The British government made it clear to the Royal Bank of Scotland (RBS) Group (NYSE:RBS) that they are the ones calling the shots, when British Chancellor of the Exchequer George Osborne ordered the largest banking institution in the U.K. to make sweeping changes to its business. The 82% state-owned RBS has no option but to fall in line with the government’s demands. Besides complying with the ICB’s ring-fencing recommendation which was approved by the British parliament earlier this week, RBS will be forced to shrink its investment banking business substantially.  More importantly, the banking group has also been directed to focus on its operations in the U.K., which could result in the group exiting some its diversified businesses in the U.S. and Asia.  Although clarity about the new business model isn’t expected until February, the bank will likely be substantially smaller outside of the U.K. Competitors like Deutsche Bank (NYSE:DB) and Goldman Sachs (NYSE:GS) certainly wouldn’t mind this reduction in competition.
We are currently reviting our $11 price estimate for RBS’s stock in view of the impact of the ICB’s recommendations on the bank.
Directive 1: Ring-Fence Retail Banking & Investment Banking Operations
The Independent Commission on Banking (ICB) published its final recommendations for banks headquartered in the U.K. this September. The most hard-hitting recommendation was for banks to separate, or “ring fence,” their retail banking and investment banking operations so that taxpayers would not be liable for the operations of the riskier investment banking operations. The move intends to make sure that retail banking operations of banks are not hit even in adverse economic environments – so that there is no need for the government to bail them out.
This move would raise RBS’ operating expenses, as the proposed changes will necessitate additional funding for banks – squeezing yields for the bank’s retail business. You can read more about this in our article, ICB Report Gives UK Banks Breathing Room with 2019 Implementation.
Directive 2: Shrink Investment Banking Unit
RBS has reduced the size of its investment banking business by nearly half since the government bailout in 2008. But the government is still not happy with the “casino” business, and maintains that RBS “needs to go further.” 
RBS will have to make “significant reductions” to its investment banking business and has been asked to scale down activities that require large amounts of capital. The bank’s equity trading arm is rumored to be a candidate for a large downsizing or even an eventual exit. This would impact the bank’s commission and fee income to a great extent, reducing our estimates above.
Directive 3: Focus on U.K. Business
In what we believe is the order that will affect RBS the most, the bank will need to cut down on its overseas operations, focusing on its U.K. business. With the U.S. contributing to nearly a quarter of the bank’s revenues, this would mean a significant decline in RBS’s top-line numbers. RBS may have to exit its Citizens & Charter One businesses in the U.S. to comply with this order – a division we believe contributes to more than 10% of RBS’s value.
This directive also could mean that RBS will have to forget its plans to expand into the fast-growing Asian economies, which would impact our growth estimates significantly.Notes:
- Britain pushes ahead with major bank shake-up, Reuters, Dec 19 2011 [↩] [↩]
- RBS May Consider U.S. Citizens Unit Sale on U.K.-First Strategy, Bloomberg, Dec 20 2011 [↩]