Q3 Results At RBS To Benefit From $1.3 Billion Provision Release

RBS: Royal Bank of Scotland Group logo
RBS
Royal Bank of Scotland Group

Nearly six years after it was pulled from the brink by the British government, The Royal Bank of Scotland Group (NYSE:RBS) seems to have finally turned the corner. While the global banking group has yet to recover fully from the impact of the economic downturn of 2008, with the U.K. government still holding an 81% stake, the bank has worked extremely hard over the years to streamline its operations and improve efficiency. And with economic conditions in Europe returning to normal, RBS’s business model is well poised to churn out steady profits.

Going by RBS’s performance figures for the first half of the year as well as the bank’s preliminary update about Q3 results released on Tuesday, September 30, it appears that the bank’s poor profitability may be a thing of the past. [1] A key factor behind this is improving credit conditions in the region, which have helped the bank dip into the huge loan reserves it has created over the years. Notably, RBS will release £800 million ($1.3 billion) in provisions in Q3 – significantly higher than the £93 million ($150 million) in loan recoveries for Q2. Coupled with the absence of any one-time impairment costs, this should help RBS post one of its best quarterly performances since the economic downturn of 2008.

The news presents a small upside to our $13 price estimate for RBS’s stock. We will update our analysis once the bank details its Q3 2014 results on October 31.

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See our full analysis for RBS’s stock

In return for its £45.5 billion bailout in the aftermath of the global economic downturn of 2008, the European Commission laid down a list of restrictions as well as compulsory divestments that RBS had to undertake over the following years. ((Darling hails Lloyds and RBS move, BBC News, Nov 3 2009)) The requirements included the disposal of the group’s Global Merchant Services (WorldPay), RBS Sempra Commodities and a 316-branch network by the end of 2013, and a complete exit from the insurance business (Direct Line) by the end of 2014. [2] The restrictions imposed also forced the group to cut down on investment banking operations, and banned it from restarting its non-core activities until the end of 2014. ((Statement on disposal of UK Branch-based Business, RBS Press Releases, Oct 15 2012)) As profits continued to elude the bank, the U.K. government (also the group’s largest majority shareholder) directed it to focus on its retail and business banking operations in the U.K. This in turn resulted in a spin off of the U.S. retail operations as the Citizens Financial Group this September.

The extent of divestments undergone by RBS over the years is evidenced by the fact that the bank’s balance sheet has shrunk from almost $3.7 trillion at the end of 2007 to $1.7 trillion at the end of Q2 2014 – a 54% reduction. While revenues fell sequentially each year, expenses were aggravated by a string of one-time charges related to litigation and restructuring. The impact of this on the pre-tax profits is seen in the table below. The figures here are obtained by converting the figures reported by RBS as a part of its annual reports using the average GBP-USD exchange rate for each year.

(in $ bil) 2005 2006 2007 2008 2009 2010 2011 2012 2013
Total Revenue 46.55 51.60 62.28 38.45 51.71 49.27 46.42 28.44 30.91
Profit before tax 14.45 16.93 19.82 -47.65 -4.14 -0.62 -1.23 -8.36 -12.90
Impairments -3.11 -3.46 -4.26 -13.80 -21.76 -14.31 -13.97 -8.37 -13.19

The impact of impairments on the bottom line stands out in this table, with this figure being as high as 42% of the bank’s total revenues in 2009. The Ulster Bank division has been the single biggest contributor towards this, with the division being responsible for almost 40% of the group’s total impairments in several quarters, while contributing less than 5% of the group’s total revenues. The fact that RBS estimates a release of £300 million ($500 million) of Ulster Bank’s provisions indicates that the poor credit situation in Ireland has bottomed out, and the division’s marginal profits over the last two quarter will improve in subsequent quarters.

With impairments being under $500 million for the first half of the year, and with the bank expected to release $1.3 billion in provisions in Q3, RBS will actually report a net recovery in loans for full year 2014. Besides the Ulster Bank operations, RBS will also release a sizable chunk of provisions related to the legacy businesses it is looking to dispose of. While RBS admits that its investment banking operations fared worse than expected in Q3 2014, we believe that the absence of any one-time charge will ensure that figures for the period are among the best since 2008.

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Notes:
  1. RBS issues Q3 2014 trading update, RBS Press Releases, Sept 30 2014 []
  2. Statement on disposal of UK Branch-based Business, RBS Press Releases, Oct 15 2012 []