Did Citizens Financial Group Cost Its Shareholders by Sitting Out the Fed’s Stress Testing?

I remain bullish on Citizens Financial Group (NYSE:CFG) and, in particular, the unique digital consumer bank it’s building. But after seeing the recently revealed results of the Federal Reserve’s annual bank stress tests — and acknowledging that hindsight is 20/20 — it does look like Citizens missed an opportunity by not opting into the program this year.

Had it done so, it might have been able to lower its capital requirements, which, in theory, would have given it more ability to return capital to shareholders. Lower capital requirements would also make a statement to the broader market about Citizens’ overall credit quality. What should investors take away from this?

Image source: Citizens Financial Group.

How stress testing impacts regulatory capital

Banks are required to hold a certain amount of capital on their books to cover unexpected losses. One way to see this is through the common equity tier 1 (CET1) capital ratio, a measure of a bank’s core capital expressed as a percentage of risk-weighted assets such as loans. All banks must maintain a base of 4.5%. Beyond that, there’s a relatively newly mandated layer called the stress capital buffer (SCB).

The Federal Reserve determines what a bank’s SCB should be via its annual stress tests, which put banks through hypothetical — and severely adverse — economic scenarios to see how they’d fare. The difference between where a bank’s CET1 ratio starts and the low point of the CET1 during the nine-quarter stressed period essentially determines the necessary size of its SCB. (You also add four quarters of dividends expressed as a percentage of risk-weighted assets.)

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During 2020’s stress testing, Citizens got a 3.4% SCB, which gave it a total CET1 capital ratio requirement of 7.9%. That was higher than all of its direct regional bank peers. Citizens Financial was not pleased with the Fed’s modeling or its ultimate SCB determination, and went so far as to request a reconsideration. But the Fed upheld its initial findings.

Under the current regulatory framework, banks like Citizens that have between $100 billion and $250 billion in assets are only required to do stress testing every other year. Most banks in this category sit out the tests in their off years because the process requires a lot of work from their regulatory departments. But I think it would have been beneficial for Citizens to opt in and try to get its SCB down to 2.5% and its CET1 ratio down to 7%, in line with its peers. Many banks did better in 2021’s tests than they did in 2020. For instance, Regions Financial, a direct peer of Citizens, also had a higher-than-average SCB of 3% in 2020, but got it back down to 2.5% following this year’s stress testing.

Why lower capital requirements are important for Citizens

There are two main reasons a lower SCB and CET1 ratio are important from an investing standpoint. First, the amount of capital a bank has to hold limits how much it can return to shareholders through dividends and share repurchases.

In this case, I don’t think the difference between a 7% CET1 ratio and a 7.9% CET1 ratio is particularly consequential. On the bank’s first-quarter earnings call, Citizens Financial CEO Bruce Van Saun noted that the bank has an internal target range of 9.75% to 10% for its CET1 ratio, well above the Fed’s requirement. However, an analyst did note that this range is a little higher than some of its peers, and surely having a 7% requirement would make it easier to bring the target range down over time.

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The second big thing that a lower SCB and CET1 ratio would have done is assure investors that Citizens Financial’s credit quality is every bit as good as its peers.

Citizens has an unusual history. It was for many years a subsidiary of the Royal Bank of Scotland (which is now Natwest Group). But in 2014, RBS spun it off via an initial public offering. At that point, the bank was underleveraged and had to grow its balance sheet quickly. So, not only does Citizens have a relatively short track record of operating independently, but investors and analysts are naturally going to question whether a fast-growing bank’s credit quality will hold up over the long term. That’s why Citizens, though it is in my opinion just as strong of a bank as some of its peers, has lagged its peer group in terms of valuation.

A successful stress test that lowered its CET1 ratio into line with those of its peers would have made a statement about Citizens’ credit quality, and perhaps driven the stock price higher. That’s essentially why Regions opted into the stress tests this year, according to its CFO, David Turner.

“When your peers are all under the floor of 2.5% and you’re at 3%, it kind of sends this message that your credit quality is worse,” Turner said. “We don’t believe that, and we wanted a very public opportunity to demonstrate that. And that’s really what this was all about.”

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Did it cost investors?

Long term, I don’t think this will be a big deal. Citizens’ internal target range of 9.75% to 10% for its CET1 ratio would not likely have changed too much over the next year, even if the Fed had lowered its requirement. In 2022, Citizens will do another round of stress tests, and it will have an opportunity to demonstrate its fitness. Meanwhile, it has been busy this year acquiring a major chunk of the consumer banking franchise of HSBC, which looks like a promising move.

But given that Citizens has long desired a rerating of its stock price and valuation relative to its peer group, I would have thought the bank would take any opportunity to show investors that it’s every bit as solid as its peers. That’s why I am a bit surprised that the bank didn’t opt into stress testing this year.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

View more information: https://www.fool.com/investing/2021/07/02/did-citizens-cost-investors-by-missing-stress-test/

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