Michael M. Santiago
On the 9th of February, the Federal Reserve Board released the hypothetical scenarios for the 2023 bank stress tests also known as “CCAR”.
The CCAR results should be released by the end of June 2023. This is a key event and a likely catalyst for Citigroup’s (NYSE:C) share price as well as other large U.S. banks such as JPMorgan (JPM). The outcomes from the 2023 CCAR test play an important part in determining the ability of the banks to return capital to shareholders in the form of dividends and share buybacks.
A key reason for the relatively low valuation for Citigroup when measured on a price to tangible book value (~0.6x) or forward P/E ratio (~8x) is the current handicap on returning capital to shareholders. Mr. Market is not valuing banks on their reported profitability, rather the key metric that matters now is how much capital, the banks are allowed to return to shareholders.
I have discussed the various puts and takes for Citigroup in this article. In summary, Citi’s strategy of becoming smaller and safer should (all else being equal) support sustainably lower capital ratios. This is of key importance for the success of Jane Fraser’s strategy. As readers may recall, Citi expects to operate with a target capital ratio (“CET1”) of between 11.5% to 12% in the medium term. Currently, Citi’s target capital ratio is 13% which is materially higher than its medium-term targets.
Now a key milestone along the way for a reduction in the targeted capital ratios is the annual CCAR exercise. The scenarios released last week, as reported by Seeking Alpha, appear to be harsher than prior tests which are obviously not great news for the U.S. banks and Citigroup specifically.
Having said that, it is important to look at the details as every bank has a different business model, and as such, the impact could be vastly different.
In this article, I will endeavor to assess the likely impact on Citigroup and its share price in 2023 and beyond.
Review of the 2022 CCAR results
The 2022 CCAR results were extremely disappointing for Citigroup where its Stress Capital Buffer (“SCB”) has gone up to 4% versus 3% previously (and 2.5% in 2020). This is the key reason why Citi has now paused the share buybacks and is still building capital.
But what caused this adverse movement in the SCB year-on-year?
Below I am comparing the key metrics for the CCAR calculation between the 2021 and 2022 results:
Author, based on data from the Federal Reserve
As can be seen above, Citi’s projected loan losses were lower in 2022 compared with 2021 across all categories. But the negative outcome year-on-year was driven primarily by lower projected pre-provision net revenue and higher losses in the “trading and counterparty” category.
It is important to note that the Fed’s CCAR models are somewhat of a “black box” in part to ensure the large banks are not gaming the system. Citi’s own models as disclosed by the firm project pre-provision net revenue of ~$45 billion compared with $28 billion under the Fed’s model – that’s a massive difference of $17 billion and by and large explain the unpleasant surprise Citi experienced in the 2022 CCAR cycle.
The 2023 scenarios compared to 2022
At first glance, the hypothetical scenarios released by the Fed appear to be harsher, but let’s look at the specifics as per the Fed’s guidance:
The current severely adverse scenario features a greater increase in the unemployment rate in the United States as compared to the 2022 severely adverse scenario. This difference reflects the Scenario Design Framework, which calls for a higher increase in the unemployment rate when the starting level of the unemployment rate is lower. The current scenario features a significantly higher starting level of interest rates compared to the previous year’s scenario, which allows interest rates to decline more forcefully in response to the hypothetical drop in economic activity and inflation. The scenario also features a larger and more rapid decline in house prices as compared to their declines in the previous year’s scenario. This larger decline reflects the Scenario Design Framework’s response to the significantly higher housing valuations at the end of 2022. The potential for spillover effects in asset markets and sharp revisions in investor sentiment are captured by a decline in equity prices and an increase in corporate bond spreads, although these changes are somewhat less severe relative to last year’s scenario. These less severe changes reflect the moves in those markets over the course of 2022 and limits procyclicality in the scenario.
The above scenario suggests higher loan losses peak-to-trough especially for unsecured credit as the rise in unemployment is higher from a low starting point of 3.5%. Having said that, Citi’s loan loss provisions as of 31st December 2022 are conservative and already factor in an unemployment rate of 5%+ and include a qualitative management overlay as well. As such, the absolute adverse impact year-on-year on the CCAR results may not be as material as some would expect.
The decline in interest rates has both a negative and positive impact on capital ratios. Lower rates would likely translate into a lower pre-provision net revenue but would also translate to a benefit to capital ratios due to beneficial movement in the AOCI reserves.
On the market shock component, the Fed highlighted the followings:
The 2023 global market shock features fading inflationary pressures, while last year’s component was characterized by worsening supply chain disruptions that put upward pressure on inflation. Accordingly, the current global market shock mainly differs from the 2022 component in the behavior of interest rates, foreign exchange rates, and commodities prices. Treasury rates fall in the current component, with large declines specified for shorter tenors and milder declines specified for longer tenors. In the 2022 component, Treasury rates increased across the term structure, resulting in an upward shift in the yield curve. Similarly, inflation breakeven rates decrease in the current component, while they increased in the 2022 component. The U.S. dollar depreciates against the currencies of advanced countries in the 2023 component, while it mostly appreciated against advanced country currencies in the 2022 component. Nonprecious metals and other commodities, such as oil and natural gas, face large price declines in the current component, while commodity prices increased in the 2022 component due to supply chain disruptions.
Clearly, the impact would depend on Citi’s trading position as well as the Fed’s models. Having said that, Citi in recent quarters has clearly “managed” its trading book conservatively and reduced RWAs. This probably had several desired outcomes including (1) optimizing capital accretion and (2) positioning conservatively the book with an eye to the upcoming CCAR cycle.
Probability distribution of outcomes
My best “guesstimate” for the CCAR outcomes are:
- Base case (40% probability) SCB reduces to 3.5% from 4%
- Moderate bear case (30% probability) SCB remains at 4%
- Bull case (15% probability) SCB reduces to 3%
- Adverse bear case (15%) SCB increases to 4.5%
The share price reaction is likely to be very positive should (1) or (3) eventuate. A (2) outcome would be largely neutral and the stock will sell off heavily if it results in the outcome (4).
Final thoughts
Citigroup’s share price is highly sensitive to its ability to return capital to shareholders. This is absolutely key for the investment thesis at Citi.
I believe the “new” more stable Citi should outperform in the upcoming CCAR cycle driven by the strong performance in the Services division in 2022 that should mechanically feed into a higher pre-provision net revenue forecast in the Fed’s models.
Given the stock trades at ~0.6x tangible book value, the math for share buybacks is as compelling as ever. With any reduction in the SCB in the upcoming CCAR cycle, I expect the stock to melt up with the expectations of massive buybacks to come.
On the flip side, if it becomes clear that the capital trajectory is materially higher for longer – this will be a significant handicap to the stock performance and investors should reassess the thesis.
At the moment, I am leaning towards a positive outcome in the upcoming CCAR cycle and thus remain very bullish.
Source: seekingalpha.com
