Second-quarter earnings results for Wells Fargo were a huge disappointment for the bank, which reported a loss of $2.4 billion and trimmed its common dividend by about 80%. But CEO Charlie Scharf left analysts and investors with one bright spot: The bank is looking to cut annual expenses to the tune of $10 billion.

Wells Fargo has long lagged its peers in terms of expense management, and with revenue likely to be limited going forward because of the low-rate environment and the asset cap Wells Fargo is currently operating under, lowering expenses is one way the bank can take control of its own destiny.

The exterior of a Wells Fargo branch.

Image source: Wells Fargo.

Lagging behind peers

Wells Fargo's expenses have long been higher than its peers. One commonly used metric by banks to judge a company's expense structure is the efficiency ratio, a measure of a bank's expenses as a percentage of its total revenue. A lower percentage is better because it means the bank is generating more revenue with a smaller amount of spending.

Bank Efficiency Ratio 2019
Wells Fargo (NYSE:WFC) 68.4%
Citigroup (NYSE:C) 56.5%
Bank of America (NYSE:BAC) 60.2%
JPMorgan Chase (NYSE:JPM) 57%

Wells Fargo had a much higher efficiency ratio than its peers in 2019. One thing to note is that this ratio has been steadily rising and has been much higher than normal since the bank's phony accounts scandal in 2016. The bank has had to spend more on costly litigation and the Federal Reserve also placed a $1.95 trillion asset cap on the company. As a result, total revenue has come down while expenses have gone up, ultimately sending the efficiency ratio in the wrong direction. However, even in 2017 and 2018, the company's efficiency ratio didn't get below 65%.

Where the company can start to cut

I am sure Scharf is a very capable cost cutter. After all, in the earlier part of his career, he worked closely with JPMorgan's CEO Jamie Dimon, who made a name for himself as a cost cutter by going into banks and trimming everything from corporate country club memberships to newspaper subscriptions.

As the nation's largest bank employer, the first and most obvious move for Scharf will be layoffs -- personnel is typically the largest expense at a bank. In 2019, Wells Fargo spent roughly $35 billion on salaries, employee benefits, and commissions and incentive compensation. The bank is already planning to cut thousands of jobs this year and eventually reduce its head count by tens of thousands when everything is said and done, according to Bloomberg. It's a hard reality, but as digital banking trends accelerate, it simply won't make sense to have the same number of employees.

Next, the bank can continue to consolidate and close branches. With 5,455 U.S. branches as of March 31, according to the FDIC , Wells Fargo still has a larger brick-and-mortar presence than JPMorgan (5,061), Citigroup (710), and Bank of America (4,259).

Why the task may be difficult

The first thing I wonder about is the bank's assumptions. Wells Fargo's non-interest expenses in 2019 amounted to nearly $58.2 billion. When asked by Matt O'Connor, an analyst at Deutsche Bank, about what the jumping-off point is for expense cuts, Wells Fargo CFO John Shrewsberry said he thinks it's around $54 billion in annual non-interest expenses once you get rid of "the excess expenses that are loaded into this quarter." So, one could really say the bank is looking to cut expenses by $14 billion from its current level.

There have certainly been loaded expenses in recent quarters due to litigation from the phony-accounts scandal, but the bank's non-interest expenses were $56.1 billion in 2018 and $58.5 billion in 2017. In 2016, the bank's expenses were $52.4 billion, so $54 billion could be a fair assumption without all of the loaded expenses, but that was nearly four years ago.

Also, the bank will still need to spend money while the expense cuts are happening. It has been widely documented that the bank needs and plans to invest much more heavily in technology. Wells Fargo spent $2.8 billion on technology and equipment in 2019, compared to JPMorgan's $9.8 billion for technology, communications, and equipment; Citigroup's $7.1 billion on technology and communications; and $4.6 billion at Bank of America, although the bank refers to the line item as "information processing and communications."

Also, Betsy Graseck, an analyst at Morgan Stanleyasked Wells Fargo executives more about where the cuts would come from, given the work the bank must do in order to eventually get the asset cap removed:

You've got new business unit heads in several places. Typically, folks like that are going to want to make investments. You're not going to touch the regulatory side. So where should we anticipate you have room to start bringing down expenses ahead of regulatory framework changes?

When will we see progress?

The company will likely begin to move ahead with job cuts later this year. But on the company's earnings call, Scharf wasn't entirely clear on whether he expected total expenses to actually be down in 2021, although he did say that "whatever sense of urgency existed before is going to be small relative to what it is going forward." The company is in a very difficult position right now with the need to invest in technology and continue to enhance its regulatory infrastructure so the Fed can eventually remove the asset cap it placed on the bank close to two and a half years ago. That's why reducing expenses by $10 billion could ultimately take some time.