Citi And The Fed: Is The Capital Return Narrative Still Intact?

| About: Citigroup Inc. (C)

Summary

Citi aims to distribute 100% of the capital it generates.

The Fed's recent proposed changes to CCAR could be a constraint on future capital returns.

Citi's capital return narrative is clearly a key reason to hold this stock.

Is the dividends and buyback story still intact?

The Fed, it seems, is moving the goalposts once again when it comes to CCAR and the amount of capital the large U.S. banks are required to maintain.

The salient facts

You can read the full speech by the Fed's "Banking Tsar", Daniel Tarullo here. I also highly recommend reading my previous article on topic, covering the impact of these proposals on Bank of America (NYSE:BAC).

To quickly summarize though, the proposals involve the incorporation of the G-SIB capital surcharge for the eight largest U.S. banks in the CCAR calculation - as such, under the CCAR, severely stressed scenarios, the banks minimum capital requirements are substantially increased under the newly proposed rules.

This essentially means that due to the new "tougher" CCAR methodology the large U.S. banks will be required to hold more capital than previously thought.

There were some offsets as well in the proposal - namely:

  1. Changes to assumptions on dividends and buybacks. In the current process, it is assumed that all existing capital actions will continue even in stressed times. In the future, this assumption will not be included anymore.
  2. Simplistic assumption around balance sheet growth. In the current CCAR process, the Fed's assumptions generally incorporate significant RWAs inflation. Under the proposed changes, the assumption is that RWAs are frozen as of the start of the stress period.

Overall, based on the Fed's analysis of prior years' CCAR results, it is expected that the incorporation of the G-SIB surcharge "would have been somewhat less than half offset" by the other changes described above.

So what does it mean for Citigroup (NYSE:C)?

Citi's G-SIB surcharge stands at 3% currently - so all else being equal, under the new proposal, the minimum post-stress CET1 minimum is 7.5% (i.e. 4.5% + 3%).

Let us now consider Citi's results for 2016 Dodd-Frank Stress Results:

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As you can see from above, the post-stress CET1 minimum ratio for Citi is 9.2% and well above the new proposed requirements of 7.5%. Furthermore, the other offsetting modifications in the Fed's proposal would add additional quantitative capacity - for example, assuming RWAs are flat at $1,138 billion, it increases Citi's CCAR capacity by approximately $7 billion.

I will caveat the above illustration by noting that the CCAR calculation is notoriously complex with several material moving parts (e.g. DTA impact) - as such, do treat the above as "back of the envelope" calculation. I will certainly track Citi's upcoming earnings calls and if there is any material divergence to my above thesis - I will update in SA accordingly.

Understanding Citi's capital allocation methodology

Citi's CFO, Mr. Gerspach, was extremely helpful recently in describing the firm's capital allocation methodology - especially so in the following slide:

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Essentially, in this presentation, the CFO explained that the firm allocates capital to its operating businesses assuming an 11% CET1 ratio (being the higher of 10% minimum CET1 requirements and its CCAR binding constraint). As such, the excess $66 billion of capital in the above slide, is properly apportioned in the following manner:

  1. $26 billion is part of disallowed DTA and, with time, should be released and returned to investors
  2. $8 billion is due to credit risk RWAs in Citi Holdings - in the process of being unwound over the next several years and thus capital will be freed and returned to investors
  3. $9 billion of capital is allocated to operational risk RWAs in Holdings and has potentially a very long shelf life. This will not go down anytime soon - so it is essentially trapped capital.
  4. $5 billion of capital is consumed in the Citi Corp - essentially to do with asset/liability management and related liquidity management activities.
  5. $18 billion of "excess capital" representing the difference between the 11% CET1 allocated to operating businesses and Citi's overall CET1 ratio (currently at 12.5%).

Citi's CFO commented on the $18 billion excess capital in the following manner:

....we have $18 billion in Other at the top of the stack, which largely represents the amount of capital we hold in excess of our target capital ratios today, or roughly 1.5% of firm-wide Risk-Weighted Assets. However, when thinking about this $18 billion in potential excess capital, it's important to note that we have yet to receive details on how the G-SIB surcharge may be incorporated into the CCAR process in the future, which will inform our ultimate capital requirements.

Well, now that the detailed proposal is out - the key question then, for analysts, in the earnings call is a simple one:

Has the capital ratios target for Citi changed as a result of the Fed's CCAR proposals and if so, by how much?

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(Citigroup's CFO, Mr. Gerspach)

My 2 cents is, as my analysis demonstrates above, the impact is modest and should not be a game-changer for Citi's capital returns trajectory.

Final thoughts

The substantial capital returns narrative for Citigroup is very much intact - the numbers clearly demonstrate this. While Citi may need to increase its long-term capital ratio targets somewhat (perhaps to 12% or slightly higher), but with a current fully phased-in CET1 ratio of 12.5% (and growing) - there is a clear runaway for the firm to return 100% of generated capital (including utilized DTAs in arrears). Finally, it is well-worth noting that the removal of the 30% soft cap on dividends is clearly a positive development for income orientated shareholders.

Dividend growth investors should certainly have Citi on their radar.

I provide quality and completely independent research on the large U.S., European, Canadian and Asian banks. I will be continuously updating developments with large U.S. and European banks; if interested in this topic, do subscribe as a "real-time follower" at the top of this article.

Disclosure: I am/we are long C, BAC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.