the announcement of its $185 million settlement with the City of Los Angeles and banking regulators, just after my MBA course in Markets, Ethics and Law had begun.

We discussed the case extensively in class and quickly came to realize that (1) because of a seriously flawed bonus plan for branch employees, (2) a surprisingly large number of these employees had gamed the system over several years, opening 2 million or so unauthorized accounts, most of which were either closed or unused. (3) The bank earned very little from all this, and (4) customers who lost money were compensated so no real harm was done, but (5) it took the bank several years to clean up the problem, (6) which only came to light after an article in the Los Angeles Times that triggered the subsequent investigation by enforcement officials. The amount of the settlement was (7) quite modest compared to several multi-billion dollar settlements announced by other large banks for misconduct by employees that were inadequately supervised.

These facts were not enough to prevent the Wells Fargo case to go volcanic.

My students were able to observe that In just a few weeks of unrelenting pressure from politicians inspired by Sen. Elizabeth Warren and the public media, Wells Fargo’s CEO for the past decade, John Stumpf, has been forced to resign in disgrace, surrendering many millions of dollars of compensation and benefits to clawbacks and other penalties assessed by the bank’s board of directors.

Several other large bank CEOs have resigned since the 2008 crisis, none however as a direct result of a media avalanche following a settlement announcement. And none of the others, almost all of which presided over much more serious management failings than Stumpf, was clawed back and subject to other penalties by the board of directors.

Indeed, prior to the announcement of the settlement, Wells Fargo was the world’s most valuable bank (by market capitalization) despite being considerably smaller in total assets than its runner up, JP Morgan Chase. Wells’ stock traded at about 1.7 times book value when JP Morgan’s was at 1.0. Wells Fargo survived the 2008 crisis with no help from the Federal Reserve, and was the rescuing acquirer (without government assistance) of the failing Wachovia Bank, the fourth largest bank holding company in the US.

Arguably, at a time when the largest players in the global banking system have been seriously weakened by an increased regulatory burden, slow economic growth and government interference in markets (to the point of being unviable as continuing businesses -- see my previous posts on this subject) Wells Fargo was the only truly healthy bank among our largest players.

Clearly eight years after the crisis, American Bank Rage driven by politicians looking for headlines has not subsided at all. It has gone too far.

Triggering a Run on Deutsche Bank

By Roy C. Smith

In November 2009 President Obama established the Financial Fraud Enforcement Task Force (FFETF) at the Department of Justice “to hold accountable those who helped bring about the last financial crisis as well as those who would attempt to take advantage of the efforts at economic recovery.”

FFETF has been very busy for the past eight years, having obtained approximately $200 billion of settlements of possible criminal or civil charges against almost all of the major banks in the US and Europe. The settlements were made with the boards of directors of the banks that preferred to avoid jury trials, further bad publicity and to get the matters behind them.

But, despite extensive investigations, FFETF has yet to indentify a single individual officer or director of a bank to hold accountable for bringing about the financial crisis (or the failure of their own banks). Thus the settlements are for crimes or misdeeds that no one actually performed, but that did not make them any less popular with the public. 

The Senate and House hearings this week on Wells Fargo clearly demonstrate that bank-rage is still very popular with Congressional constituents. John Stumpf, who until last week was one of the country’s most respected financial executives as head of the best performing large bank in the United States, must have felt that he had been attacked by a lynch mob.

During the same week as the Wells Fargo hearings, a report that the FFETF had offered Deutsche Bank to settle charges of misconduct in its mortgage backed securities business ten years ago for $14 billion began a “run” on that bank’s stock and bond prices and credit worthiness. The run has continued – the bank’s market capitalization, which was only $20 billion when the announcement was made, has dropped to $17 billion.

Deutsche Bank is now experiencing a credit crisis similar to those faced by American banks and investment banks in 2008. Deutsche Bank survived the financial crisis without a bailout, but the subsequent years have been very difficult for Germany’s largest and most prominent capital markets player. John Cryan, a Brit, is the bank’s third CEO in eight years, and he is struggling to turn things around in a slow economy with a new, very heavy regulatory burden. The bank had reserved a much lesser amount for the FFETF settlement, but the news of the huge $14 billion offer to settle was enough to start the run.

The bank’s stock price (already down nearly 50% for the year) dropped further, as did the price of its “contingent capital” bonds (which convert to equity in the event of trouble). Counterparties cut their trading limits with the bank, institutional investors shied away from rolling over deposits or maturing money market instruments, hedge funds and others withdrew funds from prime brokerage accounts, and so a continuous downward spiral was triggered.

Such downward spirals befell Bear Stearns, causing it to be rescued by a $33 billion Federal Reserve-backed merger with JP Morgan, and Lehman Brothers, which was not rescued and went bankrupt and created a market panic that spread to other banks, including Goldman Sachs and Morgan Stanley that were saved from a similar spiral by the Fed’s converting them to into Bank Holding Companies.

Though Deutsche Bank is large and better capitalized than these other firms, and thus better able to sustain a run, runs can scale upwards to bring even the biggest banks down. The German government, led by an embattled Angela Merkel, does not want to bail out Deutsche Bank – the German public has no greater love for banks than the American public – but also cannot allow it to fail. The European Central Bank, however, has the authority and the resources to offer such “loans of last resort” as may be necessary to stabilize Deutsche Bank, but, even so, runs are very scary things that no government should want to risk on any “systemically important” bank.

The US government is clearly operating at cross-purposes. On one hand it is trying to generate jobs and economic growth, for which it must have healthy banks like Wells Fargo and all the other large US and European banks operating here. On the other hand, it needs to re-regulate the financial industry to prevent future crises, and to demonstrate that offending institutions will be punished.

But the government has gone too far in the regulatory and punitive direction, apparently to benefit politically from the popular anti-bank sentiment, and the result is an overly heavy regulatory burden on large banks that has threatened the viability of their businesses, and to let the FFETF loose to bring charges against the banks that they know will not have to be proved in court because they be settled for large sums to be paid by the shareholders of the banks that had nothing to do with the offenses alleged.

Healthy banks are essential to economic growth. Healthy banks need investors (shareholders) who believe in their futures and do not fear continuing attacks from the government. Increasingly, these investors are becoming scarce.

After ten years, it is time to for the government to end the public anger against banks, which it helped to foster, and help the industry to get back on its feet. Certainly the Obama administration and its FFETF will do nothing along these lines during its remaining months in office. Based on the campaign rhetoric so far, neither competing candidate seems to want to do so either.

So, until the rage burns off, we seem to be stuck with mob rule on banking matters.

Reacting to Wells Fargo

by Roy C. Smith

 

On Sept 8, 2016, Wells Fargo announced that it had agreed to pay $185 million to settle charges of abusing customers through overly aggressive sales practices.

Two weeks later, Wells Fargo CEO John G. Stumpf was called before the Senate Banking Committee where he received a severe public dressing down from Sen. Elizabeth Warren. According to Sen. Warren, Mr. Stumpf should be “criminally prosecuted,” after, that is, he has resigned and given back his bonuses for failing “to be accountable” for his “gutless leadership.”

Apparently others in the Senate and elsewhere agree with her.  It’s an easy case to pile onto to express outrage against the banks, still America’s number one villains.

But, it is always hard for laymen like us to know enough about the facts in cases like this to form hard-edged judgments. Only the plaintiff’s side of the story has been told publicly, and the defendants are restricted in what they can or want to say. But, based on the reporting on the matter so far, Sen. Warren and the rest of us do know some things.

According to Mr. Stumpf, the bank discovered that some employees in local branches beginning in 2011 secretly opened new accounts for customers without their consent. This was an unexpected response by a considerable number of low-level branch employees to a poorly designed incentive plan to reward them for cross-selling the bank’s products for which there were quotas. This way of gaming the system spread throughout the branch network. As soon as the problem was discovered, the bank closed the unauthorized accounts, offered restitution to affected customers, and began to fire the branch personnel responsible (5,300 were fired over five years out of 100,000 branch employees, or an attrition rate of 1% a year).  Mr. Stumpf said the bank should have found out about the falsified accounts earlier, and addressed the issue more quickly than it did, but it acted in good faith once it discovered the problem.

In 2013 the Los Angeles Times reported on some of such accounts and a local lawyer began to accumulate a list of as many as 1,000 affected customers, presumably for a class action suit. The Los Angeles City Attorney read the story and began an investigation that ended with a civil lawsuit for damages. At this point the Office of the Comptroller of the Currency, a bank regulator, and the Consumer Financial Protection Bureau, (CFPB) a federal agency originally proposed by Sen. Warren and created by the Dodd-Frank Act in 2010, joined the suit as the heavy muscle. The CFPB ended up with $100 million of the $185 million (Los Angeles got $50 million).

By the time of the lawsuit, the bank was already engaged in trying to clean up the problem - responsible parties were fired, and Price Waterhouse was hired to investigate the issue independently from the bank’s own managers. Price Waterhouse found that perhaps 1.5 million unauthorized deposit and 500,000 unauthorized credit card accounts were created on which modest amounts of fees were charged. Over the five years in which the unauthorized activity occurred, fees on the deposit accounts amounted to $2.2 million ($1.50 per account), and $400,000 on the credit cards ($0.80 per account).  Against these fees, the bank paid incentive bonuses, and then had to pay the considerable cost of cleaning up. Last year Wells Fargo reported net income of $22.9 billion, so the amounts involved were not material to the bank’s shareholders.

Some observers have questioned the bank’s policy of creating ambitious quotas for cross-selling, that may have put excessive pressure on some low-pay employees causing the misconduct, though it does appear that the vast majority of branch employees responded to the quotas and incentives without breaking the rules.  Others point to failures in the accounting and control area that did not confirm new accounts with customers, or otherwise identify the problem early enough to keep it from spreading as widely within the bank as it did.  The bank and its board of directors has also been criticized for being slow and passive in pursuing responsible members of management and holding them accountable through clawbacks or other disciplinary measures.

It is clear that there were management mistakes and subsequent failures in the case. But, there is no evidence that management intended this to happen, or tried to cover it up once informed of the problem. By any standard other than Senator Warren’s, the damage done to customers did not constitute what she called a “massive fraud.”

Nevertheless, it certainly has turned out to be an expensive event for the bank, far more expensive than one might think initially.  Right after the announcement, Wells Fargo’s stock price dropped 5% while the stock price of bank’s principal competitor, JP Morgan, rose by 3%. That 8% difference amounts to $20 billion in lost market capitalization.

The market may have overreacted – the customer damages were small and further legal costs are unlikely to reach anywhere near $20 billion.  But, cumulatively the costs to Wells Fargo will be far greater than what they seem to be so far.

After the Senate hearings we learned that three US Attorneys from the Justice Department have opened criminal investigations, and the SEC is looking into civil infractions. The $185 million settlement did not involve the Justice Department – this is its first appearance on the scene.  For criminal charges to be brought against a corporation, the evidence must clear several difficult hurdles set by the Justice Department, but according to James Stewart in the New York Times, the facts in this case may be enough to do so.  Wells Fargo would have no choice but to settle any criminal charges, if made, even for a very large additional sum.  Banks cannot remain in business if convicted of felonies.

There is also the possibility of a class action on behalf of bank customers who were affected by lowered credit ratings and other difficulties as a result of the bogus accounts, and perhaps by employees who were fired for failing to meet quotas or for similar reasons. Such suits first would have to get by customer agreements requiring the use of arbitration for disputes, but sometimes they can. A guilty verdict in  federal case would invite and encourage class action litigation.

The event has surely caused some so far invisible reputation damage to the entity that before this event surfaced was America’s most admired, least sullied, and most valuable bank. In January, Wells Fargo traded at 1.7 times book value and had a market capitalization of $282 billion, in contrast to the much larger JP Morgan, that then, at 1.1 times book value, was worth $247 billion.

Even the generally supportive Wall Street Journal has suggested that Mr. Stumpf may be lucky to keep his job. Public pressure on the Wells Fargo board can only get worse. Threats of criminal investigations by the NY Attorney General of Citigroup and AIG in the early 2000s cost both of them their powerful CEOs at the time, Sandy Weill and Hank Greenberg, respectively. Losing Stumpf and or other top executives could be a further disruption to the bank.

Wells Fargo may argue that its policies and business practices over the years have been exemplary, and that customers have benefitted greatly from its products and cross-selling efforts, but in competitive businesses operated at large scale, mistakes will happen and when they do, the bank will remedy them. This is what we expect “good” corporations to do: to compete hard to get our business with good new products, but also to stand behind them and never try to cheat us. 

Wells Fargo probably believes that it has lived up to that standard for a long time, and is entitled to some benefit of the doubt when an embarrassing mistake is made. But one of the first signs of reputation damage is the loss of the benefit of the doubt.

Sorry, Wells Fargo, it doesn't work that way anymore.