Finance

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

This time last year, big U.S. banks looked ripe for a breakup. Politicians were clamoring to make the system safer and investors were looking for ways to boost sluggish performance. Today, the preference is for doing very little at all, thanks to a deregulation pledge by President Donald Trump that has fueled a share-price rally and could free up as much as $25 billion for the financial sector, according to research firm Opimas.

Yet it might be a mistake to imagine investors have wrung all the value they can out of banks. Fourth-quarter results confirmed what analysts already knew -- rising interest rates and volatility help margins and trading -- but not much else in terms of new ideas for hitting profit targets or lifting revenue. Industry return on equity is still historically low. Moreover, the euphoria building up to Inauguration Day was about events outside of banks' control. There's a risk of disappointment: Already, most bank shares have come off their post-election highs.

With that in mind, CEOs may find themselves once again facing calls -- perhaps from activists -- to break up their businesses or sell off assets to free up cash and lessen the pain of long-running cost cuts.

Time to Split?
At $160 billion, Citigroup's market capitalization is below the $190 billion that KBW analysts touted in a breakup. It's also well below its pre-crisis peak.
Source: Bloomberg

Valuations differ widely between businesses: Consumer banking is valued at almost 2 times tangible book value while more volatile institutional brokerage is half that, according to data compiled by Bloomberg. Being a smaller and simpler bank may also be in tune with the Trump administration's potential new rule-book: The Financial Choice Act proposed by Texas Congressman Jeb Hensarling offers regulatory relief for banks with leverage ratios of at least 10 percent. That's an attractive carrot but one that would force a bank like Citigroup to raise billions of equity if it wanted to stay the same size, according to Bloomberg News. Shrinking or breaking up may prove easier. 

Break Free
Citigroup trades at a discount to its peers in part because of its lower returns and offshore exposure, which means it'll take a hit if U.S. tax reform occurs
Source: Bloomberg

Citi in particular may prove a textbook case of how being too complex and too global still makes shareholders queasy. Only about half its earnings and revenue come from North America, where investor optimism is the strongest, and some of its businesses abroad are underperforming. Its Mexican unit Banamex is a laggard versus peers, according to UBS analysts, who reckon it could be valued at $10 billion to $16 billion if sold. Citi is well-capitalized and has done a lot to shrink its global footprint since the financial crisis, but its valuation still trails rivals. For all its clout in global banking and fixed-income flows, fourth-quarter revenue fell by a disappointing 8 percent.

Struggle Street
Citigroup's returns are below that of its cost of capital, and although that gap may narrow as rates rise, it is still expected to continue to trail its largest rivals
Source: Bloomberg
*The bank has a goal of hitting 10% ROTCE in 2018 and believes it can ultimately lift this figure to 14%

Any activist-inspired breakup would come at a time when some regulators are in favor of shrinking the biggest banks. The Federal Deposit Insurance Corp.'s vice chairman Thomas Hoenig, who is reportedly on the shortlist for a role as Federal Reserve vice chairman in charge of bank oversight, said last month that he supports the reinstatement of the 1933 Glass-Steagall Act, which would require the largest financial institutions to separate their commercial and investment arms. 

Still, none of this means that banks are an easy activist target. Their top shareholders tend to be mutual-fund giants that, according to a Harvard Business Review article last year, weaken the ability of outside investors to force change. It's no surprise that when Jeff Ubben's ValueAct fund took a stake in Morgan Stanley last August, it did so with no big demands. And as Bloomberg News accurately noted last year, other activists haven't had great success in the past.  Plus, if a hoped-for deregulation drive results in billions of freed-up capital, management would likely attempt to pass it along to investors anyway.

Should regulations remain stringent, there could be more of an argument for activist involvement. Already, one factor currently holding back Citi's shares is that the lender isn't in control of how much capital it can pay out to shareholders because of liquidity requirements. So while it's doing what it can within bounds (in November, it boosted its share repurchases by $1.75 billion), a breakup would give it a better shot at releasing trapped capital. 

Against the current backdrop, activists may prefer to take a wait-and-see attitude. If bullish sentiment alone sends more investors piling into bank stocks and pushes valuations toward levels not seen since the crisis, there may be little left to do. But any weakness -- especially if spurred by non-delivery of promised policy changes -- may justify more radical ideas for unlocking value. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. For context, last year, Citi shareholders had a chance to vote on a special study examining breaking up the bank but sided with directors who were against the proposal, citing that its size and scale allowed for annual operating efficiencies of up to $12 billion.

  2. Per the article: "Bill Ackman’s Pershing Square purchased Citigroup shares in April 2010 and sold them two years later as the stock declined by more than a quarter. Dan Loeb’s Third Point bought shares of Morgan Stanley in late 2012 and did push for lower pay for directors. But he sold the next quarter as the stock rose to as much as 46 percent above Third Point’s purchase price."

To contact the authors of this story:
Lionel Laurent in London at llaurent2@bloomberg.net
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net