Barclays: Valuation by analysis

We proposed that Barclays should be split into two separate banks - one focused on retail banking and the other on investment banking - in our 5 July Commentary. That presumed, of course, that the investment bank would be viable and able to fund itself on a stand-alone basis in today's challenging markets.

Here Bruce Packard, a well-known London-based independent banking analyst, argues that the real value in Barclays lies in its retail bank - which he reckons to be three times more profitable than the investment bank. He also takes issue with Barclays' claim that the investment bank generated a 10 percent ROE last year and concludes that the equity value of a bank that cannot fund itself is zero or even negative.

Earlier this year, Barclays management made a commitment to citizenship: “We have a clear sense of our business purpose – to help individuals, businesses and economies progress and grow”.

Like other banks Barclays also claims a focus on creating shareholder value. Yet it seems highly unlikely that the expansion drive of his global bank was motivated by either of these laudable goals; one might as well claim Alexander the Great's motive for marching to India was to serve the citizens of ancient Macedonia or that Napoleon had the interests of the Banque de France at heart when he invaded Russia. Joking apart, Bob Diamond did once claim that the raison d'etre for Barclays Capital was to serve sheep farmers in Wales.

With Barclays shares trading at below 200p, the share price is at a 50% discount to accounting book value. This suggests investors have become sceptical about the claims made by the former Chief Executive. In any other industry, research analysts would be suggesting that the way to create value for shareholders is for the bank to break up and so close the “conglomerate” discount. Indeed, the word “analysis” means "resolution of anything complex into simple elements”. Analysis is about taking things to pieces, in order to understand and value them. And yet despite banks, not just Barclays, trading at a substantial discount to the sum of their parts, very little self analysis goes on in the banking sector. This is probably because most analysts work at large US or European banks, and know that they are unlikely to win many friends if they suggest that breaking banks up into smaller, more easily managed parts would serve both customers and shareholders well.

Last year Barclays Investment Bank (formerly known as BarCap or Barclays Capital) reported a Return on Equity (RoE) of over 10 percent, seemingly more than the bank's cost of equity. With this 10 percent RoE it was more profitable than the group as a whole which reported an RoE of 7 percent for 2011. The more profitable a bank is the more it should be worth, and the divisions that reported higher levels of profitability ought to be the more valuable parts of the group. Surely the talented investment bankers working at Barclays can see this valuation discount, and could look to spin off the investment bank to create value for both themselves and shareholders?

But there are two ways of increasing profitability: one is to increase returns, the second is to reduce equity. Barclays' response to increasing competition and falling margins in global investment banking has been to magnify profits with mark to market accounting, and reduce equity as a proportion of total assets. Bank analysts and management should have been looking at trends in unleveraged returns, and on this basis the retail bank was more than 3 times more profitable than Barclays Capital (BarCap's pre-tax return on assets was less than 0.3 percent, versus 1.1 percent for the retail bank)

Barclays Investment Bank, with its £1 trillion of liabilities, could not fund itself on a stand alone basis without substantially increasing equity funding. Neither wholesale markets nor equity markets seem likely to provide this funding, without the backing of the group (and the implicit guarantee from UK taxpayers which supports the group.)

In the year before it needed rescuing by the Bank of England, Northern Rock's reported RoE was 24 percent and yet despite this high level of reported profitability the equity turned out to be worthless. Northern Rock shows us that, whatever the reported profitability is, the equity value of a bank that can't fund itself is zero or even negative. This is the real reason that investment bankers do not want to spin off from retail banks.