Absurd Bank Profits: Barclays Edition

Barclays Bank, the almost buyer of Lehman back in the depths of the crisis – the UK government vetoed the proposed acquisition – just reported that it made an $18 billion profit in the fourth quarter. That’s a stunning turn around for a bank that was in the same boat as all the other major global banks just a year earlier.

Already idiots in the financial press, the banking industry’s regular cheering section, are touting the profit as a great example of why the so-called Volcker rule would be harmful. The point being that a majority of the Barclays profit came from investment banking not commercial banking. Apparently this is indisputable proof that the big banks ‘need’ to be behemoths with both proprietary and customer trading, and both investment and commercial banking operations.

Naturally it proves no such thing.

The fact that Barclays made so much money on its investment banking and trading activities merely highlights the difficulties that still dog commercial banking. The lending that Barclays does to the real economy by way of business and personal loans will most likely languish near zero profit for a few more quarters as loan losses rise and the inevitable cleaning out of rotten portfolios continues. This is totally normal: bank profits sometimes lag the economy as it takes a while for borrowers to default, and then for the bank to write the loan off completely. Some of these losses will be recouped later on as the bank seizes collateralized assets and then sells them off, so today’s losses are mitigated by tomorrow’s recoveries. Commercial banking traditionally follows credit cycles such as this, so there is really no news in the troubles Barclays may be experiencing in its commercial operations.

And, as we all know, this credit cycle is a highly exaggerated one.

Why was that?

This is where the big bank apologists go off the rails: the cycle is askew because of all that trading and securitization the big banks did. The economy is in the throes of a deep crisis still because the banks put it there. So to claim that the big banks ‘need’ trading profits to alleviate losses from their lending to the real economy is like saying an arsonist needs matches to light a fire to stay warm after having burned the house down.

It is special pleading run amok.

The fact of the matter is that the Volcker rule, along with other draconian re-regulation, is designed to eliminate the banking industry as a source of macroeconomic volatility.

But there is a better argument against the big banks. One based on pure text book finance.

The shareholders of Barclays own two [or more] banks in one. A commercial bank that has long, slow, and relatively shallow credit and profit cycles; and a trading/investment bank, that has shorter and more volatile cycles with higher peaks and lower troughs. The problem from a corporate valuation point of view is that the two muddy the ability of shareholders to identify a proper long term value for the company as a whole. The share value of the investment bank should be based on its own risk/return capability separate from that of the commercial bank. The long term stock prices and P/E ratios should be very different, and appeal to very different investors. Those looking for a lower, but safer, return should be invested in the commercial bank. Those looking for a higher, but riskier, return should be invested in the trading bank. By mixing the two cash flows into one, the management of Barclays has masked, and diluted, the true value of each, leaving current shareholders deprived of an ability to mix and match their own risk/return requirements.

This is the familiar problem with all corporate take overs and the conglomerates that they produce. Large companies that span several businesses – Barclays is a good example, but Citibank is an even better one – destroy shareholder value routinely by making it difficult to value each activity separately. The sum of the parts, if valued separately, would inevitably be more than the whole. So the logical answer is to break up the company and release that value.

This will not happen.

The reason is that management has an inbuilt bias towards empire building. Bigger companies tend to pay bigger salaries and bonuses. There is more prestige in running a Fortune 100 company, and the career track for managers is far more exciting in an organization that makes acquisitions as a form of ‘growth’. The interesting fact is that all the studies I am aware of tell the same story: acquisitions destroy shareholder value. This is because, in order to make the deal, an acquiring company pays a premium to the target company’s shareholders. This premium is justified to existing shareholders of the acquiring company by appeals to the economies of scale and efficiencies that the acquirer is said to be able to wring from the combined company. Most often those economies turn out to be over estimated or totally specious. The premium is never earned back and the shareholders are left with an economic loss.

How do companies get away with this?

Two methods:

Their boards of directors are populated by like minded executives who see the same opportunity for personal aggrandizement in their own situations. So they naturally support management’s rosy estimates. Plus, as is the case in Barclays, managers make later claims about the way in which profits from one business ‘protected’ the losses in other businesses. This cross subsidy of one business is said to justify the diversification managers advocate.

Strict, and conservative, financial analysis contradicts this cross subsidy argument. Managers are advocating that their company is a ‘portfolio’ of cash flows, the sum value of which is greater than that of the parts. Cross subsidy, cross selling and economies of scale are all arguments presented to defend this agglomeration strategy. The counter attack is this: why not simply allow the shareholders to decide how to construct the portfolio? Let managers concentrate on extracting maximum value from each business rather than wasting time in managing a portfolio. The advantages are those I have mentioned already: it is much easier to value a vertical business than a conglomerate, so the share price/value of a vertical, stand alone, business will tend to be higher through time than that of the same business embedded inside a conglomerate. Plus the managers of a vertical business will be more adept at its management: they won’t be wasting time on issues and problems outside their skill set.

Naturally the discussion gets clouded by the possibility that an industry gets so dominated by conglomerates that society as a whole suffers, not just the shareholders. This is exactly where banking has arrived. Now the situation changes. In cases such as modern banking the shareholders tolerate their lost value because the managers of the conglomerates can extract oligopolistic profits from customers – this is what I have mentioned before as ‘rent seeking’. An example of which is Goldman’s absurd bonus policy. The employees of Goldman extract rents from society by rigging and dominating specialized markets, and by using ‘insider’ information to make bets against the assets of their own customers – they short assets they just sold, or they take positions in markets based upon information they gather from customers in other markets. This generates above normal profits for the company which enables the employees to pay themselves huge bonuses while still buying the acquiescence of their shareholders. The cost of rent seeking is transferred from the shareholders alone and spread to society as well.

So banks like Barclays and Goldman are doubly offensive to text book capitalism.Which mean that the defenders of Barclays are barking up the wrong tree.

The break up of the big banks is not just an argument based upon the fear that they could destroy the economy at any moment – although that remains a potent argument as well. The really strong point against them is a purely capitalistic one: the shareholders would be much better off. Plus we would all benefit from the destruction of rent seeking profit accumulation.

All of which is a long winded way of saying that the defenders of Barclays are totally wrong.

But you all knew that anyway didn’t you.