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Last month the Fed released the rules for its upcoming stress test creating headaches for Citigroup (NYSE:C), while executives at Bank of America (NYSE:BAC) remain confident. Both the banks have attractive valuations. However, I believe Bank of America will pass its stress test. Therefore, investors can expect a dividend hike or an increase in share buyback. As Citigroup has an extensive presence outside the US, the bank could face headwinds qualifying the test. Investors can use this event for short-term gains by selling Citigroup and buying Bank of America.

Comprehensive Capital Analysis and Review (CCAR) Scenarios

In an annual exercise the Fed determines the robustness of most of the large cap US financial institutes in order to make sure the banks will keep operating through times of financial and economic stress. This time the Fed created elaborate financial market and economic scenarios for the participating 19 large financial institutes. Each scenario includes 26 variables including exchange rates, interest rates, incomes, unemployment and economic activities.

The following are the key takeaways from the Fed's release regarding the upcoming stress test:

  1. Domestic scenarios are less stressful compared to the previous stress test
  2. Fearing a spillover of the US recession to the rest of the world, the international scenarios are made more stressful

I will attempt to look at the impact of these scenarios on Bank of America and Citigroup .

Bank of America

Executives at Bank of America are confident that the bank will pass the upcoming stress test. Earlier in an investor conference sponsored by Goldman Sachs (GS), the CEO of Bank of America told participants "It's pretty clear we've got the capital we need." Bank of America does not have an extensive presence outside the US. Therefore, the stressful international scenarios would not reduce the bank's chances for qualification.

Bank of America has conducted several initiatives including trimming operations and staff in order to win an approval for raising dividends or share buyback. The bank has already met the capital requirements for Basel III as its common equity ratio has reached 8.97% against the regulatory requirement of 8.5%. At the end of the third quarter, the bank's tier 1 capital ratio was 13.64%, an improvement from 12.4% in December last year. Bank of America maintained a tier 1 common capital ratio of 11.41%, which improved from 9.86% over the same time period. Compared to this, the tier 1 capital ratio for Wells Fargo (NYSE:WFC) was 11.5%.

Bank of America posted better than expected bottom line when it reported its performance for the third quarter. Against estimates of $0.18, the bank reported an adjusted bottom line of $0.28 per share. Improvement in revenues from trading, investment banking and mortgage lending helped the bottom line surpass its expectations, partially offset by litigation. The heavy litigation surrounding the bank is now hurting its profitability.

Citigroup

Citigroup was one of the four banks to have failed the previous stress test. This became one of the reasons why the ex-CEO Vikram Pandit had to exit. Improving the bank's chances for qualification was among the top priorities for the new CEO. However, I believe this would remain a challenging task as Citigroup is America's third largest bank with an extensive global presence. According to the latest SEC filings, Citigroup's domestic operations contributed only 44% to its bottom line, whereas around 22% is contributed from its operations in Asia. The Fed assumed a sharp slowdown in China when it built its international scenarios for the upcoming stress test. This more stressful international scenario for the upcoming stress test could be a cause of potential headaches for Citigroup as it has a large exposure to Asia compared to other US money center banks.

Citigroup's tier 1 common capital ratio under Basel III was 8.6% at the end of the most recent quarter. Though the ratio is marginally above the regulatory requirement of 8.5%, a comparison with Bank of America's ratio reveals that Bank of America is better positioned. At the end of the third quarter, Citigroup was able to improve its tier 1 capital ratio of 13.9% by 40 basis points during the past nine months. The tier 1 common capital ratio improved 100 basis points to 12.7% over the same time period. Compared to this, the tier 1 capital ratio for JPMorgan (NYSE:JPM) was 11.9% at the end of the third quarter of the current year.

Citigroup's most recent quarter remained impressive. The bank's reported bottom line of $1.06 exceeded the street's estimates by 6.9%. Much of the improvement was a result of growth in the bank's core business. Besides, the bank also benefited from an upward trend in revenues from fixed income trading.

Valuations

Bank of America trades at a 32% discount to its tangible book value, while Citigroup trades at a 34% discount to its third quarter tangible book value.

Source: Headaches For Citigroup, Bank Of America Confident