Essay on “International Banking: The Royal Bank of Scotland”

Bank History and Overview

The Royal Bank of Scotland Group Plc. or the RBS refers to a holding company of one of the leading and largest financial services and banking groups (Datamonitor Report, 2011). Primarily, RBS operates in the United Kingdom, the United States (Citizens), Asia and other international markets through its main subsidiaries NatWest and Royal Bank. The RBS is headquartered in Edinburg Scotland with an employment base upwards of 150,000. Historically, RBS was founded in 1727 as a corporation by grant of a Royal Charter (Datamonitor Report, 2011). RBS expanded all over Scotland during the 19th century and by the 20th century; it had established its presence in several parts of England. It acquired several acquisitions such as Glyn Mills and Williams Deacons Bank through its strategic expansion in England. Equally, it amalgamated with the National Commercial Bank of Scotland, which had already diversified its networks and customer bases across the region (Datamonitor Report, 2011). During the 1970s, RBS expanded to other oversea finance and leasing markets such as Hong Kong and the US.

Other business initiatives undertaken by RBS include setting up of a car insurance company in 1985 to deal with selling auto insurance to customers (Datamonitor Report, 2011). This direct telephone insurance service was referred to as the Direct Line Insurance. Other investment activities included the acquisition of Citizens Financial Group that guided RBS to acquire several struggling banks across the United States. Retail banking became the core business of RBS during the early 1990s and this spurred the bank’s merchant interests, a move that guided the acquisition of Adam & Company. Direct banking, a round-the-clock telephone service was launched in 1994 while online banking service was introduced in 1997. Since then, RBS has undergone several organization changes and re-engineering activities that focused on commercial and corporate customer requirements (Datamonitor Report, 2011).

Situational Analysis

Speaking of RBS business environment, the groups’ business environment is diversified in financial and banking activities. The Royal Bank of Scotland Plc. has its business activities diversified into nine core divisions. These includes but not limited to Global Markets, RBS Insurance, US Retail & Commercial Banking, Wealth, UK Retail, Central Items, and Ulster Bank. This means that RBS operates in different environments that can be analyzed using several aspects including political, economic, technological, social, and level of competitiveness.

First, PEST analysis can be used to analyze RBS’s political, economic, technological, and social aspects. Politically, RBS operates in environments characterized stability with well-developed regulatory and financial systems (Barth, Caprio, and Levine, 2006). Such regulations are critical in protecting operational activities (Mullineux, 2009). For instance, the Financial Services Authority (FSA) is influential in regulating banking and financial activities across the UK (Financial Services Authority Board Report, 2011). Equally, most governments in the operating regions intervened the activities of the banking industry during the financial crisis through bailouts and economic packages. Economically, RBS operating regions were heavily hit by the 2007-2011 global financial crises, and this had an adverse effect on operational activities of RBS. Reduced GNP, declined demand for credit services, low revenues, and declined consumer confidence are some of the economic effects that RBS suffered during the global credit crunch. However, the low capital costs and probable demand for credit increases can enable RBS to capitalize on the effects of the credit crunch.

Social aspects that affected RBS during the 2007-2011 global financial crises include effects relating to consumer confidence, interest and pension worries, and career attitudes among others (Berezin, 2008). It was emphatically crucial that RBS maintains its corporate social responsibility to enhance its reputation during the crisis. Technologically, financial information systems and software platforms facilitate data mining activities, risk analysis, neural networks, and criteria for financial scanning for RBS (Elving, 2009). These tools strengthen the analysis and assessment of expenses, liabilities, and revenue streams.

A Bank evolution before, during, and After the Banking Crisis of 2007-2011

The global financial crisis of 2007-2011 is the recession to hit the banking industry since the global recession of 1930s (Elving, 2009). Invariably, the crisis is linked to the Euro crises and Europe Sovereign Debt crisis, plays a fundamental role in influencing the welfare of banks and other financial institutions. The collapse of the Northern Rock and Icelandic banking system and the crisis that affected the Royal Bank of Scotland threatened many account holders. The global financial crisis of 2007-2011 led many banks to purchase risky assets for later resell. Due to less demands of these assets, many a financial institution found themselves on the verge of insolvency. Deposit withdrawals from panicking customers worsened the financial situation for such banks. In times of financial distress, even a solvent financial institution or bank may fail to realize its obligations given the opaque and illiquid nature of its assets (The Times, 2012). During the financial crises, bank runs, implicit, and explicit deposit guarantees increased the likelihood of the crisis.

For the Royal Bank of Scotland, the period after the 2007-2011 global financial crises spells a period of recovery and rebuilding. A statement released by Philip Hampton, Group Chairman of RBS shows that the overall financial performance of the group represented a step-change. Operating profit is one of the factors that reflect improved performances of the Royal Bank of Scotland. External market recovery, internal rebuilding processes, and improved economic conditions are other factors that represent another significant stride for the Royal Bank of Scotland. However, the recovery to improved performance could have come that easily given the uneven spread of economic recovery across many countries, particularly the European period suffered a massive deal of financial turbulence. RBS shocked the world on February 2009 when it announced a loss of £24.1bn from 2008, a figure recorded as the highest in the corporate history of the United Kingdom. During the same period, RBS’s former Chairman Sir Tom McKillop and Sir Fred Goodwin were summoned to appear before the Treasury Select committee to explain the roles they played in the global financial crisis (Huisman, 2011).

Royal Bank of Scotland, the Global Financial Crisis, and strategic moves

Before the Global financial crisis, RBS had established itself as one the leading banking partners providing financial services to corporations and financial institutions all over the world. Other services included the provision of extensive ranges of debt financing, investment services, and risk management services. Primarily, majority of these services were provided through the Global Banking and Markets division of RBS. In 2008, RBS made an announcement of £20bn capital raising programme underwritten by the HM treasury. However, the terms of the share offer seemed unattractive to the majority of RBS shareholders and hence, the UK government acquiring a majority stake in the bank. This shows that the global financial crisis made RBS, a proud financial institution with a fine heritage in prudent banking to be bailed out by the government.

RBS bosses, particularly the Chief Executive, Sir Fred Goodwin, were overoptimistic with regard to the prevailing economic situation and never took precautionary to cushion adverse financial and economic fluctuations. Despite warnings from the Financial Services Authority and the Bank of England, RBS bosses failed to oversee possible challenges that lay ahead. Risk recognition was a crucial element that lacked in the institution before the credit crunch. Following the failure shares offered to investors, the CEO resigned and as well, the Chairman offered to step-down at the expiry of his contract. The government continued injecting funds to RBS thereby increasing its ownership percentage. The release of full year trading losses and write-downs of goodwill amounted to the £24.1bn in losses. A fall in share price from 354p per share to 10.p per share followed this announcement.

Earlier in June 2008, the Royal Bank of Scotland made frantic efforts to raise £10bn cash from the sale of its assets and this led to the £3.6bn sale of Angel Trains, RBS’s subsidiary. Welsh and English RBS branded branches were also sold off and as well, NatWest branches in Scotland. Other failed investments included the loss of the 4.26% stake it held in the Bank of China thereby affecting the profitability of its wealth management division. Although a desperate measure, the closure of RBS tax avoidance department enabled the bank to avoid a £500m tax levy. This move was influenced by two key factors that included the high government stake in the institution and lack of funds.

The consumers also benefitted from dramatic cuts in certain fees and levies operated by the bank and this included declines in monthly maintenance charges, card misuse fees, and unpaid item fees (Datamonitor Report, 2011). However, there was massive retrenchment at the bank that led to nearly 3,700 job cuts. Many employees also suffered unpaid bonuses. GE Capital also acquired the factoring and invoice financing business from RBS at undisclosed amount. Credit rating agencies such as Moody’s downgraded RBS in 2011 due to what was termed as weaknesses in its financial system. Perhaps, the greatest loss to RBS during the financial crisis can be attributed to the purchase of the Dutch Bank, ABN Amro. It is argued that the RBS did not get a fair deal from the acquisition of ABN Amro due to overpayment. In conjunction with Spanish bank Banco Santander and Belgian bank, Fortis, RBS acquired ABN Amro for £49bn. RBS used funds from the investment and wholesale banking division, an already ailing segment of RBS from its risky assets. Worse, the acquired bank ABN Amro was already exposed to the effects of the subprime mortgages coupled with the depletion of its capital base (Datamonitor Report, 2011).

Investment and Mergers

Before the crisis

RBS had undergone several mergers and acquisitions (Kemal, 2011). In 2000, RBS acquired the National Wesminster Bank (NatWest) in a deal worth £21 billion. IN 2001, RBS purchased a large share of capital from Virgin One business and as well, as Euro Sales finance. Direct Line Group (RBS Subsidiary) acquired Royal Insurance. Nordisk Renting and Santander Direkt Bank’s loan and credit card portfolio were acquired in a move aimed strengthening US and European operations. Churchill Insurance Group was also acquired during this period(Datamonitor Report, 2011).

During the crisis

During the last five years, RBS has undertaken several investment initiative and mergers. Starting in January 2007, RBS’ global banking and markets division entered into a joint agreement with Renaissance Capital to provide currency, credit derivatives, and interest rates to corporate, government, and institutional clients in Russia. February the same year, RBS’ subsidiary, Citizens Financial Group acquired GreatBank in the US thereby enabling Citizens to be the fourth largest commercial bank in Chicago. The acquisition of ABN AMRO in late 2007 was perhaps the largest acquisition and one of the worst in the history of RBS. Although the consortium was led in conjunction with Fortis and Santander, RBS used its own resources. Ventures in 2008 included the sale of ABN AMRO private equity assets and 65-branch retail banking network in Indiana. RBS sold its 4.3% stake in Bank of China and started a wealth management business in India in January 2009 (Datamonitor Report, 2011).

In efforts aimed at boosting its capital management portfolio, RBS received a £3 billion from the British government. Several fund management assets and contract of RBS were sold to Aberdeen Asset Management PLC in early 2010. In August 2010, Santander UK plc. bought 318 branches and associated liabilities and assets from the RBS group and as well, 80% interests in Global Merchant Services were also sold. Other initiatives included joint ventures with RBS Sempra Commodities (RBSSC) and Sempra Energy (Datamonitor Report, 2011).

After the Crisis

As earlier mentioned, the financial crisis of 2007-2011 spelled a bad period for the RBS group and since then, the group has implemented plans to guide its financial performance and subsequently guide the road to recovery. Among the major initiatives under the development plan include rebuilding and recovery, enhancement of business achievements, and implementing measures to lessen effects of the economic backdrop (Worthington, & Welch, 2011).

RBS’ SWOT analysis

Owing to its diversified banking and financial activities in Europe, Asia, and UK, RBS uses key strategic moves to ensure that it enhances its competitive advantage. Equally, the support from the UK government shows that RBS is an important institution in improving financial activities across the region.

Strengths

As a strategic approach, RBS increasingly uses mergers and acquisitions (M&A) to improve its level of competitiveness in addition to expanding its portfolio and reduction of business risks (Altunbas., & Ibanez, 2004). Equally, mergers and acquisitions enable RBS to enter new markets, geographical regions, and capitalize on the economies of scales (Kemal, 2011). Even though increased number of global franchises increases its exposure to risks, this move enables RBS to be a leading global financial group. With presence in more than 50 countries, RBS confers its competitive advantage.

Its strategic importance in the economy of the United Kingdom enabled it receive government support in times of distress. Currently, HM Treasury owns approximately 84.4% of stake at RBS meaning that the government has interests in all RBS activities. Another RBS’ strength lies in the ownership of leading corporate and retail franchises across the UK financial sector. For instance, the retail sector of UK banking comprises of strong brands from NatWest and RBS. RBS Insurance also forms a major part in the UK retail and SME markets.

From a financial approach perspective, RBS exhibits a declining reliance on wholesale funding for its efforts of improving the risk profile. This move was evident during the financial crisis where RBS minimized its reliance on volatile wholesale funding (Royal Bank of Scotland Group, 2010).

Weaknesses

Strategically, RBS is at risk of being controlled by the state in part due to the large stake controlled by the government and as well in part due to provisions of the Government’s Asset Protection Scheme (APS) that RBS entered in 2009 (Sutton, Lannoo, and Napoli, 2010). Although, RBS received critical support from the government during this period, this moves spells a price for RBS. Financially, restrictions placed on dividend payments prevents RBS stakeholders from paying dividends on coupons and Tier 1 securities and other restrictions laid on ordinary shares (Royal Bank of Scotland Group, 2010).

Opportunities

Strategically, RBS can utilize restructuring opportunities to reposition itself as a leading provider and supplier of financial services. RBS also has a restructuring plan that was designed to be implemented over five-year duration ending 2013. This turn-around plan was aimed at addressing the weaknesses identified during the rescue package offered by the government. Currently, the progress on the restructuring plan has been phenomenal particularly, the development of the non-core division aimed at housing businesses and assets that do not conform with revised RBS risk appetites and strategies. Primarily, the creation of the non-core portfolio is fundamental because it facilitates key improvements within the group. This includes funding, risk, and earning profiles and as well, material exposure and concentrations.

Other strategic opportunities include reviving partnerships with leading institutions particularly those in emerging markets such as China and Asia pacific. RBS made substantial progress from its partnerships with the Bank of China that enabled it to issue 1.2 million credit cards. This opportunity also enabled RBS to access one of the fastest growing markets in the Asia Pacific region.

Speaking of financial opportunities, RBS has the capabilities of focusing on investment banking thereby enhancing its opportunities of increasing profitability. This means that there are increased chances of hiring more staff to boost the investment banking, merger and acquisitions, and debt underwriting (Ashby, 2010).

Threats

Several threats stand in the way of affecting operational activities of RBS. First, several measures have been put in place to bring structural reforms in the banking sector, competition in the industry, and enhanced stabilities. Among these measures is the setting up of the Independent Commission on Banking (ICB) by the UK government, a move that could bring adverse effects on RBS. Findings from this commission will provide a framework for guiding all competitive activities within the banking sector in addition to putting in place measures that could strengthen the stability of these institutions. Similarly, reports from the Treasury Select Committee are likely to affect the structure of RBS.

Financially, IFRS regulations have led the group to incur deferred tax assets on those losses that were expected to revive future profits. Deferred Tax Assets are quantified depending on the current level of tax legislations and prevailing accounting standards (Oxera, 2011). On the other hand, increased regulatory changes relating to quality in insurance, particularly the elimination of gender as a rating factor throughout the insurance industry will affect insurance operations of the RBS group. Competitive pressures will mount among insurance companies thereby leading to a lower rate of premiums paid on insurance contracts (Oxera, 2011).

Performance measurements

Revenue analysis

Starting with the revenue analysis, the RBS Group recorded a reduction of 3.5% of total revenues in the FY2010 as compared to the FY2009 results. The groups’ revenues are calculated depending on the core business divisions with the Global Banking and Markets division recording the highest figures. Alternatively, revenues are also analyzed depending on their geographical locations, which comprise of the UK, the US, Europe, and the rest of the world. The UK region accounts for more than 60% of the total revenues followed by the US and Europe.

Ratio Analysis

Income Statement: 10-Year Summary

Source: MSN Money, 2012

Balance Sheet: 10 Year Summary

Source: MSN Money, 2012

RBS Fundamentals

Market Capitalization

In terms of market capitalization, the RBS ranks as one of the leading large-cap stocks as of 28 April 2012 with a market capitalization of USD 43.60bn. in the past 12 months, the RBS stock has reached a high of GBp 42.76 and a low of GBp 17.34. As of 28th April 2012, the current stock price was GBp 24.35. This figure places it 43.1% under its 52 week high and 40.4% over its 52-week low (Money Center Banks, 2012).

Price level analysis

Using Peter Lynch’s methodology of comparing projected earnings growth and dividend, RBS can be said to fundamentally undervalued if comparisons are made with the original theoretical price. When compared to the aggregate of other European Banks, RBS’ valuation appears less attractive (Money Center Banks, 2012). However, the fundamental price potential for RBS is rather good even though other stocks in the industry might appear better.

Technical trend and relative performance

For nearly a month, the medium-term technical trend of RBS has been negative with a price of GBp 26.1 with an adjusted technical reverse point of GBp 26.62. Using the DJ Stoxx 600 reference index, the four-week relative performance against the reference index is -12.1% (Money Center Banks, 2012). Given the negative technical trend, it is evident that underperformance for RBS is validated. Critically, this shows that majority of investors are interested in other stocks.

Risk Analysis

In order to assess the risk equity of RBS, several risk analysis tools will be used. This includes but not limited to beta, correlation, and volatility, and the risk factor in bear markets. Beginning with Beta as a risk measurement tool, a situation where beta is greater than 100 represents a more volatile and risky stock. For instance, a beta value of 1.93 indicates a 1% variation in indices, which happens to be the case with RBS. Similarly, correlation refers to the degree of similarity of stock fluctuation compared to the reference index (Money Center Banks, 2012). RBS has a correlation rate of 0.80 meaning that index variations explain 80% of its stock movements. On the other hand, volatility is used to measure the magnitude of low and high stock or index movements. RBS’ annualized volatility for April is 30.5% (Money Center Banks, 2012).

Using the risk factor in bear markets to measure the behavior of RBS in less performing markets, it shows that RBS exhibits a tendency of amplifying the risky positioning of the group in situations of market decline. The risk factor in rising markets also depicts situation-sanctioned pressures for the RBS.

Analysis of Ratios and Financial Reports

Five-Year Plan Strategy

The effects of the financial crisis uncovered several key issues that undermined RBS and these issues included risk concentration, leverage, and business stretches. The continued sale and rundown of assets weakened the performance of the RBS group (Royal Bank of Scotland Group, 2011). This necessitated the need to change the balance sheet by focusing on risk objectives. The five-year plan 2009-2013 was developed to focus on three key objectives (Essinger, 2009);

• Restoring RBS’s performance to undoubted standalone strengths
• Providing efficient service to customers
• Rebuilding sustainable value for all shareholders

These goals are interdependent on one another because customers cannot be served in an unsafe and risky banking environment (Essinger, 2009). Equally, the banks’ standalone strength cannot be rebuilt without rebuilding shareholder value.

RBS’ strategy of serving customers is embedded in different frameworks that guide the process of satisfying customer value and streamlining customer service prepositions. Creating sustainable strength for the bank started with the creation of improvements in liquidity and capital in 2009. By 2010, Risk Management objective was launched to aid the Group in approaching risk issues such as audit and risk functions. This has been fundamental in enabling the ban to create a safe, sustainable, and valuable banking environment to all people (Royal Bank of Scotland Group, 2011). Lastly, the creation of sustainable value to shareholders was developed to enable the bank to develop a strong foundation for all its core businesses. This option has been fundamental in enabling RBS to generate a 13% increase in equity return in FY2010 and aims to extend this figure by upwards of 15% by 2013. This is aimed at increasing confidence from the banks’ investments will generate increased values and core synergies (Rose, 2009). Importantly, realization of sustainable value is seen as a major move for convincing the UK government to sell its stake in the institution.

Several measures have been taken to realize RBS’s strategic and core business objectives. RBS has targeted several market-leading franchises and market positions to improve customer satisfactions. Income growth by focusing on sustainable businesses is another move taken by the bank (Royal Bank of Scotland Group, 2011). Other key strategic moves include focusing on cost control and rigorous capital and cost allocation programs.

Speaking financial measures, RBS reduced its balance sheet scale by de-risking and shrinking the Balance Sheet as a move for careful control of future growth. Measures have also been put in place to reduce over-reliance on wholesale markets to improve its liquidity reserve. On the other hand, realization of a strong capital base has been achieved through excess risk maintenance equity capital and running off-excessive risk concentrations.

Progress so far

RBS has managed to achieve several key accomplishments and economic improvements despite uncertain volatilities and tight monetary policies in several countries. RBS’s core businesses have remained resilient while the Group has managed to realize annualized cost savings of £2.5 billion and expected to exceed £3billion by 2013. The loan-on-deposit ratio by the end of 2010 was 117% and the reliance on wholesale funding reduced from £250 billion in 2009 to £157 billion in 2010 (Royal Bank of Scotland Group, 2011).

On risk management, RBS has stood strong in the line of realizing four-risk objectives that include maintenance of capital adequacies, delivering stable growth in earnings, ensuring efficient and stable access to liquidity and funding (Royal Bank of Scotland Group, 2011). The risk management model has been concentrated on the management of liquidities and risks on the balance sheet. These measures have enabled the bank to record tremendous improvements towards overcoming the effects of the 2007-2011 financial crises.

Conclusions and Recommendations

The analysis conducted in this paper reveals that the failure of the Royal Bank of Scotland amidst the global financial crisis can be blamed on a liquidity run. On the other hand, the system-wide liquidity crisis was well rooted in the market uncertainty that banks could have lost. This factor was fundamental in determining the nature of the banks insolvency and capital inadequacies. Studies show that RBS had strong capital resources totaling £68bn but registered loss of £40.7 bn. According to a report by the Financial Services Authority in the UK Financial Services Authority, several key factors can be blamed for the failure of RBK in 2008 (Financial Services Authority Board Report, 2011). These factors were;

• Notable weaknesses in capital position of RBS and this was attributed to poor management decisions and inadequate global regulatory framework
• The acquisition of ABN AMRO without taking heed of possible risks
• Uncertainties and concerns over underlying asset quality of RBS
• Over-relying on risky short-term wholesale funding
• Substantial losses occurring from credit trading activities leading to the erosion of consumer and market confidence
• underestimation of how bad losses can affect structured credit
• the prevailing crisis in the banking sector

Based on the information gathered and presented in this study, the future prospects for RBS are still difficult. First, the 84% government ownership means that the government will continue to dictate its operational activities including investment, operations, and financing thereby impeding strategic moves (Wilson, 2011). Credit write offs cannot guarantee the bank future profitability either and as well, the staff restructuring. The volatility of its risk portfolio also calls for important measures to be put in place. For this reason, I recommend that RBS do the following:

Use its strengths and opportunities to overcome the threats and weaknesses
Concentrate on the rebuilding and recovery plan in order to enhance its financial performance and gravitate its return to operating profits (Rose, 2009).
Convince the government to sell its stakes in the Group
Reduce its exposures to particular type of risks by forming a strong risk restructuring and management plan
Strengthen its core business that will enable the institution to achieve its future objectives
Invest in sustainable banking and corporate social responsibility initiatives

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