NEW YORK (The Deal) -- Citigroup's (C - Get Report) recent string of divestitures and technology upgrades should provide some flexibility to distribute more capital to shareholders this year in the wake of Federal Reserve stress test results set to be released Wednesday.
Although Citigroup may be the biggest name anxiously awaiting the results, industry watchers expect that the big winners will be a group of well capitalized mid-sized regional banks, including Fifth Third Bancorp (FITB - Get Report), Huntington Bancshares (HBAN - Get Report), KeyCorp (KEY - Get Report) and U.S. Bancorp (USB - Get Report).
With the tests — March Madness for financial institutions — the central bank is asking the 31 largest banks to make sure that they have sufficient capital buffers to withstand a hypothetical "deep and prolonged" recession similar to the one that shook the economy in 2008. The banks that score best will be able to make substantial capital distributions to shareholders.
The first round of test results came in on March 5, and all 31 banks were above minimum levels. Those results now factor into the much more important tests coming up.
Bank results Wednesday could differ significantly from last week because the second round includes each institution's proposed capital distribution plans, including dividends and share repurchases, for the next five quarters.
In addition, this time around the central bank considers "qualitative matters" such as whether an institution has adequate risk-management tools in place. The banks are also expected to release their capital distribution plans after 4:30 p.m. EDT Wednesday.
In the first round, Citigroup had a low leverage ratio of 4.6%, and its Tier 1 risk-based capital ratio was at 6.8%, just slightly higher than a 6% minimum required in that category. That result suggests that the bank likely will still have some significant limitations on its capital distributions for the next five months.
However, there is only one direction -- up -- for Citigroup after it was the only one of the biggest U.S. banks that failed its capital distribution stress test last year on qualitative grounds. As a result, it was only permitted to distribute 2% of earnings to shareholders.
Several observers argue that the bank has a much better chance of passing the test this year, partly because it has taken steps to improve its global data collection systems at the same time that it has diminished its size by divesting assets and stakes over the past year.
CLSA analyst Mike Mayo said that he expects Citigroup to pass the test and be permitted to have a capital distribution of $7 billion or between 35% and 40% of earnings.
He argued that the institution is likely to fare better on the Fed's qualitative and risk-management review this year because it has simplified its business, among other changes.
Mayo said the big bank's announcement this month that it is selling its subprime lending unit, OneMain Financial, and similar moves have improved Citigroup's position.
"Absolutely this has helped them with risk management," he said.
"There is a network benefit through their reduction in size. Citi is embracing the message from regulators in words and in deeds," Mayo said.
Nevertheless, Citigroup remains a complex global bank despite the improvements. And just because analysts think that Citigroup will pass on Wednesday doesn't mean that the mega-bank will be permitted to distribute a much higher percentage of earnings in distributions to shareholders in the form of stock buybacks and dividends.
Brian Kleinhanzl, an analyst at Keefe Bruyette & Woods, said that his firm estimates that Citigroup will still be among the most restricted of the big banks in terms of capital distributions after the results are released.
That said, KBW estimates that Citigroup will be permitted to have a total net payout of 35% over the five quarters starting in April, a meaningful increase in distributions, and one that fits with Mayo's expectation of 35% to 40% of earnings.
"You have to walk before you can run," Mayo said.
And he suggested that heads will roll at Citigroup if it fails the test this year.
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"We'll know Wednesday whether Citi CEO Mike Corbat still has a job," Mayo said.
Despite the attention that Citigroup will receive, most analysts argue that a handful of regional banks are likely to have the greatest flexibility to distribute capital to shareholders.
A Sterne Agee report noted that minimum Tier 1 common capital at the regional banks is projected to be 100 basis points higher than at the largest U.S. banks, suggesting that overall they are much better capitalized than their bigger rivals.
In a Feb. 25 report, Sterne Agee estimated that Fifth Third Bancorp, Huntington Bancshares, KeyCorp and U.S. Bancorp will be permitted to distribute 71%, 78%, 77% and 72%, respectively, much higher than Citigroup.
However, the report also estimates that BB&T (BBT - Get Report) M&T Bank (MTB - Get Report) and Zions Bancorp (ZION - Get Report) will only be permitted to distribute 32%, 32% and 10%, respectively, of earnings to shareholders. Zions came in barely above the minimum Tier 1 capital ratio of 5% on Thursday, with 5.1%.
A February KBW report had similar estimates for the same banks, though analysts there expect BB&T and M&T to return 55% and 45% of earnings, respectively.