The decision marks the second time in three years that Citigroup has failed to win the Fed's approval for its plan to return money to shareholders, known as the "capital plan."
Officials at the bank never saw the rejection coming, a source close to the matter said on Wednesday.
The rejection underscores that whatever strides Citi's chief executive, Michael Corbat, has made in fixing the bank's difficulties, he still has work to do. Shares of Citigroup, the third-largest U.S. bank, fell 5.4 percent to $47.45 in after-hours trading.
Since taking the reins at the bank in 2012, Corbat has been working hard to cultivate close relationships with regulators in Washington. His predecessor, Vikram Pandit, had a famously testy relationship with the Federal Deposit Insurance Corp's then chairman Sheila Bair, among other regulators.
But even after mending fences in Washington, Corbat was blindsided by the Fed's decision to nix his plan for paying out money to shareholders. His first hint that something might be awry with the bank's capital plans came last week, when the Fed disclosed its views of how global turmoil would affect the bank's capital levels, the source said. The Fed's projections were much less rosy than Citi's.
The bank, like its competitors, faces two opposing goals. It wants to have large amounts of capital to please regulators; it also wants to please its shareholders, and high levels of capital weigh on profitability.
Citi was one of five banks whose payout plans were rejected by the Fed on Wednesday. Three were the U.S. units of European banks. The fifth, Zions Bancorp, was expected because it was the only bank last week to fail a model run of a simulated crisis similar to the 2007-09 credit meltdown in the first part of the Fed's stress tests.
The Fed said it approved capital plans submitted by the remaining 25 big banks in this year's tests.
Corbat, said in a statement that the Citigroup is "deeply disappointed" by the Fed's decision and that the bank's request for returning additional capital to shareholders was modest.
Last year, the Fed granted Citigroup permission to buy back $1.2 billion worth of shares and said it could continue to pay $120 million a year in dividends, representing a quarterly rate of a penny a share.
This year Citigroup sought to spend more than five times as much buying back shares and to lift its quarterly dividend to 5 cents a share. The bank earned $13.67 billion last year.
Analysts, on average, had estimated that Citigroup's quarterly dividend would increase to 12 cents per share, according to surveys by Thomson Reuters.
ANALYSTS SEE PROBLEMS IN CITI'S COMPLEXITY
On Wednesday, the Fed said that Citigroup has improved its risk management practices in recent years, but the bank cannot determine well enough how its revenue and income would be hurt under stressful scenarios around the world. The bank's internal examination process does not sufficiently consider how global crises could influence its broad number of businesses, the Fed added.
In 2012, the Fed rejected the plan by Citi's then CEO Pandit, a step that contributed to his ouster in October of that year. In the 2012 test, Citigroup did not prove to the Fed's satisfaction that it could adequately measure risk in loans to some consumers in Southeast Asia, where credit rating standards are not as well developed as in the United States, according to a person familiar with the matter.
The Fed said on Wednesday that some of Citigroup's deficiencies had been "previously identified by supervisors as requiring attention" and that "there was not sufficient improvement."
A Fed official said that regulators had raised their expectations for banks with each set of stress tests, and it expected improvements in areas that had previously been identified as needing work.
Citigroup's complexity -- it operates in over 100 countries, and was built over decades of acquisitions -- may be working against it, analysts said.
"Citi needs to make this defeat into victory by improving the pace of restructuring," said Mike Mayo, an analyst at CLSA, saying the bank should consider breaking itself up more dramatically than it already has.
The other banks blocked by the Fed on Wednesday in their plans for higher dividends or share buybacks were the U.S. units of HSBC, RBS and Santander, due to weaknesses in their capital planning processes.
Zions, the fifth bank whose plan was barred, was the only bank out of 30 to miss minimum hurdles for regulatory capital in a first stage of the stress tests, which simulate a future crisis as severe as the 2007-09 credit meltdown.
"Both the firms and supervisors have more work to do as we continue to raise expectations for the quality of risk management in the nation's largest banks," Fed Governor Daniel Tarullo said in a statement on Wednesday.
The five banks can continue with shareholder payouts at the same pace as they did last year. They can also change their proposals and resubmit them, a move that Citigroup said it is considering.
Fed officials told reporters that capital distributions at the banks had been sufficiently modest in past years that they could continue at current levels without hurting the firms.
The Fed's criticism of internal controls, risk-identification and other planning elements at the foreign banks underscores regulators' concerns about the safety of those firms' operations in the United States.
Foreign banks will have to wall off their U.S. units and meet tougher capital requirements under rules recently finalized by the Fed.
The Fed has said HSBC, RBS and Santander all would likely fall under those new rules.
Two large Wall Street banks, Bank of America and Goldman Sachs, had to resubmit their capital plans after seeing their first set of stress test results.
Bank of America received approval to increase its quarterly dividend to 5 cents per share from 1 cent per share previously, and approval for the authorization a new $4.0 billion share buyback program. Last year, the Federal Reserve approved Bank of America's request to redeem $5.5 billion in preferred stock and $5.0 billion in common shares.
The annual tests aim to determine whether banks are robust enough to weather the next crisis. Under the toughest stress scenario considered this year, the banks had to show how they would cope with the stock market falling by 50 percent. The eight biggest banks had to weigh the impact of a default by their largest derivatives trading counterparty.
Last week, the Fed looked at what the banks' capital levels would look like in stress scenarios, assuming they did not change their payouts to investors. In the results released on Wednesday, regulators looked at whether banks could carry out their planned capital distributions and still maintain a buffer in a downturn.
(Reporting by David Henry in New York and Emily Stephenson in Washington; Additional reporting by Douwe Miedema in Washington, and Peter Rudegeair and Lauren Tara LaCapra in New York; Editing by Dan Wilchins and Leslie Adler)
By Emily Stephenson and David Henry
Stocks treated in this article : Citigroup Inc
, JPMorgan Chase & Co.
, Zions Bancorporation
, Bank of America Corp
, Goldman Sachs Group Inc
, Morgan Stanley
, Wells Fargo & Co
, Banco Santander, S.A.
, HSBC Holdings plc
, Royal Bank of Scotland Group plc