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It’s become a tale of a modern Pyrrhic victory.
During the decade preceding the global financial crisis (GFC), the Royal Bank of Scotland (RBS) embarked on an empire-building binge, increasing its scale fivefold to become the biggest bank in the world, with a balance sheet more than 1.5 times larger than the UK’s annual GDP (a measure of the market value of all the goods and services produced in the economy).
But its meteoric growth was spearheaded by reckless management and unethical practices, which all came crashing down when the British behemoth rushed to buy ABN Amro (which they carved up along with Banco Santander and Fortis), failing to deploy the necessary due diligence which might have shone a light on the Dutch bank’s complex toxic assets. Overnight, billions were wiped off the RBS balance sheet, forcing the UK government to provide an emergency capital injection to the tune of £45 billion (the world’s largest bailout) lest it be faced with systemic financial Armageddon.
More than a decade later, the image of RBS remains tarnished, but behind the scenes, a new story – and opportunity for bond investors – has been unfolding.
To survive – and to appease the European Commission and its new owners, the British taxpayer – the bank had to embark on a programme of intense retrenchment, restructuring, simplification, recapitalisation and general de-risking. The scale of these changes has been as monumental as its pre-crisis growth, driving significant change in its management and, as importantly, its culture.
There is still work to do, improving efficiency and modernisation, but the balance sheet is now rock solid. So strong that the recent Bank of England annual stress test (widely considered to be akin to a disorderly Brexit coinciding with a global recession worse than the GFC) predicts that RBS’ capital low point in such a scenario would still be more than double what it was before the start of the GFC. Scars from the past, coupled with uncertainty in the future, leave the bank willing to forgo chasing profits in favour of conservatism – exactly what a credit investor wants to see.
Culturally, the bank is putting customers ahead of profits too. For example, RBS encourages those mortgage customers that move from fixed term rates onto the standard variable rate (SVR) to refinance with a cheaper product. This is counter to many peers who prefer to capitalise on customer inertia, effectively overcharging them to boost profits for shareholders.
This new safety and customers first culture at RBS might not be immediately appealing to equity investors, but from a credit perspective what matters is how resilient a business is. RBS’ level of protection is akin to donning waterproofs and wellies, while carrying an umbrella on the off chance it rains.
However, despite recent progress, RBS’ credit ratings remain tainted by its chequered past and do not yet fully reflect the bank’s fundamental improvements. As such, RBS bonds continue to trade cheaply relative to its peers. What’s more, the uncertainty around Brexit’s impact has led to a general aversion to UK bank risk, causing further dislocation between valuations and fundamentals. While fluid, this dislocation is understandably more apparent in US dollars and Euro markets than in RBS’ home sterling market.
We expect this discount will be reappraised over the medium term as credit ratings are upgraded, but for now, it has been and remains an attractive investment for our clients. It is an example of how we aim to add value through thinking differently, and maximise value through currency flexibility.
Equity investors might well see RBS as an ugly duckling, but through the lens of a credit investor, it looks rather like a swan.
The views expressed in this blog should not be considered as advice or a recommendation to buy, sell or hold a particular investment and it does not in any way constitute investment advice.
This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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