If you read articles and analyses on banks -- Wells Fargo (NYSE:WFC), in particular -- you'd be excused for thinking that the California-based lender is a simple operation that's easy to manage. But this is false.
The general story line goes something like this: Firms like JPMorgan Chase and Bank of America are incredibly complex organizations thanks largely to their sizable Wall Street operations -- namely, trading and investment banking. Therefore, because Wells Fargo is much more focused on traditional commercial banking, it's simpler and easier to manage. This is why, so the story goes, Wells Fargo weathered the financial crisis of 2008-09 better than many of its too-big-to-fail peers.
But this misses a fundamental point about banking. What's hard about banking has less to do with the number or nature of business lines that a particular firm has, and more to do with its ability to balance robust risk management against the ever-present desire for rapid revenue growth.
What makes this balancing act so difficult is that risk management and revenue growth conflict with each other. The easiest way for a bank to grow revenue is to increase its loan volume. And the easiest way for a bank to increase its loan volume is to reduce its credit standards -- that is, to make it easier for anyone and everyone, irrespective of creditworthiness, to get a loan. But reducing credit standards means taking on a higher risk of default, which is precisely what risk managers are paid to minimize.
It would be an understatement to say that spurring rapid growth while simultaneously focusing on credit risk is a delicate dance. More often, as the economy soars and revenue generators at banks make more and more money, their opinions take precedence over risk managers. This happened at countless firms in the lead-up to the crisis, and, at least in my opinion, it was this subordination of risk managers that got so many of these firms into trouble.
But Wells Fargo is an exception. Since at least the late 1970s, under the tutelage of the now legendary Carl Reichardt, the nation's fourth-largest bank by assets pioneered the "Wells way," which focuses in no small part on balancing these conflicting objectives. It consists of aggressively acquiring new customers, who can then be cross-sold additional products. But all along the way, Wells Fargo stresses risk management.
In the lead-up to the financial crisis, it steered clear of the most toxic corners of the subprime mortgage market while its competitors dove right in. For instance, Wells Fargo didn't offer negative amortizing loans, which defer a portion of customers' monthly interest payments and adds it to the underlying loan principal. Meanwhile, Wachovia did. This helps explain why Wells Fargo had to be Wachovia's white knight at the nadir of the crisis and not the other way around.
The story was the same with JPMorgan Chase, which has similarly gobbled up the market share of less risk-savvy competitors over the past decade. Prior to the crisis, its CEO, Jamie Dimon, had to fend off analysts, investors, and presumably even employees who pushed the bank to go for broke by underwriting riskier loans and ramping up the origination of highly leveraged securities tied to the subprime mortgage market. Afterward, those same people claimed Dimon was a genius for essentially ignoring their advice.
The point is this: Going against the grain is difficult and complex. There aren't formulas and algorithms that teach you how to do this. It's innate. It's unmeasurable. It's a part of a bank's culture. Thus, whenever people claim that Wells Fargo is a good investment because it's simple and easy to manage, this misses the point. Wells Fargo is a good investment because it has mastered the most complicated skill of all: the ability to operate countercyclically.
John Maxfield has no position in any stocks mentioned. The Motley Fool owns and recommends Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.