Can This Bank Go From Good to Great?

Without a doubt, Citigroup has come a long way since the financial crisis. Capital levels have improved, asset quality is better, and the bank has a renewed focus on its core business. I think it's safe to call Citigroup a "good" bank at this point in time.

"Good" is definitely better than some of the other words that have been used to describe Citigroup over the years, but the bank is definitely not at the "great" level yet. However, if certain things were to happen, Citigroup could go from good to great over the next several years.

Why Citigroup is a "good" bankThere are a few reasons I would refer to Citigroup as a "good" bank.

For starters, the bank is much better capitalized than it was just a few years ago. Since the end of 2010, Citigroup's Tier 1 Common capital ratio has improved from 10.7% to 13.4%, and regulators recently found that it would only fall to 8.2% in a worst-case scenario, well above the required 5%.

Also, Citigroup has put most of the legal issues left over from the financial crisis behind it, as CEO Michael Corbat stated in the most recent earnings report that included $2.7 billion in legal charges.

Finally, and perhaps most importantly, Citigroup has done a good job of getting rid of its "legacy assets" and focusing more on its core business of providing banking services to consumers and corporations. The Citi Holdings division still has $98 billion in assets, but this is less than one fourth of the amount it had at this time in 2010. And, the division (which has lots of mortgage-related assets, among other things) was actually profitable for the entire year of 2014, mainly thanks to the strength of the U.S. real estate market.

Further emphasizing that Citigroup has reached the "good" level is the recently announced stress test results, which finally allowed the bank to plan a dividend increase for its shareholders.

What makes a bank great?What are some of the "great" banks, and why do they fall into that category?

Three banks I consider to be great are Wells Fargo, TD Bank, and U.S. Bancorp. All three produce solid returns and run more efficiently than most of their competitors, and they have grown their businesses at an impressive rate.

The biggest characteristic that all three have in common is their level of risk (or more specifically, the lack thereof). All three of these banks generally avoid the riskier parts of the banking business, such as trading and investment banking, and focus on the core business of community and business banking.

In a nutshell, great banks are able to produce market-beating growth and profitability without putting their shareholders at too much risk. How can Citigroup do that?

How can Citigroup get there?The most obvious path to becoming a great bank is to keep doing what it's doing in terms of winding down its legacy assets. While it's absolutely true that $98 billion in potentially bad assets is better than $400 billion, it's still a large amount, especially considering Citigroup's entire market cap is about $162 billion. In the event of another recession, those assets could certainly cause the bank's profits to erode rather quickly.

Another thing I'd like to see Citigroup do over the coming years is to decrease its exposure to risky foreign markets. Out of the big U.S. banks, Citigroup has more exposure to emerging markets than any of them, which leaves the bank and its profits vulnerable to foreign recessions and currency fluctuations, among other things.

On a positive note, Citigroup is already starting to do one thing great banks should do: return as much capital to shareholders as possible. As part of the stress test results, Citigroup is approved to return $8 billion to shareholders over the next five quarters, but the vast majority ($7.8 billion) is in the form of a share buyback.

This could go a long way toward adding value for shareholders. Currently, Citigroup is trading for almost 20% less than its book value, meaning the company is buying back shares for just 80% of what the assets they represent are worth. In other words, if the current valuation holds, the buyback will create an additional $1.5 billion in value for shareholders without any change in the business itself.

Time will tellCitigroup (for now) seems to have learned its lesson from the financial crisis, but only time will tell if the bank continues on the path to greatness, or just remains a good bank that trades at a cheap valuation. Still, I applaud the progress the bank has made so far, and I look forward to seeing what the bank does over the next few years. There is definitely the potential for greatness there.

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Matthew Frankel owns shares of The Toronto-Dominion Bank (USA). The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Citigroup Inc and Wells Fargo and has the following options: short April 2015 $57 calls on Wells Fargo and short April 2015 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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