After the most recent series of bank stress test results released by the fed this week, several banks faced greater scrutiny over their financial practices. Out of 30 banks tested, five banks, including Citigroup Inc., Zions Bancorp, and the U.S. units of HSBC Holdings PLC, the Royal Bank of Scotland Group PLC, and Banco Santander SA did not receive the FED’s approval. Citigroup Inc. in particular faced the largest setback after the Federal Reserve rejected the bank’s proposal to reward investors with higher dividends and stock buybacks. According to the Wall Street Journal, the bank’s second rejection in three years was the result of the bank’s deficiency in it’s ability to project revenue and losses under stressful scenarios in parts of the firm’s global operations. This comes even after the results showed that Citigroup’s Tier 1 common capital ratio was above regulatory thresholds, and at 6.5% above many other banks that did receive approval.As the Fed pointed out, this rejection was based on qualitative problems with the stress tests, such as with internal risk management which oversees tasks including financial risk audits and organizational risk assessment. At the end of the day, while the quantitative measures looked good on paper, the Fed did not appear satisfied with the level of safety and foresight Citigroup has shown in the past few years after the financial crisis. As a result, Citigroup and the other four banks must submit revised capital plans and suspend any increased dividend payments, the latter of which will likely cause disappointment to shareholders.
While Citigroup’s rejection certainly is not a great outcome for the bank, as it may damage its reputation and credibility as a lender and insurer. And it’s certainly an embarrassment because this recent development makes Citigroup only the second bank, aside from Ally Financial, to have its capital plan rejected twice by the Federal Reserve. But overall it isn’t necessarily a bad thing for the firm. First, the firm has a strong store of capital set aside, which could act as a buffer in case of a strong negative shock to unemployment or the stock market. Second, Citigroup’s rejection is a signal by the Fed that the firm needs to correct perceived deficiencies in its operations. Like in a first submission of an article to an academic journal, the Fed, like the peer reviewer, can send back Citigroup’s capital plan with harsh critiques, edits, and an outline of the necessary requirements. This may serve to point out potential problems in risk management or governance that Citi had previously missed. Since these problems may eventually hurt the firm down the line, if uncorrected, it’s in Citigroup’s best interest to, like an academic economist, take the critiques with a grain of salt and use them to form a plan to fix the company’s risk management. This may mean a reorganization of managers and executives, and the employees in the deficient departments may face layoffs, but if Citi can fix their deficiencies they may come out of this a healthier company.
On the other hand, the people who will face the most problems as a result of the Fed’s rejection are the shareholders (Citigroup’s stock fell 5% after hours today), and the firm’s new CEO Michael Corbat. As a consequence of Citi’s failed capital plan, it has been refused the ability to raise its dividend, which currently sits at a quarterly penny-a-share, and to engage in a share buy-back program. This doesn’t bode well for Corbat, since pleasing shareholders is one of the main goals of a modern CEO. The inability to issue a dividend means that the shareholders won’t be rewarded directly, and the inability of Citi to issue a stock buyback means that shareholders won’t enjoy the benefits of “concentrated” stocks (after a buy-back a shareholder will essentially own a larger share of the company). And the lack of confidence by the Fed in Citi’s risk procedures may make investors wary of the company in the near future, meaning that the company may face negative returns in the shortrun, which may further agitate some shareholders. Overall, this is hardly a pleasant start for the new CEO.