Last updated: March 27, 2014 6:58 pm

News of Fed rejection was shock to Citi

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Citigroup’s senior executives knew 24 hours before the market that its capital plan had been rejected by the Federal Reserve, but the news came just as much as a shock to them as it did to investors.

“Surprise would be an understatement,” a Citi executive said on Thursday, as the bank faced a slumping share price and some analysts’ calls for heads to roll.

Its shares closed 5.4 per cent down, the biggest drop since November 2012. Analysts at Bernstein and Keefe, Bruyette & Woods removed their “outperform” ratings on the bank.

Citi’s plan to increase its share buyback from $1.2bn to $6.4bn and raise its dividend to 5 cents from 1 cent was rejected publicly on Wednesday as part of the Fed’s annual stress tests of 30 financial companies.

The Fed failed five banks and passed 25 others, paving the way for tens of billions of dollars to be distributed to shareholders of the successful banks including JPMorgan, Morgan Stanley and Wells Fargo.

Zions Bancorp, a Utah-based bank, was the only bank to fail on a quantitative basis after falling short of the Fed’s minimum tier one common capital ratio of 5 per cent.

The Fed objected on qualitative grounds to four banks’ plans, saying they had inadequate processes for measuring their future capital needs.

Bank of America and Goldman Sachs were allowed to reduce what they were asking for in their capital plans – including share buybacks and dividends – winning final Fed approval on Wednesday.

US banks are in a much stronger capital position than they were more than five years ago during the financial crisis. But the Fed is not letting up on the banks: instead, it is raising the bar. That has raised criticisms of the rationale behind its analysis, especially in the more subjective qualitative measures.

Citi executives learnt on a conference call at 4.15pm New York time on Tuesday that the bank had failed the tests on qualitative measures of how it would fare in a crisis scenario.

The Fed said it had raised its expectations for the largest and most complex banks and found fault with Citi’s ability to project revenue and losses, as well as its ability to develop scenarios that reflected the “full range of its business activities and exposures”.

Mike Corbat, Citi chief executive, dialled in to the call from a business trip to Korea, but within hours he had cut short his visit to catch an early flight back to New York. On Wednesday, after a board meeting, he sat with Bill Dudley, president of the New York Fed.

[Fed is indicating] it’s too early, we aren’t satisfied that this company is in the final form it needs to be in. Why are you returning capital when you need it?

- Person familiar with Citi

The Fed is indicating “it’s too early, we aren’t satisfied that this company is in the final form it needs to be in. Why are you returning capital when you need it?” said a person familiar with Citi, who added that the Fed may want Citi to shave off more of its businesses.

In last week’s preliminary stress test results, which excluded banks’ plans for higher share buybacks and dividends, Citi’s estimates diverged more from those of the Fed than any bank except Goldman Sachs.

The Fed estimated Citi’s tier one common capital at 7.2 per cent, 280 basis points below the bank’s appraisal, according to Moody’s.

Criticism has fallen on Mr Corbat who became CEO in 2012 after Vikram Pandit was ousted months after the bank first failed the Fed’s tests. He has tried to bolster a relationship with regulators, meeting Mr Dudley and Fed governor Daniel Tarullo once a quarter.

A top 20 Citi investor said the Fed’s decision resulted in the bank’s share price falling by more than was justified by the loss of 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.”

Another top Citi shareholder said: “The companies would benefit from the Fed being more consistent year-to-year and more transparent, but the Fed was pretty happy with a lot of banks, so clearly Citi dropped the ball and the Fed does not shoulder all of the blame.”

Another executive at a rival US bank said he thought overall it was “a good process”, which should be matched for rigour in Europe. “I hope the Europeans do something similar,” he said.

Analysts had raised concerns about Citi’s qualitative performance ahead of the tests after the bank said in March it had received subpoenas from US prosecutors just days after revealing an alleged fraud in its Mexico business.

The subpoenas, relating to the Bank Secrecy Act and anti-money laundering measures, came after three years of requests by US regulators to improve anti-money laundering controls.

Last year, Citi made a modest capital request and passed the tests. Even this year, it performed strongly compared to its peers on quantitative measures.

In a memo to staff on Wednesday Mr Corbat said: “Since becoming CEO, I have spoken with many of you about the need to hold ourselves accountable for what takes place at our firm. I am accountable for getting this right.”

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