Finance

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

"Is it safe?"

Laurence Olivier's chilling question in the film Marathon Man is also being asked by investors in Europe's investment banks. Years after the financial crisis, most firms are still struggling to generate returns above their cost of capital.

Barclays CEO Jes Staley reckons the answer is: we're getting there. Touting his core business' double-digit returns on tangible equity, he has tried to paint a positive picture of progress with restructuring and cost. He told Bloomberg Television on Thursday:

"If you can generate a return that is above your cost of capital, I think you're doing reasonably well given this environment." 

But even if a buoyant third quarter for debt trading helps dispel some of the gloom, there's a lot we still don't know about the cost of running a U.K. or European investment bank over the coming years.

Looking Up
Optimism that debt trading is rebounding has helped banks to outperform the broader market
Source: Bloomberg

We are only at the beginning of a wave of structural overhauls imposed by regulators who want banks to isolate certain activities and layer them with extra capital to lessen the risk of a costly taxpayer bailout. The cost of safety is going up.

U.K. banks including Barclays will have to ring-fence their domestic retail operations by 2019. There are set-up costs: HSBC has estimated its bill at 1.5 billion pounds ($1.8 billion), while Barclays expects 1 billion pounds in implementation costs, or half annual pretax profit.

But that assumes the untangling of operations goes smoothly. A messy Brexit timetable would surely add to those costs, given specific provisions of the overhaul depend on the U.K. remaining a member of the European Economic Area. And banks like RBS have shown that unpicking IT systems alone can take years and cost far more than predicted.

BarclayCarved
The U.K. bank's planned new structure will have most of its assets located outside the U.K. ring-fence
Source: Company filings

Then there's the cost of funding a bank that's less diversified. Barclays' operations outside of the ring-fence will primarily be a transatlantic investment bank with 195 billion pounds of assets. S&P reckons that should carry a higher risk premium. The ratings company said in March the non-fenced unit would likely be rated one notch below the 70-billion-pound domestic business.

In good times, that may not matter and Barclays says it expects both businesses will deserve an investment-grade rating. But at times of stress that differential may prove painful, especially if regulators fight to protect the ring-fenced bank first.

There are other structural hurdles abroad. Banks face a bigger bill in the U.S., the most important source of global investment-banking revenue. There, new rules will require banks to set up a separate holding company. Higher capital requirements for big global banks are also being considered.

U.S. Gap
Estimated capital shortfall versus U.S. peers under new rules, according to Bernstein estimates
Source: Bernstein

Bernstein analysts estimate Barclays' U.S. operations have a $9 billion capital gap compared with their U.S. peers, while Credit Suisse's is around $2 billion. Banks may end up with multiple ring-fences, according to Fitch.

There are ways to soften the impact of all this. Barclays is shrinking itself globally by selling assets such as its African bank. RBS is resurrecting its NatWest Markets brand for its investment bank, which may boost confidence in its standalone brand power.

But we're likely see rising, not falling, costs. The ring-fencing process may lead to competitive disadvantages, soak up management time and create transition costs, according to S&P.

There's also the question of credibility. Will the costs involved be worth it? The Bank of England has watered down the planned level of capital buffers initially recommended by John Vickers, architect of the ring-fencing plan. For Mark Carney, extra capital is "not costless to society." For Vickers, lower buffers mean there's a need for "continuing vigilance" to stop banks from putting as much as business as possible within the ring-fence.

If he's right, that suggests there's still a way to go before investors can believe that 2019 is the final destination on the road to safety and profitability.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lionel Laurent in London at llaurent2@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net