Royal Bank of Scotland’s woes a major obstacle to recovery

The former head of Royal Bank of Scotland said in 2009 it could take up to five years to recover from the biggest bank bailout in British history.

At the time, this seemed a formidable period for British taxpayers to wait before receiving some of their money back. But nearly eight years on, and under a new chief executive, RBS is still some way off from returning to private ownership.

The bank reported a £2 billion loss for the first half of this year, putting it on track for its ninth successive annual loss. Its shares languish at 195p, significantly lower than the 502p paid by taxpayers to rescue it in 2008.

Investors and analysts believe RBS, which is 73 per cent owned by the UK government, is a few years away from moving into profit and returning to health. It is not expected to pay a dividend until at least 2018, a decade after its £45 billion taxpayer-backed rescue.

Delay

Much of the reason for the delay is that RBS was in such a mess after its collapse in October 2008, that it was not strong enough to support the drastic restructuring needed to turn it round.

Stephen Hester, who took over as chief executive from Fred Goodwin in late 2008, focused on propping up the bank and fixing its balance sheet, stripping out £1 trillion of assets.

A more radical overhaul – which has involved pulling out of 25 markets globally to focus primarily on the UK and Ireland – has only begun in the past few years. The bank spent £630 million on restructuring in the first half of this year.

Ross McEwan, who was promoted to chief executive in 2013 from running its retail business, has also encountered fresh obstacles. Ongoing restructuring costs, charges for past misconduct, and diminishing revenues as the bank shrinks have hampered his recovery plans.

Britain’s vote to leave the EU in June has only added to RBS’s woes, prompting predictions of a UK recession and triggering a cut in interest rates that puts pressure on the bank’s profit margins.

"The Hester period was an attempt to clean up legacy issues without a fundamental restructuring of the bank," says Ian Gordon, an analyst at Investec.

“The McEwan era is more ambitious and time consuming – abandoning the investment bank, a fundamental restructure of the group, migrating to a UK-focused lender. Unfortunately it’s coincided with lower for longer rates.”

Rates

Low interest rates weigh on all banks’ profit margins, but particularly RBS, as it has a surplus of deposits with a higher proportion already paying close to zero per cent. On Monday the bank started charging some of its large corporate customers for holding cash on deposit in an early example of a UK lender imposing negative interest rates.

Like other banks, RBS has had to increase its capital levels to protect against potential economic downturns, which has eaten into returns.

"Whilst it's easy to suggest that former CEO Stephen Hester should have been more aggressive in the early days of his tenure, the regulatory goalposts have shifted quite considerably in the interim," says Matthew Beesley, head of global equities at Henderson Global Investors.

“New capital rules and lending requirements have made some businesses considerably less attractive than they were.”

Litigation issues have cost RBS tens of billions of pounds. In the first half of this year, it set aside another £1.3 billion. Total conduct and litigation provisions since 2008 have amounted to about £14 billion.

Shareholders who bought into a £12 billion 2008 rights issue before being heavily diluted in the subsequent bailout are suing RBS and former management for allegedly misleading them over the state of the bank at the time. RBS revealed this month that it was forced to earmark about £750 million after entering talks with shareholders in the second quarter – even though no settlement was reached.

Meanwhile, a large fine looms for mis-selling mortgage-backed securities in the US. A US government agency last year estimated the bank faces up to $13 billion to settle the claims.

Blunder

The latest blunder is the failed creation of Williams & Glyn, the UK retail and small business bank RBS was ordered to divest as a condition of its bailout under EU state aid rules.

The bank has spent seven years and £1.5 billion carving out Williams & Glyn. Its plans to sell the division in 2012 to Santander UK collapsed because of IT troubles. This month, RBS said its aim to list the business as a standalone bank had also failed – meaning it was reverting to trying to sell the branches and assets to a rival, possibly Santander.

Some analysts suggest Mr McEwan could have tackled some issues differently.

Mr Gordon at Investec says RBS could have kept Williams & Glyn on its systems, rather than carving out a completely standalone bank – in a move similar to Lloyds Banking Group’s divestment of TSB. “The Williams & Glyn fiasco can only be described as mind-boggling,” he says.

However, bankers briefed with the original plans said the aim of creating a standalone system was to provide Williams & Glyn complete autonomy and flexibility to create new products.

Henry Dixon, manager of the GLG Undervalue Assets fund, says he sold out of RBS in May following concern over separating Williams & Glyn.

He says: “I utterly commend what they’re trying to do with regards to deleveraging the balance sheet.

“But the big frustration is the interest rate outlook, as their biggest asset is deposits. It’s been very difficult for them to draw a line in the sand with litigation, when you’ve seen others settle in the US.

Irish commerical property

Others say the slow progress for RBS is more a reflection of the scale of the task.

Mr Beesley at Henderson points out that RBS lost more money – £50 billion – through operating losses in the eight years to 2015 than its current market capitalisation.

“With the prospect of more losses yet to come, it speaks volumes about the scale of the clean-up job that Ross McEwan and his management team have faced,” he says.

Under Mr Goodwin's tenure, and after its £49 billion acquisition of Dutch lender ABN Amro, RBS briefly became the largest bank in the world, with more than £2 trillion of assets on its balance sheet at its peak in 2008 – the last time it was to pay a dividend.

Unchecked loan growth in risky areas such as Irish commercial real estate and exposure to collateralised debt obligations – subprime mortgages that were packaged up, sliced into various risk categories and sold to investors – led to RBS’s near-collapse.

Of the UK high street banks, RBS still has the largest exposure to commercial real estate, sitting at £25 billion at the end of June according to credit rating agency Moody’s.

Still, Mr McEwan has made significant progress in a number of areas. The bank has disposed of about £200 billion of “non-core” assets over the past two-and-a-half years. Its capital buffers have improved from 8.6 per cent to 14.5 per cent during Mr McEwan’s tenure. He has also reduced costs, staff and retrenched from capital-intensive investment banking to focus on UK commercial and retail.

Charges

Underneath the restructuring costs and litigation charges is a “core” bank that has delivered a profit over the past six consecutive quarters.

Mr McEwan said earlier this month: “The core bank is generating £1 billion of pre-tax profit per quarter, and it’s returning 11 per cent on equity. Costs are lower, and still falling; our capital ratio above our target; and we have a much better risk profile than probably ever before.”

However investors believe conduct and restructuring problems will continue to overshadow the bank’s progress.

"The real issue is that there are a number of legacy issues not going anywhere anytime soon," says Jamie Clarke, a fund manager at Liontrust, who prefers challenger banks that are free of such legacy issues.

For a brief time last summer the UK government raised hopes that it would be able to return RBS to the private sector by 2020, delivering "the largest privatisation proceeds of all time", according to former chancellor George Osborne.

But the shares have lost more than 40 per cent of their value since the government sold £2.1 billion last August at 330p each.

The latest challenges of lower interest rates and an expected downturn in the UK economy following the vote to leave the EU look likely to only hold back the bank’s recovery further.

The fresh trials leave the government of prime minister Theresa May with the problem of whether to sell the shares at knockdown prices, accepting it will never recover all of the state aid or hold tight as it waits for RBS to progress along its very long road to recovery.

– Copyright The Financial Times Limited 2016