Why Citi’s Flunked Stress Test Is So Troubling

Why Citi’s Flunked Stress Test Is So Troubling

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Citigroup CEO Michael Corbat was reportedly blindsided last week by the news that his bank had flunked a Federal Reserve stress test for the second time in three years. That’s troublesome on multiple levels.

Citi’s embarrassing verdict not only means that Corbat and his team failed to win the confidence of their Fed regulators, but also that they failed to build the right kind of relationships with their overseers. Frankly, this kind of news shouldn’t have arrived out of the blue.

Apparently it did. Plainly speaking, Citi failed because its leadership wasn’t smarter about what was happening with its regulators. Citi’s capital levels comfortably exceeded the Fed’s threshold, but Corbat and Citi’s directors still had to scramble and hold an emergency board meeting to figure out just what lay behind the Fed’s concern about the “overall reliability of Citigroup’s capital planning process.”

Related: Why Bigger Banks Take Bigger Risks…. With Your Money

Investors were clearly shaken by the news, too. Citigroup’s shares have fallen about 6 percent since the stress test results became public, along with the Fed’s rejection of the bank’s plan to boost dividend payouts and increase stock buybacks.

In all, five banks failed to get approval from the Fed for their capital plans. The Fed said Zions Bancorp wouldn’t have enough high-quality assets on its books at the low point of a future recession. (Zions had been hoping to boost its dividend this spring; that now seems unlikely, unless it resubmits a plan in the next 90 days that regulators find addresses the deficiencies.)

The failures at Citi and the U.S. retail banking divisions of HSBC, the Royal Bank of Scotland (RBS Citizens Financial) and Santander Holdings USA were less quantitative in nature, meaning that there’s a lot more room for regulators to use their judgment and discretion rather than simply go by the numbers. That’s both worrying and encouraging – depending on who those regulators are and how tenacious and insightful they happen to be.

Right now, it seems they’re not prepared to put up with any B.S.

The bank may feel that they’ve made strides in their relationships with regulators, but regulators think they’re not being listened to — and that kind of perception gap doesn’t augur well.

Related: Big Banks Push Back Against Fed Studies

If you’re a Citigroup investor and have held on until now, you may want to start thinking about cutting your losses sometime soon — and preparing for some, ahem, interesting discussions at this spring’s annual meeting.

The truth about the stress tests is that, while they give regulators more oversight of the country’s biggest banks – and the ability to temporarily halt plans to distribute cash in the form of dividends or buybacks – they’re far from being a panacea. Perhaps the best aspect of the stress tests is that they tell bank CEOs that they’re being watched and held accountable.

Without the stress tests, would Michael Corbat have spent as much time answering what I expect were uncomfortable questions from his board about how well prepared Citigroup is, in both financial and managerial terms, to ride out a future storm? Members of Congress, regulators, the press, individual shareholders can scream all they want; it’s Citigroup’s board, however, who have the power to fire Corbat.

What stress tests can’t do is correctly anticipate what’s going to happen next time around. Anyone who followed the stock market crash of 1987 missed the signals leading up to the 2000 bear market; similarly, those who were looking for clues in 2007 to the next selloff often missed them because they were looking for something familiar, not a credit crunch. When we prepare for the next crisis, we do so by looking in the rear view mirror. It’s normal, even inevitable, and it’s a fallacy that all risk managers recognize.

Related: 5 Years After the Crisis – What Banks Still Haven’t Learned 

Are all our banks safe from catastrophe? Probably not. After all, weeks after JPMorgan Chase successfully completed its 2012 stress tests and started pushing for reformers to ease up on their proposed changes, the bank had to reveal the first batch of the gargantuan “London Whale” losses. That eventually cost the bank $6.2 billion, and didn’t pop up anywhere on the stress tests. The London Whale didn’t threaten the very existence of the bank, or of the financial system, but it was a reminder that surprises — even large ones — could still lurk in our post-crisis banking world.

So if you’re a Citi customer, is this the time to panic, and run to open an account elsewhere? Is your money safe?

The reality is that as long as your assets on deposit with your bank are below the $250,000 that is insured by the Federal Deposit Insurance Corporation, you’re probably fine.

For now, I draw comfort from the fact that this batch of Fed regulators seems to be taking its job seriously and isn’t there to simply rubberstamp bank plans to return capital to shareholders. Clearly, they don’t want to be the guys hauled up in front of a bunch of angry members of Congress asking why they allowed banks with inadequate capital planning functions to boost dividends – or to be blamed by outraged citizens for a repeat of 2008.

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