Citigroup Shouldn’t Have Any Problem Passing This Year’s Stress Tests

Citigroup (C -0.27%) has had its fair share of issues with the annual stress tests in the past. But there's little reason to think it won't sail through this year's tests, from which the Federal Reserve will release the first round of results on Thursday.

It all boils down to capital, and specifically the common equity tier 1 capital ratio. The CET1 ratio reflects how much high-quality capital a bank has relative to a risk-weighted measure of its assets.

The Federal Reserve building in Washington, D.C. Image source: Getty Images.

The purpose of the stress tests, which the Dodd-Frank Act of 2010 mandate, is to assess whether banks with more than $50 billion in assets on their balance sheets have enough capital to survive and continue lending through an economic downturn akin to the financial crisis.

In this year's tests, which the Fed administers, it's assumed that the unemployment rate spikes to 10%, gross domestic product contracts by 6.5%, stock prices lose half their value, home prices drop by 25%, and commercial real estate prices fall 35%. And that's just the beginning, as the central bank also makes assumptions about interest rates, asset volatility, inflation, and foreign-exchange rates between the dollar and a number of major currencies.

If a bank has enough capital to make it through this gauntlet and still maintain a CET1 ratio of at least 4.5%, then it passes the first round of the Dodd-Frank Act Stress Test (DFAST). If a bank isn't able to maintain a 4.5% CET1 ratio, it fails.

Going into this year's test, Citigroup's CET1 ratio was 14.1%. That marks a decline from its entry point last year, but it's nevertheless meaningfully higher than the showings of Citigroup's peers. Among the nation's eight biggest commercial banks, JPMorgan Chase currently has the second-highest CET1 ratio, at 12.5%.

The net result is that Citigroup has $110 billion in excess capital above the 4.5% regulatory minimum.

Data sources: Citigroup, author's calculations.

This gives Citigroup an enormous margin for error. To put it in perspective, in last year's test, Citigroup was projected to lose $27.6 billion over DFAST's nine-quarter time horizon. That would eat up only a quarter of Citigroup's excess.

Thus, assuming Citigroup experiences a similar loss in this year's test, which is reasonable given that the underlying assumptions in the tests haven't changed much, then the New York-based bank would still have $83 billion in CET1 capital above the 4.5% benchmark needed to pass the test. That's more than enough to allow Citigroup's shareholders to assume it'll sail swiftly through this year's test.