RBS privatisation: Investment pros and cons

Background to privatisation

Over the 13 months between October 2008 and November 2009, the UK government was forced to bail out Royal Bank of Scotland no fewer than three times to shore up a balance sheet stricken by the financial crisis: as a result, taxpayers now own 81% of the bank.

In the wake of the bail-outs, RBS appointed Stephen Hester as its new chief executive: he has spent the past four years restructuring the bank in order to rebuild its balance sheet, move out of high-risk trading activities, shed toxic assets and manage its legacy issues.

While much has been achieved - at the cost of tens of thousands of jobs and the closure or sale of large parts of the bank - problems remain. The bank's profit during the first quarter of 2013 was its first for 18 months.

RBS has transformed itself since the dark days of near total collapse five years ago

Still, that was enough to prompt speculation that the Treasury might begin to move towards a sale. And in June, the Chancellor used his Mansion House speech to announce a review of whether RBS might be split up.

The break-up would follow the model used at Northern Rock, where a bad bank, owning the institution's most toxic assets, was split out.

One test of whether the break-up should go ahead, said George Osborne, is whether it would accelerate the privatisation of RBS. And despite his insistence that he will only sell when the time is right, the Chancellor remains keen to offload the RBS stake as quickly as possible. First, though, he must find a new chief executive, with Hester having quit within days of the break-up review being announced.

Likely timetable

This depends on who you believe. In May, Sir Philip Hampton, RBS's chairman, filmed a video message for employees in which he said he expected the government to begin selling shares in the bank during the middle of 2014.

By contrast, Robin Budenberg, the chairman of UK Financial Investments, the body that manages the government's holdings in the banks, published a report in July warning that no privatisation was possible until RBS made a "sustained return" to profitability. Sustained is a subjective term, but RBS lost a packet last year before bouncing back during the first half of 2013 - it's some way off being a bank with an established track record of consistent profitability.

In practice, the timing of a privatisation depends on the results of the bad bank review, which is due to report in the autumn. If it concludes hiving off RBS's bad assets would be conducive to an earlier privatisation, it's possible that the Chancellor might move quickly. There's just about enough to time to split the bank in two and get a privatisation of the good bank away before the general election in May 2015, market conditions permitting. Don't bet your house on it though.

Likely method of privatisation

It is too early to say, but it seems likely Osborne would offer the public an opportunity to buy RBS shares, having committed to do so in the privatisation of Lloyds Banking Group.

David Prosser weighs up the likely benefits of the action for RBS's rival in:Lloyds Banking Group privatisation: Investment pros and cons.

Most likely is a model that follows the plan now being mooted for Lloyds - limited share sales to institutions to test investors' appetite and reduce the taxpayer's stake, and then a retail offer, possibly combined with further placings.

Still, there are other possibilities, including the giveaway advocated by the Policy Exchange think tank, which would see all adults in the UK offered free shares in both RBS and Lloyds.

First, though, the Treasury must decide what it wants to sell - RBS in its current form, or a much smaller bank without the bits judged too toxic to offload.

Should you invest?

As ever, the answer to the question depends on the price you're invited to pay. And since, in RBS's case, it's not even clear yet what you'll be buying, investors are a long way off being able to form a view. Still, both the bulls and the bears can start to make their case.

Factors in favour of investing:

• There is no denying RBS has transformed itself since the dark days of near total collapse five years ago. The bank's return to profit during the first half of the year would have come even sooner had it not been for a series of technical accounting charges incurred last year - as well as provisions for various scandals. At the operating level, its recent performance has been much more impressive than the headline figures suggest.
• It's not just the bank's trading performance that is improving. The restructuring work undertaken by Hester has paid off. The bank was finally able to exit the Treasury's punitively expensive Asset Protection Scheme last year. And while the Prudential Regulation Authority said in June that RBS's balance sheet was £13.7 billion short of the capital required for comfort, much of the shortfall has already been plugged, not least thanks to the sale of Direct Line Group. It shouldn't prove necessary to tap investors or lenders for further funding.
• Even the £390 million fine RBS copped earlier this year for its role in the Libor scandal comes with a silver lining - unlike other banks, it has at least reached a settlement. On payment protection insurance (PPI), meanwhile, RBS's exposure to the scandal is notably smaller than that of Lloyds and other rivals.
• Looking ahead, RBS has substantial value in its business to be unlocked, including a healthy market position in retail banking - not least through its NatWest brand - and the prospect of a streamlined investment banking operation that will contribute less volatile returns to the group. If economic recovery is sustained, both arms are capable of growth.
• The next step for the bank is to resolve how to sell off more than 315 branches it was ordered to divest by the European Commission. A deal to offload the network to Santander collapsed last year and RBS has been considering an initial public offering for the unit instead. Sorting this issue should finally allow the bank to restore dividend payments - possibly as soon as next year - which will reassure investors. Dividends on RBS preference shares recommenced in 2012.
• These bullish arguments aside, the prospects for a smaller RBS with fewer toxic assets post break-up would also be more persuasive - again, depending on the price.

The headwinds facing RBS remain daunting

Factors against investing:

• Against those arguments, it must be said that the headwinds facing RBS remain daunting. Not least, the bank hasn't yet announced a replacement for Hester - until it does so, the ship is rudderless.
• The departure of Hester, who was effectively ousted by the Chancellor, underlines the political difficulties that the bank faces. It's not just that the Treasury gets to pick and choose who runs the bank - its every action, from a loan denied to a small business to what it pays executives, is scrutinised through a prism of hostility towards the banks. Operating in such an environment is intensely difficult.
• Then there are the financial constraints. RBS has been improving its balance sheet through the sale of assets, but often at firesale prices, and it is running out of things it can sell. Deleveraging continues, but is increasingly challenging, and the pressure from the regulators isn't going away. The bank may be out of the danger zone, but there is further work to be done and this heavy lifting will constrain the business. Besides, the suggestion that RBS still needs to be broken up rather gives the game away. Many of its worst-performing assets - Ulster Bank and the UK real estate operation - are unsaleable and can't be wound down.
• Another negative is that while RBS is now able to move on from the Libor scandal, other exposures are still current. Its PPI problem may be smaller but with provisions of £1.8 billion already, it's still an issue to take seriously, and there's no guarantee the figure won't rise. It also has an exposure to the rising compensation bill for businesses wrongly sold interest-rate swaps.
• In addition, there's a looming legal action from the Royal Bank of Scotland Action Group, a collection of hundreds of individual investors and institutions who claim the bank misled them during its disastrous rights issue in 2008. An adverse judgement could be hugely expensive.
• Finally, there's the mixed economic outlook to consider. Sustained growth and an improving housing market would help ensure RBS's bad debt problems do not return with a vengeance - sadly there is no guarantee of either.

In a nutshell

With no clarity on price, process or what will be sold, it's too early to take a view on the privatisation of RBS. That's probably a good thing - given today's problems, the bank is a tough sell.

Nor should investors underestimate the practical difficulties of such a massive share sale, which is bound to create market anomalies and overhangs that take time to resolve.