Barclays has a problem. According to the banking regulator, it doesn't have enough capital to cope with possible losses in future financial downturns.
The Prudential Regulation Authority (PRA), the UK's new banking regulator, undertook a comprehensive review of British banks earlier this year. This exercise identified a number of banks and building societies which were short on capital, notably Barclays, Royal Bank of Scotland and Nationwide BS.
The problem at Barclays is what's known as its 'leverage ratio' - its equity capital divided by its total assets. At Barclays, this ratio is only 2.2%, which means that for every £1 of risk capital, Barclays has £45 of assets on its balance sheet. The PRA regards this leverage ratio as too low and would like all British lenders to increase their leverage ratios above a minimum threshold of 3% by mid-2014.
For Barclays, this means that it needs to increase its equity capital by more than a third. To do this, the bank has decided to act in three ways:
- Raise £5.8 billion via a 'rights issue', offering over 3.1 billion new shares to existing shareholders, priced at 185p each.
- Raise a further £2 billion by issuing hybrid debt securities known as contingent convertibles (bonds that convert into shares or get wiped out if Barclays is under stress).
- Increase its capital base by retaining earnings, shrinking its balance sheet by disposing of up to £80 billion of assets, and other means.
Selling discounted shares
Of the three courses of action mentioned above, the most important for owners of Barclays shares is its rights issue. In a rights issue, a listed company offers new shares to its existing shareholders, usually at a discounted price and as a fixed proportion of their current shareholdings.
Therefore, if you already own, say, 1,000 Barclays shares, then Barclays is giving you the right to buy a further 250 shares at 185p. In this example, these additional shares will cost £462.50, with this extra cash going to bolster Barclays' coffers.
To encourage its shareholders to buy these new shares, Barclays is selling them at a steep discount. On Monday, before this news broke, Barclays shares traded at 309p each. At 185p, the new shares trade at a 40% discount to the pre-announcement price.
Following the announcement, Barclays shares have slid. At the time of writing, they are down to 289p.
What the rights issue means for you
If you own Barclays shares in your own name (for example, in a stock-broking account or as paper certificates), then the bank will write to you, inviting you to take part in the rights issue. Before the deadline, you have three options:
- Take up your rights shares by paying for them in full, stumping up £1.85 for each new share.
- Decline to take part in the rights issue and sell your 'nil-paid rights' in the open market in return for cash. This cash sum is likely to be less than the drop in the value of your existing shares after the rights issue closes. Existing shares will be worth less because Barclays is increasing the number of shares in issue by a quarter (25%).
- Sell enough of your rights so that you can buy some of the new shares you've been offered, without coughing up extra cash. In stock markets, this compromise is known as 'tail swallowing'.
If you simply don't have the extra cash Barclays wants, then you cannot take the first option. In these circumstances, your best bet is probably to tail swallow, using your nil-paid rights to buy a few extra Barclays shares. This won't require any extra cash and will help to reduce the dilution of your existing shares caused by 3.1 billion new shares appearing in circulation in September or October.
Should you buy these shares?
Of course, the answer to this question depends entirely on your own personal financial circumstances and attitude to risk. Then again, these facts may help you to make up your mind:
- As a major bank, Barclays is heavily exposed to the volatile world of investment banking, also known as 'casino banking' because of its high risks.
- Barclays has been hit by a number of major scandals in recent years, including mis-selling payment protection insurance (PPI) and interest-rate swaps, as well as manipulating the LIBOR market for inter-bank rates. It's currently under investigation by the Financial Conduct Authority over a previous injection of capital by gas-rich Middle Eastern state Qatar in 2008.
- That said, Barclays shares trade comfortably below the underlying value of its assets, reckoned to be worth 336p a share. Buying Barclays shares means getting its assets at a discount.
- In the longer term, Barclays will remain a powerhouse of British banking.
- The extra capital provided by the rights issue and other measures will make Barclays' balance sheet stronger. As a result, the bank will raise its dividends (regular cash payouts to shareholders) strongly from 2014 onwards, increasing its dividend-payout ratio from 30% to 40%-50% of after-tax earnings.
- Barclays shares have traded between 161p and 338p in the past 12 months, so they trade nearly 15% below their one-year peak as I write.
- The shares offer a dividend yield of 2.3% and trade on a price-earnings ratio of nine. These are modest ratings for a big bank -- but banking has been anything but plain sailing since the global financial crash.
I don't own any shares in Barclays (other than within FTSE 100 tracking funds and the like). However, were I an existing shareholder, I would probably take a deep breath, write a cheque and take up my rights shares in full. At 185p, I reckon future risks are mostly priced in, making these new shares a modest bargain.