Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 13 February 2013

Barclays Makeover And Returns From Banking


Antony Jenkins, the new CEO of Barclays, looks set to close the chapter started by Bob Diamond. He’s the latest to embrace cuddly capitalism, the new fashion in finance brought on by the current environment of regulatory scrutiny. However despite the 8% rally in Barclays’s stock, whether fuzzy objectives and good intentions will ultimately benefit shareholders remains open to question. The principal-agent problem which bedevils all public companies is probably more acute for financial institutions. As Adam Smith highlighted more than two centuries ago:

The trade of a joint-stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of these proprietors seldom pretend to understand any thing of the business of the company; and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half yearly or yearly dividend as the directors think proper to make to them. This total exemption front trouble and front risk, beyond a limited sum, encourages many people to become adventurers in joint-stock companies, who would, upon no account, hazard their fortunes in any private copartnery...The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own... Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

It is instructive to remember that investment banks were partnerships run for the benefit of partners and employees (forget the chicanery during the roaring 20s, even in regulated 1955 people were wondering ‘Where Are the Customers' Yachts?'). This didn’t change when Bear Stearns and Salomon Brothers heralded the age of immense profit by separating ‘adventurers’ from their money. Even astute investors like Warren Buffett were forced to pay for some free lunches.

Hence the popular perception that investment banks are largely run for the benefit of employees. This seems correct if one looks at the accounts and employee costs in relation to profit and dividends during the 7 year boom-bust-recovery cycle of 2005-11. Employee compensation took precedence at Goldman Sachs, arguably the top investment bank over the last decade and Barclays, the vehicle for Bob Diamond’s Icarusian ambitions. Over the period, Goldman’s employee compensation costs were 1.3 times pre-tax earnings and a whopping 22.5 times distributed dividends. The numbers for Barclays were 1.5 and 6.8 respectively. In comparison the poster child of UK banking and national champion by default, HSBC paid employees only 1.1 times profit before taxes (PBT) and 2.4 times dividends. This compares quite favourably with Centrica, a primarily UK-based gas and electricity utility (Table-1). 
 
Table-1: Investment banking is lucrative but maybe not for the shareholder
Period: 2005-2011
Compensation / PBT
Compensation / Ordinary Dividends
Dividend / PBT
Goldman Sachs
1.28
22.45
5.7%
Barclays
1.52
6.81
22.3%
HSBC
1.09
2.44
44.9%
Centrica
1.07
2.74
39.1%
Source: Annual reports, Author’s calculations


At this stage, investment banking proponents will point out that dividends are only a small part of the total return earned by shareholders. Unfortunately this doesn’t help either as Table-2 shows. Shareholders in Goldman Sachs lost 1.5% per annum including dividends through the cycle from 2005 to 2011. It is no wonder that Barclays shareholders are irate as they lost 6% per annum in the same period (‘only’ 2.8% if 2012 is counted). Despite adopting utility-like payouts, HSBC could not escape the investment banking maelstrom and returned only 1.8% between 2005 and 2011. Compared to such abysmal returns Centrica returned 9.4%.

Table 2: If only bank shareholders made utility-like returns

Share price
(Start of 2005)
Share price (End of 2011)
Dividends (2005-11)
Return @ 2% discounting
Barclays (£)
440.77
171.48
134.85
-5.99%
HSBC (£)
581.99
465.22
276.11
1.78%
Goldman Sachs ($)
95.81
88.96
9.42
-1.51%
Centrica (£)
169.08
275.55
84.77
9.44%
NB:
  1. Given 2012 annual results are yet to be announced for all but Barclays, the chosen period runs until 2011.
  2. Discount rate chosen is close to inflation to get an idea of real return
Source: Yahoo Finance

It was good while it lasted but now unfortunately investment banking is feeling the wrath of regulators, policymakers and the general public who are suffering from selective amnesia about their role in the boom and consequent bust. Like Captain Renault in Casablanca, they are shocked to find gambling going on in banks. Therefore they want to clamp down on “casino banking” and promote a more staid and antediluvian image where banks are like utilities, prospecting for funds from those who have them and supplying to those who need them.

The only problem with utility-like banking is that it doesn’t exist. The critical difference between utilities and banks is in how they satisfy the demand for their product, be it gas, electricity, water or funds. For utilities, irrespective of demand, they can only supply upto a maximum physical limit and cannot conjure up water, electricity or gas out of thin air. However, banks on the other hand can and do conjure up loans from thin air to satisfy demand. As long as loans are profitable and made to people the bank deems creditworthy, it can create loans irrespective of its deposit base by borrowing in the market for funds (Note: The ‘reserve constrained’ banking theory of ECON101 is not applicable to reality). This is what leads to periodic banking crises when rosy expectations are belied and loans go sour. History shows that investment banking or the lack of it doesn't make much of a difference to this cycle.

However as an investor, one needs to adhere to current fashion rather than sermonise about what ought to be. In any case, disemboweling investment banks through regulation as the price for engendering moral hazard is probably an improvement for the shareholder. However, how much of an improvement is debatable in the current low-yield environment of ultra-easy monetary policy. Staid retail banks struggle in a deflationary environment as net interest margins fall and economic distress leads to higher NPLs. Moreover, a chase for low-quality assets to raise yield income usually ends badly. An inflationary environment is even worse as it submerges the large stock of fixed income assets on the balance sheet. The only environment conducive for banking returns is non-inflationary, consistently expansionary (NICE). Unfortunately the NICE years are over with the advent of the ‘new normal’ and banking no longer promises high returns. This is true both for the shareholder as well as the employee.

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