Barclays restructuring and the outlook of Investment Banking

Barclays Plc Market Cap (as of 09/05/14): £41.91bn

On May 8th, 2014 the CEO of Barclays Group, Antony Jenkins, presented a new restructuring plan of the London-based bank, stating that Barclays will be shifting its focus to areas where it has the capability, scale and competitive advantage over its competitors. Following in the footsteps of UBS, Credit Suisse and RBS, the British bank joined a recent movement of gradual pulling out from investment banking by dismissing about quarter of its IB staff and moving ca.£400bn of assets to a non-core, “bad bank” unit.

Restructuring Plan:
The initiation of the restructuring plan was directly related to the underperformance of the bank’s capital-intensive fixed income business, where revenues fell by as much as 40% in the first quarter of 2014. Given that FICC accounts for 71% of the total investment bank risk-weighted assets (RWAs), it greatly exposes the entire Group to volatility in a single low-performing area. As a result, reorganizing of the bank’s core operations and consequent employee lay-offs needed to take place. The total expected job reduction tally of the Group amounts to 14,000 employees for 2014. The most hurt business area is the Barclays Investment Bank where 7,000 employees (27.5% of its total staff) will be laid off over the next two years. The management expects such rescaling of the IB business to result in a 53% lower leverage exposure and a ca.£102bn reduction in RWAs over the next two years.
In order to improve its returns, Barclays intends to primarily focus on four core businesses: Personal and Corporate Banking, Barclaycard, Africa Banking and Investment Banking, which will continue concentrating on well-positioned UK and US markets while exiting those with tight regulations and lower returns. As the bank intends to shift the capital towards more conventional banking and growth businesses, it also created a Barclays Non-Core unit, popularly dubbed the “bad bank”, where ca.£115bn of its RWAs will be moved. The Non-Core unit will consist of assets not meeting ROE requirements, those non-fitted to the new bank perspective as well as capital-heavy assets. The latter will mainly be pulled from the Investment Banking division (ca.£90bn), while the rest will be derived from Europe Retail and to some extent Corporate, Barclaycard and Wealth RWAs. The restructuring will require additional expenditure of £800mm for investment bank reposition only, with the aim of reaching £1.7bn in cost cuts next year and another £0.7bn the year after. Core businesses are expected to maintain the average adjusted ROE of 12%+. The restructuring plan is summed up in the picture below:

Source: Barclays Company Data

Industry outlook:
Such bold restructuring raises a question: how is the Investment Banking sector going to evolve over the next few years?

In order to answer the question we first have to take into consideration a few facts that are affecting the banking sector as a whole. Firstly, banks are gaining much more visibility in the shape of regulation and over the next 12 to 24 months many of the remaining post-crisis rules will be finalised. In particular, banks need to respond to game-changing higher leverage caps which could be settled at 4 or 5%: higher than many European banks have assumed. This fact will inevitably force a tougher re-evaluation of where the balance sheet is deployed, having a particularly strong negative impact on the economics of Flow Rates and Credit, Corporate Lending, Repo and Prime. Importantly it also changes the economics of cross-subsidy models whereby cheap financing is used to support the sale of higher margin products, and the banks’ portfolio mix. Secondly, according to data provided by Oliver Wyman and Morgan Stanley Research Global, industry revenues will be characterised by a cyclical improvement in Equities and IBD being offset by another poor year in FICCA. Thirdly, client demand is changing rapidly, which is having a negative impact on margins given that clients are planning to polarise spending, paying partner banks and specialists, but squeezing the rest. Against this backdrop there remains over-competition in areas where banks have no competitive edge. Fourthly, the Balkanisation of banking markets will remain a key constraint. Despite clients seeming to value global capabilities both in content and in execution, it is becoming very clear that they do not need this characteristic from every bank. This implies that more banks will look to pull back and focus more squarely on their core business areas. Finally, new value is expected to be created outside the boundary of the wholesale banks as supply chains loosen and non-bank capital picks up a larger role (the so called Shadow Banking System). Oliver Wyman estimates that $20bn to $30bn of new capital will be created by this system, compared to current industry book value of ca. $400bn, due to the fact that with leverage constraints biting, non-bank forms of capital will be more active and a lot more competitive since these institutions do not bare any cost associated with tighter regulations.

The above discussed should not neglect the fact that banks have already done a lot to stay competitive, mostly by stripping out non-core operations. Unfortunately, it appears that there is more to be done. In fact, over the last four years about 20% of the industry capacity has been withdrawn through strategic decisions on participation and through the focus on reducing Basel III RWAs. However, the challenge now appears to be the optimisation of the core business. Banks will have to pull back another 6-8% of capacity while redeploying resources to the areas where client demand is growing and needs are unmet. According to this logic, the future of the sector should be characterised by a more varied structure, as banks reshape themselves following their strengths and financial resources rather than mimicking the market leaders.

Fixed Income, Equities & Corporate Banking prospects:
As our last point, we would like to examine the changes in three main business areas (Fixed Income, Equities and Corporate Banking) within the Investment Banking sector.

Firstly, we have to notice that Fixed Income is in the midst of a profound change that will define the future supply side structure. A weak revenue environment and a continued regulatory pressure have already created an urgent case for change. As already mentioned, the Rates/FX business looks particularly pressured due to the ghost of rising rates, leverage constrains and lack of liquidity in some secondary markets. On the other hand, some areas of Credit are under-served. Even though a range of business models are likely to remain viable, only a subset of banks is expected to generate attractive returns. These include banks with clear advantages, such as specialist execution and origination in less liquid markets, access to franchise clients, or depth in emerging markets.
Compared to Fixed Income, the prospects for Equities seem much brighter, with rising indices and growing revenue pools, despite the value delivered to the bottom line and the benefits of growth not being shared among participants. According to Morgan Stanley Research Global and Oliver Wyman the improving revenue environment in 2013 saw Equities returns move strongly positive and they forecast further growth over 2014 and 2015 period (Base Case: 5% -10% revenue growth in 2014 in global Equities). However, even the advantaged scale players need to rethink the cost and service model in light of changing regulation and more importantly of client expectations which appear to indicate that the quality of research is crucial.

Finally, the Corporate Banking franchise offers attractive top-line growth but, similar to Equity, this will only translate into strong returns for some. According to Oliver Wyman, “Over-supply, increased leverage, funding and capital-related costs will lead to below-hurdle returns for many banks. To improve returns, banks must define narrower corridors where they compete, streamline coverage and better integrate products and capabilities.” In particular, the sector is expecting corporates to be a core driver of top-line growth in the next 2-3 years. In fact, over the last 5 years, corporates have hoarded cash and now are finally in a better position to expand as the economic outlook improves, especially in Europe. This underscores the view of the positive growth prospects for corporate finance revenues. On the other side however, the growth outlook for debt and derivatives seems more tempered, primarily due to the rising cost of derivatives and strong debt issuance over recent years as a result of low interest rate environment.

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