January 11, 2013 10:12 pm

Hester prepares to jump hurdles at RBS

You wouldn’t know it to look at the share price, but Royal Bank of Scotland and its chief executive Stephen Hester face a nightmarish year.

A hint of what is to come emerged this week, as the part-nationalised bank – whose stock is trading at an 18-month high – prepared for a costly settlement with regulators over its involvement in the Libor rate-rigging scandal.

RBS-graphic

RBS-graphic

Much more lies ahead. Over the coming weeks, there will be the inevitable political row over bonuses, new regulatory capital demands, and a renewed attempt to sell a portfolio of more than 300 branches, ordered by the EU’s state-aid authorities, after Santander backed away from the purchase late last year.

At the same time, Mr Hester is trying to complete the five-year task of winding down a complex book of “non-core” investments – defusing what he has is described as a balance-sheet “time-bomb” that still hangs over the bank.

RBS’s booming share price is, therefore, arguably more to do with improving sentiment towards the banking sector as a whole, as investors take heart that banks – and the eurozone – look a little less vulnerable. Shareholders may have also taken the view that many of RBS’s challenges in 2013 are already well known and relatively inconsequential in terms of the group’s future prospects – so they should not act as a drag on the stock.

However, that leaves the share price – which is being watched closely by the government, given taxpayers’ 82 per cent stake in the bank – vulnerable to blow-ups, if RBS runs into further difficulty in the year ahead.

Having closed on Friday at 360.2p, the shares are now approaching the level at which the state’s £45bn bailout money was injected. The so-called government “in-price” works out at somewhere between 410p and 500p, depending on the value put on various complicating charges imposed at the time of the rescue.

Whether the shares can reach this level will depend on how they react to RBS’s four main hurdles in the next 12 months.

The first of these is now imminent. Over the next two or three weeks, the bank is expected to finalise a deal to pay an expected £300m-£400m in settlement costs to regulators on both sides of the Atlantic.

A further element of the Libor fallout, as the Financial Times reported on Thursday, will be whether the bank decides to recoup up to half of its expected Libor settlement cost from the bonus pot set aside for investment bankers.

That could be a neat way for Mr Hester to dodge his second looming challenge: the perennial bonus row.

He has already waived his own annual payout for 2012, following an embarrassing IT failure that left millions of customers unable to access their accounts for several days last summer. But to slash payouts to investment bankers by as much as 40 per cent from last year’s total would cause resentment internally, given that RBS’s pay levels are already lower than many rivals’.

Meanwhile, the third – and most potentially disruptive – risk for investors will be rumbling along in the background: the bank’s capital shortfall.

At present, the Financial Services Authority, under pressure from the Bank of England’s influential Financial Policy Committee, is in the process of calculating the capital shortfalls of the UK’s lenders.

Last November, the FPC warned of three reasons to be wary of banks’ current capital levels: their self-calculated “risk weightings” on certain assets were too aggressive; certain of their assets, particularly property, were probably overvalued; and regulatory fines and customer compensation risked eating into their funds.

In aggregate, the committee identified a capital hole of up to £50bn.

In a recent note to clients, analysts at Autonomous, an independent research house, said RBS was the most exposed to the regulatory crackdown. “RBS . . . has exposure to each of the areas under review, and it has the fewest easy options for raising capital,” Autonomous said.

With equity issuance politically impossible, the bank essentially has three routes to find capital of up to £12bn, the analysts concluded: issue contingent convertible debt (so-called Cocos); shrink the investment bank more radically; or, most dramatically, sell Citizens – its large US retail subsidiary.

Mr Hester has been particularly resistant to selling Citizens. Without it, he said late last year, RBS would be a “second-best Lloyds”, focused almost exclusively on the UK market.

But while these capital raising measures would mean shareholders avoid the dilution of an equity issue, all of them will potentially hurt investors. A shrunken investment bank or a Citizens sale would strip out earnings, while the high coupon on a CoCo would steadily eat into them.

Fourth for Mr Hester is finding a buyer for its RBS branches in England and Wales, largely comprising SME customers, and its NatWest branches in Scotland.

Currently, lowball private equity interest dominates: from JC Flowers and Apollo; from Virgin, backed by WL Ross; and from a smaller outfit, Anacap.

On top of that, there is plenty of scope for other bad news. More money will need to be set aside to cover compensation for mis-selling claims, and the bank is also facing unspecified money-laundering charges from regulators.

In terms of macroeconomic risk, RBS also has significant exposure to Ireland, where its lending stands at £36bn.

In combination, these problems are likely to add up to a break-even year, at best, in 2013, analysts predict – compared with the £2.8bn pre-tax loss that RBS racked up in the first nine months of 2012.

By the end of this year, though, Mr Hester is confident that the back-breaking work will be over. Aside from all of the one-offs, the long drawn-out process of winding down an initial portfolio of £256bn of toxic and other “non-core” assets should be all but complete. He had already got it down to about £60bn by the end of last year, with the remainder comprising mostly corporate loans and commercial property assets.

Assuming all goes to plan, that should set up 2014 to be a year of revival. Twelve months from now, Mr Hester hopes to be drawing up plans for a dividend policy that could start paying out by mid-2014.

That in turn should lead Mr Hester to the holy grail: a share price that is close enough to the government’s average investment price to allow it to begin the reprivatisation of the bank. Only then will the chief executive feel able to call the turnround mission he began in 2008 a success.

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