Barclays ( BCS ) is defending its business model as the British government assesses the proposed reforms recommended by the Independent Commission on Banking (ICB) in Britain. The ICB which was headed by Sir John Vickers, a former chief economist at the Bank of England, has suggested that investment banks should be separated from retail banks. If implemented, these changes would certainly impact The Royal Bank of Scotland Group ( RBS ), HSBC ( HBC ) and Standard Chartered Bank ( STAN ).
Interestingly, competitors like Citigroup ( C ), Bank of America (BAC), UBS (UBS) and JPMorgan Chase (JPM) which are headquartered outside the UK, but have significant presence in the country would be spared the axe.
Our price estimate for Barclays stands at $18.30 , a roughly 8% discount to market price.
The ICB and its Findings
The coalition government in the UK entrusted the 5-member ICB with the task of understanding how stable and competitive the financial system is in the UK. The ICB was also charged with the responsibility for suggesting how to handle banks that were "too big to fall".
The biggest suggestion by the ICB was to break-up large banks and separate their investment banking and retail banking divisions. This suggestion was on the back of the government having to bailout RBS and Lloyds and use taxpayer money during the economic crisis. The bailout was essential as the top six British banks handle about 90% of all deposits, and with no restrictions on the use of assets in retail deposits by investment banking arms, banks were transferring their investment risks even to customers having simple savings accounts.
Understanding the Impact on Banks
The potential reforms recommended by the ICB would force the retail and investment banking divisions of the major banks in UK to have different capital structures termed as "subsidiarisation". A report by the management consulting firm Oliver Wyman suggested that banks will consequently have to face significant costs due to the difficulty in moving capital across their divisions and would have to arrange for different sources of funds for the newly separated divisions. This could result in additional annual "frictional" cost between GBP 12 and 15 billion ($20 to 25 billion) for the banks.
So How Could this Impact Barclays?
The frictional costs would directly affect the operating margins for both of Barclays biggest sources of value - the sales and trading division, and the consumer banking division. The operating margin for Barclays' sales and trading division was almost 35% in 2010, and we expected the value to be maintained in the years to come. But frictional costs could bring this margin below 25%, wiping out almost 15% of the estimated value of the stock.
The consumer banking margins would be affected to a lower extent, but could potentially fall by about 5% from our current estimates of 18%. This would eat up another 5% of the stocks value.
The imposed reform has the potential to reduce Barclays' value by more than 20%, bringing our estimates down from the current value of $18.30 to around $14.50.