The most popular tag used for Citigroup (C, Financial) is perhaps “the globally diversified banking group.” Well, one cannot deny the fact that Citigroup has spread its wings in various directions and though it might have had a good last quarter, it needs to streamline its operations. As a matter of fact, breaking up Citigroup is under serious consideration as a political campaign theme (Read the story here). In a recent deal, Citigroup has decided to sell its Japanese retail banking operations to Sumitomo Mitsui Banking Corporation (SMBC, Financial) with the intent to rationalize its business model.
Exiting the Japanese business
A few months back Citigroup had named Japan as one of the 11 countries where it sought to exit the retail banking operations owing to lower profitability. Acting on the same, the deal made by Citigroup with SMBC will be completed by late 2015 and is expected to bring in around 40 billion yen ($330 million) in cash for the diverse banking group. This particular transaction joins the likes of other such initiatives taken by Citigroup since the 2008 crisis. Beginning 2008, the banking group focused hard on shrinking its business size by doing away with loss-making units housed under Citi Holdings division. Over the last six years, Citigroup has done a commendable job in reducing its business assets from almost $900 billion to just over $100 billion.
This is a phenomenal feat for Citi considering that it stands to gain well from a streamlined global presence. One of the strengths available to Citigroup is its international presence and plethora of financial services, which enables the group to generate different revenue streams. The strong international presence allows Citigroup to source cheap funds in form of low interest rate deposits from the regions where it operates, which in turn helps it achieve better net interest margins. As the bank caters to the demand for loans globally, its interest income is not overly dependent on the interest rate environment prevalent in any single country.
Legal costs galore
In the second week of December, Citigroup mentioned that it would record $2.7 billion in litigation expenses and another $800 million in repositioning charges, leaving the third-largest U.S. bank "marginally profitable" in the fourth quarter. This was reiterated by CEO Mike Corbat at the Goldman Sachs 204 U.S. financial services conference. As such, it is reasonable to expect that the banking group might have a hard time on the bottom line figures. To give you a brief background, the legal costs have stemmed from government investigations into possible manipulation of foreign exchange markets, setting of LIBOR interest rates and lax compliance of money laundering rules. Past legal charges have foreshadowed settlements of cases.
Analysts have revised their profit estimate in accordance with this announcement made by the bank. Before the announcement, analysts had expected Citigroup would make about $3.4 billion in the fourth quarter, instead of a small profit. Though there have been serious cost-cutting efforts by the bank using various channels, the legal expenses still weigh heavy on its income statement and that has hampered value generation for shareholders. Data shows that Citigroup has paid about $13.1 billion in fines over the last five years. Though it is petty when compared to its peers like Bank of America (BAC, Financial)Â and JP Morgan Chase & Co (JPM, Financial), these legal settlements have definitely played a monumental role in keeping down its profitability.
Final Words
Coming back to the abovementioned story which covers the anger of Senator Elizabeth Warren over power display of Citigroup lobbyists, I believe that the point of breaking up Citigroup’s business might be a prudent point. It is true that Citigroup has a strong ability to pull strings in the Washington’s power corridors and because of this ability, the bank has been able to manipulate laws in its favour and encouraged its inept risk management policies. If one may recall, the insatiable desire to take on more risk coupled with inefficiency at managing risk led to a $45 billion fund outflow from the U.S. government’s coffers to bail out the bank. In spite of such a magnanimous debacle in the past, Citigroup does not show signs of steep learning. Just this year, the bank’s capital plan was rejected by Fed on concerns that it had appalling deficiencies. It is easy to strike off this instance as one-time occurrence but the reason I mentioned the quantum of legal costs above is to make investors aware of the high risk practices adopted by the bank.
Undoubtedly, Citigroup is focused on rationalizing its business structure and maintaining operational costs but the big flaw that it fails to address and probably won’t in the future as well, is its risk management strategy. The news reference provided in first paragraph highlights Citi’s intent to use its lobbying power and twist laws with the intent of beefing up its portfolio with risky derivatives. Such action is indicative of the probability that the bank can easily run into troubled waters. Hence, it is not worthwhile to invest in a company whose fundamentals are shaky and where probability of catastrophes is high.
