On March 24th, I wrote a post about’s the Fed’s stress test. 29 out of 30 banks passed the test, but the bank that fell below the Fed’s standards was Citigroup. To re-summarize what the stress test actually is- the Fed takes each particular bank’s balance sheet and puts it through a rigorous simulation involving high inflation and severe unemployment. The first portion of the test involves quantitative measures such as leverage ratios, capital levels, and other quantitative measures that test whether the bank can withstand an economic shock. From here, the Fed checks the bank’s capital levels over time. Each bank later proves itself to the Fed through a qualitative test, which measures how the bank would pay dividends and manage capital given that the economy is operating in a recession.
Since the Fed gave its decision on Wednesday, shareholders are not happy because Citi will not be receiving the Fed’s permission to increase dividends and share buybacks. Shareholders reacted by selling Citigroup stock, which is now down about 4%, falling $2.71 to $47.45. Mentioned in WSJ, one portfolio manager at a hedge fund “said he liquidated his Citi holdings after the failed stress test. The investor said he was frustrated because he had had discussions over the past six months with Chief Financial Officer John Gerspach and members of the bank’s investor-relations team, and had been reassured that the bank’s relationship with regulators ‘was improving every single day,’ the investor recalled”.
However, it seems that Citigroup’s capital levels aren’t the actual problem. Their capital levels were actually above the Fed’s minimum threshold of 5% (during the simulated economic recession)- at 6.5% to be exact. The concern was that Citigroup failed the second portion of the test, in which the bank failed to sufficiently prove to the Fed how it would successfully manage capital through a recession. Another reason why the 2014 test was such a big concern was because Citigroup failed to pass the 2012 stress test as well. Even though Citigroup passed the 2013 test, the Fed notified the bank that they needed to refine their risk models and loss estimates. Apparently, Citigroup underestimated its projected losses by about $15 billion in 2013.
Since the 2008 financial crisis, the second portion (qualitative portion) has became much more important. It measures how the bank would actually manage a recession, incorporates past lessons and concerns, takes into account how a bank handles its technology, and also tests how it would handle costly litigation. In my opinion, I think the Fed stepping up their game is a great thing. Even though banks may not like the tightening in regulation, it sends the message that banks need to step up their game as well. For the most part, the Fed is seeing good results. This is evident through 29 out of 30 banks passing the test and according to the WSJ article, banks have more than doubled capital levels since 2009. I think that the market’s perception is what’s most important. Even though Citigroup has ample capital, it needs to convey to its share holders that it can manage this capital throughout a recession. Although the first portion of the stress test is important, the second qualitative portion is what’s practical and relevant for shareholders.
In recent news, the topic of Citigroup failing the Fed’s stress test has become even more controversial. After reading more on the topic, my opinion of the test has also changed. Given that the test was only created in 2009 after the financial crisis, it is still an its nascent stages. Apparently, the portion of the test (qualitative portion that measures banks’ predictions about losses under stressed conditions) that Citigroup failed is considered a “building block” of the test. The Fed is still improving this portion of the test and commented that many other banks have “work to do” in these areas. According to Mr. Corbat, CEO, he believed that the bank had settled with the Fed a 2015 timeline. However, the Fed judged that Citi hadn’t made enough progress on the issues that required more attention. I think that a reason for this may be that Citigroup also failed the stress test in 2012, so the Fed may have kept this in mind while basing their decision. This also brings up the issue of the Fed incidentally failing one bank just to prove to investors that the test is actually valid- given that the stress test is still in its early stages. Also, we’ve seen asymmetric information involving the stress test in 2012 when JP Morgan publicly disclosed its stress test results before the Fed released results for all banks. Thus, their stock went up 7%, other banks were furious, and the Fed attributed the situation to a “miscommunication”. After reading more information about the actual validity of the stress test, Citi seems as if it wasn’t as worse off as the Fed projected it to be. Effectively, we cannot ignore that they still passed the capital level requirement. It seems to me as if this was a scenario where Citigroup received the short end of the deal on a test that still needs work.