Why Being Forced To Shrink Investment Banking Arm Was A Good Thing For RBS

RBS (NYSE: RBS) was one of the largest banks in the world before the financial crisis of 2008. Its £2-trillion balance sheet was bigger than most banks at the time. However, the bank has changed considerably since the recession. It has shrunk considerably in size – moving away from a business model that predominantly focused on investment bank operations to one that depends almost completely on traditional loans-and-deposits banking. Notably, a bulk of the reorganization started in 2012 when the bank slashed its investment banking activities. The large-scale reorganization plan was triggered by conditions imposed on RBS as a part of its bail-out at the peak of the recession as well as stricter regulatory changes in the wake of the downturn.

But what if no such conditions had been imposed on RBS, and it had chosen to retain a full-fledged investment banking division? Trefis answers this question and highlights how RBS’s revenues and profits would have trended if it had continued to focus on its investment banking operations in an interactive. We focus on trends after 2012, as that is when the bank reorganized its investment banking operations.

We Use Trends In Investment Banking Margin and Revenue Growth For RBS’s Peers To Extrapolate RBS’s Numbers

• To paint a picture of how RBS’s investment banking business would have fared over the years, we first determine how its 4 European peers (UBS, Deutsche Bank, Credit Suisse and Barclays) actually performed. This is the benchmark we use to extrapolate RBS’s investment banking revenues and profits.
• Additional details about the trends in average revenues and margins for the investment banking operations of these banks is available in our interactive dashboard.

Based on the extrapolated numbers, we conclude that:

#1 RBS’s Total Revenue Would Have Been Much Higher

• If RBS had not reduced its IB activities and grown at the same pace as other European banks, RBS’s revenue in 2018 could have been £18 billion – almost 35% higher than its actual revenue of £13.4 billion.
• Moreover, the contribution of IB to total revenue could have reached 33% as opposed to just 11%.

#2 RBS’s Operating Income Would Have Remained Higher Over The Period

• As RBS’s IB margin would have been higher, it would have helped the bank generate higher profits.
• Details about how we arrive at our forecast for RBS’s Revenues and Profits for the scenario when investment banking operations had a trend comparable to peers is available in a separate interactive dashboard: How Could RBS’s Pre-Tax Profits Have Trended If It Continued Its IB Activities?

#3 Higher IB Margins Would Have Nudged RBS’s Overall Operating Margin Upwards

• RBS’s IB margin could have been much higher, providing the bank’s overall EBT margin an upward push.
• The bank’s EBT margin in 2017 could have been 22% as opposed to just 17%.
• Notably, though, the bank’s decision to cut down its trading activities is bearing fruits. RBS’s actual EBT margin in 2018 was 25% while if the bank wouldn’t have cut down its IB business, the margin could have been lower at 24%.
• And the gap would only have widened going forward due to weaker economic conditions in Europe, and the growing dominance of U.S. investment banks.

#4 Consequently, RBS’s Share Price Would Also Have Been Higher

Additional details about what RBS’s share price would have been under the alternative scenario are available in our interactive dashboard.

CONCLUSION: With The Benefit of Hindsight, RBS’s Decision To Cut Back Its Investment Banking Activities Looks Like The Right Move

• Although RBS’s decision to cut down its trading operations adversely impacted the bank’s performance in the earlier years, the bank is starting to enjoy its benefits now.
• One-time restructuring charges and impairment costs had an adverse impact on the bank’s bottom line. However, the bank’s focus on the higher-margin retail business is helping the bank churn out more profits than it would have if it were to continue with IB operations.
• Although RBS’s revenues and EPS figure would have been higher if it retained full-fledged investment banking operations, the narrowing gap between actual and potential revenues indicates that the current model will be more profitable going forward.
• Also, the increased regulatory requirements linked to a bigger investment banking arm would have raised RBS’s capital requirements considerably – weighing on the bank’s return on equity.
• This, in turn, would have very likely made the bank’s return to the private sector a much slower process.
• Taking everything into account, the imposed focus on retail banking and the subsequent exit from many investment banking activities looks like the right decision for RBS in the long run.

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