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| Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks |
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Barclays encouraged analysts to view these hedging gains as gifts that will keep on giving, by stating that it expects returns on the structural hedges to remain broadly stable over the next two years. It acknowledged that a rise in short-term interest rates would reduce the value of the hedges but said that enhanced product margins would offset any fall.
Barclays did not have a eureka moment during 2010 and discover the perfect cash-spewing hedge, of course.
The interest rate swap and government bond trades it conducted to generate the gains were curve-management exercises that Barclays and its peers have used as a matter of routine for years.
But its recent annual report marked the first time that Barclays has disclosed the effect of these hedges, which cover core current account balances and deposits, along with group equity, rather than the trading books within Barclays Capital.
The details of the transactions and the self-congratulatory tone in which they were described should set off warning bells.
The gain on hedging of product balances is likely to have come from interest rate swap trades designed to convert low- or zero-interest short-term accounts to medium-term rates. The £1.403 billion gain for last year would be consistent with receiving fixed rate in maturities such as three years on deposits to the tune of £30 billion to £50 billion.
Barclays might be overly sanguine in asserting that the effect of any rise in short rates on the value of these swaps would be offset by a rise in margins on the underlying products, but it could probably manage the impact of a rise in rates easily enough, except in the unlikely event of a sudden upward surge in official short-end rates.
The £1.788 billion gain in hedges of its group equity in 2010 was boosted by a tactical decision to trade out of gilts in the second half of last year, then re-establish positions when yields had jumped at the end of the year, however.
Barclays appears to have timed that shift well, as it racked up a gain of £500 million with its initial gilt disposal, then rebuilt the hedge at a level that it said limited potential losses on future hedging income to £140 million, realized over 10 years.
A tactical shift of this type involves a call on interest rates – in this case gilt yields. Barclays got it right in late 2010 but it could easily get a future call of the same type wrong.
And senior managers at Barclays – and at other banks – will soon be sorely tempted to take comparable calculated risks in the fixed-income trading businesses that remain at the core of their investment banking operations.
The single biggest issue facing investment bank managers for 2011 and 2012 is how to cope with the effect of changing capital charges for fixed-income instruments.
The gradual implementation of Basle III means top dealers do not face an immediate prospect of a capital shortfall. But changes to risk-weighted asset (RWA) calculations are coming and will have a big impact on the returns from fixed-income business lines.
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The sharpest rise in RWAs will be for credit trading, followed by interest rate trading and financing. These three business lines will account for 81% of the RWA increase for the 16 leading investment banks, according to an estimate by analysts at Mediobanca that pegged the likely jump in RWAs under the move from Basle II to Basle III rules at roughly $2 trillion. Equity trading and some fixed-income areas, such as currency and commodities dealing, will be less affected. Banks with a high reliance on fixed-income revenues face a tough job in mitigating the effect of the new capital rules and containing their costs without ceding market share.
Barclays Capital is widely believed to have made the most revenue from interest rate trading last year, while Goldman Sachs led in credit trading and Bank of America Merrill Lynch in financing.
Exact splits are not available, as most banks still do not detail the contribution of different sales and trading business lines, preferring instead to try to steer investors and analysts toward judiciously chosen snippets of information in presentations.
That could change as the impact of RWA changes becomes more widely acknowledged as a key determinant of likely future earnings.
Mediobanca said that the impact of the capital shift, even allowing for mitigation of RWA rises, implies a 6% fall in average returns on tangible equity for banks, based on its 2012 estimates. Its estimated declines ranged from 1.8% for HSBC to 8.9% for Deutsche Bank.
Those levels are sufficiently important to motivate banks to increase disclosure to convince investors that they are managing the shift in capital rules effectively.
UBS broke out its revenues from individual fixed-income and equity business lines in its recent quarterly results. This marked a first for the industry that might be copied by rivals. The move towards greater disclosure did not go entirely smoothly, however.
UBS followed up the increased business-line detail with a statement that it is targeting SFr100 billion ($108 billion) of RWA mitigation by asset disposals or business realignment. That was widely viewed as both highly optimistic and fundamentally inconsistent with its stated goal of rebuilding its investment bank as a top-tier player.
Scepticism about bank statements on RWA mitigation is warranted, if only because of the industry’s disastrous track record on overall cost management.
Asset disposals have to be handled by individual managers, who often have a personal stake in businesses they have developed. And realignment of product mixes can be difficult in an industry where advancement comes from defending and extending individual fiefdoms.
The route-one approach to business adjustment – shut down an underperforming desk or product line – is relatively straightforward. Reworking a range of business lines while retaining key staff and the market share that is crucial to margin maintenance is much more difficult.
It will also involve decisions on the timing of asset disposals and hedging of exposure that could have consequences for earnings, particularly in sectors such as credit trading.
Standalone proprietary dealing units are becoming a thing of the past for investment banks, which will at least remove one source of earnings mystery for shareholders.
But there are plenty of areas where investors are still expected to take bank chiefs on trust. Hedging decisions that shade into position-taking and RWA-mitigation trades are likely to remain in the shadows for the foreseeable future.
See also
