My eyes usually glaze over at headlines about Banks getting fined for yet another scandal. Yawn, just a cost of doing business, too much regulation, a few rogue traders, move on, nothing new to see here. But there was something different about the Wells Fargo story. This was not another story about a few wild eyed traders taking a short cut. This was a story about thousands of staid consumer bankers doing that.
No, this is NOT a story about Bad Bankers and Good Fintechers. To see bad Fintechers in action just read the Zenefits story. This is a story about digital headwinds meeting a “make target at all costs” culture.
In short, this is what happens when we get to Acts 3 to 5 of the Creative Destruction 7 Act Play.
Yes, you could see this coming if you knew which Act the play was in.
The Creative Destruction 7 Act Play
If you are in a market that is going through wild, disruptive change where nobody knows how it will play out, you might be thinking:
“We have seen this movie before.”
Markets go through fundamental disruptive change in fairly predictable phases.
Here are the 7 acts in the Creative Destruction play. These stories have played to packed audiences in creative markets such a recorded music, newspapers, books, telecom, magazines, software (again and again and again) and are playing out now in markets that used to be boringly stable such as banking, accounting, legal services, education, car manufacturing and Healthcare. This is what happens when software eats the world.
Act 1. The Old Guard Dominate
This is when a few big companies dominate a market that has not fundamentally changed for decades (or hundreds of years in the case of banking). Mergers, debt leveraged acquisitions and “roll-ups” have locked the old guard into behemoth structures. No entrepreneur would think of competing against these companies and, if they did, no smart investor would back them.
Act 2. Straws In The Wind
This is when a few visionary/crazy entrepreneurs see opportunity. Occasionally VCs get active at this stage, but all too often VCs are part of the established order and do not see enough reason to believe that the times are changing. It takes guts to see a few straws blowing about and bet that this is caused by an invisible wind. The signs of change are far from obvious but “the answer my friend is blowing in the wind”.
Act 3. Denial
The changes are now real and the old guard management can see it. But they don’t know how to react, so they reach for high pressure management to make the numbers work. In some cases, management also reach for creative accounting tricks to smooth out earnings and make it look as if nothing has changed (known as fraud in most circles).
Act 4. The weird turn pro
The crazy entrepreneurs who started at Act 2 are now gaining real traction and major amounts of capital. They are experimenting frenetically to find what is really sustainable/scalable. This is the time “when the going gets weird, the weird turn pro” (quote from Hunter S Thompson, who was certainly weird but also professional enough to write best-selling books). During this Act there are lots of stories in the media about these strange entrepreneurs but, as the old guard numbers still appear to be OK, the accepted wisdom is still that nothing will fundamentally change.
Act 5. Blow up
This is when reality can no longer be glossed over. This is when we see scandals such as Wells Fargo (and the News Corp phone hacking scandal). This can lead to investors taking a cold hard look at the numbers and when the new numbers do finally appear, it can trigger a stock crisis, often with a restatement of earnings and a change of CEO.
At this stage the reality can no longer be denied and we see real crises in big companies. These crises may lead to radical transformation, or they may lead to Chapter 11 restructuring and fire sales. Before that happens we see the kind of behavior we just saw with Wells Fargo (which went on a long time during Act 3, Denial, when hardly anybody was paying attention). This is new for banking, which has not had a major headwind like this in hundreds of years. However, bankers can study other markets that got hit by the digitization truck – for example Media.
The News Corp phone hacking scandal
News media got hit by the digitization truck before banking. To put it another way, software feasted on news media before it looked for the next tasty morsel in banking.
The day the News Corp phone hacking scandal hit I happened to be meeting with an esteemed Wealth Management firm that had put up a list of their highest conviction stocks. Right at the top of the charts was News Corp. Oops. When questioned they responded:
“Stuff like that happens, it’s impossible to predict that kind of thing where rogue employees run amok”.
Yes. that is true and the rationale for putting that stock top of the charts based on financial metrics was impeccable. Yes, the problem that crashed the stock that day was a Black Swan event and they are by definition impossible to predict. The rogues were fired. Story over? No. Nobody could predict who would go rogue and when and in what form, but it was reasonably predictable that somebody would go rogue fairly soon in some way. It was an inevitable event even if it was not an imminent event where you could predict the timing. The reason that the employees went rogue was that their business was slap bang in the path of digital disruption. Valiant efforts by sales people (Wells Fargo) or Journalists (News Corp) cannot save companies from digital disruption. Top management attempts to make that happen usually end in scandal.
Act 6. Reconstruction
This is when a new power structure starts to emerges. This is when we see IPOs from the visionary entrepreneurs who started in Act 2. Sometimes they stumble post IPO and never recover. Sometimes they stumble post IPO, recover and grow to strength; I believe this will be the story of Lending Club (which is why, disclosure, I bought some stock in May).
Act 7.The new old guard dominates
Many entrepreneurs make the mistake of seeing how quickly the new guard arose and think that they can also be deposed quickly. The entrepreneurs who made it to this stage will be tenacious, paranoid and really hard to beat – until the next wave comes along. For example, in the Centralized Internet era we have GAFA (Google, Apple Facebook, Amazon) and BAT (Baidu Alibaba TenCent) who deposed analog media and bricks and mortar retailers and will dominate until the Decentralized Internet gets to prime time. Until that happens, don’t bet against GAFA and BAT.
So far it has not been dramatic for Wells Fargo
For those who are new to this story, the New York Times has the best summary.
The CEO has been grilled in the media (eg by Jim Cramer) and tomorrow will be grilled in Congress (where Elizabeth Warren is likely to be tougher on him than Jim Cramer) but I suspect that what the CEO really worries about is a quiet chat with Warren Buffet.
The Wells Fargo stock has dropped about 10%, nothing compared to the drop in Lending Club following their bad news in May. The Lending Club Board fired the CEO, took their pain upfront and moved on, which is classic crisis management.
I suspect the Wells Fargo stock decline is far from over, even if it is already cheap by most standards. The reason is simple – while Lending Club has a digital tailwind, Wells Fargo faces a digital headwind .
What to do with all those branches
Wells Fargo has the biggest branch network in America with 6,314 branches.
Our thesis, explored in this post, is that we will soon see a 10x reduction in bank branches. If you think that is impossible look at HMV, Blockbuster and Borders. Managing growth after the digitisation truck hits is very, very hard. In that analysis, we defined 3 possible strategies for legacy Bank branches:
- Close them quickly– get the pain over quickly, reposition the bank, free up management bandwidth. The problem is – who wants to buy your Retail Branch network? There is always a buyer, it is simply a question of price.
- Close them slowly– don’t spook investors, cut costs to squeeze more cash from the older customers, manage the pain and look for smarter semi-automated ways to increase revenue per customer (more footfall conversion and more conversion of door entry to revenue).
- Double down and improve the LTV part of the CAC/LTV ratio through cross selling.
Wells Fargo clearly adopted the last option.
Failure is not built into this story. Barnes & Noble did well while Borders failed. Blockbuster had a strategic plan that would have crushed Netflix and then they inexplicably snatched defeat from the jaws of victory. HMV could be an escape from the ashes of bankruptcy having left its CD selling days behind.
Companies may survive, but the pain for employees will be deep. My thoughts go to the 5,300 who lost their jobs at Wells Fargo. Layoffs in banking will be huge pain for families. Creative Destruction sounds OK at 30,000 foot but horrible if you are in the Destruction part. Despite the name, Destruction precedes Creation. The pain comes first.
The real worry is not Jim Cramer or Elizabeth Warren
The real worry for Wells Fargo is loss of trust by millions of consumers; I assume Warren Buffett will be saying something along those lines to the CEO and the rest of the Board. Trust can take a long time to develop but can be lost in a heartbeat. Or as we say in the social media age, trust can be lost in a single tweet that goes viral.