R. Christopher Whalen
Jan 27, 20226 min
January 27, 2022 | In this Premium Service issue of The Institutional Risk Analyst, we return to Citigroup (C), one of the top three banks in the US and among the highest risk franchises in the US financial services industry. Founded in 1811, Citigroup was a banking pioneer in the early 20th Century, establishing outposts in retail banking markets from Europe to Africa and the Middle East, to China and Japan, and later Mexico and the Americas. Now the offshore empire of Citi is being dismantled under CEO Jane Fraser, including the retail banking business in Mexico just south of the US border. The model going forward apparently is international capital markets, private banking and subprime consumer lending in the US. When the rationalization of Citigroup is complete, will the Citi that Never Sleeps still have a reason to exist?
Source: Google
In Q4 2021, Citi reported down revenue in single digits, but a 33% drop in earnings due to rising operating expenses and the cost of disposals. Even a significant release of loan loss reserves could not put a good face on a messy quarter that included a $1.2 billion charge for winding down the Korean retail business. Citi has announced agreement with UOB Group (UOB) on the sale of Citi’s consumer banking franchises in Indonesia, Malaysia, Thailand and Vietnam.
Even if we are mindful of the costs involved in the disposal of these businesses, and the fact that Citi and other banks are often light in Q4, the performance at Citi was especially disappointing but not surprising. Over the past five years, Citi has underperformed the top-five banks in terms of both operational factors and equity market valuations. With the exception of Wells Fargo (WFC), which continues to suffer from the dysfunction within the CSUITE, Citi has trailed the group.
JPMorgan (JPM) and Bank of America (BAC) have been the best performers in terms of stock price, but we’d argue that the value destruction at BAC under CEO Brian Moynihan has been far worse than the studied mediocrity of Citi. For reasons apparent only to behavioral psychologists, Buy Side managers cannot help but buy BAC for their clients’ portfolios, one reason this name is consistently among the most actively traded large bank stocks.
Citi's business mix is high-risk and highly variable, as illustrated by the fact that Q4 2021 earnings were less than half of Q1 2021. Even with the higher spread on its consumer loan book, Citi's costly funding mix and operating expenses leave shareholders short compared with JPM or USB. Over the past month, of interest, the performance of the top-five banks has inverted, with WFC outperforming the group, followed by U.S. Bancorp (USB). Notice that JPM, which missed badly in Q4 2021 earnings, is now the laggard with BAC #4 in the group.
As banks retreat from some of the lofty equity valuations seen in 2021, the group is going to start to more heavily reflect fundament performance and less the hopes and dreams of Buy Side Managers, who mostly have no idea about bank operations. The degree to which quantitative easing or “QE” by the Federal Open Market Committee has boosted bank valuations – this even as fundamentals have declined rather precipitously – will no doubt be a subject of interest for researchers in years hence.
Source: FDIC/WGA LLC
One CIO asked us this week about why Citi has been engaged in a “fire sale” of assets. The simple answer is that many of these business have such poor operating performance and therefore elevated efficiency ratios that Fraser had no choice but to cut and run. The chart below shows efficiency ratios for the top-five BHCs plus Goldman Sachs (GS) and Peer Group 1. Notice that C, BAC and WFC all have efficiency ratios above the Peer average, while JPM and USB are below.
Source: FFIEC
For large banks today, an efficiency ratio starting with a “5” is the goal, but Citi and other large banks have been losing ground in terms of profitability since 2019 under the constant pressure of the Fed’s QE. In addition, much like the General Electric (GE) of old, Citi in many ways is a legacy conglomerate. It is comprised of business lines that did not necessarily make sense, either as standalone units or as part of a larger whole. Many of the offshore retail businesses that have been sold were simply too small.
The poor operating performance historically also is attributable to another aspect of Citi, namely a small core deposit base in the US. Only half of Citi’s business is supported with deposits and only half of that is in the US. The chart below shows the top five BHCs and Peer Group 1. Notice that Citi is the weakest performer in the group besides WFC, which has suffered badly due to regulatory sanctions.
Source: FFIEC
Notice that the unweighted average of net income to average assets for the 132 large banks in Peer Group 1 is less volatile than the results for the largest banks. Where Citi has an advantage over other banks is the gross spread on its consumer loan book, a portfolio that is relatively sub-prime compared with the other top-five banks and Peer Group 1. Notice that Citi’s gross spread on loans and leases is hundreds of basis points higher than the rest of the group.
Source: FFIEC
The strong cash flow from the consumer lending business has been an important part of the Citi revenue model for many years, to some degree offsetting the poor operating metrics of the offshore retail banking businesses. The loss rate on Citi’s portfolio, however, is also elevated compared with the other four banks in the top five. In many respects, monoline credit card lender CapitalOneFinancial (COF) is a better comparable for Citi’s consumer business than is JPM or BAC.
Source: FFIEC
The final piece of the puzzle that helps us to understand the mediocre operating performance of Citi is the cost of funds for the group. As the chart below illustrates, the cost of funds for C is considerably elevated compared to its asset peers and the unweighted average of the 132 banks in Peer Group 1. This relatively expensive funding is a major structural disadvantage for Citi, especially in a period of high credit losses.
Source: FFIEC
The current strategy of Fraser to finally, after years of delay and obfuscation, sell the underperforming offshore retail business leaves Citi with a two-legged strategy in a four legged banking market. The bank has no retail banking business outside of a few MSAs in the US and no asset management strategy, with the sale of Smith Barney to Morgan Stanley (MS). Citi’s capital markets unit is limited, although as we noted in our last comment, C has the second largest derivatives exposure after JP Morgan and Goldman Sachs.
In past years, we have joked about merging Citi with Deutsche Bank (DB), another global banking institution with a limited core deposit base and a weak middle market banking presence in any market. A combination would at least consolidate two second-tier investment banks, but leaves unanswered the basic question we ask again and again: Why does this bank exist? What market does it serve and how will it grow in the future? The exchange between analyst Mike Mayo and Jane Fraser during the Q4 2021 earnings call illustrates the point.
During the Cold War, Citi was an outpost serving American interests in all the right places around the developing world. The irony of Citi selling the retail business in Mexico while keeping the problematic private banking business will amuse long-time students of the bank's operational troubles when it comes to money laundering. Today, like DB, this $2.3 asset bank has lost its reason to exist. Ultimately, the history of Wall Street’s institutional money center banks has been one of atrophy and eventual consolidation. The weak have bought the strong. The only problem is that today, in 2022, there is no obvious suitor for Citi.
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