Thursday, March 27, 2014

The Fed's Stress Test Gives Citi Heartburn

We were in the minority when Citicorp removed Vikram Pandit from the CEO position and replaced him with Michael Corbat.  There were loud huzzahs from many quarters, from Sheila Bair to the financial press. Things were going to move much faster now, the chorus said, and shareholders would be rewarded handsomely; the stock did extremely well, but today the Fed took the wind out of Citi's sails by both announcing that it had failed its 2014 Comprehensive Capital Analysis.

Analysts' euphoria has reached such ridiculous heights that the WSJ reports analysts expected Citi to raise its dividend from $0.04 per share to $0.53 a share.  Analysts have been known to access controlled substances from time to time, but it would also seem that they were probably pointed to this kind of increase by  naive management guidance.

The bizarre thing about the CCA, is that Citi passed the quantitative portions of the test.  Consider this,
"Therefore, even if the supervisory test for a given BHC results in a post-stress Tier I common ratio exceeding 5 percent and post-stress regulatory capital ratios above the minimum requirements, the Federal Reserve could object to that BHC's capital plan based on qualitative assessment of the practices supporting its capital planning."
Now the problem is that the Federal Reserve has become another reviewer of Sarbanes-Oxley.  Consider this quote from the 2013 auditor opinion letter on Citi's financial statements on Form 10-K.
"We (KPMG) also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Citigroup’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 3, 2014 expressed an unqualified opinion on the effectiveness of the Company’s internal control over
financial reporting.
But if the Fed, using another set of arbitrary standards, opines that the capital planning process is inadequately supported by reliable practices, then this inadequacy must be reflected in the financial statements.  But, surely the auditors must have gone into more detail than the Federal Reserve?  Something has gone seriously wrong with the CCA process.

Let's be clear that nobody is a hero in this episode.  CEO Corbat deserves a reprimand from the board for allowing his company to be blindsided by its principal regulator. His job was to be far out ahead of this process and to make any changes necessary to achieve the corporate goal of passing both the quantitative and qualitative tests. Former CEO Pandit was said to be "prickly," but CEO Corbat seems inept in dealing with the arbitrary Fed framework. Also, his aggressive plans for capital return to shareholders were premature and unwarranted.

Mr. Corbat, in turn, should probably quite a few changes to his financial organization's senior ranks, and for that matter, to his board.  Why? There is no excuse for not being able to run a stress test, which is not new, to the Fed's specifications.

KPMG should also take some accountability, or they should explain to regulators that they stand behind their assessment of the banks's internal controls, on which they rendered an unqualified opinion.

Remember, finally, in the Fed's recently released FOMC minutes archive the discussion revealing that the Federal Reserve couldn't even figure out that IndyMac was failing even when mortgage brokers and most of the industry knew it months before.

The Federal Reserve didn't adequately audit its member banks in the past, and that is plain even for its staunchest apologists. However, now it seems to have gone too far in setting standards and seemingly not applying them consistently, while also treading upon regulatory oversight of other organizations, like the SEC.

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