What is the Fed Up to with the Citigroup Rejection?
By Roy C. Smith
April 7, 2014
For the past week an outraged Citigroup board of directors has been asking, “Why is the Fed picking on us?
“We are no longer the overly-aggressive, run-amuck bank we were in the past. We’ve totally changed our board, replaced our CEO twice, shrunk our balance sheet by 20% by selling off $700 billion of non-core assets (including a large, well loved brokerage business), laid off 50,000 employees, reduced leverage from 18.5 times equity at its peak in 2007 to 10 times today, increased deposits as a percent of assets from 38% to 51%, and restored $13.7 billion of profits. No other major US bank has restructured itself since the crisis as much as we have.”
The question comes after the Federal Reserve’s unexpected rejection of Citigroup’s plan to increase dividends and buy back some stock following its annual bank stress test. The bank also failed a similar stress test in 2012, an event that helped engineer the replacement of Vikram Pandit by Michael Corbat. This time, however, Citigroup’s under-stress capital ratios were well above minimums and exceeded those of its peers.
Being allowed to boost its quarterly dividend and repurchase some stock, were key short-term goals of the new Citigroup management team. All of the peers passed the tests, and were allowed to increase dividends.
So why did the Fed fail only Citigroup -- for “qualitative” reasons -- and deny its request for a modest increase in quarterly dividends (to five cents a share, from one cent)?
The Fed isn’t saying. It has muttered something about failings in Citi’s capital planning procedures and some unsatisfied past deficiencies. It has promised a full report in the future, but it doesn’t have to explain itself fully nor is it likely to do so.
Citigroup, after all, was the Fed’s biggest mistake of the modern banking era. It approved the merger of Citicorp into Travelers Insurance in 1998, which was illegal at the time (the Glass Steagall law that separated banking, investment banking and insurance was still in effect) without wondering what the complex new entity would use its powers to do or how it would be managed. The merger set up the repeal of Glass-Steagall a year later, which the Fed, under Alan Greenspan, endorsed enthusiastically.
Citigroup immediately became very aggressive, plunging itself into financing the technology bubble of the late 1990s. Citi’s subsequent loan losses, fines and legal settlements from this period consumed about half its investment banking profits for the five years through 2003. The NY State Attorney General forced the removal of Sandy Weill, Citigroup’s CEO and “founder,” after misconduct allegations in 2003. Its $13 billion “Doctor Evil” bond rigging scheme infuriated regulators in Europe in 2004. It was also one of the first big banks to fall in with mortgage-backed securities, parking them creatively in special off-balance sheet investment vehicles in London. All of this occurred under the not-so watchful eye of the Fed, its principal regulator.
Citigroup was the first major US bank to collapse in 2008, requiring more than $45 billion in federal bailout assistance (during the crisis it wrote off $143 billion, more than all of the $121 billion of capital it had in 2007). For several years it was the poster child for both bad bank management and faulty bank oversight.
The Fed hasn't forgotten any of this, and may still wonder exactly what the business model of the new “Citicorp” is to be after Citi-Holdings is gone, and the Citigroup name dispensed with.
Investment banking (still 33% of recurring profits in 2013) is still a key business for Citigroup, even though it has dropped to sixth place in a ranking of originations of investment banking transactions that it led in 2004. As markets recover, the Fed may wonder if Citi will reappear in its old kick-ass, big-balance-sheet mode subjecting itself again to huge amounts of market risk in an effort to recover its previous rankings and share price.
The Fed may also worry that Citigroup is too-big-to-manage. Despite cutbacks, it still operates several different businesses in 100 countries and employees 250,000 people. Its activities in emerging market countries (24% of recurring profits) that operate through subsidiaries run by locals that report to local regulators have been problematic for Citigroup, HSBC and Standard Chartered in recent years as major fraud cases and instances of non-compliance with US and European money laundering rules have surfaced.
But the real story may be that the Fed, itself under new management, truly wants to be a different type of regulator -- one that is going to be strict, proactive and controlling. The post crisis environment certainly creates an expectation for such a regulator, one whose stress tests, for example, are taken seriously. Rejecting Citigroup, without much of an explanation, might be an indicator of this transition.
Indeed, the US government has held nothing back in demonstrating that the biggest banks should fear its powers. JP Morgan has learned this lesson from the Justice Department and other regulatory agencies over the past year.
The Fed also failed three subsidiaries of European banks, even though they too met the minimum capital requirements. This may have been a warning shot to make sure Europeans understood that their US operations have to be fully compliant with all facets of the new rules.
Maybe too, the Fed wants to send an additional, Thatcher-like, message to the ECB: “Don’t go wobbly on the European stress tests, Mario. If we can be tough so can you.” Maybe its time to fail a major European bank, if only to encourage the others.