Discover Financial Investors Should Officially Be Worried

By Markets Fool.com

Last month, the Federal Reserve Bank of Chicago entered into an agreement with Discover Financial Services (NYSE: DFS) whereby Discover would take immediate actions to improve its compliance with the anti-money laundering requirements of the Bank Secrecy Act. Translated into business realities, this means that Discover is probably getting ready to spend millions of dollars and redirect countless resources to upgrading its compliance programs. The exact scope is still to be determined, but investors in this credit card company should be worried.

Continue Reading Below

What has Discover done wrong?
According to the agreement, signed on May 26, the Federal Reserve found serious deficiencies in Discover's compliance with anti-money laundering laws. The deficiencies were serious enough to be brought to the attention of the board of directors at Discover and prompt a Consent Order from the FDIC.

That order forces Discover to undertake a massive effort to resolve the deficiencies found by the Federal Reserve, and then take steps to make sure the compliance issues don't happen again.

The board of directors must design and adopt a comprehensive plan to increase its oversight of Discover's compliance program. This plan must include a budget to fund new employees, create new systems, and "fully address the organization's compliance risks." We'll come back to that budget shortly.

Management must then implement that plan, post-haste, including an enterprise-wide risk assessment of Discover's Bank Secrecy Act and anti-money laundering systems and compliance.

All of this must be done within 60 days, by the way, so you can rest assured the company is hard at work on it as I write. Once implemented, Discover will file monthly progress reports with the Federal Reserve. At some indeterminate time in the future, the Fed will, maybe, release Discover from the order.

Continue Reading Below

A case study in regulatory nightmares
What kind of an impact could this have on the bottom line? To answer that, we can look to another large bank currently in itsthirdyear of rebuilding its Bank Secrecy Act and anti-money laundering programs.

In August 2012, M&T Bank (NYSE: MTB) and Hudson City Bancorp (NASDAQ: HCBK) agreed to merge. Today, nearly three years later, the banks are still waiting on regulatory approval. The hangup is M&T's compliance with the Bank Secrecy Act.

In fact, M&T is operating under a consent order from the Fed very similar to the one Discover signed last month. You can compare them yourself hereand here.

The long approval time for the merger is not for lack of trying. M&T has invested hundreds of millions of dollars to satisfy the Fed, and the Fed has yet to sign off on their efforts.

M&T's chairman and CEO, Robert Wilmers, has spoken to the bank's efforts, progress, and frustrations multiple times over the years, most recently in his year-end 2014 letter to shareholders, published in March.

According to Wilmers, M&T spent $266 million in 2014 alone on new technologies, systems and process, new employees, and consultants. All of those expenses are a direct result of the Federal Reserve's demands to upgrade the bank's Bank Secrecy Act compliance. And don't forget, that was just in 2014.

In 2013, the bank added 285 new employees and 151 non-staff consultants, a consortium of Ph.D.s, statisticians, and computer programmers, alongside the lawyers and compliance experts you'd expect. Those hires alone cost the bank $60 million.

Those expenses continue to accumulate with every passing day, as the Fed hasn't yet approved the merger or terminated the consent order.

M&T's net income for 2014 was down 6% year over year to $1.07 billion.In this context, that $266 million spent upgrading its compliance programs is a huge dollar amount. Wilmers said it was an "unprecedented amount in unprecedented times."

Discover Financial shareholders should be very nervous.
Just because M&T Bank has had such a hard time satisfactorily complying with the Fed's consent order does not automatically imply that Discover will have the same fate. It's impossible for us to gauge the depth of Discover's compliance problems sitting on the outside of the company.

However, if Discover has even a slightly similar experience as M&T has, then shareholders can be sure that expenses will rise, resources will be diverted from growth to compliance, and the share price could potentially stall out. I, for one, would be worried.

The article Discover Financial Investors Should Officially Be Worried originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.