The outlook was already pretty bleak for share repurchases at Citigroup (C +1.94%) in 2022. Management previously told investors to expect modest amounts of share repurchases in the second half of the year. But now, the large U.S.-based bank is very unlikely to repurchase any stock after results from the Federal Reserve's annual stress testing came out worse than expected. Here's why.
Higher regulatory capital requirements
All banks must hold a certain amount of regulatory capital in case of a severe economic downturn. Banks pay out dividends and conduct share repurchases with excess capital over the amount of capital they are required to hold.
A good way to evaluate excess capital is to look at a bank's common equity tier 1 (CET1) capital ratio, which is a measure of a bank's core capital expressed as a percentage of its risk-weighted assets such as loans. The Federal Reserve sets a CET1 requirement for each bank every year, and then banks typically manage capital levels above that. CET1 capital is composed of three layers: The base 4.5% level, the stress capital buffer (SCB), and then the surcharge for global systemically important banks (G-SIB) like Citigroup.
Last year, Citigroup's required CET1 minimum ratio was 10.5%. The bank ended the first quarter of this year with an actual CET1 ratio of 11.4%. However, Citigroup's required CET1 ratio is going up in 2023.
The base 4.5% level is the same, but then Citigroup expects its G-SIB charge to increase from 3% to 3.5%. The bank's SCB is also expected to rise from 3% to 4% after recent stress testing saw the bank's capital levels fall more than expected in the Fed's severely hypothetical economic scenario. So, by Jan. 1, 2023, Citigroup's required CET1 ratio will rise to 12%.
Citigroup needs to build capital
With its CET1 requirement rising, Citigroup no longer has excess capital and, in fact, needs to build capital between now and January. Management has been preparing for this, but the added increase in the SCB due to stress testing may have caught management off guard.
On the bank's first-quarter earnings call, Citigroup CFO Mark Mason told investors that the bank expects to manage to a 12% CET1 ratio by year's end. However, banks typically don't manage right at their required CET1 ratio -- they typically manage above it. So it's likely Citigroup will manage above 12%.
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Key Data Points
Management did have a plan in place to increase its CET1 from 11.4% to 12% by year's end, which involved building capital by $7 billion to $8 billion. Citigroup planned to do this through quarterly profits, benefits from a deferred tax asset, and the sale of international consumer banking units, which the bank is doing as part of its transformation plan.
Mason said the balance of what's left would be used for share repurchases -- which would be tremendously beneficial while Citigroup trades at a significant discount to tangible book value, or its net worth. However, if Citigroup needs to manage its CET1 above 12%, it seems unlikely that there would be any excess capital left for repurchases now.
Why repurchases could start again in 2023
The good news here is that Citigroup may not have this high a CET1 requirement for long. It's divesting 13 international consumer banking divisions, which could very well bring down its CET1 requirement in 2024.
Furthermore, Mason expects to close the sales of several international units by the end of the year, freeing up $4 billion of capital. In total, the 13 sales are expected to free up $7 billion of capital. Citigroup has also previously announced plans to sell its consumer banking division in Mexico, which could free up another $4 billion to $5 billion of capital at a minimum.
All in all, the combination of building capital from the business and making the bank simpler could enable Citigroup to restart more material share repurchases in 2023. And who knows, maybe management will find a way to free up some capital for more modest repurchases in the second half of this year -- but I think that's very unlikely right now.
