Did Citizens Financial Group cost its shareholders dearly by avoiding the Fed’s stress tests?

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I remain optimistic on Citizens Financial Group (NYSE: CFG) and, in particular, the unique digital consumer bank it is building. But after seeing the recently revealed results of the Federal Reserve banks’ annual stress tests – and acknowledging that the pullback is 20/20 – it looks like citizens have missed an opportunity by not choosing the program this year.

If he had, he might have been able to reduce his capital requirements, which in theory would have given him a greater ability to return capital to shareholders. Lower capital requirements would also make a wider market statement on the overall credit quality of citizens. What should investors get out of it?

Image source: Citizens Financial Group.

How stress tests impact regulatory capital

Banks are required to hold a certain amount of capital on their books to cover unforeseen losses. One way to look at this is through the Tier 1 Capital Ratio (CET1), 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 is a relatively newly mandated layer called the stress capital buffer (SCB).

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

In the 2020 stress tests, Citizens achieved an SCB of 3.4%, giving it a total CET1 capital ratio requirement of 7.9%. This was higher than any of his direct regional bank peers. Citizens Financial was not happy with the Fed’s modeling or its final SCB determination and went so far as to request a review. But the Fed confirmed its initial findings.

Under the current regulatory framework, banks like Citizens with between $ 100 billion and $ 250 billion in assets are only required to stress test every other year. Most of the banks in this category pass the tests during their off years because the process requires a lot of work from their regulators. But I think it would have been beneficial for citizens to sign up and try to reduce its SCB to 2.5% and its CET1 ratio to 7%, in line with its peers. Many banks did better in the 2021 tests than in 2020. For example, Regional finance, a direct peer of Citizens, also had an above-average SCB of 3% in 2020, but brought it down to 2.5% as a result of this year’s stress tests.

Why lower capital requirements are important to citizens

There are two main reasons why a lower SCB and CET1 ratio is important from an investment perspective. First, the amount of capital a bank must hold limits the amount it can return to shareholders in the form of dividends and share buybacks.

In this case, I don’t think the difference between a CET1 ratio of 7% and a CET1 ratio of 7.9% is particularly big. During 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. above the Fed’s requirements. However, one analyst noted that this range is a bit higher than some of its peers, and having a 7% requirement would surely make it easier to narrow the target range over time.

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

The citizens have an unusual history. It was for many years a branch of the Royal Bank of Scotland (which is now Natwest Group). But in 2014, RBS separated it via an initial public offering. At this point, the bank was under-leveraged and had to increase its balance sheet quickly. So not only does Citizens have a relatively short experience of independent operations, but investors and analysts will understandably question whether the credit quality of a fast-growing bank will hold up in the long term. This is why Citizens, while in my opinion just as strong a bank as some of its peers, has lagged behind its peer group in terms of valuation.

A successful stress test that lowered its CET1 ratio to that of its peers would have made a statement about Citizens’ credit quality and possibly raised the share price. This is essentially the reason why regions have opted for stress testing this year, according to its chief financial officer, David Turner.

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

Has it cost investors?

In the long run, I don’t think it’s going to be a big deal. The citizens’ internal target range of 9.75% to 10% for its CET1 ratio probably wouldn’t have changed too much over the next year, even if the Fed had lowered its requirement. In 2022, Citizens will perform another round of stress tests and have the opportunity to demonstrate their fitness. Meanwhile, it has been busy this year acquiring much of the consumer banking franchise from HSBC, which appears to be a promising initiative.

But given that Citizens have long wanted a revaluation and valuation of its stock relative to its peer group, I would have thought the bank would take any opportunity to show investors that it is just as good. strong than its peers. That’s why I’m a little surprised the bank didn’t go for stress testing this year.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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