stress tests

Citi and four other banks stumble in Fed stress tests

March 26, 2014: 4:00 PM ET

The Fed approves the capital plans of 25 others. Goldman and Bank of America were forced to resubmit.

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FORTUNE -- The Federal Reserve approved the capital plans of 25 of the nation's 30 largest banks on Wednesday as part of the final leg of its annual required stress tests.

Citigroup was the most notable bank among those that had their capital plans rejected. The Fed said it was troubled by Citi's inability to predict how much it could lose in a severe economic downturn. Three of the five other rejected plans were of U.S. subsidiaries of foreign banks. Zions Bancorp (ZION), which also failed the first part of the Fed's stress test process last week, also had its capital plan rejected.

The rejections ban Citi and the four other banks from increasing their dividends or share repurchases for the next year, something shareholders have been eagerly anticipating. Although when it comes to the foreign banks, the Fed may have a limited ability to enforce that restriction.

In addition, Bank of America (BAC) and Goldman Sachs (GS) were confidentially asked last week to resubmit their capital plans. The Fed said those banks would also have failed this week's stress test had they not resubmitted their plans. In both of those cases, the banks had proposed dividends or share repurchases that would have put them in jeopardy of falling below the minimum the Fed requires on a key financial ratio had the economy entered another severe recession. Both of the banks' resubmitted plans, which cut back how much money they would spend on dividends and share buybacks in the next year, were approved by the Fed.

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Still, the stress test showed, once again, that the nation's largest banks are in far better shape than they were going into the financial crisis, and better than they were even a year ago. Most banks submitted a plan to the Fed to increase their dividend or buy back shares. Both moves generally boost share prices and are cheered by investors but can deplete needed capital to cover losses from loans or bad investments. Banks used to be able to up these payouts without much oversight. But since the financial crisis, banks now have to get these distribution plans approved by the Fed each year.

By all accounts, the Fed has made its stress tests more strict over the years. For the past few months, the Fed has warned banks that it might reject their capital plans not only on whether they could weather a financial crisis, but how well they did at planning for one. The later part is where it appears Citi failed.

It's not the first time Citi (C) has struggled with the Fed's stress test. Two years ago, the bank was similarly barred from increasing its dividends or buying back shares. Last year, though, Citi came out of the stress test with a clean bill of health, and the highest post-stress test capital ratio of any of the big banks. This year, the Fed said that while Citi would likely be able to survive a severe downturn, the bank seemed unable to "project revenue and losses under a stressful scenario for a material portion of the bank's global operations."

What's more, the Fed said Citi had been aware of the Fed's concerns for some time, but had done nothing to improve them. Last week, for instance, Citi estimated it would have nearly $24 in losses in the Fed severe adverse economic scenario. The Fed said Citi could lose as much as $46 billion.

In a statement, Citi's CEO Michael Corbat said he was "deeply" disappointed by the Fed's decision. "The additional capital actions represented a modest level of capital return and still allowed Citi to exceed the required threshold on a quantitative basis," said Corbat. Citi had asked to be able to spend an additional $5.2 billion on share repurchases in the next year and up its quarterly dividend to $0.05 a share. Instead, the company's dividend will be stuck at $0.01. Share buybacks will be limited to $1.2 billion.

The stress tests only add to Citi's recent problems. Last month, Citi was forced to restate its earnings after admitting that its Mexican unit, Banamex, had been the victim of a multi-year loan fraud. Officials are investigating, and it appears at least one Citi employee may have been in on the fraud. A Fed official said the rejection of the bank's capital plan had nothing to do with that inquiry. Citi's shares dropped nearly $3, or 6%, to just above $47 in after-hours trading.

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Despite the Fed's initial rejection, Bank of America said it will increase its dividend to $0.05 a share, from a current $0.01, in the second quarter, based on its revised plan. That will give the bank an annual dividend yield of about 1.16%. It also said it planned to buy back $4 billion worth of its own stock in the next year. That was down from $10.5 billion a year ago. CEO Brian Moynihan said in a statement that he was "pleased" with the results.

Goldman, which also passed the test only based on its revised plan, declined to say how much it would increase its dividend, if at all, or what it was approved to spend on share repurchases.

Wells Fargo (WFC), which came out of last week's stress test looking the strongest of the big banks, said it plans to up its dividend to $0.35 a share in the second quarter, up from $0.30 a year ago. The firm also said its board had approved the bank to buy back an additional 350 million shares in the next year.

JPMorgan Chase (JPM) said it was upping its dividend to $0.40 a share, from a current $0.38. It also said its board had authorized $6.5 billion in stock buybacks, which is roughly equal to what the bank has spent repurchasing shares over the past two years. Morgan Stanley (MS) said it would double its dividend to $0.10 a share and spend $1 billion buying back shares in the next year.

The three U.S. subsidiaries of foreign banks that had their capital plans rejected were HSBC North America, RBS Citizen's Financial, and Santander Holdings USA (SOVPRC). The Fed only looked at the U.S. divisions of those banks. And it is unclear how much authority the Fed has over the overseas banks. But the Fed's finding might signal troubles at those firms in general. Santander, for instance, has struggled to meet its own financial projects during the past two years.

"With each year we have seen broad improvement in the industry's ability to assess its capital needs under stress and continuing improvements to the risk-measurement and management practices that support good capital planning," said Federal Reserve governor Daniel Tarullo in a statement. "However, both the firms and supervisors have more work to do as we continue to raise expectations for the quality of risk management in the nation's largest banks."

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