Almost a decade after the 2008 global financial crisis, new regulations are finally being phased in. The related increase in costs (direct and indirect) has forced both Barclays Group Africa (BGA) and Old Mutual to consider selling or unbundling some of their subsidiary businesses – which may actually be to these businesses’ benefit over the long term.
The 2008 crisis is still haunting the global economy
The cause of the events that unfolded early in March can be traced right back to the global financial crisis, even though almost a decade has passed since the crisis. For many, the most vivid reminder of this event that changed the economic landscape so drastically, is the highly acclaimed movie “The Big Short”, which was released on 15 January 2016. The movie portrays the greediness of the large investment banks and how they gradually imported significant risks into the global financial system without the mainstream gatekeepers blowing the whistle. It took a few brave (and eccentric) men to exploit this, and once the truth came out, the world was facing financial Armageddon. As a result, taxpayers around the globe had to step in to keep the system from collapsing.
New regulatory rules that followed the crisis are only now being phased in
In the aftermath of the crisis, regulators and governments vowed to never allow the same scenario to happen again. They promised to implement new rules and regulations and undertook to collect money on behalf of taxpayers for the massive bailout that followed. A whole host of new capital requirements were drawn up for insurers and banks in various corners of the world, forcing them to hold more capital and take less risk. The most notable of these is Basel regulations for banks and Solvency Assessment and Management (SAM) for insurers. In addition, many regulators introduced a different scale of levies and fees on assets, with the levies and fees for risky assets being much higher.
These rules were to be phased in over many years to allow financial institutions to strengthen their balance sheets by keeping more liquid assets and less risky assets. For many years, the weakened banks struggled to comply with the demanding rules. In fact, it took almost a decade for the big global banks to rebuild their balance sheets, as they were forced by market forces and the regulators to de-gear. In many cases. the institutions are only now feeling the impact of these regulations.
Elevated costs are responsible for the recent divestment announcements from BGA and Old Mutual
As a result of the introduction of additional levies and fees, it has become increasingly expensive for regulated financial institutions to hold significant stakes in other financial services companies. These elevated costs are the real driving force behind the divestment announcements from BGA and Old Mutual that we have seen in the past few weeks.
BGA – Barclays Plc must reduce its risk-weighted assets to improve their capital ratios
In the case of BGA (the old ABSA combined with Barclays’ African operations) there is a levy imposed on Barclays Plc for holding 62% of the equity. The levy is calculated on the sum total of BGA’s risk-weighted assets, despite Barclays Plc only deriving 62% of the economic benefit from those assets. According to Barclays Plc, the estimated additional expenses on the holding from regulations range from £40 million to £80 million per year, which amounts to a staggering R1.3 billion at the middle of the range.
In the last four years, Barclays Plc has generated £20 billion of profits before levies, taxes and conduct issues. Over this period, the company has paid roughly £20 billion in levies, taxes and conduct charges. This means they have not generated any retained earnings to grow the capital base (as shown in Figure 1). In the same period, the capital requirements have increased substantially, and will continue to do so up to 2019. Since the capital base has not grown (apart from the rights issue a couple of years ago), the only way to achieve higher capital ratios is to reduce the risk-weighted assets. To get to the 12% self-imposed target in 2018, Barclays Plc has no choice but to further reduce risk-weighted assets. In light of this, selling a major holding in rand-denominated assets in Africa will get them materially closer to this goal.
Old Mutual – international capital requirements render its stake in Nedbank inefficient
Old Mutual Plc, as a London-regulated and listed insurer, has different capital requirements than a bank. However, its material investment in a rand-denominated bank in Africa in the shape of Nedbank does not come cheap from a regulated capital point of view. Prudent financial institutions always carry surplus capital as a buffer between the minimum regulatory required capital and what they may need in the event of a shock to the financial system. Although both Nedbank and Old Mutual Life South Africa have surplus capital, the capital does not qualify as surplus capital under the London rules. This forces Old Mutual Plc to hold more capital in London in lower-earning, lower-risk assets to demonstrate a buffer that is greater than the minimum requirement. This inefficient capital amounts to a whopping £900 million in Old Mutual Plc’s books.
Despite other contributing factors, the cost of regulation remains the main culprit
In both instances there are secondary reasons that cannot be ignored. In Old Mutual’s case for example, a reduction of £80 million in head office costs plays a significant role. However, the main reason for the divorce proceedings is undoubtedly the cost of regulation.
We South Africans are often pessimistic about ourselves, and ask: what is wrong with us? In this case, there is nothing wrong with our banking sector. In fact, our regulatory environment and quality of management teams are both world class. What we cannot ignore, however, is the weak and volatile rand, low growth outlook over the medium term, and the political uncertainty. Nevertheless, all these issues simply made the decisions to sell and to unbundle (in the case of Nedbank) so much easier.
The long-term prospects for both BGA and Old Mutual remain positive
We remain holders of both BGA and Old Mutual. Over the long term, both banking groups could benefit from the fact that management can be 100% focused on running banks in Africa, instead of reporting back to London or waiting for approval from London.
In the case of Nedbank and Old Mutual South Africa, it is important to note that the two South African operations funded a large portion of Old Mutual Plc’s dividend, which remain highly cash generative. More control over future cash flows will also be a big benefit. The break-up of Old Mutual will unlock value as the businesses will be valued more appropriately on their own and the hefty central costs will be saved. We believe the proposed breakup should add at least 15% to the value of Old Mutual. If the full central cost rationalisation comes through, value may be boosted even further.
BGA offers good value at a dividend yield of over 6% and we believe that the bank’s earnings will be much more resilient than many sceptics expect. However, we are mindful that this perceived scepticism could limit benefits until the shareholding is finally resolved.
By Jan Meintjes