Monday, May 12, 2014

Barclay's Epiphany is Long Overdue

Roy C. Smith

The market warmly welcomed Barclays’ announcement on May 8th that it was going to slash the headcount and risk-weighted assets of its investment bank. Its stock price rose 7% on the news.  
It was about time. Barclays’ 2009 acquisition of the US business of Lehman Brothers proved to be a bridge-to-far that destroyed shareholder value and left the bank with an unstable business model.
Barclays ranked 5th on a 2013 list of global capital market leaders by origination of transactions. But membership in this elite group proved to be very expensive for Barclays, whose commitment to capital markets after the Lehman acquisition was too much for it to manage, and too heavily dependent on fixed income, currencies and commodities.
Its decision to back down from investment banking will mean that it will probably disappear from the top ten list and there will no longer be any UK owned bank among the market leaders, even though the market is still centered in London.
Of course, Barclays, like all its global banking peers, never expected the investment banking business to be so difficult over such a long period – five years -- nor did it fully appreciate the extent of the aggregate regulatory burden that would be imposed on it, or the costs of legal settlements and reputation damage that it would incur.
These factors have largely destroyed the economic viability of the global capital market business model. Since 2009, the leading banks, on average, have failed to earn their cost of capital, with eight or nine of the top ten banks each year generating negative EVA (economic valued added, or ROI less the cost of equity capital).

A Need to Change Strategies
For the past few years it has been fairly obvious that the global investment banks would have to change their business models significantly to adjust to the times.
Citigroup and Morgan Stanley were the first to act with the sale of Citi’s Smith Barney retail brokerage business to Morgan Stanley. Though mainly a downsizing act for Citigroup, which left its large investment banking unit intact, it reflected a major strategy change for Morgan Stanley, which diluted its investment banking exposure by the addition of one of the world’s largest retail businesses.
Morgan Stanley’s revised strategy has still not produced a positive EVA, but over the past two years its stock price has risen 125%, more than any of its US investment banking competitors.
The next to move were Credit Suisse and UBS, both of which announced a Barclay’s like downsizing of investment banking a year ago. While UBS dropped in the global investment banking league tables to 9th position in 2013 (and may drop out of the top ten in the future), its stock price outperformed its European peers in the last year. Both banks, however, are still posting negative EVA.
Frozen in Place
But several of the global investment banks, though maintaining market share, were well out of favor. The stocks of Barclays, Citigroup, Bank of America, and Deutsche Bank traded at an average of 72% of book on March 31, 2014 and their average EVA was minus 7.8%. These banks have focused on cost cutting and eliminating non-core businesses, but have not moved to reduce their dependence on investment banking, which amounts to about half their profits. To them, the investment banking units are too important to dismantle; to investors these banks seem locked into a business model that is neither working, not viable.
Barclay’s actions seek to break the ice and return it to “normal,” which will mean concentrating on UK retail and commercial banking. 
Deutsche Bank, trading at a miserable 59% of book value and -5.2% EVA, needs to do something dramatic to free itself – possibly spinning off its London based investment bank to the bank’s shareholders.
For Citigroup and Bank of America, however, “normal” is increasing beginning to look like Wells Fargo, a growing and profitable basic-banking franchise in the US.
The New Normal Bank
Wells Fargo, with a market capitalization of $259 billion at March 31, 2014, is the world’s most valuable bank. It trades at 1.7 times book value and has an EVA of +4.4%. It finances 71% of its balance sheet (which is almost a trillion dollars smaller than JP Morgan’s) with deposits, and pays out 55% of profits in dividends and stock repurchases. Citi and Bank of America (after its reset) payout only about 1%.
Wells Fargo increased its syndicated lending activity in 2013, and landed in 10th place in the capital market origination table for the first time with only 13% of its revenues from investment banking sources.  Its share may rise further as other banks follow Barclays, UBS and Credit Suisse out of the market.
Citi’s and Bank of America’s shareholders ought to be asking “why can’t we be normal like that?”

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