“If you’re big in diversification it reduces the risk”

April 2012

Conversation with Dick Kovacevich, chairman emeritus of Wells Fargo, on – sub-prime mortgages – the discipline required in risk management – the impact of regulatory costs on financial services

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Here is the transcript of the video.

Emmanuel Daniel (ED): Dick Kovacevich, until 2010, was the chairman and chief executive officer of Wells Fargo, an institution that survived the US financial crisis, become stronger as a result of acquisitions made in that period and is today, one of the strongest institutions in the world. Tell us what it is about Wells Fargo that made it able to survive the US financial crisis? What were the disciplines in place that enabled it not to repeat the mistakes that many other US institutions did?

1. Avoiding risky sub-prime mortgages

Dick Kovacevich (DK): Well, I think one of our greatest strengths over the past 25 years has been our risk management. We have done a great job of that. We’ve avoided many crises in the past, and we basically avoided this crisis as well. Even though we were a leading mortgage company, we did not participate in the origination of sub-prime mortgages, exotic sub-prime mortgages that turned out to be a very high risk, which we knew they would.

ED: This frenzy for originating sub-prime mortgages – when did it actually start in the U.S.?

DK: I would say that the level of sub-prime mortgages – there’s always been some sub-prime mortgages, and it was well less than 10% of all originated mortgages, and they’ve been around for a long time. But what happened is, in the beginning of 2005, the percentage of originated mortgages of the sub-prime level went up to 50% of the market. That was a huge increase.

And these were not just ordinary sub-prime mortgages, the risks were amplified because there was negative amortization of these mortgages, stated income, and low documentation of the mortgages. It was almost an invitation for fraud. We recognized this as these products were being created and decided that it would be totally inappropriate for our customers. And even though we could have originated these loans and sold them to the marketplace, it would not be consistent with our ethics and our values.

ED: During that period, everybody else was growing their market share and I figure that Wells Fargo would have been losing market share, you would have been slipping. How did you keep morale during that period when you were counter-intuitive, or rather, intuitively on the other side?

DK: In fact, prior to the crisis, we were leading in the market, with 15% market share. In those three years of the exotic originations, we lost four percentage points, $160 billion of originations each year and were no longer the leader. But again, our views, because we’ve been through these processes before, was that if it’s the wrong thing to do and if it turns out that you were right not to do the wrong things, you will be rewarded in the future.

So, yes, it was painful for a while, but since we’ve, again, had this discipline in the past, our people do know that we will gain the advantage in the future if indeed it blows up, and of course it did. What happened is we went from 15% market share in the 2005 period, and then in 2006, 2007, and 2008, we went down to 11%. Today, our market share in mortgages is 33%, and we would never have been able to triple or double, depending on where you want to start, our mortgage market share if we had not avoided the problems and then taken advantage of the situation once the people who did these mortgages left the market.

ED: In your more than 30 years of experience in financial services, you’ve probably seen this several times before, and you’ve internalised the discipline required. How does someone in your position internalize the instinct for this? What is your view of the financial services? What is the one thing you should put your finger on so that you don’t lose perspective?

2. Maintaining discipline in risk management

DK: Doing the right thing is the right thing to do. It’s as simple as that. If you really know when risk is exceeding a normal level, you have to have the discipline to say, “This is risk that we should not take, we’re not getting paid for. It’s wrong for our stockholders and for our company, and it’s wrong for the borrower.” What surprises me is how many people failed to see this. Because the risk taken in the sub-prime mortgage was the most excessive I’ve ever seen.

And what people don’t quite understand, there were only about 20 institutions that did most of this damage. In fact, there was only one commercial bank that was really part of the 20. The rest were investment banks which were securitising and selling these mortgages, and almost all of the originators were either non-banks, like a country-wide, or they were savings and loans associations (S&Ls). What’s shocking is that 8,000 commercial banks today are being vilified and are having additional regulation put on them and only one of the 8,000 were actually a commercial bank, and the rest weren’t even commercial banks, and yet we’re being punished.

ED: Going forward, right through the 2000’s, in the last 10 years, investment banks have introduced this get it off your books, have it as a traded asset, they’ve also been taking on the liability side of the business and making investments and so on for commercial banks. The Volcker rule coming in place is trying to put fences around that. Do you think the days of great profitability are over in financial services?

3. The impact of regulatory costs on financial services

DK: I think that the increase in regulatory costs, many of which were not the cause of the crisis and will not avoid the next crisis, has reduced the profitability. I think that over time – and it might take as much as five years – people will realize that these additional costs are not making the industry safer. They are increasing costs to the banks, who in turn charge their customers more.

I think it’s likely that some of these excessive regulations that are not necessary for protection of the taxpayer or to reduce the probability of having another crisis will be eliminated. What does reducing debit card fees have to do with this crisis? It’s more of anger and punishment with the thought that, again, the banks caused this problem. It really wasn’t commercial banks. It was the investment banks and S&L’s, and yet we’re all being punished as if we were guilty when the most of us, the vast majority, didn’t even participate in this issue.

ED: Because of regulations, you’ve seen non-bank financial institutions come in as shadow players and taking some market share right to the 2000s. You had Country Wide calling the bluff of mainline banks like yours, and in the 1990s, it was the mono-liners and so on. Do you think that all of this regulation is going to create substitutes which are not financial institutions taking on specific business lines and getting around regulations?

DK: Absolutely. That’s what happened in the past and is happening in the future. Let’s take proprietary trading for instance. There is no indication to me that proprietary trading had anything to do with this crisis. People are going to do proprietary trading and will go outside the banking system and could well cause another crisis, and then this will be blamed upon banks again. So the S&Ls could only get big as they did and do these originations because their regulators were not as involved as the Office of the Comptroller of the Currency to see the risks that were being taken. Investment banks got big because commercial banks for a while weren’t allowed to be in their business.

Quite frankly, if we eliminated the Glass-Steagall Act 40 years ago we wouldn’t have had this crisis. people think that the elimination of Glass-Steagall caused this problem. It’s just the opposite of that. These banks, the investment banks, could not have got as big as they did if they weren’t protected by Glass-Steagall. And even Barney Frank has said – and I don’t often agree with Barney Frank –that if the insured depositor institutions were the only ones in this business, this crisis never would have occurred, and he’s absolutely right.

ED: But with interest rates continuing to be low, and access to credit being very open because there’s so much liquidity in the marketplace, that risk continues, wouldn’t you say?

DK: Both yes and no. I want to repeat; of the 8,000 banks out there, only one of these caused this problem, so why should it be any different in the future? People are missing the fact that the vast majority of all insured depositor institutions behaved appropriately. If they behaved appropriately in the midst of this big bubble, where you could have made a lot of money for a while?

ED: It is a disciplined industry.

DK: I think they did a much better job, and that’s not coming out anywhere.

Emmanuel Daniel (ED): You’re seen very clearly, and globally, as the father of cross-selling, the father of making the customer essential of a main street bank. Give us the gist of how that thinking evolved in you and how much work was involved in creating that within Wells Fargo, which as an institution, is also seen as a leader in terms of cross-selling – seven products per customer for retail – and the infrastructure that you needed to put in place and the thinking of people. What was involved in creating this? Do you think that you have a lead in that respect, which makes it difficult for other institutions to follow?

1. Diversification of risk

Dick Kovacevich (DK): What’s interesting about this is that we’re credited with cross-selling being a revenue-generating machine, but this was really started going back to risk. In my opinion, what causes failure in banks or any other financial institution is concentration of risk. Even if you do a good job of underwriting, but if all your business is in, commercial real estate, and macro-economic forces cause the commercial real estate market to collapse, you’re going to have a big problem even though you did a pretty good job of underwriting it.

My view of how you manage risk in a financial institution is to diversify the risk. Never be too big in anything, because the macro-economic forces can cause things to happen that’s really not your fault in many ways. You do not want to be a narrow bank that offers only commercial loans and takes deposits. You want to be a financial services company. So you’re in the mortgage business, you’re in the commercial lending business, you do leasing, you get a lot of fee income, you do credit cards, debit cards, you do all of those things. If one of those sectors has a problem you will still do okay because the rest of the sectors are doing well.

The more I got involved with that diversification, we discovered, that there are many other benefits, and one of the most important is the fact that the average customer, both commercial and consumer, buys about 14 financial products, in the past from a variety of about five or six companies because nobody offered the full suite of products. Because we were diversifying, we started to provide a whole suite of products to these customers.

If you think about it, the incremental cost of selling an additional product to an existing customer, is very low, compared to the selling of that same product to a new customer. You don’t have to advertise it, you don’t have to go through an account-opening process, the customer’s probably already in your store, so you can just sell them that other product. It turns out that the cost of selling a product to an existing customer is only about 10% of selling that same product to a new customer. So it’s a 90% cost versus a 10% cost.

If you do that, you can reward the customer for doing more business because you have a nice margin that you can share with the customer. Everybody wins. Furthermore, you find out that the more products you sell a customer, the more loyal they are. They will stay with you longer. When you have customers who are able to purchase a bundle of products that in aggregate are cheaper than buying it from five separate competitors, you’re going to have a very successful company.

ED: Which retailer thinks the way that you do? Which retailer do you look at to get your inspiration in terms of this product-per-customer?

DK: Let me ask you this. What does Walmart not sell?

ED When you walk into Walmart, what is it you cannot walk out with?

DK: And what is one of the lowest margin businesses in corporate America?

ED: Retailing.

DK: Which part of retailing has the lowest margin?

ED: Discount retailing?

DK: No. It’s groceries.

2. The secret to successful cross-selling

DK: So why did Walmart enter the lowest margin industry in the world and now dominates the grocery business? Do you think the margins of Walmart’s grocery business are better than Safeway’s? The answer is, “no.” So why did they do it? The reason is people go into a grocery store five times more often than they go into a general merchandise store. And so when they added groceries to their general merchandise store, the sales of the general merchandise went up 27%. That’s a form of cross-selling.

Think of Home Depot. Before you wanted to paint a room, you had to go to a paint store, a plumbing store, and a lumber yard. They took all these various products that were being sold by someone else, put it all together, not only made it convenient, but then someone in that store was an expert to say, “Here’s how these things work better.”

And that’s what our people do, say, “Should you have a long-term certificate deposit (CD), given your risk profile, or should you have a mutual fund? Or should you have an annuity?” You couldn’t get this advice from all separate providers, because if I was only selling CDs, I wasn’t going to tell you that mutual funds are better for you.

So you could only have confidence that you were getting advice if the provider had all these various products and was selecting from all the products that they had what was best for you. So this was in the customers’ best interests. This was common sense. And I wasn’t a banker. I came from retail and marketing, General Mills. So I think I had the advantage of –

ED: Of having seen it from that perspective.

DK: Of starting with the customer, not starting with, “I’ve been doing checking accounts all my life, so that’s what I’m going to do for the rest of my life.”

ED: That’s the front end of the business. The back end is the product itself. Walmart sources its products from the lowest sources and so on. How does a financial institution look at the origination of products? What’s the Wells Fargo approach?

DK: Let me ask you this. Are the products that Walmart sell any different from the products that Target or Safeway sells?

ED: A mutual fund is a mutual fund is a mutual fund.

DK: I would like to convince our customers that our checking account is a better checking account than Bank of America’s, but the truth of the matter is, they’re commodity products, just like Walmart is.

So the differentiation is not in the product; the differentiation is how you distribute commodity products. When you look at Walmart’s skill, it’s basic logistics. Of taking these commodity products and being able to sell more of them per square feet than others, making sure they get into the stores and so on. It’s the same with us. We take these commodity products and help the customer decide which one of those are in their best interest and bundle them in a way that is both less expensive –you’re taking some of the cost of the logistics away because you’re putting it all under one roof – and of more value to the customer, because you’re giving them the exact products that they need. But they can do it all online, they don’t get 12 statements coming every month that someone’s paying postage on, so it’s more convenient, costs less, and satisfies their needs better. If you can do all those three things, you can be very successful.

ED: Is there something that main street banks like Wells Fargo understands about the customer and being customer-centric which is different from Bank of America’s, or an insurance company’s idea of being customer-centric?

DK: I would say everyone admires our cross-selling. I’ve had many CEOs who come to talk about cross-selling and they go back and write a memo to their staff saying, “I want you to cross-sell tomorrow.” That’s not how it works. The bad news is that this is hard to do. It sounds easy. Going back to the Walmart example, does anyone not understand Walmart’s strategy? So why doesn’t someone duplicate it?

ED: Because it’s too hard.

3. Implementing a superior business model

DK: It’s hard. The best strategy is a superior business model that is hard to implement. A superior business model that anyone could copy the next day is going to become the commodity return two weeks later. So you don’t want a superior business model that’s easy. You want a superior business model that’s hard. To do this right, you have to change the culture of your company, you have to figure out a way to bring the expert of a particular product to the customer – we call it “partnering.” You have to have the technology that tracks what the customer has with you today and what they don’t have. Many banks don’t even have that information at the sales counter.

And so there are about 100 things – and I’m not exaggerating when I say 100 – you have to do to change your company if you really want to do cross-selling and be customer-focused. Many companies, when they start down this road, say, “This is going to cost me hundreds of millions in new technology; it’s going to take years; I’m going to have to change my culture. All those are costs up front before you see the benefit.”

What they don’t realise, is because of these economic advantages – you can give a better deal to customers and because they’re being loyal – over time, cross-sellers are going to take business away from them. Things are going to wind up one of these days where there isn’t independent investment banks left anymore. They have either gone bankrupt or they’ve been bought by commercial banks where you’re starting to see this bundling.

DK: Some of these commercial banks have bought a lot of different companies but have not integrated them. They’re basically a conglomerate and say, “Go cross-sell again,” but none of their systems support it. They haven’t changed the culture of the people – this being a people’s business – and they haven’t incented people to perform cross-selling. You have to inspect what you expect, and they don’t get that. That’s why just like Walmart, everyone knows their strategy, but no one can compete because they’re so far ahead of the rest in implementing their strategy.

For that very same reason, that’s why it’s been difficult for our competitors to implement ours. We started our strategy a long time ago and built our systems and culture appropriately. It’s very hard for the others to make the investments necessary to compete.

Emmanuel Daniel (ED): Another thing you’re famous for is the mergers and acquisitions that you’ve carried out. At the time of your retirement from Wells Fargo, it became a $1.3 trillion institution. At the time when Norwest bought Wells Fargo, it was initially worth around $20 billion?

Dick Kovacevich (DK): No. When I started at Norwest, and by the time we bought Wells Fargo, it was worth $100 billion. But when we started, we were at $20 billion.

ED: What is sustainably achievable in scaling? Especially with the hindsight that you also need to be customer-centric, you need to have consistent propositions and all that you’ve said about incentivizing your staff and so on, what’s achievable in terms of scalability and can Wells Fargo continue to grow?

1. The misconception of “large is bad, large is risky”

DK: One of the common misconceptions is that large is bad and large is risky. Yet, more smaller banks fail than big banks. I would argue that at $1.3 trillion today with 100 different businesses, 20-25 individual products throughout all of the United States, that Wells Fargo today is less at risk of failing than the old Norwest, which was basically a commercial bank very narrowly focused in the mid-West and very dependent upon on agriculture, which almost failed in the 1980s. It was a troubled institution that I was asked to come in and try to help correct the problems within.

Take, for example, the old Norwest in the five states where our businesses were. We had a 10% banking market share. Today, in those same five states, our market shares for banking may be 15-20%. But we’re bigger than that because we’re in financial services as well. However, in terms of the financial services market share, we only have about five percent.

ED: In terms of total assets.

DK: However you want to define it – revenue, assets, we won’t get into it, that’s pretty complex. The financial services business is about five times bigger than the traditional banking business, so if you get bigger – if we went from $20 billion in assets in Norwest in those five states to $1.3 trillion in assets in those five states, we would be much riskier and at risk of failing. But if the reason you have grown is you went into new states where you had zero market share and built it to 10-15%, why is big bad? And the reason small banks fail is because they’re usually not even in one state. They may only be in three cities. If a branch closes down, that’s why they fail.

I would argue geographic diversity is crucial. Texas banks back in the 1980s were some of the most profitable banks in all of America. They had the highest PE ratios and only failed because the state failed.

2. The disadvantages of concentration

Remember the savings and loan association (S&L) crisis? They failed because they were concentrated in two products: commercial real estate and residential real estate. They weren’t big, and yet everyone said, “Big is bad.” Concentration is bad, and the bigger you are in concentration, that’s even worse. But if you’re big because of diversification, it reduces the risk.

That was the reason we got into financial services. If we wanted to grow with the same product line, we were going to face more risks. And I said, “I don’t want more risk; I want less risk.” So I’ve got to diversify. That then allows you to grow without taking more risks. What we have today, is having gone from offering just two or three products to offering 20-25 products. This diversification actually reduces risk.

ED: The Wells Fargo franchise that you’ve described, is it uniquely North-American? Is it uniquely American in that we would not find Wells Fargo becoming international in its core consumer franchise outside of the US? You mentioned Wamart, and Walmart has been a touch and go case outside of the US. It has had a lot of learning experiences in China, and not been as straightforward in Europe. This, being mindful of the fact that you are a great trade finance bank outside of the US.

DK: We’re number one in the world at that. As a matter of fact, but when we acquired Wachovia, we acquired a financial institution group that was doing a fabulous job.

ED: So you’re adding complexity to your institution. The call proposition is not as straightforward as the Wells Fargo of San Francisco. The diversification has brought other forms of businesses which are becoming equally significant.

3. Wells Fargo’s operational complexity

DK: You have two choices. Do you want to do something that you’ve been doing all along and know how to do and become concentrated – and therefore, have more risks because of external factors? You can still run that very well, but the external factors can do it, or you can trade off risk – let’s call it credit risk – for operational complexity.

You control operational complexity. A macro event is not going to cause your operational complexity to blow up. But an economic crisis which you have no control over could cause all kinds of businesses to go bad. I would rather trade off things I can control to reduce overall risk than things I can’t control.

The quick answer is Wells Fargo will not – I’m not in charge anymore, but I think it’s unlikely –grow, retail-wise, internationally. We already serve financial institutions and we’re also going to introduce overseas commercial banking offices to serve our US customers, but we’re not going to do local business to any great extent. The reason being we still have tremendous growth opportunities in the US. But the truth of the matter is, there are many more similarities between commercial and retail banking, internationally, than there are differences. So the skills can still transfer.

ED: Is this between countries or regions?

DK: Between countries and regions. When I was running the New York banking division for Citibank, I used to say that there were greater differences between the retail banking businesses in the Bronx and Manhattan than there were between New York and Hong Kong. People all over world want to save, borrow, have a mortgage and own a credit card.

The difference is the culture of the organization. It’s much easier for us to first expand domestically and get our market share than to try to establish a relationship or acquire a company in an international situation. So I don’t think that will be on our agenda for some time. Maybe never, even.

Emmanuel Daniel (ED): Given the daily publicity that you see on regulation in the newspapers, do you think there is more regulation today?

1. Increased regulation in the banking sector

Dick Kovacevich (DK): When I first joined the banking business, it was already very heavily regulated. You couldn’t even bank across state lines. There was something called Regulation Q; you could not offer a savings account for more than 5%. The prime of your lending was determined by regulation. So things were already being highly regulated, from the product and geographic point of view, prior to the 1980s.

However, it was subsequently deregulated, because of the concentration issue. They deregulated products, pricing, and geography. We were in that mode until the recent crisis where there was less regulation when it came to products and geographic location. But with the advent of the Dodd-Frank bill, I would say the regulatory burden today is multiple times greater than it’s ever been.

ED: It’s 2,000 pages worth of regulations.

DK: There’s going to be tens of thousands of further regulations. The thing I want to emphasise is that the Dodd-Frank Bill would not have prevented the last crisis, and will not prevent the next crisis. The regulation is more of an anger towards, and punishment of banks, even ones who did no wrong, for this crisis.

I’ll say two things to support that. What does limiting debit card fees has to do with risk and the risk of bank failure? It increases the probability of a bank’s failure because about 5-10% of our fees are now gone. And debit cards were of no risk. In fact, the travesty of this is how a small bank survives the Dodd-Frank Bill. The Dodd-Frank Bill was proposed to be, “We’re going to be able to eliminate big banks from growing.” The one thing you know for sure about increased regulation, is that it increases concentration, because who wants to enter a business which is highly regulated? The marginal players leave you.

Look at all the highly regulated industries: pharmaceuticals, telephones, cable television, network television, railroads, airplanes, nuclear reactors, cigarettes – they’re all more concentrated than industries that are not regulated. So they’re doing the opposite of what they should be doing. And what happened in this crisis, in my opinion, was that 20 financial institutions – most of whom were not commercial banks – became the problem, not the rest of the 8,000 or so banks. It was a failure of regulators, not regulations.

Let me ask you a rhetorical question. Would you agree that City Corp had some of the problems in this financial crisis that caused some of the issues? So what regulatory authority did the Federal Reserve Board not have, to reign in the risk of City Corp prior to this crisis?

ED: That was not applied, you mean.

DK: I can’t think of any reasons. And yet, they said that they didn’t have the authority.

2. The state of affairs in the US

ED: One final question, on the future of the US. What do you see about Asia from where you sit in San Francisco that makes you reflect about the future of the US, and how do you think that future should play out?

DK: I have never been more concerned about the future of the US than I am now. When I grew up, we were a country that for every generation since our founding in 1776, had a higher standard of living, and expected to have a higher standard of living than the previous generation. It happened for every generation. One of the most important reasons why that occurred was good education. My siblings and I were the first people to go to college in my family. If you had a good education, the sky was the limit and you could be anything you wanted to be.

Ours was a free enterprise system, where you could make a lot of money if you were good. You could start companies. It was just a vibrant economy with every new generation expected to do better than the previous generation. That is not the case in America today. My children, or this generation, will be the first one that will have a lower standard of living, and the question is, “Will their children have it even lower or are we sinking?”

And yet I come to Asia – and I’ve been coming here now for about 30 years – and I see just exactly that same kind of momentum that we used to have. Every generation is going to have a higher standard of living than the previous one. The education levels are much higher than they are in the US, and that’s why you know it’s going to continue that way. There are entrepreneurs here. Every country you go to, you see new businesses being created, and they’re competing on a worldwide stage just like America was doing.

ED: So what does America need to do to stop that slide? I mean, it’s probably just a door stop that’s required to stop the slide.

3. His fears for the future

DK: I think what seems to have happened in the US, is we have to suffer so badly that we finally do the right thing. That’s probably what’s happening right now. People are – there’s all kinds of changes that are happening politically, and we’ll see which direction we head – and I am confident that we will, that America will come back, because we’ve always have had to go to the precipice before we start doing the right thing. But it is scary. I think we’re heading down a path, quite frankly, towards the European model, and that has never worked.

ED: Where the state is large and entrepreneurship is small.

DK: Exactly. 56% of France’s GDP belongs to the state. France has never had an unemployment rate lower than seven percent for 30 years. That’s where we want to be? That’s where our policies are heading, in my opinion. And I think it’s a mistake. That’s not to say we don’t need to make changes and there were some sins that were made that need to be corrected, but the fundamental way to create increased wealth for everybody is the free enterprise system.

If you look at the countries that are doing well today versus the ones that aren’t, those countries are freer today than they were in the past, businesses are freer, it’s closer to free enterprise, and they have a highly improved and educated work force, much better than the previous generation. Those are what worked for America, that’s what’s working for Asia today, and we’ve got to get back to that.


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