Citigroup Inc's relationship with the Federal Deposit Insurance Corp is frayed, sources told Reuters, and the regulator wants to replace Chief Executive Vikram Pandit, the Wall Street Journal reported.

U.S. officials have spoken to former U.S. Bancorp Chief Executive Jerry Grundhofer, who recently joined Citigroup's board, to assess his interest in the top position at the bank, the paper reported, citing people familiar with the matter.

The FDIC, under Chairman Sheila Bair, is concerned there are too few senior executives at the bank with commercial banking experience, the paper reported.

The FDIC recently pressed another regulator to reduce its confidential ranking of Citi's health, the paper said. Such a move would let regulators control the company more tightly.

The Financial Times said Citigroup recently had to delay raising $33 billion in capital after the FDIC warned it was in discussions to place the company on the list of banks at greater risk of failure as part of its efforts to replace Pandit.

The fight over the rating has been defused and Citigroup could launch the conversion of preferred shares into common stock to strengthen its capital as early as next week, the newspaper said citing people familiar with the situation.

Citigroup for its part believes too many government regulators are getting involved in its operations, creating additional layers of bureaucracy in a bank long seen as bureaucratic, people familiar with the matter told Reuters.

Citigroup Chief Financial Officer Ned Kelly told the Wall Street Journal that the FDIC is our tertiary regulator, behind the Office of the Comptroller of the Currency and the Federal Reserve.

The FDIC is heavily exposed to Citigroup. The bank had roughly $300 billion of deposits in the United States as of March 31, much of which were guaranteed by the agency. The bank has sold about $40 billion of debt guaranteed by the FDIC, according to Reuters data.

And the FDIC helped guarantee a portfolio of troubled assets that was originally about $300 billion. To pay for that insurance, Citigroup issued $3 billion of preferred stock to the FDIC, and another $4 billion to the U.S. Treasury.

SPOTLIGHT ON BAIR

Bair, a Republican appointed by former President George W. Bush, has been praised by both Democrats and Republicans involved in financial regulation reform. She was early to raise concerns about the housing crisis.

But her independent thinking can sometimes translate to clashes with people who disagree. Earlier this month, an FDIC board meeting on how to charge banks for deposit insurance turned into an unexpectedly heated discussion between Bair and John Dugan, the head of the Office of the Comptroller of the Currency.

A financial industry representative said Bair has chafed at having to saddle the FDIC and its dwindling deposit insurance fund with sizable risks connected to government programs that are targeted to help large banks.

One such program was the debt guarantee program announced in October, in which the FDIC agreed to back new debt issuances by banks in an attempt to bring more liquidity and confidence into the financial sector.

It's pretty clear the FDIC did not want to do the big loan guarantee program, the representative said. I don't know if it was because she wanted to protect the insurance fund or she didn't like protecting big banks.

PARSONS AFFIRMS FAITH IN MANAGEMENT

We went through a rigorous stress test process, the results of which were agreed to by appropriate regulatory agencies and clearly reflect the significant progress made by this management team over the last 15 months to turn Citi around, Citigroup Chairman Richard Parsons said in a statement emailed to Reuters.

Parsons said Citigroup has reduced its balance sheet by nearly 25 percent and riskier assets by over 50 percent.

We have raised an unprecedented amount of capital and, upon completion of the pending public exchange offer, Citi will be among the best-capitalized banks in the world, Parsons added.

The FDIC did not immediately respond to a Reuters email seeking comment on the newspaper report.

(Reporting by Karey Wutkowski and Dan Wilchins; Additional reporting by Ajay Kamalakaran in Bangalore, and Juan Lagorio in New York; editing by Mike Nesbit, Andre Grenon, and Carol Bishopric)

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