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Royal Bank of Scotland - Shining through the fog

Steve Clayton | 30 October 2015 | A A A
Royal Bank of Scotland - Shining through the fog

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NatWest Group plc Ord GBP1

Sell: 204.90 | Buy: 205.10 | Change 1.70 (0.84%)
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Third quarter results from RBS show a continuing picture of robust financial performance at the core bank, dragged down at the reported level by the ongoing costs of clearing up the mistakes of the past. Restructuring costs and losses within the investment banking division as it is sharply reduced in scale, dragged group profitability down to token levels. RBS actually declared a profit for the period from continuing operations of £1m.

The overall result was broadly as expected and the shares moved modestly lower in early trading.

Income fell from £3.64bn in Q3 2014 to £3.05bn, whilst ongoing costs also dropped, from £2.44bn to £2.28bn. However, restructuring costs jumped from £167m to £847m, offset by a decline in litigation and conduct costs from £780m to £129m.

The decline in income was predominantly due to a £394m fall in the investment bank, reflecting its planned reduction in scale.

Profits of £705m were booked in Personal and Business Banking, £427m in Commercial & Private Banking, whilst the investment bank, the Corporate and Institutional Banking division lost £1,012m.

The divisional adjusted return on equity generated by the businesses were 26.1% for PBB (with 33.6% earned by NatWest and RBS, diluted by Ulster Bank's 11.3% outcome). The CPB division earned 12.7% and the investment bank limped to an outcome of -6.9%. The unadjusted outcome for the investment bank was -33.0%.

Conduct costs remain a major issue for the bank. A full settlement for historic US Mortgage Securities activities has yet to be reached. RBS warn that conduct costs could substantially exceed the provisions already made.

Capital ratios are strong, but subject to downward revision, should such conduct costs come in at high levels. Adjusting for the exit from Citizens in the USA, RBS reported a Common Equity Tier 1 ratio of 16.2% (2014: 15.3%) and a Liquidity Coverage Ratio of 139%, the latter far ahead of regulatory requirements (to be at least 100% by 2018). The leverage ratio improved to 5.6% (2014: 5.1%).

The group reported further progress in winding down non-core assets, with the Capital Resolution division having reduced assets from £29bn to £11bn over the year.

Interest margins were broadly stable at 2.09% for the quarter and 2.12% for the year to date. The group released £79m of provisions against impaired loans, as a very benign credit quality environment continued.

Our view:

RBS is like an upside-down swan. All you can see are the ugly bits paddling furiously in the air, whilst the swan itself glides serenely beneath the surface. The Go-Forward bank, which is centred upon the core NatWest and RBS retail and commercial banking operations, is performing increasingly well, and the Exit Bank is looking closer to actually being exited. RBS announced the disposal of all of its remaining Citizens shares shortly after publishing the Q3 results.

Conduct costs, aka whopping fines, continue to dog RBS and clearly, they expect a few more to turn up. Once they are out of the way though, and the Exit bank and CIB division are much reduced in scale, there will be less to detract from the underlying performance of the Go-Forward bank.

That looks better and better, with returns edging into the mid-teens. Personal and Business Banking on mainland UK generated an extraordinary 33% return on equity in Q3. Cash generation should improve once fines and restructuring are done and ultimately, RBS will be benefiting from a lower cost base, without those exceptional drains on cash flow.

At that point, it ought to be a straight-forward, consumer and business-oriented bank, earning relatively stable returns and in time, capable of paying strong dividends. Legacy issues mean these are pushed back to no earlier than early 2017, suggesting a final payment for FY2016 could be the maiden payment from New RBS.

In the longer term, if RBS can maintain a return on equity in the mid-teens, then we would expect its shares to be rated accordingly. At the moment, the stock trades below its 384p tangible NAV (tNAV). That might see some further reductions as fines and exit costs chip away. The enticing question is, of course, what dividend yield, might a well-capitalised bank stock, valued below tNAV, but generating double-digit returns on that equity, be capable of offering?

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.