Spending became a major theme in the second quarter of the year for big banks, and it was back on the agenda when Citigroup (NYSE: C) reported higher spending in the second quarter and released new full-year spending guidelines. Banks are currently in a strange limbo as the economy recovers and they try to cut COVID-related spending and return to their normal execution rates.
Citigroup also faces unique cost challenges related to the regulatory issues the bank must resolve and the investments required to complete a reshuffle of its strategy. While spending is high and may remain so for the next several quarters, I would prefer the bank to invest now and think about a longer time horizon. Here’s why.
Address regulatory issues
In the second quarter of the year, Citigroup reported total operating expenses of nearly $ 11.2 billion, which is an increase of about 1% from the first quarter of the year and about 7% compared to the second quarter of 2020. The bank also reported a decrease of 64%. second-quarter efficiency ratio, which is a measure of a bank’s spending expressed as a percentage of revenue (so less is better). That’s up about 7% from the first quarter and isn’t rated as very good – Citigroup has reported an efficiency ratio of less than 60% in the past.
CFO Mark Mason also revised the bank’s spending forecast for the full year upwards, saying spending will increase in average single-digit percentages from 2020, which has lowered the bank’s spending forecast for the full year. action on the day the profits were published. But despite the seemingly negative indications, I don’t think it’s a big deal if you explain how the expenses are allocated and how they might pay off in the years to come.
Last year, regulators slapped Citigroup with a civil fine of $ 400 million and a consent order that tasked the bank to correct long-standing issues with its risks and internal controls. Due to the necessary investments in this infrastructure, Citigroup management had previously forecast spending up 2% to 3% in 2021 compared to last year. But as Mason has always said, those investments made to meet the consent order are also necessary investments to modernize the bank.
In the middle of last year, Citigroup accidentally wired $ 900 million to the wrong parties, an error later attributed to a “clerical error” and “outdated” software. A court ruled that $ 500 million of that amount does not have to be returned to the bank, so I’m all in favor of improving internal controls and automating manual tasks. Mason also said investments related to the bank’s consent order fall within that 2% to 3% range as expected.
Make strategic investments
Mason attributed the new spending that will cause an average percentage increase in full-year spending to strategic investments. When new CEO Jane Fraser took control of Citigroup earlier this year, she also launched a strategy refresh to eliminate inefficient parts of Citigroup’s sprawling operations and focus on banking businesses that can grow to scale. and generate returns above the industry average.
The refresh began when Citigroup announced earlier this year that it plans to pull out and sell its consumer banking franchise in 13 global markets. Franchising for consumption in these markets did not necessarily generate bad returns, but it used a lot of capital, was very inefficient, and the costs of credit in these markets doubled during the pandemic in 2020. Fraser also said that the bank did not have the scale necessary to be competitive in these markets.
Mason said the strategic investments the bank chose to make earlier than planned include those in wealth management and commercial banking. Citigroup is also investing more in already strong lines of business such as securities services, investment banking and treasury and commerce solutions (TTS).
These are good areas to invest in, as areas like wealth management are less capital intensive, while companies like TTS in a normal rate environment can generate a tangible return on equity in the 30s. Mason also gave all indications on Citigroup’s recent earnings call that spending forecast could rise again, saying, “If we see more investment opportunities in 21 or 2022, we will pursue them because , again, we know we can deliver on the benefits and returns associated with implementing this money. “
Higher expenses are acceptable at this time
While everyone wants every quarter to be a good one, Citigroup is in the process of improving its internal controls and updating its strategy, which means things are likely to get a bit worse before they get better. Both are needed to modernize the bank and also find a strategy that finally produces better returns and more in line with its peers.
Although Mason increased the bank’s spending forecast, I was happy to see most of the revised forecast geared toward strategic investments and businesses that are already strong and can generate better returns. A simpler Citigroup will likely lead to a better performing bank, and with stocks trading below tangible book value (equity minus goodwill and intangibles), I really think Citigroup could have a lot of benefits in the long run.
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.