FORTUNE — The banks are really under fire these days. The temporary detente between the government and the banks, which was agreed to after the financial crisis nearly sent the world back into the economic Stone Age, is clearly over. Bank chieftains are being hauled on TV to be heckled by Congress and regulators are tightening the noose around their necks.
But, of course, the mother of all scandals continues to be Barclays’ manipulation of Libor, the key bank reference rate used in setting the borrowing costs for trillions of dollars worth of loans. While Barclays (BCS) has already paid $450 million to settle the case with U.S. and UK regulators, analysts believe that the bank could still face dozens of lawsuits from affected parties, potentially exposing the bank to losses in the range of around $1 billion to as much as $10 billion.
The scandal has already claimed the bank’s chief operating officer, chairman and chief executive. When Barclays reemerges from this scandal it will not be the same bank. But Barclays has been trying to figure out what it is for some time now.
Under the stewardship of Robert (Bob) Diamond, this very British retail bank became one of the most powerful financial players on Wall Street. Diamond, who is American, achieved this by gutting Lehman Brothers in 2008 after it had declared bankruptcy. Diamond managed to rip Lehman’s heart out of its still beating chest by acquiring the North American investment banking division for just $1.75 billion. And he was able to do it without having to absorb a lot of the toxic junk.
Diamond spent the next three years pumping millions of dollars into the investment banking business, which was known up until this March as Barclays Capital, with mixed success. While the division was profitable, making around half of the bank’s earnings in 2011, it still didn’t have a strong return on equity, meaning it wasn’t very efficient. It did have some success in building a mergers and acquisition franchise, placing number five on the M&A league tables last year, but the division was barely, if at all, profitable, according to a person with knowledge of the matter.
Where the investment bank stood out was in its fixed income trading business, most of which was acquired from Lehman. The division consistently ranks second in the league tables for fixed income deals done, just behind banking giant JP Morgan (JPM). Fixed income trading contributed the lion’s share of the profits that were attributed to the investment bank in 2011. That year the division made around $5 billion, 53% of the bank’s total profit. That’s not bad considering that Diamond bought all of Lehman’s good North American assets for just $1.75 billion.
But all the success that Diamond achieved during his tenure as chief executive has essentially been wiped out thanks to the what is being called the Li(E)bor scandal. Fixed income products use a variety of metrics, most notably Libor, as a benchmark. It would therefore not be a stretch to assume that some, if not a good portion of the bank’s profits can in some way tangentially be linked to its playing with Libor. The courts could possibly label those profits ill-gotten gains of some sort and either claw back or slap the bank with a heavy fine.
With all this drama it’s no wonder Barclays’ board is reportedly thinking about hiving off the investment bank from its quiet and equally profitable commercial bank. Talk about splitting the bank up in the past has rested on concerns that the investment bank was undervalued as part of the Barclays financial supermarket. That’s clearly not the case here.
It had also mulled a split on concerns that the UK would be instituting tough regulations forcing all British banks to spin off their investment banking divisions. There have been teams of people roving around Barclays for months evaluating how a split up would work and informing department heads as to what would happen, according to a person with knowledge of the matter. The concern has waned in the last few months, though, as a special government panel decided against a total split. It instead will require banks to “ringfence” their commercial bank from any fallout from the investment bank.
But what if Barclay’s investment bank were spun off? It would look eerily similar to what Lehman Brothers looked like before it crashed and burned in 2008. Like Lehman, it will derive the lion’s share of its profits from peddling fixed income products. But the investment banking division, or “Lehman II,” doesn’t rake in the dough brokering Treasury bills, though. No, Lehman II is a fixed income derivative powerhouse – yes, the same such alphabet soup that caused so much trouble during the financial crisis.
According to Barclays’ “living will,” which was presented to the Federal Reserve last week, the bank lists as its first “core business line” in the U.S. “fixed income securitized products.” It goes on to say that the bank is a “major provider” of fixed income securitized products, listing examples such as agency residential mortgage-backed securities (RMBS), asset-backed securities (ABS), commercial mortgage-backed securities, mortgage to-be-announced securities and residential credit (non-agency RMBS and subprime). Yes, they said subprime.
While securitized products aren’t necessarily evil, they have proven to be quite a hot potato. Levered to the heap, Lehman got caught holding it and was mortally wounded. Lehman was relatively small compared to the bigger banks that had both commercial and investment banking. The government allowed the bank to fail thinking that the fallout would just impact Wall Street, not Main Street. That turned out to be a bad assumption.
That begs the question: If Lehman II found itself in trouble today, would the U.S. or UK governments intervene to save it? Probably not. But if Barclays’ investment bank was on the verge of collapse, while it was still paired with the commercial bank, you can bet that both governments would intervene. The last thing either of the two governments want now, with the troubles in Europe and the U.S. presidential election, is some cataclysmic bank run.
Yes, we are talking about “moral hazard” and believe it or not, it is alive and well. A glance over the living wills submitted to the Fed by the “systemically important” banks show that they have no real plan to fail gently. They all said they would sell some assets to cover the shortfalls in their balance sheet, but that’s hard to do when the market is panicking. That means the government will have to step in if there is ever a flicker of trouble at systemically important institution. This latent protection is why the U.S. banking system didn’t implode in 2008. So while the thought of Lehman rising from the dead again might make some bankers and traders that bleed green happy campers, it seems, at least for the time being, to be too risky to be out on its own.