Barclays; Anyone See an Iceberg?

The hand wringing class warrior liberals, led by Rusty Cable and the Boy Clegg, joined by innumerable Tories who are torn by a deep seated sense of self need and corrosive envy of their contemporaries in the City cannot help but focus on "Bankers Bonuses."

As we have discussed here before, this is the wrong target for legislators and regulators to be aiming at. They need to be closely examining the origin of the "profits," on which the bonus payments are based. In fact, not much has changed since the crisis, which has thrown ordinary decent people into penury, and precious little has been done to stop a reoccurance of a bad thing happening. Some might say the system is even less robust now than before.

Not to worry though, I'm here to help them ask the right questions.

When I joined the City the compensation system was very simple. Everyone was paid a reasonable basic salary and in good years the bonus pool was distributed by partners. In bad years  the bonus pool was reduced or cut to zero. Typically, the partners went unpaid and perhaps, might have put something together to give the junior staff a modest lift. That culture is dead, gone and buried. Now, individuals are compensated come what may. Their inflated sense of self worth has long ceased to have any correlation to actual profitability.

Indeed, Barclays is a case in point. By their own internal measurements BarCap, (the investment bank), actually made a loss so why they are paying anything is something of a challenge for the enquiring mind. If though, you want one scary statistic to mull over then think about this. BarCap's Gross Notional Derivative Exposure is growing again, up 24% year on year to £48.8 trillion.................................

Our old friend and contributer, Bankvilgilante has been looking under the skirts of Barclays and is somewhat troubled:

"The Barclays stock price performance on results day, and YTD, reminds me of 2010. Surging upwards on rumours of "good" FY 2009 results and then well-crafted FY results that drag in momentum investors. And then a long slow slide as actual results for the year show up a far less rosy, less spun reality. This might well have applied to all Euro-banks in 2010 and is what may be occurring in 2011 for the sector again.

Barclays is not an attractive entity to own. Eighty (80%) of 2010 PBT was from BarCap, £4,780mn. And this is more or less normal situation at Barclays Group these days. Some very high loan losses from something called "Barclays Corporate" led to that unit showing a negative PBT of £631mn and possibly inflated the BarCap relative contribution to group profits, but not by much.

The "Corporate" loan losses came from what was once the Spanish unit inside what was once "Global Retail and Commercial Banking". It's not easy to keep up with the constant re-shuffling of operating units at Barclays, itself a bad sign from any company, especially a bank. What the heavy losses in that unit illustrate is that non-organic, non-BarCap growth at Barclays is very challenging and not such a priority anymore.  There were also losses in Western European Retail, falling Pre-Provision Profits in UK Retail (8% down), flat profits in Barclaycard (quite recently a major growth story) and in ABSA (a recent, expensive acquisition).

So Barlcays is BarCap, and BarCap is Barclays. Mysteriously BarCap has 80% of the PBT but only 35% of the "economic capital". This ratio doesn't seem right, but then the head of BarCap is now officially running the bank and all the best paid, best brained, people are in BarCap. Those BarCap guys effectively run the capital allocation and it is no surprise it massively favours them. Thus, BarCap is the growth pole inside the group as it shows the best return on economic capital, by far.

It's just that no one should want to own Barclays as BarCap's real, market-tested, economic capital would be 2x or more what it gets allocated internally, and the cost of that capital  (COE) would be above the group's own 12% COE calculation. BarCap returns would then be below the COE and,logically, it should shrink severely. Barclays itself showed an "economic loss" for 2010 of £2,488mn an increase from the 2009 "economic loss" of £1,890mn. The loss is calculated by deducting a capital charge at a 12.5% COE from net profits. More "losses" going forward would be a problem, surely, for the group. However, the new CEO, approved by the FD and the Board, is going to lower the COE to 11% in 2011 and 10% in 2012.

This should help.

I note that that old bugbear of mine, the Gross Notional Derivatives volume is growing again, up 24% YoY to £48.8tn (yes, trilliion). Obviously this is not a risk, according to banks, as the positive replacement values (the asset) are just £420bn  and the negative replacement values (the liability) a handy £15bn lower at £405bn. The accumulated, unrealised gain (sorry, positive balance) on derivatives, was up by £1.5bn in 2010. These derivatives are mostly interest-rate derivatives. The £420bn assets is subject to bilateral "counterparty netting" that reduces the net exposure to £80bn, and £37bn of collateral is held for the gap, leaving £43bn of "net exposure less collateral" according to Barclays. There are many risks in all this: the valuation of the gross notional derivatives to get the replacement values only a small minority of the contracts are traded on exchanges or even centrally-cleared; the quality of the counterparty netting, especially its legal enforceability across subsidiaries and jurisdictions in the event of a group-wide default; the quality of the collateral.

In my view, Barclays is operating in something of a fantasy-land, egged on by brokers at similarly structured investment banks and seemingly unconstrained by the regulators. However, market reality does eventually assert itself as all the investment banks compete hard with each other, driving returns down, leading to higher (largely hidden) gearing, and much volatility in results. They can't help themselves while they are able to arbitrage the benefits of sitting in (on?) a core Too-Big-To-Fail retail bank."

Icebergs Ahead?