Citigroup Fails Fed Stress Test: Is It Time For a Break Up?

Citigroup

Citigroup (NYSE:C) executives learned at 4:15 p.m. New York time on Tuesday that the bank had failed the Federal Reserve’s annual stress tests, but that result does not mean the institution could not withstand prolonged market stress like the financial industry experienced between June 30, 2008 and December 31, 2008 — the worst of the financial crisis. “The Federal Reserve expects large, complex bank holding companies (BHCs) to have sufficient capital to continue lending to support real economic activity while meeting their financial obligations, even under stressful economic conditions,” explained the central bank in the preface to its 2014 report. And, as the results suggest, Citigroup could not deliver.

“Surprise would be an understatement,” a top Citigroup executive told the Financial Times, describing the reaction of the bank’s leadership to the failure. Shareholders responding by bidding down shares of the bank’s stock, while some analysts called for a leadership change or a break up of the bank.

Not only did the Fed’s assessment find that Citigroup — the third largest U.S. bank by assets — had failed to sufficiently correct deficiencies it had pointed out after the 2012 test, but the central bank also took issue with the “reliability” of the bank’s financial projections under the hypothetical economic conditions of the test. Specifically, the Fed said it had concerns about Citigroup’s “ability to project revenue and losses under a stressful scenario for material parts of the firm’s global operations.” For that reason, it received a failing grade.

Wednesday saw the release of the Feds official results, and the 24 hours between executives being informed of the results via conference call and the market learning of the failure, saw anger and bafflement coursing through the bank’s leadership; it was the second time in three years that Citigroup’s capital plan for its sprawling operations fell short of the qualitative measures set out by the central bank. As a result, its plan to increase dividends and repurchase stock was denied.

Now, as sources familiar with the company’s thinking told The New York Times, bank executives are still struggling to understand the Fed’s reasoning and how best to respond just a day after the results were learned via conference call. “Needless to say, we are deeply disappointed by the Fed’s decision regarding the additional capital actions we requested,” Chief Executive Officer Michael Corbat said in a Wednesday press release.

Failing the stress test represents another stumble for Citigroup and a setback for Corbat, who has tried to rehabilitate the bank by limiting its exposure to risk and cutting costs. The bank is currently reeling for the discovery of fraud at its Mexican unit, which has forced the company to adjust earnings and prompted questions regarding the bank’s global risk controls. Plus, the banking is still working to erase the negative image the financial crisis produced. Citigroup suffered huge losses during the global financial crisis, necessitating a massive stimulus package by the U.S. government in November of 2008.

Corbat replaced Vikram Pandit in late 2012, after the bank’s capital plan was denied for the first time. Pandit — whose tenure encompassed the financial crisis — was fired as Citigroup’s board of directors feared his poor management and strategy execution was hurting the bank’s credibility with investors. From December 11, 2007, the day Pandit was named CEO, to his departure on October 16, 2012,  the bank’s stock plummeted a split-adjusted 89 percent.

For a time, it seemed the leadership changes at Citigroup was producing fundamental changes within the bank’s operations; it passed the Fed’s 2013 stress test and its stock soared as a result. But 2014’s failure has already prompted investors to speak out against the management style of the bank’s leadership.

Shares fell 5.4 percent on Thursday, the largest single-day decline recorded by Citigroup’s stock since November 2012. Analysts at both Bernstein and Keefe, Bruyette & Woods removed their “outperform” ratings on the bank.

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Because the Federal Reserve did not give detailed reasons for its rejection of Citigroup’s capital plan, speculation has run rampant as to why. Several possible reasons have circulated; was the central bank punishing Citigroup for the $400-million fraud uncovered at its Mexican unit last month? Was the Fed attempting to look tough? Was the bank regulator subtly pushing for a break-up of Citigroup, a desire of several investors, analysts, and other regulators over the past years. Regardless of the Fed’s reasoning, its decision will likely have  investors, analysts, and regulators reconsidering the question: Is Citigroup too big to manage? It is a question that has dogged the company ever since Stanford I. Weill created the banking conglomerate in a series of mergers almost two decades ago. Few banks have the presence of Citigroup, with operations in more than 100 countries and around half of all operations coming from foreign countries. By comparison, Bank of America (NYSE:BAC) operates in 40 countries and generates about 14 percent of revenue outside the U.S.

In a further blow, Citigroup’s rivals, JPMorgan Chase (NYSE:JPM) and Bank of America, were allowed to announce capital redistribution plans to return corporate cash to investors via increased dividends and share buyback programs. The capital plans of the American units of three international banks — HSBC (NYSE:HSBC), Spain’s Banco Santander (NYSE:SAN), and the Royal Bank of Scotland (NYSE:RBS), which operates under the Citizens Bank brand in the United States — were also rejected.

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Source: Federal Reserve

To be clear, Citigroup did show that it could survive a series of stressful economic situations, and that it could pay dividends and buy back stock while maintaining a minimum capital cushion. According to the Federal Reserve’s adverse scenario, Citigroup’s capital plan left it with a minimum Tier 1 common ratio of 6.5 percent — a far greater of a cushion than Bank  of America’s 5.4 percent ratio and JPMorgan’s 5.t percent ratio. Still higher standards meant Citigroup could not increase its dividend from 1 penny to five cents a quarter and repurchase $6.4 billion in shares, moves that were meant to build confidence in the bank’s restructuring efforts.

“The Fed is saying that the bank’s financial processes are not where they should be, and this is five years after the crisis,” CLSA banking analyst Mike Mayo told the Times. “It is not as though they haven’t had time to clean up their act.”

In the more than five years that have passed since the financial crisis, America’s largest financial institutions have been under intense legal and regulatory scrutiny. After the financial crisis, politicians and regulators searched for a means to repair the structural problems within the United States and the international banking system in order to insure that a similar financial meltdown would never happen again. Of course, legislation was at the forefront of those efforts. While its effectiveness has been debated, the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010, brought the most significant changes to financial regulation in the United States since the reforms that took place following the Great Depression. Chief among its provisions, alongside the so-called “Volcker rule”, which was intended to reduce banks’ ability to take excessive risks, are the stress tests.

Overall, the results of the Fed’s stress test — called the Comprehensive Capital Analysis and Review — showed that country’s banking system has been repaired substantially since the crisis. But the central bank has continued to raise the standards of its annual stress tests as the economy improves and the banking industry recovers. And Moshe Orenbuch, a banking analyst at Credit Suisse, told the Times that “in raising the bar, perhaps the Fed felt Citigroup didn’t make the cut.”

Banking executives have been generally displeased that regulators are tightening standards, arguing that that regulations aimed at making the financial system safer have also made hurt economic growth by tightening credit. Citigroup investors have also complained about the Fed’s regulations. One large shareholder told the Financial Times that by preventing the bank from pursuing its capital allocation plan, the Fed made Citigroup’s share price fall more than was justified by its loss of so-called dividend-paying power. “The Fed is moving markets without being clear and it is frustrating. If Citi cannot predict how much capital it can return to shareholders, it makes it harder to run the business and it makes it very hard for me to value the business,” the shareholder said. “The Fed function becomes more of a mystery, more whimsical, and it seems to strike Citi more often than the others, and that makes you stand back.”

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