Bank Of America And Citigroup: Which Is The Better Investment? (Part II: Capital Allocation)

| About: Bank of (BAC)
This article is now exclusive for PRO subscribers.

Summary

Part II of this series of articles is all about comparing and contrasting Citi's and BAC's underlying capital allocation approach.

I will explain what investors are actually buying into when investing in these banks.

Investors may be surprised to find out, but Citi and BAC are earning solid returns on their core businesses.

Sadly, they give a substantial portion of it back due to legacy issues.

When will the ghosts of the 2008/2009 financial crisis cease to haunt these firms?

In the first article of this series, I focused on Citigroup's (NYSE:C) and Bank of America's (NYSE:BAC) capital positions. To quickly recap, prima facie it appears that Citigroup has a capital advantage, as it operates with a substantially higher CET1 ratio of 12.1% (compared with 9.8% for BAC) and continues to generate more capital due to monetization of Deferred Tax Assets (DTA) that are currently excluded from its regulatory capital base.

Of course, the challenge for Citi is to be able to return all that excess capital to shareholders.

One point on BAC's capital position that I previously omitted to include, is a discussion around the impact of its outsized operational risk RWAs.

As can be seen from above, BAC has $500 billion in operational risk RWAs - in other words, almost 32% of its capital resources is supporting operational risk RWAs as opposed to creating revenue-generating loan assets.

A few points on operational risk RWAs:

  • It is largely a discretionary number prescribed by the Fed (so it is really a 'blackbox' for investors and the firm).
  • The number is hugely impacted by industry conduct events and legal settlements (e.g. U.S. mortgages related fines, U.K. customer redress, etc.).
  • Over time (albeit perhaps an undetermined time frame), the outsized impact will likely decline and BAC can improve its operational risk management and models to reduce impact
  • Currently, operational risk capital consumption is a material drag on BAC's reported ROE - however, over a longer time frame, expect the outsize impact to slowly abate somewhat.

A bird's eye view of capital allocation

The below chart summarizes the capital allocated and ROTCE for the various divisions of both banks:

In simple terms, the dashboard above shows how much capital is allocated to the bank's various divisions and what return is being generated based on FY2015 financial disclosures.

A few observations on BAC's and C's core businesses:

  • Both firms allocate similar amounts of capital for Consumer businesses (Citi $35 billion and BAC $42 billion, although Citi's number does include some business banking as well).
  • Similarly, for IB businesses, Citi allocates $76 billion versus a total of $70 billion for BAC.

In the next article in this series, I will undertake an extremely detailed comparison of these firms' core businesses - I will be considering the following factors:

  • Risk-adjusted returns on capital
  • Near- and medium-term outlook
  • Business mix and diversification benefits
  • CCAR metrics
  • Macro considerations (e.g. interest rates, EM slowdown)

What about non-core and corp. centers?

This is where it gets really interesting.

Let's look at each firm separately beginning with Citi Holdings - a division housing its non-core assets.

As can be seen from above, Citi Holdings is already relatively small and profitable. The main assets remaining are U.S. mortgages that are extremely well-provided for (63 months of Net Credit Losses). The division also carries operational risk RWAs of $49 billion - in other words, $6 billion of the $17 billion of allocated equity is in respect RWA that will likely remain for the foreseeable future, even if the underlying assets are not on the books anymore. Investors should think about it as residual legal or conduct exposures.

All in all, Citi Holdings will have a negligible drag on Citigroup Group ROTCE by the end of 2016. The operational risk RWAs do not really matter much either - given that Citi's binding constraint is CCAR (which is modeled on the basis of Standardized RWAs methodology) whereas operational risk RWAs primarily arise in the Advanced methodology.

Citi corporate centre division has $47 billion of capital allocated - on the face of it, a huge amount. However, the majority of that equity is really Citi's DTA (~$30 billion). As discussed in the previous article in this series, Citi is consuming the disallowed DTA at reasonable pace, so over time, the drag from Citi Corp. will materially decrease. During 2015, the DTA exerted a 200 basis drag on Citi's reported ROTCE of 9.1% - in other words, Citi would have generated in excess of 11% ROTCE excluding the impact of the DTA.

It is a no-brainer for Citi's management - accelerating the consumption of Citi's DTA is key to generating shareholder value. It is safe to assume that key decisions around inorganic acquisitions of U.S. credit card portfolios, such as Best Buy (NYSE:BBY) and Costco (NASDAQ:COST), included DTA considerations.

What about BAC non-core and corp. centre divisions?

The story is quite different for BAC.

Considering Legacy Asset & Servicing (LAS) first:

As can be seen from above, LAS is still generating a loss on its allocated equity of $24 billion (primarily driven by legacy portfolio servicing). It is interesting to note that allocated equity has increased by $7 billion since Q4 2014 - this is due to increase of operational risk RWAs under the adopted Advanced RWAs methodology.

In contrast to Citigroup, the Advanced RWAs derived capital requirement is the binding constraint for BAC - as such, the drag from operational risk RWAs is meaningful for the firm.

All Other division is a mix of a traditional corporate cost-centre (ALM activities and residual unallocated expenses) as well as a non-core unit (legacy assets) - the financials for 2015 are presented below:

Couple of observations on above:

  • All Other makes a $2.5 billion pre-tax loss and Net Loss of ~$500 million post tax benefits.
  • The firm curiously does not disclose allocated capital for All Others, but I worked back from total TCE number and subtracted all other allocated equity numbers to obtain an estimated $27 billion (perhaps BAC is testing investors' algebra skills).
  • Legacy residential mortgages have reduced 30 percent year on year - so in time, some of the drag will hopefully abate.
  • Frankly, there is not enough disclosure to project a capital trajectory for this division (so investors should exercise some conservatism in this instance).

Summary and final thoughts

Both firms are generating handsome returns from underlying core businesses - however, they give back a big chunk of the returns in other divisions.

For Citi the drag is primarily the DTA - there is a reasonably clear trajectory, though, for this drag to abate. It is not a big surprise Corbat is intensely focused on consuming DTA as quickly as possible.

The stabilization of the U.S. dollar should provide tailwinds for DTA utilization as previously discussed in this article.

BAC is delivering very good returns in its consumer businesses and solid returns in its corporate/business banking businesses. However, the drag from LAS and All Others will likely persist for the foreseeable future - especially when considering the impact of operational risk RWAs that likely to take a long time to decay.

To move the dial on its valuation, it looks like BAC will need to earn higher returns in its core businesses to effectively compensate for drag in non-core businesses.

In the next article of this series, I will analyze in great detail the core businesses of these firms, so stay tuned if of interest. I am also considering expanding this series to discuss the impact of breaking up the large U.S. banks - so if there is interest in this topic, do let me know.

All financial data in this article have been extracted from Citi's and BAC's recent 10-Ks.

I cover U.S., European, Asian, Canadian and Australian large-cap banks, identifying long and short opportunities. If interested in the topic, I encourage you to sign up as a "real-time follower" or message me if interested in a specific banking name.

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.