A Hobson's choice is defined in the Cambridge Dictionaries Online as:
A situation in which it seems that you can choose between different things or actions, but there is really only one thing that you can take or do
Barclays' (NYSE:BCS) CEO found himself in a classic Hobson's Choice scenario - while it appears like he had real strategic options, in reality, there was only one thing he could do.
Evidently, most of the analysts covering the stock completely miss the point - which is somewhat of a concern, as these guys probably drive much of the stock action.
In this article, I will explain why the strategic path Mr Staley chose is really the only logical choice - in fact, I reveal what is really going on at Barclays.
Recapping Barclays recent strategic announcements
There were two inter-related key strategic decisions made:
- Sell Barclays Africa in an economically rational manner over 2 to 3 years.
- Maintain the under-performing Investment Bank at approximately same size.
The market was surprised with both decisions - many analysts expected the shrinking or sell-off the investment bank. Others were puzzled by the sacrifice of the perceived growth option of Barclays Africa.
Following the release of the earnings and strategy update - the stock got hammered and was down 10% at one juncture.
What is the real story?
The analysts are right factually - Barclays investment bank is a perennial under-performer which currently does not earn its cost of capital. In fact, in 2015 the IB earned mid single digit ROTCE which is well below its cost of capital which is estimated at 10%.
In other words, the IB is currently destroying capital.
Should Barclays reduce the IB size further?
While many bank analysts were pushing for further shrinking of the IB. The answer to the captioned question is a resounding "No."
The rationale of maintaining the current size is persuasive. IBs require certain scale to remain profitable. There are significant fixed costs of trading systems, compliance, middle and back office etc - revenue needs to be sized appropriately.
Shrinking the IB to profitability is certainly not a workable proposition.
What about unwinding the IB over time?
On the face of it - it sounds like an attractive proposition. Unwind the IB and release capital that can be redeployed in the profitable retail bank or returned to shareholders in the form of dividends.
The problem is that unwinding an IB business is prohibitively expensive and materially erodes book value. As soon as the business moves to run-off mode, the revenue disappears instantly but the running costs and capital allocated remain. Selling down assets (such as derivatives) is plausible depending on markets' bids but generally at a material discount to net asset values.
So in conclusion, the unwind of the IB over time will likely result in material book value erosion (which rapidly destroys shareholders value).
Should Barclays sell the IB?
That is the most interesting option which is probably still a live one but perhaps a longer term one than an immediate possibility. In a nutshell, Barclays is forced to "ring-fence" its IB in an intermediate holdings vehicle with its own capital, board, governance etc - this certainly adds execution flexibility to this option (realistically though further out in 2018/2019).
Barclays CFO commented on this strategic option in a recent analysts briefing:
The only silver lining to that cloud is you do get actual legal perimeters in place in a way that Barclays has probably never had. So at the moment, as I say, we've got a single legal vehicle, Barclays Bank PLC and everything essentially hangs off that. You have a Barclays brokerage in the US, there's a broker-dealer but this really puts in much more coherent, if you like, legal perimeters where the entire operations of what we would previously call the division sit inside legal perimeters. Now, that's not a prediction that we do anything with them, but it certainly gives options at around 2018, 2019 of strategic flexibility that we just don't have at the moment. So previously, to take a very theoretical thing, possibly people have said, well, why doesn't Barclays just sell its Investment Bank? Well, before you even answer that question, have you got anything you can sell, have you got a legal perimeter, can someone actually take a share in something? So at least in the future we will have clean legal perimeters. In fact, to the extent that because they're going to have to have independent boards and their own governance operations associated with them, they genuinely are "available for sale". That's not a prediction that we're going to do anything with them but that is some flexibility that we just don't have and very few banks have.
So what is Mr Staley and the board really thinking?
There is clearly no immediate credible solution for the IB performance issue - shrinking or unwinding it is immensely value destroying. And selling it is not possible given current legal structure (let along finding a willing and able buyer). Theoretically, the board could announce intention to sell or IPO the IB, once the U.S. intermediate holding company structure is in place - but doing so now would potentially be near suicidal. Once such announcement will be made - their best people (and clients) will likely leave immediately rather than wait for uncertain future and the situation could quickly descend into a death spiral for the division. Come 2018 there would really be nothing much left to sell. Mr Staley know this too well.
So in reality, the only choice left is to try and make the IB work in the next couple of years and hope the industry as a whole will start earning its cost of capital. Mr Staley is the right man for the job with his extensive IB background and being trained in the well-regarded JP Morgan's school of banking.
Mr Staley was brought in to Barclays to fix the investment bank. If he is unsuccessful in 2 to 3 years, he will not likely survive as CEO. The strategic option of selling the IB will then likely reappear.
The firm's current management is betting that the IB can get ever more efficient and that IBs (as an industry) will, in the medium term, start earning their cost of capital.
Personally, I would not bet against this CEO. At current valuation of 0.6x tangible book value with Barclays core already earning its cost of capital - I know the stock is a bargain.
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Disclosure: I am/we are long BCS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.