Barclays Bank, the City shuffle

Barclays Bank’s history goes back three centuries and includes many acquisitions, the latest significant one being the investment banking and trading units of Lehman Brothers in 2008[1].  The 2007-2008 Great Recession left the bank weakened, and while Barclays avoided a government bail-out, it had to conclude several rounds of capital raising which brought it some controversy.

In 2015, it hired a new CEO from JP Morgan, Jes Staley.  Mr. Staley, the former CEO of JP Morgan’s investment bank, set forth a strategy based on a presence in two key markets, the UK and the US and three business activities: retail banking and credit, corporate banking, and investment banking.  In support of this focus, Barclays divested from its African banking operations in 2017 ending its presence on this continent[2].

While its US counterparts have fully recovered from the Great Depression, in large part thanks to massive fresh capital injections, Barclays has languished, tempting hedge funds and activists to build equity stakes.  In 2018, a fund managed by Mr. Bramson disclosed a 5.2% equity position.

Mr. Bramson is less flamboyant that his American peers.  Nevertheless, it is understood that he wants Barclays to phase out its equity, currency and bond trading while keeping its M&A advisory and capital market activities as these are supporting the bank’s corporate banking business.

If true, this recommendation would make sense: trading is risky and uses a lot of capital. It could be painful for more than management’s ego, as in a good year trading can produce good profits.

So it is not surprising that Barclays would explore defensive strategies.  It is however shocking that it would consider merging with the likes of Deutsche Bank or Standard Chartered Bank.  While Barclays denied it had considered a merger, as reported by the Financial Times, there was no denial that Barclays’ chairman had met with director(s) of Standard Chartered.

Full year 2017 results show how passably Barclays performed:

On a GAAP basis, Barclays produced a £1.9 billion net loss vs. a net profit of £1.6 billion in 2016,

It reported an adjusted return on tangible equity[3] of 5.6%[4], which translated into an adjusted return on actual equity of <4.9%,

Cost to income ratio was a high 73%, with Barclays International’s at 89% for 4Q17 vs. a still high 78% ratio for 4Q16 (US Corporate & Investment Banking and US credit cards),

Corporate & Investment Banking used £176.2 billion of risk weighted assets (RWAs) out of a group total of £313 billion, or >58% [Barclays doesn’t break out Corporate and Investment Banking].

By comparison, JP Morgan numbers were as follows:

On a GAAP basis, JPM showed a $25.5 billion net income for 2017 vs. $23.2 billion in 2016,

It reported an adjusted return on tangible equity of 12%, which translated into an adjusted return on actual equity of 10%,

Cost to income ratio was 57%, with Corporate & Investment Banking at 60% in 4Q17,

Corporate and Investment Banking used $826 billion in assets, or 33% of group total and 30% of group common equity.

Clearly, JP Morgan is far more profitable than Barclays, yet follows a much less risky strategy as evidenced by its lower allocation of resources to Investment Banking.  Even then, C&IB at JP Morgan is much more profitable whatever benchmark is used[5].

One intriguing difference between the two banks is the ratio of RWAs to total assets; at Barclays it was 28% at 12/31/2017 vs. 60% at JP Morgan.  While accounting rules are different, Basel III rules apply to both banks, and any resulting difference in risk assessment shouldn’t be in a ratio of 2:1, particularly given the superior risk management displayed by JPM.

In sum, Barclays is faced with major profitability challenges.  For several years, its investment banking unit has struggled, it is clearly undersized yet management seems loath to downsize and refocus it.

Merging with Standard Chartered would compound Barclays problems.  It would also make a mockery of the recent spinoff of Barclays Africa.

Back in July of 2014, when STAN traded at 1,218p/share, I wrote that it should trade in the 878p-912p.  Almost four years later, after a new and well regarded CEO took charge, the stock trades at 754p.

Besides the cultural problems which led the previous management to break US laws and earn the bank heavy fines, STAN faces strategic challenges.  The biggest one is that it operates in 70 markets and derives some 90% of its income from emerging economies in Asia, Africa and the Middle East.

Yes, it operates in regions that will likely enjoy the fastest growth over time, but these will also experience the greatest volatility.  By and large, emerging markets are also characterized by weaker institutional frameworks and less stable political systems.

Crucially, STAN operates as a global bank without having the size to do so successfully.  In its key markets, it faces competitors which are both stronger and more focused.  The result is mediocre profitability.

At the close of 2017, STAN had total assets of $664 billion compared to $1.5 trillion for Barclays.  It earned $1.3 billion after tax (vs. a loss of $191 million in 2016) for a return on average equity of 2.5%.  In 2017, its cost to income ratio was a high 71%.

By comparison, HSBC, the leading British global bank, earned $11.9 billion in 2017 on total assets of $2.5 trillion.  HSBC’s performance was better but still mediocre, with a return on equity of 5.9% and the bank is in the midst of a strategic and operational review.

Combining with STAN would compound and extend Barclays’ problems: a lack of size and a lack of focus, not to mention the challenge of fusing very different corporate cultures.  Barclays should know about the cultural risk as it has had to deal with the Lehman Brothers integration.

One of the most difficult decisions for major corporations to make when facing strategic choices is to accept down-sizing at least temporarily.  Barclays has a great name and tradition as well as expertise in its home market.  Like Deutsche Bank[6], another grandee facing tough choices, it can’t compete globally for investment banking business or sustain a global trading activity.

The hard truth is that, as a result of tough new regulations, banks need to hold more capital than before the 2007-2008 crisis, and even more so to engage in trading.  Lacking size and excess capital, Barclays should listen to Mr. Bramson and refocus its efforts.  PNC and Wells Fargo are successful examples of banks focused on servicing their retail and corporate clients without engaging in global trading.  In Europe, so is BNP.  Deutsche Bank itself has announced large cuts in headcount and a reduction in international investment banking and trading.

The following efficiency and valuation benchmarks offer a simple reality check:

Banks	Total Assets at 12/31/2017	Cost to Income Ratio in 2017	Current Price to Tangible NAV
Barclays	$1.1 trillion	73%	0.8
Standard Chartered	$664 billion	71%	0.8
HSBC	$2.5 trillion	61%	1.4
JM Morgan	$2.5 trillion	57%	2.1
Deutsche Bank	$1.8 trillion	90%	0.4

I think that, in the end, Barclays will be persuaded that Bramson’s recommendations are good for shareholders to whom management is, ultimately, accountable.  I also think that it will be a volatile ride as there will be cultural pushback by Lehman Brothers and JP Morgan alums, and changes at the board and executive levels are likely.

Where could the stock price settle, should Barclays reform itself successfully?  A well run bank should be valued at 1.5 times, or more, its common equity.  Right now, Barclays shares trade at a multiple of 0.67.  The potential is clear and the math is simple.

What is the downside?  At the current share price and with the announced dividend hike raising the yield to 3% p.a., it appears limited barring a major adverse macro-event.  Maybe 10%?

What if Mr. Bramson fails partially or totally?  He may hit a wall, or his campaign may be protracted and end up in failure.  The truth is that major shareholders are unhappy with the stock price; I can’t see management or the board chairman surviving unless the stock price converges towards book value.  That is a 25% to 49% improvement (whether tangible or nominal book value is used).

In the end, I can summarize my views about the possible stock outcomes of the Bramson campaign as follows:

Stock price appreciation	Probability	Expected appreciation
-10%	25%	(2.5%)
+20%	25%	+ 5.0%
+50%	25%	+12.5%
+70%	25%	+17.5%
		+32.5%

Assuming a 2 year horizon, the pre-tax IRR is 18% p.a.  It drops to 13% p.a. if the horizon is extended to 3 years.  I am long the stock.

Mr. Bramson has done the math and we wish him good luck.

May 24, 2018

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[1]  Barclays bought ING Direct UK from the ING Group in 2009 for an undisclosed consideration.

[2]   It retains a 14.7% stake in Barclays Africa Group.

[3]  Since 2008, banks have used tangible equity as a more conservative input to calculate market capitalization to book value ratios, as it excludes such items as goodwill and other intangibles.  It is however NOT conservative to compute return on capital as banks carry such intangibles in their books at a positive value.

[4]  Excluding certain “non-recurring” costs from restructuring and litigation.

[5]  In 2017, JPM’s Investment & Corporate unit earned $10.8 billion after-tax for a 14% GAAP return on equity and 44% of bank total.

[6]  Barclays is luckier than Deutsche Bank in that its home market is more rational.