The silver lining for Barclays shareholders in Libor-gate


Euromoney Skew, Sid Verma
Published on:

The Libor scandal is unlikely to dent the group's earnings and could add impetus to chief executive Bob Diamond's belated cost-cutting drive.

What now for besieged equity holders in Barclays?

Last week’s free-fall in Barclays stock, after the Libor scandal, triggered a flurry of broker notes with buy recommendations on the FTSE-listed shares, citing manageable litigation costs and attractive valuations. Although the stock surged 5% on Monday open, in response to Marcus Agius’s decision to resign as chairman, it’s still trading at an estimated price to net asset value ratio of 0.41 for the 2012 fiscal year.

Brokers had expected a positive re-rating of the bank subsequent to its first-quarter results when it announced profit before tax of £2.4bn, a 22% year-on-year increase, driven by stronger-than-expected performance in its UK retail unit and corporate banking franchise. But the intensification of the eurozone crisis and the recent Libor scandal have dragged shares lower.

Nevertheless, analysts are keen to point out that the £290m fine to settle regulatory investigations into the manipulation of Libor barely represents a headwind for earnings.

In Investec’s words in a note published on Monday: 

Around one-third of this fine was actually provisioned in Q1 2012, with the balance to be taken in Q2. Analyst speculation in relation to the scale of potential litigation risk (in our view) considerably overstates the hit to Barclays. As things stand it is unclear whether Barclays “successfully” manipulated LIBOR rates at all, and to the extent that LIBOR rates were manipulated, all available evidence suggests that culpability will be shared, and the scale of "achieved" manipulation comparatively modest.

In short, once markets wake up to the prospect of industry-wide litigation, Barclays’s shares should outperform. More profoundly, the group is in the black but it faces two strategic challenges: the need to build up its capital cushion while generating a decent return on equity above the cost of capital.

In this respect, the Libor scandal should serve to reinforce the urgency of Bob Diamond’s cost-cutting mission, reckons the broker. 

Meanwhile, on fundamentals, we re-iterate our view that a more radical
programme of cost reduction within Barcap is required. In contrast to Bob’s view
as stated on 26 April, we do not believe that a Barcap cost:income ratio of 63% in
a seasonally strong Q1 is consistent with delivery of a full-year result within
Barcap’s targeted range of 60-65%. Ironically, the backlash over the LIBOR
scandal may yet usefully exert fresh pressure over pay excess in that division.

The Libor scandal is just one issue in a long lists of complaints for shareholders. As this Société Générale chart lays bare, Barclays Capital has a higher compensation-to-revenue ratio than most of its peers, which makes it one of the few banks where the burden of deferred compensation is rising, while its awarded compensation is higher than reported:

In other words, Barclays’ pitiful adjusted return on equity in the 2011 fiscal year at 6.6% - compared with a 11.5% cost of capital - from 6.8% a year earlier flies in the face of the 13% ROE target, which should have prompted a dramatic reduction in its cost base. The hope is that the Libor scandal will add impetus to a cost-cutting drive.

Seperately, in the near-term, analysts are relatively optimistic that Barclays can weather new oncoming headwinds: the investigation into the mis-selling of swaps to small businesses and continued dysfunction in peripheral Europe.

Again in Investec’s view: 

In other developments, the (surprising) news that Barclays assesses no material
impact (in group terms) from the interest rate swap mis-selling investigation is a
source of relief. Confirmation of a softening of regulatory requirements in terms of
liquidity buffers should prove incrementally positive to income, while detail on the
promise of fresh cheap central bank funding to promote lending is still awaited.

In its first-quarter results, Barclays reported a liquidity pool of £173bn, of which 90% is held on deposit with central banks and highly liquid government securities. It reduced exposure to peripheral Europe and used the long-term refinancing operation (LTRO) to ease its euro funding gaps in Spain and Portugal. These actions have created the impression that investors should take a relatively-more constructive view of the lender in the near-term compared with continental European banks and some of its global investment banking peers, brokers conclude.

But with awful return on equity prospects, calls for Diamond’s head, reputational damage from recent scandals, uncertainty over the cost of ongoing investigations, not to mention the fact that few see financials as an investable asset class in the current market climate, investors have a non-trivial number of reasons to snub the stock.