RBS: yet another British Jekyll and Hyde Bank

There was a whole load of stuff going on in the banking
world last week about Q3 bank results and, in particular, whether the Royal
Bank of Scotland should split into a good bank and bad bank.

Like Northern Rock – or should that be Jekyll and Hyde? – the idea is to  take the toxic assets on RBS’s books – all £38 billion of them! – and place them in a separately run business that can wind down those investments and/or realise some value for them.

Picture sourced from TheClubHouse1.net

A tough job, but someone has to do it as it is these investments
that are dragging down the bank, many would say.

The real issue is not that the bank is still limping along with
a poor preforming book of business –not just in the toxic asset area but across
the board – but that the UK government wants to sell the bank back to the private
sector and cannot do this whilst it still has potentially explosive debt and assets.

As a result, it announced last week – the first major
announcement since Ross McEwan took over as CEO from Stephen Hester – that the
bank’s bad assets will be placed into a separately run business internally. 

Through the Good
Bank/Bad Bank review we have been working with the UK Government and their
advisers to assess how far we’ve come in tackling the assets that still drag on
our performance.

Restructuring RBS for the future

We will now create an
internal ‘bad bank’ to manage down about £38 billion of our riskiest assets.
These consume 20% of our capital, and we plan to remove them from our balance
sheet over the next three years.

The internal ‘bad
bank’ will be called the RBS Capital Resolution. It will have strong,
transparent governance through a board sub-committee that reports regularly to
the main board.

We will also
accelerate the IPO of Citizens. The process will begin in the second half of
2014 and should complete by the end of 2016.

Reducing risk

Five years ago, our
non-core assets totalled £258 billion. Since then we have made good progress in
reducing risk through our Non-Core division: £220 billion of asset reduction to
date. But we are still held back by risky, underperforming assets such as
commercial real estate, Ulster Bank and the Non-Core division.

Dealing with these
assets now will strengthen our capital position, and speed recovery in our core
business and the path to privatisation. It will also remove distractions that
have taken so much management time in recent years, stopping us concentrating
fully on the customer. (“A balance sheet clean-up does not make a great bank on
its own” Ross McEwan, RBS Group Chief Executive.)

Review of all our businesses

Ross McEwan has
announced a complete review of all our businesses, and will reveal a new plan
for the way we serve our customers in February 2014.

You can read Ross McEwan’s full statement here. 

The expectation had been that it would place these assets
into a separately run company outside of RBS, as Northern Rock did.  Northern Rock was split into a good bank, which
was sold to Virgin and is now Virgin Money, and a bad bank called Northern Rock
Asset Management (N-RAM) in 2010.

N-RAM is now part of UK Asset Resolution, which also holds
that bad assets of Bradford & Bingley (the good bits were sold to
Santander).

This bad bank is fully owned by the UK Treasury and manages
a residential mortgage book of business worth around £50 billion and supported
by nearly £20 billion of government funding. 
Eventually, this book of business will close as mortgages are repaid,
moved or written off.  In the meantime,
for a bad bank, it’s not doing badly.  From
N-RAM’s 2012 annual report:

In 2012, the Group
increased underlying profits by £86.1m to £876.0m (2011: £789.9m) having also
absorbed an increase on the interest rate charged on the Government loan from 4
May 2012 which had an adverse impact of £95m.

Will RBS’s bad bank match this result and was it worth
placing this into an internal rather than external split of business?

To answer these questions, I don’t intend to reinvent the
wheel, so here’s the view from the Financial Times:

What exactly goes into this “bad bank”?

RBS will put £38bn of its most “high risk assets” into
a new “capital resolution division” in 2014. 
These will include £14.8bn of assets from its core unit and £23.5bn of
non-core assets, as well as £9bn of assets from Ulster Bank, the struggling
Irish business RBS acquired in 2000. The bank aims to sell or run down 55-70
per cent of these bad loans in the next two years and the rest by 2016.

What happens to the rest of Ulster Bank?

RBS said it would undertake a comprehensive review of Ulster
Bank to “identify a sustainable business model for supporting the Northern
Irish and Irish economies” which will report in February 2014.  “We need to ensure that we have a viable and
sustainable business model for Ulster Bank as part of this review. It’s an
important business for the whole island of Ireland and we understand the need
to get this right,” Ross McEwan, new RBS chief executive, said on Friday.

Is this good news for taxpayers?

RBS will have to write off up to £4.5bn of problem loans in
the quarter, driving the bank to a “substantial loss” for the full year.  However, the bank said the new structure
would free up £10bn-£11bn of capital which it can lend to small businesses.

RBS said the new structure would allow it to reduce
risk-weighted assets by £35bn by the end of 2016 and bolster its capital
ratios. The bank will seek to have a core capital ratio of about 11 per cent by
the end of 2015 and 12 per cent a year later.

The Bank of England welcomed the plans. “These actions
should create a more resilient institution that is better able to support the
real economy without any expectation of further government support,” it said.

George Osborne, chancellor, said the plan meant less
exposure for the taxpayer. “RBS will deal decisively with the problems of the
past by separating out the good from the bad,” he said.

What do the critics say?

Shares in RBS fell 7 per cent on Friday to 341.3p in late
afternoon trading, the second biggest faller in the FTSE 100. That is below the
407p price at which the government would break even on its 81 per cent stake.

Former Bank of England governor Mervyn King and former
Conservative Chancellor Lord Lawson had previously said RBS would fully recover
only if it was split into a good and bad bank.

Critics of the new plan say the internal bad bank is very
similar to RBS’s existing programme to run down non-core assets. In 2012, the
non-core division reduced funded assets by £36bn to £57bn and risk-weighted
assets reduced by £33bn to £60bn.

Marc Kimsey, at Accendo Markets, said: “Traders hoping for a
treat were spooked by the Halloween numbers delivered by RBS this morning. The
ringfencing of £38bn of bad loans, expected never to be repaid, avoids an
actual good bank – bad bank split, but what really is the difference?”

Pat McFadden, the Labour MP who sits on the Parliamentary
Commission on Banking Standards, tweeted: “So RBS will have an internal bad
bank, as it has had for five years.”

What happens next?

Chancellor George Osborne said he thought it “unlikely’’
that the bank would be sold off before the next general election in May 2015.

Meanwhile, Mr McEwan has launched a review of RBS’s business
activities and plans to update investors about its strategy in February. The
review covers customer-facing business, IT and operations and decision-making
structures.

The Financial Times
also looked at the options that had been open to the government, and the pros
and cons of each approach.  This is also
worth a look:

Internal bad bank

Pros: This is a
relatively straightforward restructuring, and does not have to be formally
approved by minority investors, so it can be done much faster than a more
formal split. That would pave the way for the reprivatisation of RBS to begin
more quickly. It would mean that the lender would not have to transfer the
non-core assets off its books and so would avoid crystallising losses on the
loans. The bank would benefit from any further recovery in the value of the
assets. Also, having experienced bankers manage the wind-down should maximise
the value of the assets.

Cons: Keeping the
non-core assets within RBS make it harder for the new chief executive to
present a cleaned-up bank. In turn, bankers say it will make it harder to
convince new investors to buy into RBS – at least until the rundown was making
progress. An internal bad bank would largely be viewed as a cosmetic change,
potentially undermining the government’s efforts to overhaul the bank.

Full-blown separation

This more extreme option would have seen RBS’s riskiest
assets carved out of the bank and taken into state ownership. The chancellor
has made clear that the government will not pump any more money into the bank,
so any such transfer would have to be capitalised by the lender. Investors have
urged Mr Osborne not to press ahead with this kind of formal split, which they
say would destroy value in the bank and delay its return to private ownership.

Pros: Stripping
RBS of its toxic assets entirely would be a more effective way to clean up the
bank. Bankers say it would remove a big distraction for the new management
team, enabling them to focus on growing the core business and increasing
lending. The bank’s capital position would also become more transparent. These
factors could help create a more compelling investment story for the
government, making it easier to attract new shareholders and start selling its
81 per cent stake. RBS would receive upfront cash for the assets, while
taxpayers would benefit if the value of the loans improved.

Cons: This kind
of split would be more complex and time-consuming than an internal
restructuring. Bankers estimate that it would take at least 12-24 months to
implement, making it unlikely that the reprivatisation could begin before then.
Investors have signalled that they would oppose such a move because losses on
the assets would be crystallised as they would be repriced to reflect the
current, lower, market values. Analysts say these losses could top £15bn.

Central bank support

Another option that has been discussed by officials is to
split out RBS’s unwanted assets and buttress them with funding from the Bank of
England. A similar structure was created for UBS after the financial crisis,
with support from the Swiss National Bank. However, it is understood that this
idea was quickly dismissed by the Bank of England, and the Treasury.

Pros: Such a move
would have rid RBS of the problem loans without costing it capital. It would
have provided greater protection against souring loans, potentially
strengthening the perception of the bank to investors.

Cons: Involving
the Bank of England would have made the transaction more complex. Also, the
central bank is not set up to act as a backstop for bank loans over the long
term.