Citigroup's Business Model Is 'Not Sustainable,' Says Societe Generale

NEW YORK (TheStreet) -- Citigroup's (C) business model is "not sustainable in [the] new regulatory era," and the bank needs ramp up its efforts to simplify its operations, according to Societe Generale's equity research team.

The Societe Generale analysts, including Murali Gopal, Andrew Lim and Axel Richard on Friday downgraded Citigroup to a "hold" rating from a "buy" rating, while cutting their price target for the shares to $52 from $58, following the surprising rejection of Citigroup's 2014 capital plan by the Federal Reserve on Monday.

The Fed announced the results of its Comprehensive Capital Analysis and Review (CCAR) on Wednesday. This was the second part of the regulator's annual stress-test process, incorporating banks' submitted plans for capital deployment to the same nine-quarter "severely adverse" economic scenario used in the first part of the stress tests that were concluded the previous week.

Citi passed the first round of stress tests with a minimum Tier 1 capital ratio through the severely adverse scenario of 7.2%, well above the 5.0% required to be considered well-capitalized and pass the tests. For CCAR, the bank submitted a capital plan calling for $6.4 billion in common-share buybacks and an increase in the quarterly dividend to a nickel from a penny. If the bank were to deploy this much capital, its minimum Tier 1 common equity ratio through the severely adverse scenario would be 6.5%, still significantly above the required 5%.

But the Federal Reserve's rejection of Citi's capital plan wasn't based on those numbers. It was based on "qualitative concerns, including the "significantly heightened supervisory expectations for the largest and most complex BHCs in all aspects of capital planning."

The Fed went on to question Citigroup's ability to "project revenue and losses under a stressful scenario for material parts of the firm's global operations, and its ability to develop scenarios for its internal stress testing that adequately reflect and stress its full range of business activities and exposures." The regulator also said it had previously identified some areas of concern to Citigroup, but had not seen "sufficient improvement" in these areas.

CLSA analyst Mike Mayo in a note to clients Wednesday had some harsh words for the Federal Reserve: "In the new world of Big Brother Banking, the government can make decisions such as this, even if a bank is well above regulatory minimums, allowing a new level of regulatory discretion. The Fed's decision makes it look like there is no level of capital that is sufficient whereby Citi could repurchase stock."

He also wrote that it might be a good time for Citigroup to sell its Banamex unit in Mexico, which recently identified a $400 million fraud that forced the parent company to restate its 2013 earnings.

The Societe Generale analysts delved further into Citigroup's international operations, calling the bank "excessively diversified as beyond Mexico, Brazil, Korea and India no other EM contributed more than 1.5% of total revenues."

"We believe operational/regulatory risks outweigh the upside potential," the Societe Generale analysts added. "In our view, Citi needs to come up with a credible plan to restructure its business model."

With the possibility that Citigroup's revised 2014 capital plan may not include any buybacks or dividend increase, Societe Generale estimates the bank's book value could rise by $24 billion over the next two years. But this may not do much for the stock, according to the analysts, unless the bank begins significant capital deployment. The continued buildup of excess capital will also lower the bank's return on equity.

With so many emerging-market units contributing relatively little, Societe Generale sees a "tremendous opportunity" for Citigroup to simplify its business. Emerging markets the bank might consider exiting include Russia, China, Poland, Indonesia, Turkey, Thailand, the Philippines and Argentina.

Of course, if Citigroup were to exit so many emerging markets, the company could be sacrificing its unique long-term positioning to ride these markets to fabulous profits. The company would have quite an identity crisis.

The Society Generale team pointed to JPMorgan Chase (JPM) as a good example of a competitor doing everything it can to get its regulatory house in order, citing that bank's recent deal to sell its energy trading business, as well as other steps to lower its risk. "Last year, JPM committed its top management and a significant amount of resources to address its own issues surrounding the capital planning process," The Societe Generale analysts wrote.

JPMorgan on Wednesday received approval from the Fed to raise its quarterly dividend to 40 cents a share from 38 cents and for $6.5 billion in share buybacks from the second quarter of 2014 through the first quarter of 2015. And the CCAR results showed JPMorgan's minimum Tier 1 common equity ratio through the severely adverse scenario and including the above capital deployment would be 5.5% -- way below the Fed's estimated minimum Tier 1 common equity ratio for Citigroup under Citi's submitted capital plan.

So investors can expect plenty of announcements from Citigroup this year, as it works to improve its internal stress-testing systems and possibly sheds businesses in order to make the Federal Reserve happy.

Citigroup's stock was down slightly in early trading Friday to $47.42, while JPMorgan Chase was up 0.3% to $60.07.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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