Incentive Programs Gone Awry

Last week, news broke of a large fine of $185 million assessed against Wells Fargo.  The bank’s employees had opened 1.5 million in bank accounts and applied for 565,000 in credit cards that were not authorized by customers.  This practice dates back to 2011.  Wells is refunding $2.6 million in illegal fees to customers and fired 5,300 employees over this incident.  Wells has 40 million retail customers. 

Richard Cordray, head of the Consumer Finance Protection Bureau, stated, “Unchecked incentives can lead to serious customer harm, and that is what happened here.”  For those who are familiar with Wells in the industry, what came out in the news this week has been going on for a long time.  This is no surprise to anyone. 

Wells is known as having a strong culture that promotes sales and cross-selling.  I have known many former Wells employees who are well trained and smart, but who left the bank because of the high pressure environment.  I know of bankers who would get multiple calls from supervisors during the day to track sales efforts and results.  The sales culture went into overdrive here and it makes me wonder how many phony accounts were done from greed and how many from an attempt just to keep one’s job. 

Clearly, this also shows a banking culture that is not serving its customer base and is only concerned for profits.  It also shows a lack of commitment to the communities they are in and an attempt to pad the pockets of the shareholders and leaders of the company.  I am a little happier every time I drive by the vacant Wells building in my rural South Dakota community.

The real issue here is not just with the employees who opened the accounts, it is the actual system, the sales culture, that was set up and firmly established at the bank that encouraged and rewarded these actions.  In many positions at Wells, if you wanted to get your boss off your back, get promoted, and also receive bonuses, finding ways to open new accounts is the key.  The other issue with Wells is that many of these accounts remained open when a cursory review of the activity in the account, would indicate that something is wrong. 

A much more dangerous threat to the US economy than the fraudulent customer accounts, is the huge amount of derivative holdings by the largest banks in the country.  Derivatives played a big part of the financial meltdown in 2007-08 and subsequent freezing of the credit market.  As long as we have a stable market, derivative holdings should not be a concern.  But the real concern is when there is mass instability, when the counter party risk holders cannot fulfill their role, that derivatives become a “weapon of financial mass destruction” as Warren Buffet puts it.

So why should banks traffic in this?  The simple answer is money.  According to the Office of the Comptroller of the Currency’s 1st Quarter 2016 report on derivative holdings of banks, banks made nearly $5.8 billion in revenue just in the first quarter in their derivative trading.  Wells clocks in at the 5th largest derivative holding bank with just under $6 trillion of contracts held by a bank with total assets of $1.7 trillion.  The other four largest bank derivative holdings are with JP Morgan Chase, Citibank, Goldman Sacs, and Bank of America.  The top five banks hold a tidy $182 trillion in derivatives while they have total assets of $6.8 trillion.  In this quarter Goldman Sacs earned over 33% of its gross revenue from derivative trading.  The total credit exposure of the derivative holdings of the top four banks in the first quarter 2016, is listed at 482% of their total risk based capital.

To put some of these numbers in perspective, the Gross Domestic Product of the U.S. economy last year was $17.9 trillion.  The entire world GDP is estimated to be $73 to $78 trillion in 2016.  So the holdings of the just the top five U.S. banks is over 2.3x the entire world economy?  At what point does “too big to fail” become “too big to bail?”  The next major bailout will not only come from the government, but also from bank depositors. 

It is sad to say, but we have learned no lessons in the financial crisis as shown with the derivative holdings to be higher now than it was at that time.  There seems to have been no concerted effort to stem this tide.  In fact, it seems there is an effort among some of our politicians to cozy up to the big banks by receiving millions of dollars to give short speeches to banking officials. 

So large banks and their trade associations will point the flaw in the system at the credit unions who do not pay taxes.  But of the $16.122 trillion of assets held at financial institutions, only 7.5% of that is held at banks.  17% at banks other than the largest 100, while the top 100 hold over 75% of the banking system assets.  The total $1.2 trillion in credit union holdings is less than the $1.7 trillion asset size of Wells Fargo! 

Clearly the “credit unions are the problem with the banking system” argument is the magician’s sleight of hand, designed to take your focus off real systemic risks in the financial system.    Real solutions need to be put in place to prevent another meltdown.  At the rate we are going, I would expect another one to occur that will make the last financial crisis appear to be a walk in the park.

Real reform needs to be accomplished.  Perhaps issuing a tax on speculative derivative trading with portfolios that have over $1 million could be implemented.  New rules that prohibit financial institutions, that are under the government’s insurance funds, limitations to the size of their derivative holdings may help. 

With the election coming up this fall, it is important for the voter to understand who owns the ear of the candidates.  Who or what industry group has given the most money in contributions or paid for speeches?  It is most likely that they will control the agenda of any candidate from the highest office in the land all the way down to the local level.