Citigroup | Fundamental Analysis

Citigroup CFO Mark Mason lately visited the GS financial services conference and noted that the bank would suspend its share buybacks in Q4. This hidden comment took many shareholders by surprise.

Part of the thesis of needing to own Citigroup now is that the bank can buy back a large number of shares as long as the stock is trading below book value (TBV), which is what the bank would be worth if it were liquidated. In case a bank buys back shares below TBV, the math works so that TBV goes up, and bank shares usually trade relative to TBV, so a rise in TBV is very good for the stock in the long run.

The ability to buy back shares below TBV is rare, so investors were excited that Citigroup would be able to grab this opportunity while eliminating all of the bank's other problems and planning a new growth path. Let's take a look at why the bank was forced to suddenly suspend share buybacks and what this implies for the stock going forward.

Banks are complex organizations, and they have numerous rules about how much capital they must hold in reserve for all their operations that could lead to losses (such as loans). In 2022, another intricate regulatory rule, called the standardized approach to assessing counterparty credit risk (SA-CCR), will come into force. Basically, the SA-CCR will require large banks like Citigroup to modify the way they calculate the risk associated with derivatives contracts.

As you know, derivatives, which are financial instruments such as mortgage-backed securities, played a role in the Great Depression. The overall result of the SA-CCR is that most large banks will see an expansion in risk-weighted assets (RWA). Banks hold regulatory capital based on accumulated RWA, so if their internal regulatory capital ratio is 10% or 11% and then the RWA grows, they must hold more regulatory capital to maintain that ratio. And the more regulatory capital a bank holds in reserve, the less money it has left to invest in the business or distribute capital, such as paying dividends or repurchasing shares.

Mason said the SA-CCR would result in a $60 billion to $65 billion increase in RWAs, which could require Citigroup to hold an additional 0.50-0.60 percent of its regulatory capital. That's not an inconsequential amount. Curiously, however, I haven't heard of any other major banks that have suspended share buybacks because of the SA-CCR despite the need to increase RWA.

This may have been the case with Citigroup because the bank has embarked on a strategy update with many moving parts. For example, the bank is exiting 13 global consumer banking franchises as part of a broader idea to wind down areas where it does not have enough scale to compete and is instead investing in the bank's higher-margin businesses. Citigroup announced in the fourth quarter that it was winding down its consumer banking franchise in South Korea, which could result in costs of up to $1.5 billion. Citigroup posted a $680 million pre-tax loss in the third quarter due to the sale of its Australian consumer banking operations.

Mason said the fourth quarter will be something of an "anomaly" when it comes to the bank's capital return philosophy and share buybacks, especially mentioning SA-CCR and expenses for Korea. Since SA-CCR requires an increase in RWA, and Korea expenses affected earnings this quarter, the bank may have run out of room over its target regulatory capital ratio to be able to conduct the stock buyback it originally planned.

The suspended stock buyback is disappointing because it appears that management either didn't plan the capital buyback very well or didn't effectively communicate that information to shareholders. Mason said the bank will resume share buybacks next quarter at the level of the third quarter, which also fell a bit short of investors' expectations in terms of Citigroup's buyback volume.

With Citigroup trading at such a low stock price and now well below TBV, the bank should buy back as much stock as possible. With the poor track record that Citigroup has had over the previous years, it really can't afford to make such mistakes because shareholders are sick of it.

However, analysts still believe in the renewal strategy and the Citigroup story. But that's mainly because a bank with the kind of U.S. deposit market share that Citigroup acquired and its successful investment banking unit shouldn't be trading so below book value.