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Investment Banking Will Help Turn Around Barclays PLC

Investment bankers aren’t exactly flavour of the month, or year — well, decade, so far. The self-styled masters of the universe had a not inconsiderable hand in trashing the financial system and destroying the savings of an army of small investors in high-street banks in the process.

But loathe them or just tolerate them, they do provide a service for which there is demand, and the business makes money for investors as well as the bankers themselves. It could prove lucrative for shareholders in Barclays (LSE: BARC) (NYSE: BCS.US).

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Top ten

Both Barclays and RBS currently rank among the top 10 global investment banks. RBS’s former CEO Stephen Hester lost his battle to keep a big investment banking operation within the state-owned bank. Before he was unceremoniously ousted by the Chancellor, he’d agreed to shrink investment banking to a third of total revenues. That suited popular opinion and political expediency, but possibly Mr Hester had the more economic motive.

When new CEO Antony Jenkins inaugurated his strategic review of Barclays last year, many thought it would presage a shrinking of the investment bank that brought in well over half the group’s profits. In fact, the review was remarkably kind to the investment bank. A couple of embarrassing activities — structuring tax avoidance schemes and speculating in food commodities — were summarily ditched, and the bank retreated from Continental Europe and Asia.

If all goes to plan, the investment bank will be delivering a return on equity of 11-12% by 2015 and around 14-15% consistently once legacy assets have run off. Risk assets will be about half the group’s total.

Vindication

If it works, it will be a vindication of Barclays’ daring and counter-cyclical decision to buy Lehman’s US business when it failed in 2008. Barclays now has a leading position in investment banking in the US and UK, the two biggest markets. The bank boasts that its US clients see it as a US institution, whilst its UK clients see it as British.

The investment bank is now toeing the more sober group line. Costs have been cut, risk assets trimmed, and stable, low risk revenues emphasised.

It’s not all plain sailing. On Wednesday, S&P downgraded Barclays a notch over concerns of riskiness in investment banking due to volatile markets, unwinding of quantitative easing and the eurozone crisis.  And the Frank-Dodds Act requiring foreign banks to ring fence their US operations will affect Barclays more than most banks.

Cheap

I think Barclays’ shares, trading on a forward P/E of 8.2 and 0.7 times book value, are cheap. But with the investment bank set to remain half of Barclay’s business, you need to be comfortable with the risks and prospects for investment banking to rate the shares a buy.

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> Tony does not own any shares mentioned in this article.

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