Wells Fargo's office tower in Charlotte, North Carolina. Image source: iStock/Thinkstock.
It isn't a coincidence that Warren Buffett looks for durable competitive advantages and, by way of Berkshire Hathaway, is the largest shareholder of Wells Fargo (WFC 1.54%). Thanks to regulatory changes since the financial crisis, the nation's third biggest bank by assets is more deeply entrenched in its industry than ever before.
The most important regulatory changes bear directly on how much leverage banks can use to juice profits. Even the most diversified universal bank gets close to half its revenue from net interest income. This is earned by buying interest-earning assets with money borrowed from depositors and other wholesale fund providers. Holding all else equal, the more leverage a bank uses, the bigger its earnings.
Data source: Wells Fargo's 2Q16 earnings release. Chart by author.
Prior to the financial crisis, banks faced the same rules when it came to leverage, irrespective of size and complexity. It didn't matter if you were JPMorgan Chase, which has $2.5 trillion worth of assets on its balance sheet and is incredibly complex, or U.S. Bancorp, which has $438 billion worth of assets and adheres to a simpler business model.
Nowadays, though, size and complexity matter. Last year, the Federal Reserve finalized a rule that requires eight of the nation's biggest banks, known as global systemically important banks, or G-SIBs, to hold more capital than their smaller, simpler counterparts. In addition to Wells Fargo, the list includes:
- JPMorgan Chase
- Bank of America
- Citigroup
- Goldman Sachs
- Morgan Stanley
- Bank of New York Mellon
- State Street
But while all of the banks on this list now have to hold more capital (and thus use less leverage) than a standard regional bank, some of them are hit harder than others. With respect to Wells Fargo's closest competitors, for instance, JPMorgan Chase and Bank of America have to hold 3.5% and 3% more capital, respectively, relative to their risk-weighted assets. Wells Fargo, by contrast, faces a G-SIB buffer of only 2%.
As a result, even if you exclude Wells Fargo's long history of superior management and profitability, it still has a leg up on its closest competition. This doesn't necessarily mean Wells Fargo's stock is a buy right now, since you need to factor in valuation, too. But it does mean investors are probably safe to expect the California-based bank to outperform the nation's three other megabanks (JPMorgan Chase, Bank of America, and Citigroup) with respect to profitability.
If there ever comes a day when Wells Fargo's shares take a plunge, as all stocks do from time to time, it might be worth adding some to your portfolio.
