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Option value

12 Jan 2012 By Margaret Doyle

Royal Bank of Scotland, the state-owned UK lender, is cutting its investment bank, again, and is merging it with its international payments unit. The new division aims to make more than the 12 percent groupwide cost of capital. It must do at least that to have any value. But it is a big ask given regulatory and political headwinds.

The cash equities business was never a strength for RBS – not even after the purchase of Hoare Govett which came with the disastrous ABN Amro acquisition of 2007. The fixed income business is stronger. Indeed Greenwich Capital Markets, acquired with NatWest, is something of a jewel in what is otherwise a pretty tarnished crown. Helped by Greenwich, America contributes the largest share of RBS’ investment bank revenues, almost one-third of the total. It also earned a healthy 24 percent return on equity in 2010.

Sadly, the strengths are shrinking. Greenwich was a big player in now-diminished U.S. mortgage trading and returns will come under further pressure because Basel regulations require RBS to assign more capital to fixed income. Moreover, new UK rules that will ring-fence retail banks from riskier wholesale arms raises the latter’s cost of funding. Analysts at Credit Suisse forecast that, without restructuring, return on equity at the investment bank would have shrunk to 6 percent.

The restructuring outlined on Jan. 12 might be enough to boost returns above the 12 percent. But for the time being, potential buyers are likely to bid only at a sharp discount to the 15 billion pound book value of the investment bank. If RBS can show it can jump the 12 percent cost of capital hurdle, it might find buyers ready to pay a more acceptable price. But there is still plenty that could go wrong. UK politicians’ propensity to want to bash bankers could throw a spanner in the works, though commercial imperatives – for the time being at least – appear to have the upper hand.

Soldiering on with the investment bank may be RBS’ best option, but that doesn’t mean it’s an attractive one.


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