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Legal woes and regulatory pressure seems unending for Citigroup Inc. (C - Analyst Report). Most recently, following the initiation of Federal authorities’ criminal inquiry into the fraud worth $400 million in Citigroup’s Mexico-based subsidiary, the company’s shares crumbled. The stock price toppled 1.16% to $47.68 and continues remain in the red after-hours.

In late February, following the fraudulent activity, the company recorded post-tax $235 million (pre-tax $360 million) as charges, which led its net income for 2013 to fall to $13.7 billion from $13.9 billion. The fraud involved Banco Nacional de Mexico (Banamex), which is Citigroup’s Mexican unit, Oceanografia S.A. de C.V. (OSA), a Mexican oil services company, and a key supplier to the Mexican state-owned oil company, Petróleos Mexicanos (Pemex).

FBI and prosecutors from the United States attorney's office in Manhattan are looking into the matter. They are skeptical about Citigroup’s internal controls over its operations which led to such fraud. Though Citigroup believes that the fraud is isolated, the regulators are examining whether the bank was equally responsible.

The regulators are also examining whether Citigroup ignored warning signals related to its controls. According to the law, following warnings related to any illegal activity, banks must address such activity and initiate compliance programs to examine the matter. If the banks fail to abide by such law, it is considered a criminal violation. Notably, in 2012, HSBC Holdings plc (HSBC - Analyst Report) was blamed for substantial lapses in its anti-money laundering compliance and was fined with $1.9 billion for its misdeeds.

Banamex Case in Detail

As of Dec 31, 2013, through an accounts receivable financing program, Banamex provided short-term loan of $585 million to OSA for financing accounts receivables due from Pemex. Therefore, Banamex had around $33 million as outstanding loans directly aided to OSA or letters of credit issued on the behalf of OSA as of Dec 31, 2013.

Notably, in Feb 2014, after receiving information about OSA’s suspension from getting new Mexican government contracts, Citigroup and Pemex performed diligent reviews of their credit exposure to OSA and the above-mentioned program over the past few years. Consequently, a considerable amount of accounts receivables recorded by Banamex related to the accounts receivable financing program with Pemex was discovered to be fraudulent.

Further, Citigroup’s investigation, along with documents presented by Pemex revealed that papers of merely $185 million were valid, of the $585 million of accounts receivables payable to Banamex by Pemex as of Dec 31, 2013. However, the amount of difference worth $400 million has been recorded as operating expense in Transaction Services in fourth-quarter 2013, offsetting compensation expense of about $40 million related to the Banamex variable compensation plan.

At present, Citigroup is continuing its review to recover misappropriated funds and identify persons who are guilty in the case. Notably, Mexican authorities are providing their full assistance.

Capital Plan Rejected

Last week, Federal Reserve rejected Citigroup’s capital plan under the Dodd-Frank Act supervisory stress test 2014 (DFAST 2014). Notably, this is the second time in the last 3 years when Citigroup’s plan has been rejected by the Fed. It had resubmitted its capital plan in 2012 as well.

Though Citigroup satisfied the stress test requirements, the Fed objected to its plan to deploy capital to shareholders based on certain “qualitative” reasons. As a result, Citi will need to submit a revised capital plan to the Fed later this year.

The Fed did not cite the Mexican fraud as a reason of rejection but the regulator is concerned over Citigroup’s incompetence in projecting revenue and losses in a severely adverse scenario for major parts of its global business. These factors along with other reasons raise questions over the bank’s capital-planning process, which led to the rejection.

Conclusion

Citigroup has come a long way since 2008, when it had to accept $45 billion as bailout money to survive the economic downturn. One can consider a strong brand like Citigroup to be a sound investment option, given its attractive core business. However, the prevalent regulatory pressures and litigation issues remain concerns. Moreover, such inquiries would dent the firm’s reputation and diminish investors’ confidence.

Citigroup currently carries a Zacks Rank #3 (Hold). Some better-ranked major regional banks worth considering include Wells Fargo & Company (WFC - Analyst Report) and BankUnited, Inc. (BKU - Analyst Report) with a Zacks Rank #2 (Buy).

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