Bank of America's management team wants to put all of the litigation relating to the financial crisis behind it, so they can pivot toward growing the overall business for shareholders. This strategy won't be easy. The company's reputation with its customers is the lowest of any bank in America right now. Will Bank of America be able to pursue a growth strategy without alienating its customers even further? In this special report, we consider that question by taking a closer look at the company's business model and culture.

Part I: Why is Bank of America's reputation so poor?
This should be a celebratory moment for Bank of America (BAC 0.92%).

Profits are up. Its share price has risen dramatically since late 2011. And all signs suggest that America's second-largest bank is firmly on the path to recovery under the leadership of CEO Brian Moynihan. To top things off, legendary investor Warren Buffett, who has a paper profit of more than $5 billion on his investment in Bank of America, recently thanked Moynihan over dinner.

Despite all the good news, however, troubling allegations about the company's past operations continue to surface.

Earlier this year, former employees alleged in federal court that Bank of America frequently lied to homeowners who were trying to modify their mortgages under the government's Home Affordable Mortgage Modification Program (HAMP). Simone Gordon, who was employed by Bank of America from 2007 to 2012, stated,

We were told to lie to customers and claim that Bank of America had not received documents it had requested, and that it had not received trial payments (when in fact it had).

The former employees also claimed that bank employees were rewarded for increasing the number of foreclosures, and were punished for challenging the ethics of the bank.

Unsurprisingly, Bank of America vigorously disputes the claims of the former employees in this case, arguing that,

In sum, the declarants could not have witnessed what they claim to have witnessed because they were not in a position to do so – and would not have witnessed such things in any event because Bank of America's actual practices are diametrically opposite.

More recently, we learned of similar allegations against the bank in a suit filed by the Department of Justice. In a filing accusing the bank of defrauding investors, an employee involved in the origination of mortgages "admitted that the emphasis at BOA-Bank was quantity not quality and that he was pressured to increase the number of applications per week." Another employee admitted that "her superiors pressured her to process applications as quickly as possible but to keep her opinions to herself."

In response to the Justice Department lawsuit, a spokesman defended the bank's practices saying, "These were prime mortgages sold to sophisticated investors who had ample access to the underlying data and we will demonstrate that."

The two lawsuits mentioned above are ongoing, and we have no idea how they will eventually be decided. We do know, however, that legal battles are not uncommon for Bank of America, which has been involved in a dizzying array of lawsuits, settlements, and judgments over the past several years.

Earlier this week, in fact, a jury determined that Countrywide Financial, now a unit of Bank of America, defrauded Fannie Mae and Freddie Mac by selling them tens of thousands of defective mortgages. The ruling marked the first time a bank has been held liable by a U.S. court for misleading the government about activities relating to the financial crisis.

Here is just a small sampling from 2013 alone:

  • In January, Bank of America was one of 10 mortgage servicing companies that agreed with the Office of the Comptroller of the Currency (OCC) to pay more than $8.5 billion in cash payments and other assistance to help borrowers.
  • Also, in January, Bank of America agreed to pay $10.3 billion to Fannie Mae to settle a lawsuit concerning the sale of faulty mortgages.
  • And in May, Bank of America reached a $1.7 billion agreement with MBIA to settle a legal dispute over mortgage-backed securities.

Overall, Bank of America has one of the longest corporate rap sheets among the big Wall Street banks over the past several years. That's a pretty remarkable accomplishment when you consider the other banks in that select group. From 2010 through 2012 alone, the bank agreed to pay almost $42 billion to settle numerous legal disputes, according to SNL Financial. Wells Fargo (WFC 0.92%) came in a distant second by agreeing to pay out just over $8 billion during the same period.

Whether it's all the lawsuits or the actual behavior that resulted in the lawsuits (or both), Bank of America's reputation has plummeted in recent years. Among the 30 major brands studied in American Banker's 2013 Survey of bank reputations, Bank of America came in dead last. In addition to having the worst reputation among its own customers, it scored the lowest among non-customers as well.

Bank of America's customers appear to be extremely dissatisfied at the moment in comparison with consumers at comparable big banks. Earlier this year, we learned the bank had the largest number of customer complaints filed with the Consumer Financial Protection Bureau over the past 16 months. Bank of America accounted for approximately 23% of all complaints compared with 14% for Wells Fargo and 11% for JPMorgan (JPM 0.50%).

When looking at all of the lawsuits and then considering its plummeting reputation, it really makes us wonder about the sustainability of Bank of America's current business model. How has this business managed to last so long? Will its current practices ultimately fuel disruption in the banking industry?

Bank of America's management team argues that most of its problems stem from the Countrywide acquisition and issues relating to the financial crisis. As those problems continue to get resolved, the bank says it will be able to focus on more profitable activities, thereby creating more value for shareholders.

We're highly skeptical of that assessment, which appears simplistic and overly optimistic. We've recently taken a closer look at the bank, and now believe Bank of America's current business model is unsustainable. As a result, we find it hard to believe its stock will outperform the market over the long term.

Part II: How Bank of America makes its money
The fact that Bank of America is no longer among the most esteemed companies in the United States hasn't gone unnoticed by the executives in the megabank's corner offices.

A recent ad campaign provides a case in point. Designed to humble the bank in the eyes of consumers, one of its commercials depicts a time lapse of multiple generations of a single family. The patriarch gets married, buys a house, and has children and grandchildren. Indeed, the only constant is Bank of America, lurking omnisciently in the background. "We know we're not the center of your life," the spot concludes, "but we'll do our best to help you connect to what is."

The problem is that the image of a small, personable lender that cares about each and every one of its customers is simply at odds with reality. Bank of America isn't just any old bank. It's a behemoth, one of only four lenders that today make up an oligopoly in the banking industry.

When expressed in dollars, the magnitude and breadth of Bank of America's reach is almost unfathomable. It exercises direct control over $2.1 trillion in assets on its balance sheet. Its wealth management arm oversees an additional $1.9 trillion in customer assets. It's entrusted with $1.1 trillion in deposits, equating to more than one of every 10 dollars on deposit in the United States. And at its peak four years ago, it serviced $2.2 trillion in residential mortgages.

Altogether, it oversees upward of $5 trillion in assets, more than the annual gross domestic product of every country in the world except Japan, China, and the United States.

This is not to say that Bank of America is simply a carbon copy of its too-big-to-fail brethren. Unlike a Citigroup (C 0.05%) or Goldman Sachs (GS 0.15%), both of which cater to ostensibly sophisticated institutional investors and corporations, Bank of America looks to the average consumer to fill its coffers. It has a staggering 48 million households as customers, equating to 45%, or nearly half, of all American households with bank accounts. A purported 8 million are designated as "preferred," meaning that they generate more money for the bank via higher deposit balances and product usage, while the remaining 40 million customers are classified as "retail."

A strategy like this, which exposes Bank of America to the masses, has both its benefits and detriments. The primary benefit is its ability to acquire vast sums of deposits from savers across the country. According to data from the FDIC, the North Carolina-based bank currently controls 11.4% of the nation's deposits; that's 1.4 percentage points higher than the 10% cap set by federal law in 1994. And the best part is that these funds, once acquired, are effectively free. In the third quarter of this year, for instance, it paid all of 0.15% on domestic deposits -- and that's excluding the $364 billion in noninterest-bearing deposits.

The value of this franchise becomes clear once you consider that these very same funds are then loaned to borrowers at significantly higher interest rates. In the third quarter, Bank of America charged borrowers an average rate of 4.74%. Known as interest rate arbitrage, this is the very essence of a traditional bank's business model. And in Bank of America's case, it earned $10.3 billion, or nearly half of its total revenue last quarter, in net interest income from this activity alone.

But if this sounds too good to be true, then you're onto something. In short, the process of acquiring (as opposed to holding) deposits is expensive. It requires a sprawling branch network, colossal call centers, sophisticated mobile and online banking platforms, and thousands of ATMs spread across the continent. It's so expensive, in fact, that most large banks actually lose money on the typical customer account. According to research firm Moebs Services, the average checking account cost a bank $349 in 2011. Meanwhile, the average revenue per account was just $268, implying a loss of $81. In Bank of America's case, if you multiply that out by 40 million, you get $3.24 billion.

The trick, in turn, is to recoup these losses.

What's the best way to grow the business?
One way to do so is to charge upfront account fees. But Bank of America tried this in 2011 with the introduction of a $5-per-month debit card fee, and was forced to abandon the attempt months later after uproar among its customers and consumer advocates contributed to, among other things, Bank Transfer Day. Indeed, since Washington Mutual, the former savings and loan colossus acquired by JPMorgan in 2008, introduced free checking in the mid-1990s, this approach has been a nonstarter.

The banking industry has thus been forced to become more creative in its attempt to offset these losses. Much like the fees that spawned in the wake of Southwest Airlines' and other discounters' disruption of the airline industry, Bank of America has gravitated toward less transparent means to recoup the deficit. Instead of baggage fees, it charges overdraft and non-sufficient funds fees. As opposed to charging you for a can of soda, it takes a tiny proportion of every debit or credit card transaction that it processes for customers. In the third quarter of this year alone, it generated $2.5 billion from various noninterest charges in its consumer banking division.

But far from solving Bank of America's problems, this strategy has merely fueled a new class of headaches.

Over the last few years, the bank, along with the industry in general, has found itself in the regulatory and legal crosshairs over the litany of fees it charges customers and the way in which it does so. It's been sued for its overdraft policy of reordering customer transactions in order to maximize overdrafts and forced by regulators to change it, prompting the bank most recently to consider offering a new type of account which prohibits overdrafts altogether. Debit card interchange fees are now capped by the Federal Reserve. And it's been admonished for its treatment of mortgage and credit card holders.

All told, Bank of America has rung up tens of billions of dollars in legal and regulatory expenses for various fee-based transgressions.

The result has been to refocus Bank of America and its peers on the traditional method of revenue growth, which, not unlike your local McDonald's ("Would you like fries with that?"), involves up-selling.

The initial priority of any bank is to acquire new customers, which is typically accomplished by offering free checking accounts. On Wells Fargo's second-quarter conference call, its CEO said that he "dreams about checking accounts." These are "formational accounts," he explained. It's how banks get their foot in your door, after which the objective becomes to get you hooked on additional, and many times fee-based, products.

Moynihan touched on this in a presentation he gave in 2009. Discussing Bank of America's colossal deposit base, he noted,

We are going to maximize this franchise in everything we do, including, importantly, maximizing the value of the Merrill Lynch transaction, and sending every customer we can into [our] team of 15,000 financial advisors.

This also includes getting Bank of America customers signed up for credit cards, mortgages, and car loans. As he mapped out two years later,

...for a consumer, that's a core transaction account through the financial investment advice from Merrill Lynch and U.S. Trust, helping them borrow on a short-term basis using their card or on long-term basis for their home or their car.

If you're a current Bank of America customer, then you're well aware of this push. Hardly a week goes by that a BankAmericard application isn't in your mailbox or you aren't contacted by a Merrill Edge representative seeking to advise you on one thing or another.

Beyond this, the cost of maintaining its massive footprint obliged Bank of America to double down on cutting expenses. At present, it has three "distinct workstreams of expense initiatives" underway. First, it's seeking to reduce costs in its consumer real estate division primarily through the sale of third-party mortgage-servicing rights -- an intangible asset that mortgage originators retain after selling the underlying mortgages to institutional investors. Second, it remains focused on reducing litigation expenses. And third, an institutionwide program is aimed at cutting overall headcount by 30,000 and expenses by a purported $8 billion a year when all is said and done.

Thus, the experience on the customer level is likely to be less personal interaction.

With respect to its 40 million retail customers, while Bank of America pays lip service to improving the customer experience, the reality is that its priority is to reduce how much it costs to service them. Its euphemism for this is to "optimize the delivery network," which consists of migrating customers "from direct contact to self-service channels" -- that is, mobile and online services.

This is reflected in some of the more prominent metrics that Bank of America cites to investors nowadays, including the number of active mobile customers (currently 14 million) and, specifically, how many checks are deposited each quarter via its mobile platform (11.7 million in the three months ended June 30).

It's tempting at this point to conclude that Bank of America has learned its lesson. And, in fact, at least in the short run, there's a strong argument that the bank has gotten away from aggressive means to generate bottom-line growth, the majority of which is likely to come instead from cutting costs.

But net income can only grow for so long via expense reductions. At some point, the top line needs to contribute as well. And that's where Bank of America will likely come up against the same issues that it's fought to extinguish since 2008.

Bank of America's leaders have spoken clearly about where the company will look for growth going forward. As its chairman Charles Holliday said at this year's meeting (emphasis added): "Our management team led by our Chief Executive Officer created a strategy 3.5 years ago to simplify this institution and focus on growing our business with existing customers." How will it do so without raising fees or aggressively putting customers into products that might not be suitable?

It won't.

Part III: Root causes
Unfortunately, Bank of America is unlikely to grow profits without further undermining its reputation for two reasons: It probably can't, and it doesn't intend to. The company is locked into a business model that alienates its customers by deep-rooted industry dynamics and its own culture.

Basic financial products are commodities. Similar in appearance across banks, FDIC-insured deposits, home loans, checking accounts, or debit and credit cards, are a lot more like airline tickets or salt than one-of-a-kind drug discoveries or branded tech gadgets. That's because when a bank hits on a successful product, there's little to stop competitors from copying its idea.

So in the decades leading up to the financial crisis, major banks hit on two interesting ways to compete. First, provide the lowest sticker price possible with offers like "free" checking accounts, but make up the difference by cutting corners and charging hidden or bogus fees.

And second, get really big. Since customers didn't have many other ways to distinguish the apparently identical "free" banks, they tended to pick ones that offered the most branches and ATMs.

But the pre-crisis rush to get larger by building more branches and acquiring smaller competitors didn't end up making banks more efficient. Instead, the extra physical locations and megabank overhead also meant more expenses to recoup by charging still more hidden fees. Big banks are significantly more likely to charge hidden fees than smaller regional and community banks and credit unions.

"I think our mission is to produce massive amounts of profit."
The dual get-big-and-make-money strategy calcified into a business culture that you see neatly summarized in former Bank of America CEO Ken Lewis' 2008 reflection: "I think our mission is to produce massive amounts of profit."

The reason Bank of America won't consider reforming how it treats its customers is that it's not particularly focused on how it treats its customers in the first place. Moynihan practically conceded this back in late 2009: "We had such a sales culture that it could overwhelm the service culture."

Consider its strategic response to the financial crisis. Although the specific practices have changed since Moynihan's elevation to CEO, cultural continuities include a fixation on near-and-medium-term profits and insensitivity to customer concerns.

For example, Bank of America achieved poster child status in a national mortgage servicing scandal that has resulted in allegations of lying to homeowners that has so far cost tens of billions of dollars and spectacularly bad press. Yet the bank's words and actions suggest that it's actually pleased with its mortgage servicing practices.

In analyst and investor conferences, Bank of America executives explain that the mortgage servicing group has had two primary goals: cutting costs and pushing down the number of troubled loans as quickly as possible (in large part through foreclosure).

Executives don't emphasize the challenges of creative loan modifications and forbearance plans to help customers stay in their homes, or even streamlining the paperwork nightmare to improve the accuracy of its court filings and reduce the number of illegal foreclosures.

By August 2011, a full year after the foreclosure robo-signing scandal first attracted national attention, Bank of America actually took Terry Laughlin, the executive running that division, and promoted him to Chief Risk Officer, responsible for overseeing the entire company's governance and strategy for handling legal, operational, and reputational risks. That doesn't make sense if your main goal is compliance.

During the next quarterly earnings call, Moynihan summarized how successful the unit had been: "We continue to push through the process of cleaning up the delays and foreclosures. We continue to make good progress there."

In 2012, "An area where we continue to focus is our Legacy Assets and Servicing business.... we continue to see progress here. The number of delinquent loans, those are 60-plus past due, are down 24% from a year ago to 936,000 at the end of September.... We expect to see further reductions....we're reducing costs."

This summer, CFO Bruce Thompson updated, "as we look out and as we look at getting through and new Legacy Assets and Servicing being the last big piece of the expense reductions, clearly that efficiency ratio needs to get in the mid- to high 50s as we get through the Legacy Assets and Servicing [sic]. And I think if you look at that type of efficiency ratio, you tend to get to the types of returns that you'd expect us to earn on tangible common equity."

Last week, Moynihan crowed, "We continue to make progress on our expense initiatives, remaining on track to deliver the cost savings that we told you about 2 years ago in New BAC and also reducing the cost in our Legacy Assets and Servicing area."

One way to understand the institution's behavior would be to look at the work of Hannah Arendt. The German-American political theorist, whose analysis of bureaucracy is second-to-none, observed in The Banality of Evil that most damage isn't committed by sadists, but rather by ordinary people acting through bureaucratic institutions that normalize and systematize bad behavior. "Most evil is done by people who never make up their minds to be good or evil." Various psychology experiments -- most famously Stanley Milgram's Obedience to Authority -- have since confirmed that ordinary people will do awful things if you put them in the right situation.

This is the environment that produces Bank of America's most high-profile customer complaints: a newfound laser-like focus on streamlining operational processes and smarter customer relationship-management, combined with apparently institutional indifference to the effects of its behavior on the lives of its customers.

In retail banking, "we've moved from a product focus... to a customer relationship focus," the bank explains in its most recent annual letter to shareholders. Of course, this hasn't been a shift from valuing bigness and profits to focusing on what's best for customers, but rather to more carefully managing customer relationships.

In late 2011 Moynihan shared the mentality behind the new strategy: "We have 42 million [now 40 million] retail customers and many of those, don't contribute the cost of service, overcome their cost of serve [sic]. On the other hand, our preferred business, you can see is much more profitable and represents 8 million customers."

The old, clumsier Bank of America might have indiscriminately underserved all 48 million, but no longer under the new "relationship" strategy. "We're going from a one-size-fits-all service model to a differentiated model to help protect the customers who are very -- who provide a great return for us, and make sure that we have no attrition of those customers who aspire to get there."

The new Bank of America's stated goal is to become a two-track bank. In our opinion, it seems to want to protect 8 million of its customers from its most aggressive practices so that the bank can more effectively "connect" them to its more profitable products. In the meantime, it will try to collect enough money from the remaining 40 million people to cover its massive overhead without "attritioning" them too badly.

This would be a strategically smarter, more customer-relationship-savvy bank, but not necessarily a bank with reformed values. Any improvements in how Bank of America treats the bulk of its customers will be marginal, incidental to its strategic goals, dependent on the success of its cost-cutting efforts, and subject to withdrawal as it discovers new revenue and cost-cutting "opportunities."

No customer revolt -- yet
A variety of reasons exist for why Bank of America and some of its peers have been able to survive for so long despite antagonizing their customers. Not all are factors banks will be able to rely on in the future.

Many of the abuses, like hidden or bogus fees, are, well, hidden. Customers oftentimes don't discover that they've been paying such fees until years later, if ever. And it wasn't until the financial crisis that we began to see such widespread media awareness of the problem, though that seems to be changing.

Second, banks know that customers think it's a logistical and financial hassle to switch to another bank. Customers who feel locked into a relationship are less likely to leave when a bank treats them poorly. And high switching costs partially remove the business incentive to focus on customer satisfaction and retention, freeing banks to emphasize initiatives more meaningful to the bottom line like acquiring customers, upselling customers, charging fees, and cutting costs and services.

Source: wratings.

Switching costs is the same reason some cable companies, whose customers have to pay fees and jump through hoops when they want to cancel service, feel emboldened to provide customer service that's consistently ranked near the bottom of all industries.

And as with the cable industry, high market share concentration means that bank customers feel somewhat trapped. The biggest four banks -- Bank of America, JPMorgan, Citigroup, and Wells Fargo -- control almost half of the market, and none perform especially well in customer surveys about quality or trust.

What's more, financial products went largely unpoliced for decades. There hadn't been any federal regulator dedicated to policing consumer financial abuses until the Consumer Financial Protection Bureau was created in 2010.

Finally, Bank of America arguably did manage to fail under the weight of all the toxic products it sold to customers, but, being perceived as too big to be allowed to collapse without wreaking even greater havoc on the economy, it was bailed out by the government. It's unclear what would happen next time. The 2010 Dodd-Frank Act doesn't end the problem of "too big to fail", but it did ban bailouts and attempted to set up a more orderly process for allowing banks to fail without quite so much havoc. It's possible a future Congress and President would rescue the company again, though a thoroughly fed up public might demand much more punitive bailout terms.

IV: Conclusion
It's difficult to see how Bank of America outperforms over the long term.

We see a company saddled with the worst customer reputation in its industry, if not the country. Management will need to find new ways to boost profits in order to earn their bonuses. Yet Bank of America's history, business model, industry dynamics, and business culture strongly suggest that the company isn't going to grow without indulging in practices that remind customers why they dislike the bank so much in the first place.

Bank of America appears both unwilling and unable to address the causes of its reputational risks through improved practices and serving customers. Without sound practices, multibillion-dollar legal costs are lurking behind every corner. And without customer service, the company is vulnerable to disruption.

Maybe disruption will come from institutions with better reputations like Union Bank, Ally Bank, or Charles Schwab. Or maybe from new tech-savvy banks with a lower cost structure like Bank of Internet USA. Or from a company that doesn't yet exist.

But there's a tremendous opportunity waiting out there for those who can figure out how to serve customers better than Bank of America. And success requires clearing a fairly low bar. You can bet someone will eventually figure out a way.