Welcome to another issue of Net Interest, my newsletter on financial sector themes. Every Friday I go deep on a topic of interest in the sector and highlight a few other trending themes underneath. If you enjoy Net Interest, please spread the word. It really makes a difference when you recommend this newsletter to others.
Wells Fargo’s Rehabilitation
Over the past few days, the biggest banks in America all reported their first quarter earnings. It may have been their best quarter ever. In this week’s Net Interest, we look at some of the key trends that emerge. In particular, we take a close look at Wells Fargo which, for reasons we’ll get to, charted its own special course through the pandemic.
A Strange Quarter
There’s no doubt we’ll look back on the first quarter of 2021 as a strange time. Perhaps that’s the result of the economy being so much better than we had anticipated it would be. Unemployment ended the quarter at a rate of 6.0% in the US but banks had been budgeting for a lot more; last summer, JPMorgan anticipated that unemployment would be ~9.0% right about now. This shift was reflected in their earnings as they were able to release much of the provisions they’d put away for that less desirable outcome. Over the course of 2020, JPMorgan bolstered its loan loss reserve by $12.2 billion; in the first quarter of 2021, it reversed $5.2 billion of that.
The precise mechanics of this reserve-and-reverse process was the subject of a Net Interest piece last July, What US Bank Results Tell Us About the State of the Economy. Banks consider a range of different futures and filter them into a single measure, capturing their relative probabilities and severities. In last July’s piece, I remarked that bank earnings have a Christmas Carol flavour to them, reflecting elements of the past (realised revenues), the present (unrealised trading gains) and the future (credit losses that haven’t yet been incurred). The first quarter was strong because the average of all the possible futures turned out not to be so bad. In fact, in some loan categories, performance turned out to be much better than expectations. Bank of America reported that early stage credit card delinquencies are at or near historic lows. In contrast to most behavioural predictions, consumers paid down debt and avoided default.
We’re not out of the woods yet, of course. Even after its reversals, JPMorgan is still carrying $7 billion more provisions than its base case warrants. Some of that may be quite sticky because the probability we’ll now place on a pandemic will likely remain higher than whatever assumption we used in the past (even though our severity assumption may be lower). But, for the first time, we’ve experienced a recession without an accompanying credit cycle and bank earnings reflect that release.
First quarter earnings were helped too by the strong capital markets backdrop. Across the five big US-based investment banks (JPMorgan, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley) fixed income trading revenues were up 17% over the year, equities trading revenues were up 35% and advisory and underwriting fees were up 2x. These good times are set to continue for a while longer – Goldman disclosed that its investment banking backlog ended the quarter at record levels and anticipated that high levels of primary issuance, the current trajectory of economic recovery and diverging central bank policies, particularly in emerging markets, could continue to support elevated activity in markets.
The one cloud overhanging these banks is what the pandemic has done to their balance sheets. It hasn’t made them weaker; it’s made them stronger. But there is such a thing as too strong. Bank of America kicked off its earnings presentation with a claim: “The company has grown stronger during the pandemic… More capital, more deposits, record liquidity and improved capital ratios.” Such strength is great for bond holders but for equity holders it can crimp returns.
The main dynamic here is more deposits and less loans. When the crisis first hit, banks were flooded with deposits as customers flocked to the safety of cash and drew down emergency lines of credit. After that, quantitative easing had the impact of recycling securities back into bank deposits. Even among consumers there has been an increased demand for deposits. Wells Fargo said this week that as of early April, over $46 billion has flowed into customer deposit accounts related to rounds two and three of federal stimulus payments; the bank estimates that half has been spent and half remains in accounts. Median balances are up 62% from a year ago.
Across the system, bank deposits are up $3.4 trillion since the end of 2019. Normally, there’s a loose relationship between deposits and loans in a system because loans end up being deposited back into bank accounts. However, the dynamic here is totally different – while deposit demand is running unusually high, loan demand is running unusually low. JPMorgan reported a 4% contraction in its loan book in the year up to March 2021. Part of the reason is that corporate customers are able to tap an accommodating capital market and, at least in the early days of the pandemic, borrowers were rightly cautious. But the divergent trends have had a marked impact on the shape of banks’ balance sheets. As at end March, JPMorgan’s loan-to-deposit ratio was 44%; that compares with 64% at the end of 2019. Given that banks make most of their money extracting a spread between what they pay on deposits and what they earn on loans, this presents a problem. JPMorgan’s net interest margin was 1.69% in the first quarter, down from the 2.37% it took in the same period last year.
How this all pans out is uncertain. JPMorgan’s CFO said on her earnings call, “forecasting NII [net interest income] is perhaps more challenging than it’s been in a long time as many of the key inputs – market-implied rates, deposit forecast, securities reinvestment and customer behavior in card – are all quite fluid.”
The problem of ‘too many deposits’ is exacerbated by the need to lodge capital against them. That may seem weird because there’s no risk inherent in holding deposits, but it stems from the ‘supplementary leverage ratio’ introduced to rein in bank leverage. The bigger a bank’s balance sheet – and deposits inflate a bank’s balance sheet – the more capital has to be held against it. The regulatory threshold is 5%; JPMorgan is at 5.5% (it was at 6.3% at the end of 2019). It’s a rule JPMorgan management rails against. On her earnings call the CFO said, “when a bank is leverage constrained, this lowers the marginal value of any deposit… And regulators should consider whether requiring banks to hold additional capital for further deposit growth is the right outcome… raising capital against deposits and/or turning away deposits are unnatural actions for banks and cannot be good for the system in the long run.”
One bank that does not sit under this constraint is Wells Fargo. The reason is simple: following a Federal Reserve consent order handed down in February 2018, Wells Fargo hasn’t been allowed to grow its balance sheet. So while JP Morgan and Bank of America have grown their deposit bases by $720 billion and $450 billion, Wells Fargo has only grown by $110 billion. Along the way, it has generated more capital, so now its ‘supplementary leverage ratio’ sits at 6.9%.
Wells Fargo used to be one of the best banks in America. In 1989, Warren Buffett noticed and started buying shares. By the end of 1990, he had bought $290 million worth of stock as its price fell amidst a real estate bust. Buffett’s rationale was characteristically simple:
Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually, after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank’s loans – not just its real estate loans – were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
This was the way to buy bank stocks when credit risk was the chief risk they faced. (Over the years many investors made a lot of money trading Citigroup on the same basis, as we discussed in Citi Never Sleeps.)
Either side of the financial crisis, Buffett bought more. Between 2004 and 2014, he invested $11 billion in Wells Fargo stock, turning it into his largest holding (before he bit the Apple). The bank had weathered the financial crisis very well. Although it had exposure to subprime mortgages, its industry-high net interest margin – a product of its large base of cheap deposits – generated sufficient earnings to absorb most losses. Its July 2008 earnings report prompted a 30% rally in the stock, giving the entire sector some reprieve in its gradual slide down. When the heads of the nine largest banks in America were summoned to Washington three months later to receive government funds, the Chairman of Wells Fargo reacted angrily, “Why would I need $25 billion more capital?”
Yet while Wells Fargo was adept at managing financial risks including credit, market and liquidity, it failed to apply the same rigour to its management of non-financial risks. In 2013, the Los Angeles Times reported that around 30 employees had been fired for taking shortcuts to meet the bank’s goals for sales and customer satisfaction. The employees forged signatures and opened accounts in customer names without their knowledge. The issue turned out to be more widespread than management realised. In September 2016, Wells Fargo admitted that employees had opened as many as 2 million accounts without customer authorisation over a five year period (later raising the estimate to 3.5 million).
Over the years, Wells Fargo had kept a keen eye on its cross-selling metrics; it was one of the ingredients for its success. At an investor day in 2014, management highlighted how customers with multiple Wells Fargo products were stickier and more profitable (52% of customers with eight products would make an additional product purchase the following year compared with only 12% with one product; and average profit from customers with eight products was 5x those with three). Yet something went wrong when the grand strategy was translated into an incentive plan for employees. Branch managers were assigned quotas for product sales and were eligible for performance bonuses if they met them. Corruption crept in.
It’s an age old problem that can be difficult to mitigate. Jamie Dimon references the broad problem in his latest shareholder letter: “In Vietnam, when a major city once had a rat population problem, the government devised what it thought was an easy, foolproof solution: Pay people to kill rats. All people had to do was bring in a rat tail to be paid. What the government didn’t consider was that people would breed rats for a supply of rat tails to sell. (All compensation schemes should be continuously re-evaluated.)” 
Although the financial impact on Wells Fargo was muted, the reputational impact was huge. An independent review in 2017 criticised the bank’s leadership, sales culture, performance systems and organisational structure as root causes of the scandal. The CEO was forced to go and his successor didn’t stick around for long either. In early 2018, the Federal Reserve announced that it would restrict the bank from growing any larger than its total asset size as of end 2017. Janet Yellen was chair of the Federal Reserve at the time. She said, “We cannot tolerate pervasive and persistent misconduct at any bank… The enforcement action we are taking today will ensure that Wells Fargo will not expand until it is able to do so safely and with the protections needed to manage all of its risks and protect its customers.”
In October 2019, a new CEO walked into Wells Fargo. Charlie Scharf has been working hard to overhaul the culture at Wells Fargo while managing the company under the constraint of the asset cap. He has changed the organisational structure of the bank, brought in new management, sold non-core business units and introduced strict cost discipline.
This quarter the bank was a bit more optimistic on net interest income than peers and it has more surplus capital. The asset cap will soon be lifted and that will give Wells Fargo more flexibility to grow.
 This is a very difficult problem for an outsider to spot. After the Wells Fargo scandal broke, I looked at other banks around the world to see if any were vulnerable to similar risks. The closest I could find was Public Bank in Malaysia. The bank had explicitly identified fee growth as a key strategic focus to drive profitability and enhance returns. It backed this up with various campaigns to boost productivity of its sales staff, especially in bancassurance. The bank’s 2018 annual report states, “in order to make the campaigns more attractive and competitive, outstanding sales staff stood to win not only cash but also gold bars, petrol cards and travel packages to Eastern Europe, Busan and Bangkok.”
More Net Interest
Grab’s Super App
Grab “the #1 Superapp in Southeast Asia” announced it’s going public this week via a merger with SPAC, Altimeter Growth Corp. The company started out in 2012 as a taxi service but expanded into delivery and other mobility verticals shortly afterwards. In 2017 it entered financial services, first via payments and then via lending, insurance and investments. Like other superapp models it partners with incumbent financial services providers like AXA, Allianz, Blackrock, Fidelity, Citi and HSBC. However, it also has payments licenses in six core markets and, as of December last year, a digital bank license in Singapore (as part of a consortium with Singtel).
In 2020, most of Grab’s financial services revenue still came from payments. Grab Financial Group did $8.9 billion of total payment volume on which it earned a commission of 3.6% (down from 4.4% the prior year). Most of the payment volume is internal to Grab, although the share that’s “off-Grab” has been increasing – from 23% in 2018 to 45% in 2020 (nothing in the disclosures on how the economics compare).
Going forward, the company projects that it will capture more financial services revenue from non-payments sources. While payments revenue is projected to remain broadly flat, non-payments revenue is projected to grow from $22 million in 2020 to $292 million in 2023, taking total fintech revenue from $342 million to $630 million (before intercompany reallocations). Grab reckons it can make a 30% EBITDA margin off these revenues.
That margin is what makes it worthwhile. The revenue contribution from fintech is expected to shrink over the coming years as delivery grows more strongly. Fintech made up 12.5% of Grab revenue in 2020 (after 20% in 2019) – that’s projected to fall to 9% in 2023. However the 30% margin in fintech compares with a 10% group margin forecast for 2023.
It’s also difficult to ascribe the economics of fintech exclusively to Grab Financial Group if financial services increase general user engagement and reduce customer acquisition costs. Grab paints a picture of a customer using the super app to hail a ride at 7.30AM, take a food delivery at 12PM, make an investment at 2.30PM and pay a bill at 9PM.
Some classic fintech firms are coming at it from the other direction. Tinkoff – which we wrote about at length here and reviewed again last week – is adding lifestyle and marketplace services to its core finance offering. It hasn’t broken down profit contribution yet but lifestyle services reached 5.3 million monthly active users recently, out of 9.3 million in total.
Consumer financial services is converging on the super app model from all sides.
The Huarong story has many of the ingredients of a classic financial company bust. The company was set up in 1999 to manage and dispose of non-performing loans acquired from Chinese bank ICBC. It did its job but got enamoured by growth. So it set up financial services subsidiaries around leasing, securities, trust, futures, and banking in a pivot towards more commercial operations. In 2014, it brought in a group of strategic investors and in 2015, it went public as a full scale financial services company.
Huarong’s key strength was its low cost funding. The Chinese Ministry of Finance retained a significant shareholding in the company, which debt investors viewed as a guarantee. The perception of that guarantee survived the company’s massive expansion, the chairman’s arrest for fraud, his execution and the company’s deteriorating financial condition. In the end, it took a whisper of speculation to question the guarantee and Huarong’s bonds collapsed.
Pension Bee is a startup online pension provider currently going public in the UK. The company provides functionality that allows customers to combine the various pensions they have accumulated over their work life and invest in a range of plans; Pension Bee also provides forecasts of how much customers are expected to have saved by the time they retire. As at end March 2021, the company had 81,000 invested customers and £1.65 billion assets under administration (up from £745 million at end 2019).
Like other fintechs, Pension Bee integrates closely with partners. It uses BlackRock, HSBC, Legal & General and State Street Global Advisors to manage pension plans, provides access to financial aggregation applications such as Starling Bank and offers on-demand pension withdrawals to the over-55s through a digital bank and virtual Mastercard.
Unlike others, its customers skew a little bit older, so a bit more affluent. Around 80% are over the age of 30 and around 40% are over the age of 40. The affluence isn’t yet reflected in the numbers, though. Pension Bee’s customers have an average pension pot of £20,000 on the platform which compares with a £29,000 national average.
Acquiring these kinds of customers can be hard but the company has a pool of 476,000 ‘registered customers’ it can draw on – same year conversion rate is around 17%. Customer acquisition costs are currently running at £232 per invested customer, but are rising. The company plans to spend around £34 million of the £55 million being raised in the IPO on marketing.
Revenue margins are 0.69% so on current assets under administration, Pension Bee earns around £140 per customer per year. The key to profitability given likely inflation in customer acquisition costs is strong customer retention (currently 95%) and appreciating asset values. At a valuation of 55-61x revenues, a lot of growth – albeit from its current low base – is anticipated.