Analysis: Citigroup looks to cut cash holdings to boost earnings

By David Henry

NEW YORK (Reuters) - Citigroup Inc (C.N) is considering cutting its cash on hand by about $35 billion, which should help the bank buy higher yielding assets or redeem expensive debt to boost earnings.

Making the change will signal that the management of the third-largest U.S. bank by assets, which had to be rescued three times by the U.S. government in the financial crisis, is increasingly confident that its worst troubles are well behind it.

The move could give a 2 percent boost to Citigroup's bottom line this year and keep the bank's lending margins relatively strong even as competitors suffer from low interest rates.

The bank has enough liquid assets to cover an estimated 37 days of the cash drain expected in a scenario of acute stress under pending new regulations, based on Citi's financial reports through December. Treasurer Eric Aboaf and other executives would like to reduce that to about 33 days of coverage, or 10 percent more than is to be required under the new international rules known as the Basel III liquidity coverage ratio.

"In the framework of managing a company efficiently, that would be a good thing to do" over the next year or so, Aboaf told Reuters in an interview.

While the move would reduce the bank's pool of cash and liquid assets by about 10 percent, Citigroup would still have 10 percent more liquidity than regulators say they will demand. JPMorgan Chase & Co, (JPM.N) which analysts and investors often see as a stronger bank than Citigroup, is below the pending regulatory minimum.

Citigroup may feel more confident, but the bank is also leaving itself a little more vulnerable to big swings in markets and economies around the world. Cash on hand is critical for staving off runs on the bank during bad times.

The Federal Reserve has not commented publicly on Citigroup's liquidity, but earlier in March it approved the company's capital plan as strong enough to withstand a stress test. The U.S. regulator is part of the international body that has drafted the new liquidity requirement that Citigroup exceeds.

"At the moment it is appropriate for Citi to take down their cash, but if we end up with very volatile capital markets and Citi is caught in that, then people will start to question them," said Charles Peabody of Portales Partners, a research firm for institutional investors.

Given Citi's huge problems in recent years it might seem surprising that it has so much leeway to reduce cash. By contrast JPMorgan, which maneuvered through the financial crisis less scathed than most major U.S. banks, has estimated it is 17 percent short of the expected Basel III levels, which are to be phased in by 2019.

Citigroup has had to be more conservative than JPMorgan because investors and regulators were less confident in it, but Citi's fortunes have turned, thanks in part to the U.S. housing market stabilizing.

During the financial crisis, while Citigroup struggled to survive, the U.S. authorities turned to JPMorgan to help them salvage failed financial institutions.

Even as recently as a year ago, Moody's Investors Service cut Citigroup's ratings as part of a broader financial services review globally. In March of last year, the Federal Reserve publicly rejected Citigroup's capital plan. It was a blow to confidence in the bank, as well as a sign of Citigroup's strained relationships with regulators. Executives at Citigroup had other reasons to be cautious too, including the European debt crisis, and the bank's portfolio of troubled mortgage assets left from the financial crisis.

But in recent months, the tide has turned. The bank has changed its leadership, pushing out Vikram Pandit and bringing in Michael Corbat, who has been assiduously building bridges with regulators. With the U.S. housing market starting to recover, the bank's losses on its portfolio of bad assets are abating, and the bank passed the Fed's stress test this year. In fact, that test suggested that Citigroup is safer than JPMorgan now. The regulator approved a plan for Citigroup to return $1.2 billion of additional capital to shareholders.

The bank's liquidity pool has reflected this shift. At the end of March 2012, Citigroup had $421 billion of cash on deposit at central banks and other unencumbered liquid assets, enough to cover about 43 days of acute stress and equal to about 22 percent of the bank's total assets, more than twice the percentage at the end of 2007 when the financial crisis had just taken hold.

In the middle of last year, as things started looking up for the bank, it quietly began to tap its liquidity, a move that accelerated in the fourth quarter as the company reduced its long-term debt by $32 billion and cut interest expense.

The draw left Citigroup's pool of liquid assets at $354 billion at year-end, $67 billion less than in March last year, but still at a level that CreditSights senior analyst David Hendler calls "robust."

"You really don't need that much liquidity," said a bond investor at a large money management firm who buys Citi debt and who declined to be named. He called the pile "excessive."

Citigroup had $1.86 trillion of assets at the end of December.

TURNING TIDE

With Citigroup lowering its cash holdings in the fourth quarter, the bank managed to lift its interest profit margin, known as its net interest margin, even as JPMorgan's margin fell.

Much the same could happen in coming quarters. While Citigroup has not committed to exactly when it will bring its liquidity down and by how much, the company, in contrast to JPMorgan, has guided analysts to expect steady interest profit margins, in the face of industry-wide low rates.

Those stable margins will help the bottom line. Drawing down the $35 billion of excess liquidity could easily save $350 million of interest expense, or about two percent of 2013 earnings, said Moshe Orenbuch, a bank analyst at Credit Suisse. The gains could be greater if the company were able to use the cash to make loans with attractive yields, he said.

In contrast, JPMorgan, which has not been under pressure to hold so much cash, is now increasing its holdings. Its Chief Financial Officer Marianne Lake told analysts in February that the company can quickly reach the liquidity requirements by steps including cashing out longer-term securities and taking in more deposits. JPMorgan intends to reach the minimum by year-end, the company said in a filing. But a measure of the bank's lending profitability, known as net interest margin, will suffer as a result, Lake said.

JPMorgan has accelerated plans to meet other upcoming Basel III requirements since losing $6.2 billion in its "London Whale" derivatives trades last year.

A JPMorgan spokesman declined to comment for this story.

Morgan Stanley (MS.N) has said its liquidity exceeds 100 percent of the new Basel III requirement, while Bank of America Corp (BAC.N) and Goldman Sachs Group Inc (GS.N) have yet to disclose their liquidity scores under the new requirements.

How good the regulators' new liquidity requirements are at showing which banks are safe won't be known for sure until they are tested in a crisis, analysts said.

The new requirements were drafted after the 2008 bankruptcy of Lehman Brothers, which happened as executives of the investment bank insisted they had more than enough liquidity.

But the sums Lehman said were available included securities that were pledged as collateral on derivatives trades, as well as instruments that could not be quickly turned into cash to pay creditors, according to a report by an examiner appointed by the bankruptcy court in the case.

Aboaf of Citigroup, which held some of Lehman's collateral, said none of the assets his bank counts as liquid are encumbered.

(Reporting by David Henry in New York; Editing by Claudia Parsons)

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