Peter Conti-Brown and Lisa Cook on the Wells Fargo Fraud Hearing

Wells Fargo chairman and CEO John Stumpf’s testimony last Tuesday before the Senate Banking Committee on the fictitious-accounts scandal at his bank raises disturbing questions for the bank, the banking industry and affected consumers. Earlier this month, the company said its subsidiary Wells Fargo Bank will pay $185 million in settlements over admissions that its employees had created fictitious customer accounts without the parent firm’s knowledge over the past five years. They had created about two million such accounts, ostensibly to meet sales targets and earn bonuses.

Some suggest that the bank’s profit model may be to blame for encouraging such practices. Now, the spotlight is on how the financial services industry should structure employee incentives, the role of the Consumer Finance Protection Bureau (CFPB) and the impact on Wells Fargo customers whose credit scores stand compromised. With the bank firing some 5,300 employees that were involved in the fraud, the debate moves to whether its corporate culture is to blame, or if those employees were indeed guilty of “wrongful sales practice behavior,” as Stumpf told the Senate committee.

According to Wharton professor of legal studies and business ethics Peter Conti-Brown, the Wells Fargo episode raises a basic question: “How profitable do you want the banks [to be] if they’re providing such a basic public-utility type service of just parking your money – in the way that we might think of an electricity company or a gas company — as opposed to a profit center?”

Michigan State University professor of economics and international relations Lisa Cook said the Wells Fargo scandal could upend existing bank profit models. She noted that in 2015, the financial services industry collected $11 billion in overdraft fees, or 8% of total profits, citing a CFPB report. Similarly, banks would covet other customer fees, she added. “[The] question is how the profit function might change if these types of practices were eliminated?”

Conti-Brown and Cook discussed these and other questions on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Here are five key takeaways from their discussion:

‘Unsympathetic and Unaware’: While Stumpf apologized for his bank mistreating its customers in his Senate testimony, Cook gave him a “D-minus” for his performance at the hearing. She said he was “unsympathetic and unaware and passing the buck” in responding to the charges against his bank. “Most disturbing was that he profited tremendously during the period when the scheme was happening,” she added. Between 2012 and 2015, Stumpf received more than $155 million in performance bonuses, according to a study by the Washington, D.C.-based Institute for Policy Studies.

Wrong Culture, Misplaced Incentives? Conti-Brown noted that he was “annoyed … the most” when Stumpf attributed the problems to a group of rogue bank tellers and that their actions did not reflect the bank’s corporate culture. According to Cook, if 2% of the bank’s workforce was involved in wrongful practices, they cannot be described as merely rogue employees. “There had to be a person at the top who knew about this,” she said, adding that the bank fired several whistleblowers that exposed the wrongful practices.

Cook also faulted Wells Fargo for allowing Carrie Toldstet, its former head of retail banking who oversaw those practices, to retire this year-end with nearly $125 million in severance payments. “All of this is suspect. It just smells, it just stinks. Being allowed to retire doesn’t suggest accountability or responsibility at the highest levels of management.”

Conti-Brown also called for bank managers to revisit how they structure incentives for employees. “In the banking industry, especially in consumer banking, we don’t have a good handle on this. Wells Fargo didn’t provide the correct solution.”

Three Unanswered Questions: Conti-Brown raised other questions: For one, does Toldstet’s retirement indicate a change of direction in the company’s practices, away from the cross-selling that helped create the fictitious accounts? “Toldstet’s retirement was not voluntary; she was counseled out,” he noted. “She was allowed to retire precisely to avoid call-back of her compensation.” (Wells Fargo critics have since demanded that the bank claw back the compensation paid to employees who indulged in wrongful practices.)

“Why did this happen at all when we created the CFPB to eliminate this kind of thing? [And] would this have continued to go on?” –Peter Conti-Brown

Second, what is the total number of Wells Fargo employees who were involved in cross-selling activities? “Not all the staff (about 220,000) are personal bankers,” he noted. “To get the denominator here, we need to know what number of people is engaged in the business of cross selling and then what number of people faked these two million accounts.”

Third, why did bank management not see red flags when some branches performed better than others? “Rather than investigating how could it be that [some] branches are such outliers compared to the rest of the company, they started celebrating it and sending people to learn from them,” he said. “It just does not pass the smell test.”

Impact on Credit Scores: According to Conti-Brown, the impact of the fictitious accounts “will be marginal” on the credit scores of the affected Wells Fargo customers, but the costs will be high for those people “who were at the cusp of between excellent and good.” He predicted that those who refinanced a house or a car loan will incur additional fees that could run into thousands of dollars. “There was real harm done to these people through the manipulation of credit scores.”

Revisiting the Regulator’s Role: Conti-Brown wondered if the CFPB’s existence “facilitated settlement and discovery as opposed to preventive measures” and suggested that its role should be reviewed. “Why did this happen at all when we created the CFPB to eliminate this kind of thing? [And If it had not been detected], would this have continued to go on, would it have spread?”

Conti-Brown also finds gaps in the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act that was passed in the aftermath of the 2008 financial industry crisis. He said it emphasizes “systemic risk regulation” and “quantitative models [using] stress tests and living wills” and overlooks problems caused by individual behavior.

“This [Wells Fargo] example shows us there is something about shoe-leather banking supervision of individual institutions to get down and weasel into information where real humans — bank tellers — are making real decisions about other humans – their customers – that simply will not show up if you are modeling on the level of stress tests of living wills,” he said.