Navigating Citigroup's Path Forward

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Citigroup's anticipatory trajectory outlined in its bull thesis remains largely intact, albeit with a shift in the projected timelines. Recent obstacles have necessitated an adjustment in the expected realization of gains, with the forecasted culmination now expected by the close of 2025.

Regrettably, the challenges identified in the initial analysis, namely the potential for escalated capital requisites and a deferral in the divestment of Banamex Mexico, have indeed transpired.

However, it is imperative to acknowledge that these obstacles are of a transient nature and the astute investor who exercises patience stands to reap substantial returns.

Positioned at approximately 0.5 times its tangible book value, Citigroup emerges as the most attractive risk-to-reward proposition within the expansive U.S. banking sector.

The preceding article on Citigroup (NYSE:C) delineated a perspective wherein the author projected a 100% appreciation in the stock's value by the culmination of 2024. This discourse serves as an update to the bullish perspective on Citigroup. The overarching conviction in the original thesis persists, albeit with an extension of the anticipated timeline to the end of 2025, given recent setbacks.

The initial discourse also illuminated the pivotal risks to the articulated perspective, specifically underscored as (1) the potential for heightened capital prerequisites and (2) the deferral in the sale of Banamex Mexico.

The latter risk entails the capital ratio target. A linchpin within the thesis rests upon Citigroup's capacity to allocate capital to stakeholders. The specter of an elevated capital ratio materializes if Citigroup's performance underwhelms during the Federal Reserve's stress assessments, and/or if regulators impose heightened capital prerequisites upon major U.S. banks. Furthermore, the suspension or considerable postponement in the divestiture of Banamex Mexico would unfavorably impact Citigroup.

Unfortunately, both of these risks have come to fruition, constituting significant short-term impediments for the stock. However, a deeper analysis of these developments is warranted.

The Federal Reserve Stress Test (referred to as "CCAR")
The evaluation of Citigroup's CCAR results unveils a disheartening scenario, particularly when juxtaposed against industry counterparts. The sentiments of disappointment were echoed by Jane Fraser, CEO of Citigroup. Subsequent to the 2023 CCAR, Citigroup's Stress Capital Buffer (SCB) was augmented by 30 basis points, equating to an elevated 13.3% targeted capital ratio. While not the most adverse scenario imaginable (which could have entailed an even greater capital ratio hike), it does dash the hopes of significant share buybacks in the immediate future.

A primary contributor to this underperformance is discerned in the Pre Provision Net Revenue (PPNR) projections, as delineated in the 2023 CCAR outcomes. A comparative analysis illustrates that Citigroup's PPNR to Provisions for loan losses stands at approximately 52%, whereas notable exemplars like JPMorgan (JPM) achieve 91%.

In the preceding year's CCAR outcomes, Citigroup exhibited a superior relative performance, with the aforementioned ratio at 75% vis-à-vis JPMorgan's ratio of roughly 83%.

This divergence between the 2023 and 2022 CCAR outcomes warrants scrutiny, with the Federal Reserve's model often cloaked in opacity. Citigroup's bewilderment over the low PPNR and the non-interest line, as disclosed in its CCAR press release, underscores this enigma:

"Citi also announced that it has initiated dialogue with the Federal Reserve to understand differences in Non-Interest Income (Non-Interest Revenue per Citi’s Financial Reporting presentation) over the nine-quarter stress period between the Federal Reserve’s CCAR results and Citi’s Dodd-Frank Act Stress Test results."

The underperformance under the aegis of the 2023 CCAR models appears to emanate largely from fee income in Citigroup's FICC trading ventures.

Proposal for Augmented Capital Buffers in Large Banks
Another complicating factor arises from the proposed regulations spearheaded by the Federal Reserve's prominent banking overseer, Michael Barrett, which is anticipated to escalate capital requisites by a substantial 19%. These proposals, unveiled in July, encompass heightening risk-weighted assets for products such as mortgages and government bonds. The Federal Reserve advocates a standardized approach to determine a "floor" for credit, operational, and trading risks in major banks, thereby supplanting reliance on internal models. These proposals are presently in the consultation phase, earmarked for implementation in 2025.

Several mitigating elements warrant consideration, including:

A gradual phase-in until 2028.
Engagement and advocacy by diverse banking associations, implying the potential for alterations in the regulations.
Major banks are adept at pivoting business models (including product pricing) swiftly to mitigate resultant effects. Drawing parallels from European banks' disclosures, an incremental increase of 5% to 10% in capital ratios appears more plausible, as opposed to the projected 20%.

Trajectory of Citigroup's Medium-Term Capital Outlook
In spite of the challenges outlined, Citigroup's capital requisites are anticipated to wane in the medium term, both in absolute and relative terms. The ongoing simplification and contraction of the firm are poised to lessen its Global Systemically Important Bank (G-SIB) score and predicted stress-related losses in the CCAR stress examinations.

Significantly, as the earnings composition transitions toward more stable and accrual-oriented sectors, such as Services, Citigroup's PPNR to Loan Losses ratio is expected to exhibit substantive enhancement. Upon completion of the divestiture of Banamex Mexico, additional capital is anticipated to be unshackled.

While it remains premature to ascertain the sustainability of Citigroup's target capital range of 11.5% to 12% Common Equity Tier 1 (CET1), as communicated on Investor Day, the trajectory of capital requisites is undoubtedly poised for a reduction from existing elevated levels. In subsequent models, a target capital ratio of approximately 12% to 12.5% is projected (marginally surpassing management's guidance).

The Impediment in Mexico
Following protracted negotiations, Citigroup announced its intention in late May 2023 to opt for an Initial Public Offering (IPO) instead of the initially projected direct sale of Banamex Mexico. It is apparent that Citigroup was ensnared in a convoluted political milieu, leaving certain aspects of the narrative cloaked in obscurity.

Ultimately, this development engenders a supplementary delay, now extending into 2025, thereby deferring the advantages associated with the divestiture of Banamex Mexico (inclusive of a diminished G-SIB score, capital requisites, and capital release) by a minimum of 12 months.

While yet another unfortunate and notable setback, its transient nature remains evident.

Concluding Remarks
Citigroup's strategic metamorphosis contends with unanticipated hurdles. This delay, however, does not annul the bullish perspective. The new projection positions the stock for an approximate doubling in value by the close of 2025 (in contrast to the initial expectation of the culmination of 2024).

Citigroup possesses an array of strategic measures to achieve its medium-term aim of a 11% to 12% Return on Equity (ROE) within the span of 2024 to 2026. Despite the tempered narrative surrounding capital returns stemming from the CCAR setback and Mexico-related delays, the anticipation of its realization in 2024 and 2025 endures.

Promisingly, the Services division has transcended all anticipations, delivering impressive year-on-year growth in the vicinity of mid-30s percentages. Of significance, Citigroup's guidance pertains to a favorable trajectory in cost containment (i.e., the curtailment of absolute costs) by the second half of 2024, a domain within the purview of the management team's control.

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