British banks like Barclays have destroyed shareholder value like no one else in recent years. Now they face the risk of Brexit. So why are the big boys piling in?
Always follow the money…
When a massive $24 billion New York hedge fund like Tiger Global takes a 2.5 percent stake in Britain’s oldest high street bank we should take note. Last Monday we learned that the fund has quietly invested over $1 billion (£700 million) in Barclays Bank PLC (LON:BARC) which has the distinction of being one of the worst performers on the London market over recent years. Consider that five years ago, at the beginning of 2013, Barclays’ shares were trading at around 300 pence but that by mid-July last year they were down to 140 pence. This morning the share price is back to around 210 pence – though still well below the estimated book value per share of 260 pence.
Part of the negative sentiment against Barclays has been the unfinished business arising from past misdemeanours. Unlike its European peers who have settled outstanding fines imposed principally by the US Department of Justice, Barclays has refused to pay a multi-billion dollar fine for allegedly mis-selling junk mortgage-backed securities before the Credit Crunch of 2008. Instead, they have held out for a better deal. As a result, the bank has been unable to increase dividend payments appropriately.
Then there is uncertainty about the bank’s senior management. Jes Staley, the American CEO is still under investigation by regulators over his treatment of an alleged whistle-blower. Mr Staley was formerly the CEO of JP Morgan’s investment bank and would not be easy to replace.
That said, analysts reckon that the bank is sound. Having disposed of businesses in Africa, France, Italy and elsewhere, Barclays has built up its capital levels to well above the required level (under the Basel framework) of 12 percent. Mr Staley’s strategy is apparently to focus on Barclays’ UK retail banking operation and its US investment banking operation. Barclays Capital became a major player in the US when the British bank bought the rump of the collapsed Lehman Brothers on favourable terms back in 2008. The US operation is likely to be a beneficiary of President Trump’s cuts in corporate taxes. Moreover, the US banking sector is profiting from incremental increases in US interest rates.
The share purchase now makes Tiger Global one of the top ten investors in Barclays. It is reported that Tiger started buying in late November when Barclays’ shares were trading at around the 180 pence mark[i] – so they have already booked a possible 16.5 percent profit. If Barclays’ full-year figures, due out next month, are beyond analysts’ expectations that could be the catalyst for the bank to announce a rise in dividends. That would no doubt stimulate the share price further.
But I suspect that the timing of Tiger Global’s move also reflects the fact that large financial institutions are getting more sanguine about the prospects for British banks post-Brexit.
Brexit & the City
Since the Brexit referendum in June 2016 – and even before – many bankers in the Square Mile have expressed fears that Brexit would require that they radically re-engineer their European business models. Many have already made contingences for a so-called Hard Brexit by the terms of which banks based in London could not offer a full range of financial services to European customers.
The main fear is that passporting rights will be lost. Under the current dispensation banks based in London, which are regulated in the UK by the Bank of England (or technically by its Prudential Regulation department), have pan-European access to their customers without having to be supervised by European-level bank regulators such as the European Banking Authority (EBA), which has overall responsibility for bank regulation within the Eurozone.
In point of fact the regulatory regimes imposed by the Bank of England and the EBA are very similar. In fact, since the Credit Crunch, the Bank of England has been more stringent in terms of capital adequacy and bank liquidity risk management than its European counterparts. So the Europeans, objectively, have little reason to fear that British banks will run amok if unsupervised by them.
If Barclays’ full-year figures, due out next month, are beyond analysts’ expectations that could be the catalyst for the bank to announce a rise in dividends.
In a rational world it would be easy to imagine that both sides could recognise each other’s regulatory regimes and standards – and that is, it seems, what the UK government aspires to in seeking a formal recognition of equivalence. In many ways this would be an improvement on the current dispensation. The Bank of England regulates not just a large domestic banking sector but the world’s major financial centre as well. As such it has been obliged to develop and apply the most sophisticated standards relating to every conceivable type of financial product.
Of course, the EU could play hardball and refuse to concede equivalence. We know – because Monsieur Macron and others have told us – that the French regard Brexit as a Heaven-sent opportunity to grab as much of London’s business as they possibly can and to take it to La Défense. The French President, during his London summit with Mrs May last week made the stunningly banal observation that either you are in the Single Market – with all that that entails – or you are not.
Yesterday (25 January), Bruno Le Maire, the French finance minister, said in Davos that Britain’s insistence on a final accord with favoured status for the City of London is a complete delusion. He told the Daily Telegraph: “It is a dead end. I told Philip Hammond very clearly that Britain cannot have a pick and choose model,”[ii].
But there is one very good reason why, at the end of the day, the Europeans may ultimately concede on equivalence. That is that, without it, they would reduce the capacity of European companies and governments to raise finance in the London market which is by most metrics the largest and deepest capital market in the world.
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Most European entities could probably raise finance in their domestic markets – but it would be more costly and more time-consuming. Financial services across the EU – be they pensions management, bond underwriting or insurance – are generally more expensive in Paris, Zurich or Frankfurt than in London by virtue of the local ecosystem prevailing and economies of scale.
Last May, when the Brexit talks were about to begin, European hardliners mooted that the EU could curtail the clearing of euro-denominated trades in London post-Brexit. Xavier Rolet, the CEO of the London Stock Exchange (a Frenchman), warned that that could cost European market participants an extra €100 billion in transaction costs over five years. Furthermore, he said, it would increase levels of systemic risk within the European financial system by making it more difficult to hedge risk.
The City processes about three-quarters of Euro-denominated derivatives. Most of such business flows through the London Clearing House which is itself owned by London Stock Exchange Group PLC (LON:LSE). Financial institutions tend to clear all currencies in one place to reduce transaction costs and London is the global centre for currency settlement.
If a satisfactory deal on financial services is not concluded then certainly both sides will suffer.
The worst case scenario
A lot is talked about the dangers to the City posed by Brexit but few people actually offer any hard numbers.
According the EU’s own figures, traditional retail and commercial banking activities account for about 55 percent of UK banking revenues. Those activities are mainly domestic, with only a marginal share of the business operated cross-border. The European Commission estimates that for credit cards, mortgages and current accounts, less than three percent of consumers have already purchased such banking services from another Member State, and that cross-border loans account for less than one percent of household loans in the Eurozone.
Therefore, the main interactions between the UK and the EU-27 in retail services occur through branches or subsidiaries of EU banks in the UK or, conversely, through branches or subsidiaries of UK banks in the EU-27. The retail and commercial activities of EU branches in the UK is somewhat limited (their total assets amount to just €260 billion or three percent of total banking assets in the UK).
UK banks operate in other Member States through branches (principally those of Royal Bank of Scotland (LON:RBS), Barclays and HSBC (LON:HSBA)) or subsidiaries. Open Europe estimates that less than 10 percent of their global revenues originate from the EU-27. Since this figure doesn’t refer to retail business activities but also encompasses wholesale activities, the share of revenues generated only by retail and commercial banking in the EU-27 remains very limited in UK banks’ global revenues[iii].
So, to put this in plain English: the loss of passporting rights by British banks, while unwelcome, would not be a disaster for British banks.
The mote in thine own eye
In any case, if anything, it is the Eurozone that needs tighter regulation, not London. As I explained during the referendum campaign, since the European sovereign debt crisis of 2010-13, the costs of numerous bail-outs have been shifted onto the books of the European Central Bank, the Bundesbank and the spider’s web of stability mechanisms (i.e. special purpose loan funds) which have effectively become bad banks where non-performing assets can be bunkered without being written down (or written off). Not to mention that under the TARGET2 payments system operated by the European Central Bank, Germany’s balance of payments surplus with the rest of the Eurozone is financed not by the transfer of foreign exchange reserves nor gold to Germany, but rather by an ever more gargantuan unsecured overdraft facility granted by the Bundesbank to the other national banks!
If anything, it is the Eurozone that needs tighter regulation, not London.
Financial regulatory divergence between the UK and the Eurozone has been driven by the fact that, back in the 1990s with the Treaty of Maastricht and all that, the core European states decided to form a currency union from which Britain – for perfectly good reasons – demurred. To “exit from Brexit” and to remain in the EU now would entail that we join the Eurozone and subject ourselves to the European Ministry of Finance that Monsieur Macron is planning (not forgetting the European Army) – and thus to, eventually, a United States of Europe.
But can you find a Remain-inclined politician who is honest enough to admit that?
Bankers’ bonuses: to cap, or not to cap?
At the end of November last year the consistently Remain-inclined Governor of the Bank of England, Mr Carney, came up for air to say that at least, post-Brexit, Britain would be able to ditch the much resented bonus cap.
The bonus cap was another token response by Brussels to the Financial Crisis which has little to do with judicious governance. No one denies that pre-Crisis bonuses were obnoxious and often incentivised additional risk-taking. But there is no evidence that the cap imposed by the 2015 Capital Markets Directive which outlawed bonuses of more than 200 percent of base salary has, of itself, made bankers more risk-averse. Rather, new attitudes to compensation have done so. For example, compliance officers and bank risk managers now sit in on high-level remuneration meetings.
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Moreover, banks now have clauses in employment contracts whereby bonuses must be reduced if there is any evidence of poor risk management. Bonuses can be clawed back if the profits that inspire them prove to have been illusory. In London such claw-backs can be applied for up to ten years – longer than in the Eurozone.
The point, once again, is not that we should de-regulate the banking system post-Brexit; rather it is that our regulations should be modelled in accordance with local conditions. Unlike most European financial centres, London competes directly in, for example, securities trading with New York, Singapore and Tokyo. Traders are mobile. London banks should not therefore be subject to unnecessary restrictions on their compensation policy.
Brexodus? You must be joking!
According to a report by the City of London Corporation (the local authority for the Square Mile) issued in mid-January, the scale of job losses in the City of London is likely to be less than they had feared. The organisation’s special representative to the EU, Jeremy Browne[iv], said:
“Relocations as a result of Brexit may end up being a bit less dramatic than it might have initially appeared. I don’t think companies are saying ‘Shall we abandon London?’ The City will remain the key international financial centre for Europe. We are looking at somewhere between 5,000 to 13,000 movements for Brexit day one from among the 1.1 million people employed in the financial sector across the UK.”[v]
His estimate is much less than that of Oliver Wyman, the consultancy firm hired by the industry body TheCityUK which said it expected job losses could be as high as 75,000. That figure was based on there being a Hard Brexit, which could involve quitting the EU with no deal in place and no transition period. Since the report from Oliver Wyman was published, the UK government has concluded Phase I of the Brexit negotiations before Christmas and a transitional period up to the end of 2020 looks highly probable.
His comments came as John Cryan, the British-born CEO of Deutsche Bank (ETR:DBK), said the number of jobs his firm will move out of London as a result of Brexit will be in the hundreds, rather than thousands. Let it be noted that Mr Cryan had previously predicted that Deutsche Bank’s 97,000 headcount will be grievously reduced (possibly halved) in Germany thanks to automation[vi].
But yesterday the BBC tracked down Jamie Dimon, CEO of JP Morgan Chase & Co. (NYSE:JPM) at Davos who told them that “more than 4,000” jobs could be moved from London to Europe if the negotiations go badly. This contradicts what JP Morgan’s investment bank boss, Daniel Pinto, said recently. But then, Mr Dimon had spent last Monday schmoozing at President Macron’s Choose France love-in with 140 global leaders at the Palace of Versailles…
Those 4,000 job losses – in the unlikely event that they occur – will be easily replaced by the current recruitment drive in the City for specialists in blockchain technology and cryptocurrencies. Not to mention traders of Indian and Chinese securities.
British banks may have turned the corner
I am afraid that I have been rather bearish about banks in general in these pages over the last two years. I have speculated that banks as we know them will probably not exist in 25 years’ time given the advent of fintech. Digital technology makes intermediation over the internet so much more feasible (be it funding or dating). The portion of the financial services in the economy has been declining since the Financial Crisis. (A good thing too.) Banks have been held back by ultra-low interest rates which are likely to persist for the foreseeable future.
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On the plus side, British banks have all re-built their capital buffers and have significant liquidity reserves. Admittedly, their profits are well down. According to Investopedia the return on equity for banks in the first half of 2017 was 9.75 percent. That is dramatically down on the days before the Crash when Lehman Brothers had a pre-tax target of 35 plus percent – a target that will probably never recur, even if it were permitted. But 9.75% ROE is well above cement and aggregates – and many other sectors too.
I suspect that Tiger Global has made a very clever call on Barclays.
[i] See: https://www.ft.com/content/e768ce1e-fd54-11e7-9b32-d7d59aace167
[ii] See: http://www.telegraph.co.uk/business/2018/01/25/davos-exposes-growing-cracks-eu-unity-brexit/
[iii] See: European Parliament Briefing Note – Brexit: the United Kingdom and EU Financial Services, 2016, available at: http://www.europarl.europa.eu/RegData/etudes/BRIE/2016/587384/IPOL_BRI%282016%29587384_EN.pdf
[iv] Mr Browne is a former Liberal Democrat MP and was a minister in the Foreign Office between 2010 and 2012, and later a minister at the Home Office.
[v] See: https://www.ftadviser.com/investments/2018/01/15/city-predicts-job-losses-due-to-brexit-overstated/
[vi] See: https://www.ft.com/content/e7844048-c3e5-11e7-a1d2-6786f39ef675