The Federal Reserve changed its annual set of tests for the 30 largest U.S. banks to incorporate the risk of a deeper slump in Asia, where Citigroup Inc. (C) has a bigger presence than competitors.
Recessions in the euro area, the U.K. and Japan are features of the Fed's "severely adverse" scenario in the new test. The main difference from last year is a more substantial slowdown in Asia, including "a sizable weakening of economic activity in China," the Fed said yesterday in a statement.
Citigroup, the third-biggest U.S. bank, employs thousands of people across Asia. Former Chief Executive Officer Vikram Pandit, originally from Nagpur, India, pushed into markets across the continent, making credit-card, personal and corporate loans in countries such as China, India and Singapore.
"Citi has the most obvious gross exposure to a slowdown in Asia," said David Knutson, a Chicago-based credit analyst with Legal & General (LGEN) Investment Management America. "My expectation is that Citi has gone a long ways over the last six to eight months to educate the Fed on the types of risks they're taking in international markets."
Pandit, 55, was pushed out by the board last month, a decision driven in part by the bank's failure to get its capital plan approved by the Fed after the last stress tests, a person familiar with the matter said in October. Michael Corbat, who succeeded Pandit, said in an Oct. 16 conference call with analysts that submitting a new capital plan to the Fed by Jan. 5 is one of the issues "I'm going to spend time focused on."
The focus on Asia was the "biggest change" to the Fed's tests, Goldman Sachs Group Inc. (GS) analysts led by Richard Ramsden said in a note to clients today.
"With around 25 percent of its revenue coming from Asia, C appears the most exposed here," the analysts wrote, referring to Citigroup's stock market ticker. Ramsden has a buy rating on Citigroup shares.
Total Asian assets in the bank's Citicorp division, which include consumer banking and trading, jumped 33 percent to $356 billion in the three years ended Sept. 30, the company said last month. Credit-card and retail loans also increased 33 percent to $89.3 billion. The unit's profit was $12.4 billion in that span.
Citigroup must prove to the Fed that these are "pristine" assets that can withstand a downturn in Asia, Knutson said.
"That's what you want to hear as a regulator, that they didn't allow themselves to be led down a dark path in the name of growth," said Knutson, whose firm owns Citigroup debt.
Mark Costiglio, a spokesman for New York-based Citigroup, declined to comment.
Citigroup should be able to withstand a severe slowdown in Asia, Bank of America Corp. analysts led by Erika Penala wrote to clients. While such a slump would be "meaningful" for Citigroup, it would also be "manageable," Penala wrote in a note titled "6 reasons not to panic about Asia stress."
The lender should pass the Fed's tests and return about $4 billion to shareholders, according to Penala, who has a buy rating on Citigroup. Her team of analysts wanted to address "press articles" implying that the Fed's focus on Asia would hurt the bank's test results, according to the note.
Citigroup fell 1.2 percent to $34.78 at 1:47 p.m. in New York. The shares have advanced 32 percent this year, compared with a 19 percent gain in the 24-company KBW Bank Index. (BKX)
The central bank started the tests in 2009 to restore confidence in the financial system after the worst crisis since the Great Depression brought down Bear Stearns Cos. and Lehman Brothers Holdings Inc. Regulators have since complemented the reviews with a capital-planning requirement to improve boards' management of risk and dividend and stock-buyback decisions.
"There will be pain for specific banks" with exposure to Asia, said Walter Young, a director in Deloitte & Touche LLP's governance, risk and regulatory services division who focuses on stress-testing and is based in Salt Lake City.
Still, most financial firms will fare "generally better than last year," Young said. Capital levels are higher and banks are "learning how to operate with 8 percent unemployment," he said.
Citigroup, which pays a one-cent quarterly dividend, is among lenders with the biggest potential increase in rewards for shareholders, the Goldman Sachs analysts wrote. The other banks are Regions Financial Corp. (RF), KeyCorp, SunTrust Banks Inc. (STI), Discover Financial Services Inc. and Northern Trust Corp. (NTRS), according to the analysts.
In the worst of three scenarios, U.S. gross domestic product plunges 6.1 percent in the first quarter of 2013 and the unemployment rate averages as much as 12.1 percent in the second quarter of 2014 -- an economic shock on the same scale as last year's stress test.
The Fed will conduct its own tests on the 19 largest financial firms, including Citigroup, New York-based JPMorgan Chase & Co. (JPM), and Bank of America, based in Charlotte, North Carolina. The remaining 11 will test themselves and submit results to the central bank.
The scenarios were developed in consultation with the Office of the Comptroller of the Currency and Federal Deposit Insurance Corp., which will use them for tests of the firms they supervise.
The adverse scenarios weren't forecasts and were "designed to assess the strength and resilience of financial institutions and their ability to continue to meet the credit needs of households and businesses," the Fed said yesterday. In the worst scenario, real disposable income contracts for five consecutive quarters, and house prices fall 21 percent from the third quarter of 2012 to the first quarter of 2015.
The Fed also will test the six biggest U.S. banks against a global market shock that includes movements in indicators such as credit spreads and bond yields as well as the market values of private-equity positions. The six banks -- Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley (MS) and San Francisco-based Wells Fargo & Co. (WFC) -- will be given the scenario by Dec. 1.
The tests should be "more favorable" to Goldman Sachs, Morgan Stanley and Bank of America because they have less international operations, analysts at KBW Inc. (KBW) led by David Konrad said in a note today. Banks with greater exposure outside the U.S. will benefit less, the analysts wrote.
Banks "need to make a convincing argument to their regulators that they know their risks well, take capital planning seriously, and that they execute capital-planning competently," said Jeffrey Brown, a managing director at Washington-based Promontory Financial Group and former head of the OCC's risk-analysis division.
The financial firms will be required to maintain a Tier 1 common equity ratio of 5 percent of assets weighted for risk throughout the worst-case scenario even with dividend and stock- repurchase plans. Regulators view Tier 1 capital as the most important for loss-absorption because it's composed of common stock and retained earnings.
The 19 biggest banks have boosted Tier 1 common equity to $803 billion in the second quarter of 2012 from $420 billion in the first quarter of 2009, the Fed said last week.
U.S regulators are imposing the biggest capital-regime change on the financial system since the 1988 Basel Accord as they execute mandates under the 2010 Dodd-Frank Act and prepare final rules to apply international agreements.
The previous stress tests featured a recession combined with a 52 percent plunge in stocks and an unemployment rate as high as 13 percent.
The Fed said in instructions published last week that it expects banks will demonstrate how they "can achieve, readily and without difficulty, the ratios required by the Basel III framework as it would come into effect in the United States."
Basel III isn't a regulation in the U.S. yet. The Fed issued three proposals related to the new standards in June. Brown, the former senior regulator at the OCC, said the Fed's emphasis on Basel III compliance in the stress test is unusual given that it isn't a final regulation.
Still, "market participants are going to expect banks to adjust rapidly" to the new Basel standards, said Brown, who advises companies on regulation. "The Fed recognizes that expectation and wants banks to demonstrate that they are prepared to meet it," he said.
Goldman Sachs, the fifth-biggest U.S. bank, would have $728 billion in risk-weighted assets under new capital rules, a 67 percent jump from the amount it had under earlier regulations and a bigger increase than rivals experienced.
The investment bank plans to cut the figure to $700 billion by the end of next year by reducing its exposure to credit risk and market risk, CEO Lloyd C. Blankfein said at a Nov. 13 investor conference.
Goldman Sachs may have an advantage over larger competitors such as JPMorgan or Citigroup, which include consumer banks as well as investment banks, because the Basel-based Financial Stability Board proposed earlier this month that those companies keep a higher capital buffer than New York-based Goldman Sachs.
"For more than a decade, larger size and complexity were viewed entirely as synergistic and virtuous," said Blankfein, 58. "For the first time it's clear that size and complexity come with a higher cost."--Courtesy of Bloomberg News