Dissecting RBS, 2012 edition

RBS has published its results for 2012. They don't look good: there is a headline loss of £5.2bn, which various commentators immediately attributed to the bank's LIBOR fine and compensation payments for mis-sold PPI and derivatives. Predictably, there was a storm of claims that RBS was a total mess and Hester was doing a terrible job as CEO, and RBS's share price fell by over 4%.

At the same time, RBS announced a bonus pool of £679m. Equally predictably, this news was greeted with howls of outrage. How can a publicly-owned bank that is making substantial losses pay bonuses? I agree, this seems difficult to justify.

But things are not quite what they seem. I spent some time reading through the RBS full report and accounts, and very interesting they are too. The picture that emerges is emphatically not a bank that is in serious trouble, although there are risks. On the contrary, Hester's claim that RBS is in better shape than at any time since its collapse in 2008 looks correct to me. But oh boy are there political implications in that report - especially for the European Union.

Firstly, let's dissect that headline loss. £4.6bn is attributed to a charge for fair value accounting for RBS's own debt. What this means is that as RBS's creditworthiness has improved in the eyes of investors, so the market value of its bonds has risen. RBS has recognised the increased value of its debt in its accounts by marking the debt to market and taking the difference between the face value of the bonds and their market price to profit&loss. As the market price of the bonds has increased, this is a LOSS - not a profit - since it means that if RBS were to buy back its own debt, it would pay more for it than it received in the initial sale. So that £4.6bn loss arises from the fact that RBS is a better bet for investors than it used to be. Perverse, but that's accounting for you. Mind you, if the EU had adopted the IFRS9 accounting standard this debt would not need to be accounted for in this way and there would be no loss.....see what I mean about political implications?

Eliminating the £4.6bn that isn't really a loss at all leaves £0.6bn. This is more than accounted for by the provisions that the commentators mentioned:

PPI mis-selling                £1.1 bn
Derivatives mis-selling     £0.7 bn
Regulatory fines              £0.381 bn

That is a loss of £2.181bn from corporate bad behaviour. And RBS's accounts note other exceptional costs, too, including £1.5bn for restructuring, and goodwill writedown of nearly £0.4bn on flotation of the telephone insurance company Direct Line. The total exceptional losses are considerably more than the headline loss of £5.2bn. How is that possible?

RBS actually posted an operating profit of £3.5 bn. Yes, a PROFIT. Which was then entirely wiped out by the fair value accounting charge, regulatory fines and compensation, restructuring costs and other exceptional losses.

On further analysis, the picture looks even better. The report and accounts show that RBS distinguishes between "core" and "non-core" business. "Core business" is the bank itself - the part that is being restored to health. "Non-core" is the legacy of bad assets and inappropriate or unprofitable business lines that RBS is in the process of winding down or selling off. You can regard "non-core" as RBS's own internal "bad bank".

RBS's core business posted an operating profit of £6.4bn. Losses on non-core business reduced that operating profit to £3.6bn. It is very interesting to see what that non-core business comprises, because it sheds considerable light on RBS's real problem.

I have argued for some time now that RBS was not brought down by excessive exposure to CDOs and other derivatives. Those were a factor, yes - but they were not the principal problem. And although RBS's unbelievably stupid acquisition of ABN AMRO was the proximate cause of its collapse, the fact was that the old RBS was a mess through and through. It was riddled with bad loans, particularly in real estate and construction. Many of those assets still remain on its balance sheet, creating operating losses year after year: impairment charges are reducing, however, as the bad assets are eliminated. The Financial Supplement gives a fascinating breakdown of impairment charges against non-core assets: property (particularly commercial real estate) and construction are the principal culprits.

The other significant contributor to non-core writedowns is Ulster Bank, RBS's Irish subsidiary (despite the name, it is incorporated in the Republic of Ireland).  Ulster Bank has a large portfolio of dud property and construction loans left over from the Irish collapse. However, not all of its business is non-core, and Ulster Bank as a whole turned in a loss of over £1bn. On p.51, RBS clearly identifies the principal cause of Ulster Bank's losses:
"The challenging macroeconomic environment across the island of Ireland had a significant impact on Ulster Bank’s financial performance for 2012."
And its CEO explains (my emphasis):
"Operating loss increased by £56m year-on-year, primarily driven by a reduction in income as a result of a smaller balance sheet....Income decreased by 6% year-on-year in constant currency terms, largely due to the high cost of deposit raising, coupled with lower interest-earning loan volumes. Impairment losses remained elevated, reflecting underlying credit metrics, new defaulting customers and deteriorating security values."
In other words, the severe austerity measures adopted by Ireland to reduce its fiscal deficit have caused distress among Ulster Bank's customers, leading to loan defaults, falling house prices and reduced demand for lending. The result has been a substantial loss for the bank. EU politicians should take note: it is not just people who are at risk when economies go into a downwards spiral due to fiscal contraction in economically difficult circumstances. Banks are, too.

And it is not just EU politicians who should take note. The decline in income noted by the Ulster Bank CEO is also apparent across RBS's retail and corporate divisions. People and businesses are paying off debt and not taking on any more. RBS notes (p.16) that it is using funds from the Funding for Lending scheme to improve access to mortgage finance, and this starts to make a difference in Q4 2012. But the overall picture is of reduced lending volumes coupled with higher costs of funding and difficulty attracting deposits. This is a significant risk for the bank, given that it can expect high impairment charges to continue for some years to come. The austerity path taken by the UK government is not helpful to it.

The decline in net income from retail and corporate lending is more than offset by an increased contribution from Markets. But the Chancellor has stated that it wishes RBS's "investment banking" activity (which includes Markets) to be much smaller, and Hester confirms this aim in his letter to shareholders (my emphasis):
"...we have set a new medium-term target for our Markets business, which is an important part of our service to corporate and institutional customers. We aim to further reduce its scale and scope, targeting capital consumption of £80 billion RWAs whilst sustaining the service provided to our customer base." 
How confident can we be that an RBS with a much reduced Markets division would be able to return to profit in an austere and difficult macroeconomic environment?

On other measures, RBS looks pretty healthy. Its retail lending is now entirely funded by customer deposits (loan/deposit ratio is 100%), it has significantly reduced its use of wholesale funding and it has a healthy liquidity portfolio. Its core Tier 1 capital ratio is above Basel requirements at 10.3% and its leverage ratio is significantly better than target. It has shed loads of staff and its operating costs have reduced considerably. And it did turn in a reasonable operating profit despite the difficult economic circumstances and high impairment charges. So what about those bonuses, then?

Politically, paying bonuses at all when there is a large headline loss is tricky. But the core bank is not making a loss. It is making quite a significant profit. Except for Ulster Bank, the losses come from impairments on residual bad assets, fines and compensation for historic transgressions, and the costs of restructuring. In other words, this loss is due to things that happened in the past. It has nothing to do with the present performance of the bank or its staff, who appear to be doing a good job of turning round a severely damaged financial institution in a difficult economic environment. I will probably get hammered for saying this, but I don't think paying bonuses is unreasonable under these circumstances. Nor should bonuses be limited to retail and corporate bank staff, who typically don't receive enormous amounts. Management are doing a good job, and it is sensible to reward them for this; and traders have created quite a bit of the renewed profitability, offsetting the decline in lending. However, bonuses should be properly constructed so they don't incentivise short-term profiteering at the expense of longer-term sustainable growth: and it should be possible to claw back bonuses that turn out not to be justified.

It would be nice to say that politics should play no part in decisions about the shape of RBS for the future or the remuneration of its staff in the present. But that isn't realistic. RBS is, after all, 81% taxpayer-owned. Government therefore should expect to have considerable say in how it is run. And it is clear that the primary objective of the Government is to set RBS up for return to the private sector as soon as possible. Many people will disagree with this: many people will feel that returning RBS to the private sector, possibly at a loss, would be an opportunity lost. But that is the intention. RBS is to return to private ownership as soon as conditions are favourable. Exactly when that will be depends as much upon Government performance in turning round the economy as it does upon Hester and his team in turning round RBS. Current economic indicators are not encouraging. I reckon RBS will remain publicly-owned for quite some time to come.

RBS results announcement
RBS Group website results page
RBS full results
Ulster Bank reports losses of £1bn - UTV
RBS lost £5.2bn in "chastening" year - BBC
RBS share price falls following full year results - Hargreaves & Lansdown


  1. A very interesting and clear analysis of the RBS losses/bonuses issue. The media frequently portray such issues as too complex for the layperson to grasp, but this blog post shows otherwise. Well worth the few minutes to read and comment.

  2. Quick note. IFRS9 allows companies to use fair value for liabilities. And EU has adopted IFRS9. Howevere fair value is a choice for each institution, not an accounting requirement. Many instituions opted for it during the height of the crisis to boost their P&Ls which was just a reallocation of P&L from the future. But many institution avoided such practice :) Fair value for liabilities is obviously a zero-sum game.

  3. True. In fact in 2011 RBS profited to the tune of £1.5bn from fair value accounting for its own debt.

  4. This is much appreciated, even though i still dont really grasp most of it! One basic question, who carries the can for the losses?

    1. As these losses arise from historic events, there is no-one to carry the can: really it isn't fair to blame current management for the mistakes of their predecessors. But the cost of the losses falls on shareholders, of course - in this case, mostly taxpayers.

  5. Thank you for this – so much more informative than most of the journalism on this subject.

    The phrase 'it has shed loads of employees' made me laugh. Could mean two very different things!

    1. Oops! Actually it still has shedloads of employees even after shedding loads....


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