Shrink to fit
The success of Barclays’ 5.8 billion pound capital increase leaves a big question unresolved – the size of the UK lender’s investment bank. The fundraising means Barclays’ equity will constitute 3 percent of its total assets by mid-2014, as regulators now require. But the new focus on so-called leverage ratios, as opposed to capital versus risk-weighted assets, jars with Chief Executive Antony Jenkins’ strategy.
Jenkins based February’s strategic revamp on a balance sheet that offered the best risk-weighted returns, offloading 62 billion pounds of the investment bank’s risk-weighted assets. When in June the UK regulator suddenly became focused on leverage ratios, Jenkins committed to shrink the balance sheet by up to 80 billion pounds of gross assets. The question is whether good returns can still be generated in the new, tougher capital world.
The strategy hasn’t been totally undermined. Barclays reckons return on equity will surpass cost of equity only one year later, in 2016. Yet the target is tougher than it looks, because the investment bank’s returns are feebler than they appear. The 15 percent first half ROE would drop below 10 percent if the investment banking arm had a 3 percent leverage ratio by itself, according to Reuters Breakingviews’ calculations.
Worse, pressure to curb gross leverage could intensify. Were regulators to insist on a 4 percent leverage ratio – as some are now starting to contemplate – an even bigger chunk of Barclays’ biggest business would not make its cost of equity.
Barclays could just about get to 4 percent without a humiliating second rights issue. Even if Jenkins only had until 2016, he could still stick to his commitment to pay out 40 percent of net income as dividends, according to Reuters Breakingviews’ calculations using Eikon SmartEstimates. But Barclays would have to issue 5 billion pounds more of expensive contingent convertible securities, exacerbating humdrum returns.
A better plan would be to further hack away at Barclays’ 1.48 trillion pound, investment bank-heavy, balance sheet. Offloading another 200 billion pounds of investment banking assets would get Barclays to a 4 percent leverage ratio on its own. Jenkins himself told analysts on July 30 that further deleveraging might be called for. Moreover, the reason Barclays shares trade below book value appears related to weak returns as well as capital. Shrinking the investment bank could kill two birds with one stone.