Fitch Lowers Outlook on Wells Fargo (WFC) to Negative; Ratings Affirmed

Fitch Ratings has affirmed Wells Fargo & Company's (NYSE: WFC) ratings at 'AA-/F1+' and Wells Fargo Bank, N.A.'s ratings at 'AA/F1+'. The Rating Outlook is revised to Negative from Stable.

The affirmation reflects the company's superior earnings profile, strong liquidity, and still benign asset quality, while the Outlook revision reflects potential damage to the firm's franchise and earnings profile following recent regulatory actions regarding improper unauthorized account openings.

The rating action follows a periodic review of the large regional banking group, which includes BB&T Corporation (BBT), Capital One Finance Corporation (COF), Citizens Financial Group, Inc. (CFG), Comerica Incorporated (CMA), Fifth Third Bancorp (FITB), Huntington Bancshares Inc. (HBAN), Keycorp (KEY), M&T Bank Corporation (MTB), MUFG Americas Holding Corporation (MUAH), PNC Financial Services Group (PNC), Regions Financial Corporation (RF), SunTrust Banks Inc. (STI), US Bancorp (USB), Wells Fargo & Company (WFC), and Zions Bancorporation (ZION).

Company-specific rating rationales for the other banks are published separately, and for further discussion of the large regional bank sector in general, refer to the special report titled 'Large Regional Bank Periodic Review,' to be published shortly.

KEY RATING DRIVERS
IDRs, VRs, AND SENIOR DEBT

The affirmation reflects the company's superior earnings profile, strong liquidity, and still benign asset quality. Fitch has revised the Outlook to Negative given the uncertain impact to WFC's franchise resulting from the potential reputational damage from the recent regulatory actions and fines related to its sales practices in its Community Banking business line. In particular, Fitch believes that the firm could face earnings pressure as a result, with earnings being a significant competitive strength for WFC.

The recent $185 million fine levied on WFC for improper sales practices dating back to 2011 was fully accrued for and represents just a fraction of WFC's quarterly earnings of approximately $5.5 billion. Customer damages appear limited, with $2.6 million refunded and with WFC earmarking up to $5 million to cover this and any additional required customer remediation. However, Fitch views the ensuing reputational damage, risk oversight failures, impact to its selling practices, and the resulting effect on earnings as much larger issues than the actual fine.

While this issue is not new, as it was first reported by the media in 2013 and the Los Angeles city attorney filed suit in May 2015, the breadth of the issue is surprising. The Consumer Financial Protection Bureau's Consent Order disclosed that WFC opened up more than 1.5 million deposit accounts and over 500,000 credit card accounts that may not have been authorized. Further, this appears to be a significant breakdown in what Fitch has long viewed as a solid risk management infrastructure.

WFC's earnings profile has been superior to peers, in part due to its cross-selling culture. WFC recently disclosed that the company would eliminate all product sales goals in retail banking effective Oct. 1, 2016. This change may impact the company's revenue streams in the future. While WFC emerged from the financial crisis in a much better position than similarly sized peers, Fitch believes this issue creates reputational risk given the issue and allegations are understandable to the general public, in a way that misdeeds at other banks are not.

There is also an outstanding lawsuit filed by the city of Miami against WFC and Bank of America for alleged predatory lending. The U.S. Supreme Court will rule whether the city of Miami is allowed to bring the lawsuits in 2017. Fitch also expects further lawsuits and investigations related to the sales practices. A class action lawsuit has been filed in Utah. Adverse outcomes on these issues could further impair WFC's reputation.

Fitch has viewed WFC's management team and risk management culture favorably. There has been a great deal of stability in the executive management ranks, with little turnover. However, this does represent a significant breakdown in the risk management infrastructure and oversight. Carrie Tolstedt announced her retirement in mid-July 2016. She formerly ran the Community Banking business line, which included the branch network. It is unclear whether there will be further executive management departures. However, Fitch expects the situation to be somewhat fluid, garnering a great deal of regulatory, political, and potential legal attention over the near term.

Providing support to the ratings and underpinning today's rating affirmation, WFC's financial performance has been solid over the past several years despite a challenging economic and interest rate environment. While current earnings are below pre-crisis levels, they exceed large regional bank peer medians and are in line with Fitch's expectations. WFC's superior earnings performance and capital generation capabilities are core strengths for the company and positive rating drivers that differentiate it from its peers.

Fitch attributes WFC's superior earnings profile to its low funding costs, efficient cost structure, and a diversified business model by geography and product type that has proven resilient over time. Further, Fitch assumes that WFC has been able to benefit post-financial crisis from a flight to quality.

It is hard to discern how much of WFC's strong sales culture also contributed to its earnings profile, but Fitch acknowledges that the bank was at the forefront of recognizing the profitability of customers who have multiple products with a bank and hence was an early and strong advocate of cross-selling. Other banks' incentive practices may have also contributed to improper sales practices, and there may be changes to compensation practices at other banks and/or regulatory findings.

WFC's stated strategic objectives are clearly articulated, and achievable. The company recently lowered its ROA and ROE targets to 1.1% to 1.4% and 11% to 14%, respectively. These growth targets are intended to reflect the company's performance over the next two years and are not long-term targets.

Fitch views the revision as expected given the challenging interest rate environment, and lackluster economic growth. Fitch also believes the adjustment is prudent and expects the company is not going to compromise its risk appetite for short-term earnings.

WFC's franchise has been considered one of the strongest of all U.S. banks, with leading market shares in many sectors and asset classes. WFC has the second most deposits in the U.S., and over 90% of its deposits are in states where its deposit market share is ranked first, second, or third.

WFC's capital profile is also considered solid, relative to its risk profile, capital generation capabilities, and target payout ranges. The Common Equity Tier 1 under Basel III Standardized Approach, fully phased-in, was 10.61% at June 30, 2016, above the company's long-term target of 10%, which includes the 2% G-SIB capital surcharge. Fitch expects that WFC's long-term capital target will be higher than many of its regional peers, which may manage to long-term capital targets of between 8% and 9.5%. Over the near term, it is not anticipated that WFC will be able to manage its capital down to 10% given relatively sluggish economic growth. Over the past six months, WFC's CET1 has only declined 16bps.

WFC's liquidity profile is considered the strongest of the large regional peer group. Since 2005, WFC has reported the lowest cost of deposits and lowest cost of total funding, on average, among its peer group. The proposed TLAC rule has a relatively higher burden for WFC than some of its G-SIB peers, given the make-up of WFC's existing balance sheet, which benefits much more from WFC's low-cost deposit funding. As WFC issues more long-term debt in preparation, its profitability will be impacted. Over the past six months, WFC issued $48 billion in long-term debt, as compared to $14 billion during the same period last year.

In addition to proposed TLAC rules impacting the composition of the balance sheet, the LCR has also contributed to a large increase in cash and short-term investments. Together, these assets account for 17% of the balance sheet, up from 11% at year-end 2012. WFC does not disclose its LCR, only that it exceeds the requirement with an internal buffer.

In terms of WFC's asset quality, WFC's NPA ratios remain elevated and above the regional bank peer median. Much of the weaker relative performance is due to a large balance of mortgage-related accruing TDRs, of which 86% are current. Despite higher NPA levels, NCOs are roughly in line with peer averages. Fitch expects loan losses will increase from currently unsustainably low levels for WFC, as well as the industry, especially under a higher interest rate environment. However, higher provisioning should not materially impact WFC's financial profile given its earnings strength. Further, excluding GE-acquired loans, total loan balances are up approximately 5% during the past 12 months, suggesting WFC is not assuming outsized risk.

While WFC is still growing mortgage, automobile and credit card loans, a mix shift is underway with a greater percentage of commercial loans than even just a year ago. Period-end commercial loans accounted for 52% of total loans at June 30, 2016, up from 49% a year ago. Commercial loans tend to have a lower loss rate than consumer loans. WFC's view of long-term losses has been reduced to 65bps from 75bps disclosed two years ago. The estimate on long-term losses includes an average cycle of approximately nine to 10 years and a recession of average severity, and the improvement reflects the aforementioned shift in the loan portfolio, and credit quality improvement to date.

Although WFC is one of the largest participants in the energy-sector, overall O&G funded loans represent less than 2% of total loans and around 12% of tangible common equity. WFC was one of the first banks to materially increase loan loss reserves for this sector. Fitch views this as prudent given a higher relative balance of sub-investment grade credits and approximately half of loans to businesses in the E&P sector. Reserves at quarter-end totaled $1.6 billion, or roughly 3.4 times realized losses year-to-date.

The ultimate future and direction of Wells Fargo Securities, WFC's trade name for its capital markets and investment banking services, remain of interest to Fitch. Although WFC continues to stress the customer-focused strategy and lack of interest in acquisitions in this space, the bank has been growing in this sector following some downsizing in 2008 and 2009 after the acquisition of Wachovia. Fitch expects any expansion by WFC in capital markets to remain a primarily customer-focused strategy, and for it to remain relatively small in terms of the bank's total business mix. Investment banking revenues comprised 1.7% of revenues in 1H16, with trading gains, gains on debt securities, and gains on equity investments contributing another 3.7% of revenues, a relatively modest amount as compared to similarly-sized peers.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

WFC's subordinated debt is notched one level below its VR of 'a+' for loss severity. WFC's preferred stock is notched five levels below its VR, two times for loss severity and three times for non-performance, while WFC's trust preferred securities are notched two times from the VR for loss severity and two times for non-performance. These ratings are in accordance with Fitch's criteria and assessment of the instruments non-performance and loss severity risk profiles and have thus been affirmed due to the affirmation of the VR.

LONG- AND SHORT-TERM DEPOSIT RATINGS

The uninsured deposit ratings of Wells Fargo Bank, N.A. and Wells Fargo Bank Northwest are rated one notch higher than Wells Fargo Bank's IDR and senior unsecured debt because U.S. uninsured deposits benefit from depositor preference. U.S. depositor preference gives deposit liabilities superior recovery prospects in the event of default.

WFC's international subsidiary, Wells Fargo Bank International's deposit ratings are at the same level as senior debt ratings because their preferential status is less clear and disclosure concerning dually payable deposits makes it difficult to determine if they are eligible for U.S. depositor preference.

HOLDING COMPANY

WFC's VR is equalized with those of its operating companies and banks, reflecting its role as the bank holding company, which is mandated in the U.S. to act as a source of strength for its bank subsidiaries. Ratings are also equalized reflecting the very close correlation between holding company and subsidiary failure and default probabilities.

SUBSIDIARY AND AFFILIATED COMPANY

Wells Fargo Bank N.A. and Wells Fargo Bank Northwest N.A. are rated 'AA'. The banks' ratings are one notch above the parent reflecting the expected implementation of total loss absorbing capital (TLAC) requirements for U.S. Global Systemically Important Banks (G-SIBs) and the presence of a substantial debt buffer in the holding company.

The VRs remain equalized between WFC and its material operating subsidiaries. The common VR of WFC and its operating companies reflects the correlated performance, or failure rate between the WFC and these subsidiaries. Fitch takes a group view on the credit profile from a failure perspective, while the IDR reflects each entity's non-performance (default) risk on senior debt. Fitch believes that the likelihood of failure is roughly equivalent, while the default risk given at the operating company would be lower given TLAC. All U.S. bank subsidiaries carry a common VR, regardless of size, as U.S. banks are cross-guaranteed under the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA).

Wells Fargo Canada Corp., Wells Fargo Bank International, and Wells Fargo Securities International Limited are wholly owned subsidiaries of WFC or Wells Fargo Bank, N.A. Their IDRs and debt ratings are aligned with WFC reflecting Fitch's view that these entities are core and integral to WFC's business strategy and operations. Their IDRs and ratings would be sensitive to the same factors that might drive a change in WFC's IDR.

SUPPORT RATING AND SUPPORT RATING FLOOR

WFC has a Support Rating (SR) of '5' and Support Rating Floor (SRF) of 'NF'. In Fitch's view, the probability of support is unlikely. IDRs and VRs do not incorporate any support.
Wells Fargo Bank International has a support rating of '1', which is an institutional support rating, and indicates that there is a high probability that WFC would provide support to Wells Fargo Bank International, which is domiciled in Ireland.

RATING SENSITIVITIES
VR, IDRs, AND SENIOR DEBT

While it is difficult to quantify the potential reputational damage to the company's franchise, Fitch will be monitoring whether notable deterioration is observed in deposits, account openings, primary checking customers, or wealth and investment management client assets. WFC's ratings could be impacted as the strength of its franchise is an important rating driver. Further, outsized earnings decline relative to peers may also point to an impact to the franchise from recent events, which could also have negative rating implications.

Fitch expects any further fines or litigation costs will be manageable in the context of the company's superior earnings profile. However, failure to maintain earnings at above peer levels will pressure WFC's ratings, as its earning profile is one of the key rating drivers. The strength of the earnings stream provides for solid capital generation capabilities, which will help absorb unexpected losses. WFC has already announced the elimination of product sales goals in retail banking, effective Oct. 1, 2016. It is unclear what implications a potentially cautious approach to sales throughout the organization may cause for WFC's revenues.

WFC's ratings may also be impacted by an observable shift in its strategy to higher-risk activities. Fitch is sensitive to a shift in the bank's risk appetite given external earnings pressures stemming from the need to hold more long-term debt for the proposed TLAC rule or from the need to hold higher capital levels given its G-SIB surcharge.

If WFC were to meaningfully increase its capital markets activities to a size in line with those of other large trading banks or be on a trajectory to do so, there may be negative rating implications given the increased volatility and risk associated with trading activities, although Fitch views this as unlikely over the rating horizon.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

The ratings for WFC and its operating companies' subordinated debt, trust preferred securities, and preferred stock are sensitive to any change to WFC's VR.

LONG- AND SHORT-TERM DEPOSIT RATINGS

The long- and short-term deposit ratings are sensitive to any change to WFC's long- and short-term IDR.

HOLDING COMPANY

Should WFC's holding company begin to exhibit signs of weakness, demonstrate trouble accessing the capital markets, or have inadequate cash flow coverage to meet near-term obligations, there is potential that Fitch could notch the holding company VR from the ratings of the operating companies.

SUBSIDIARY AND AFFILIATED COMPANY

The IDRs and ratings of Wells Fargo Canada Corp., Wells Fargo Bank International, and Wells Fargo Securities International Limited are sensitive to the same factors that might drive a change in WFC's IDR.

SUPPORT RATING AND SUPPORT RATING FLOOR

Since WFC's Support and Support Rating Floors are '5' and 'NF', respectively, there is limited likelihood that these ratings will change over the foreseeable future.
Additionally, due to the linkage in ratings between WFC and Wells Fargo Bank International, if Wells Fargo Bank International were to become less strategically important to WFC, its ratings may be impacted.

Fitch has affirmed the following ratings:

Wells Fargo & Co.
--Long-term IDR at 'AA-'; Outlook Negative;
--Senior debt at 'AA-';
--Subordinated debt at 'A+';
--Preferred stock at 'BBB';
--Short-term IDR at 'F1+';
--Commercial paper at 'F1+';
--Short-term debt at 'F1+';
--Market-linked securities at 'AA-EMR';
--Viability at 'aa-';
--Support at '5';
--Support floor at 'NF'.

Wells Fargo Bank, NA
--Long-term IDR at 'AA'; Outlook Negative
--Long-term deposits at 'AA+';
--Senior debt at 'AA';
--Subordinated debt at 'A+';
--Short-term IDR at 'F1+';
--Short-term deposits at 'F1+';
--Short-term debt at 'F1+';
--Viability at 'aa-';
--Support at '5';
--Support Floor at 'NF'.

Wells Fargo Bank Northwest, NA
--Long-term IDR at 'AA'; Outlook Negative;
--Long-term deposits at 'AA+';
--Senior debt at 'AA';
--Short-term IDR at 'F1+';
--Short-term deposits at 'F1+';
--Viability at 'aa-';
--Support at '5';
--Support Floor at 'NF'.

Wachovia Bank, N.A.
--Long-term deposits at 'AA+';
--Senior debt at 'AA';
--Short-term deposits at 'F1+';
--Subordinated debt at 'A+'.

Wells Fargo Canada Corp.
--Long-term IDR at 'AA-'; Outlook Negative
--Short-term IDR at 'F1+';
--Short-term debt at 'F1+';
--Senior debt at 'AA-'.

Greater Bay Bancorp, Inc.
--Senior debt at 'AA-'.

Wachovia Corporation
--Commercial paper at 'F1+';
--Senior debt at 'AA-';
--Subordinated debt at 'A+';
--Preferred stock at 'BBB'.

Wells Fargo Real Estate Investment Corporation
--Preferred stock at 'BBB+'.

Wells Fargo Bank International
--Support at '1';
--Long-term deposits at 'AA-';
--Short-term deposits at 'F1+'.

Wells Fargo Securities International Limited
--Long-term IDR at 'AA-'; Outlook Negative;
--Short-term IDR at 'F1+'.

SouthTrust Bank
--Senior debt at 'AA';
--Subordinated debt at 'A+'.

First Union National - Florida
--Subordinated debt at 'A+'.

Wells Fargo Capital II, X
Wachovia Capital Trust II
Central Fidelity Capital Trust I
Corestates Capital II, III
First Union Capital II
--Preferred at 'BBB+'.

Wachovia Capital Trust III
--Preferred at 'BBB'.

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