Britain got a new prime minister this week (and also a new head of state, but more on that below the paywall). With an energy crisis to confront, feeding into a cost of living crisis, she has a lot on her plate. At least the banks are doing OK. In fact, with interest rates rising, some of them are doing quite well. Luckily for Ms Truss, the UK government owns just under half of one of the banks most exposed to rising rates, NatWest Group. Formerly known as RBS, it caused one of her predecessors no end of troubles, but the bank may now be seeing the fruits of a protracted turnaround. With its latest results, the bank ramped its earnings guidance. Here’s what’s going on…

The Largest Bank in the World

There are many reasons a bank can fail: low capital, risky funding, bad lending. Royal Bank of Scotland (RBS) ticked them all. For a long time, though, management stood in denial. On the morning of Tuesday, 7 October 2008, the bank’s CEO, Fred Goodwin, took to the stage at the ballroom of London’s Landmark Hotel to address a gathering of investors at the annual Merrill Lynch banking conference. One of my hedge fund colleagues was there.

Goodwin delivered a presentation that was markedly out of touch with the financial crisis roiling markets at the time. He spoke of RBS’s “strong franchise”, its “opportunities for growth”, “operational effectiveness” and geographical spread of businesses. He wound up by insisting that the bank would meet profit and revenue targets for the full year and “had the flexibility to respond to organic opportunities as they emerge”. 

My colleague, who had been glued to his Blackberry during Goodwin’s talk, stuck up his hand and waited for the roving microphone to come to him. “Do you know of any reason why your stock price might have plunged 35% during the half hour you’ve been speaking?” he asked.

Ian Fraser picks up the thread in his book, Shredded: Inside RBS, the Bank that Broke Britain:

Goodwin mumbled an answer and went pale. He cancelled some meetings scheduled around the conference and sped back to 280 Bishopsgate. Confidence in the bank had evaporated. The shares had sunk to 95p, their lowest point since the early 1990s recession. The bank’s market capitalisation had shrivelled from £75 billion in May 2007 to £16 billion. ‘In the early hours of Tuesday morning, we thought we had time to polish the plan. By 9.30 a.m., we didn’t,’ says David Soanes, head of capital markets at UBS, one of seven external advisors to the Treasury. ‘The drop in confidence in some of the banks accelerated that morning and it was contagious.’

With the drop in confidence, RBS found it increasingly difficult to fund its operations. Andrew Bailey, currently Governor of the Bank of England was its chief cashier at the time. “I remember John Cummins, the treasurer of RBS, coming to see me,” Bailey told a journalist afterwards. “He looked like death and said, ‘We can’t survive the day. Can you get us £25 billion without anyone knowing?’ I said: ‘Yeah, we can do that.’”

The Bank of England provided sufficient emergency liquidity assistance to keep RBS afloat through Tuesday and the rest of the week. Meanwhile, government officials worked on a more permanent plan. The following Monday, its market capitalisation now down to £10.9 billion, RBS was forced to accept a £20 billion capital injection from the UK Treasury. Initially, that gave the government a stake of 58% in the bank; eventually the stake rose to 84%. The UK government was now the majority owner of the largest bank in the world by assets.

The government installed new management and imposed a few conditions: RBS was banned from paying a dividend, bonuses were curtailed and targets were set to maintain loan supply to small businesses and mortgage borrowers. Broadly, though, the government maintained a hands-off approach, affording licence to the new team, under CEO Stephen Hester, to restructure the bank.

“The Biggest Corporate Turnaround in History”

When Hester took over at RBS, it had assets of $3.5 trillion and operations all over the world. For the first few years, the high level objective was to isolate the bad assets but to maintain RBS as a full-service universal bank – complete with its global network, large lending portfolio in the US, and substantial investment bank. A “non-core” unit was established to wind down £258 billion of assets, and some businesses had to be sold as a condition for receiving state aid, as stipulated by the European Commission. But the shape of the group didn’t change much.

For a while at least, the strategy looked like it made sense. Markets improved in 2010, investment banks recovered and RBS reported a profit on a par with the average it did over 2006 and 2007.

But management underestimated the challenges ahead. Capital requirements became more onerous, meaning the group would have to corral more capital to support its large balance sheet. In addition, asset impairments continued to mount up – including from sovereign debt exposures. Government officials didn’t want to pump more capital in. They were also conscious that RBS needed to be seen to be helping British business.

Eventually in 2013, tensions came to a head and Hester was ousted. One senior RBS insider told Ian Fraser, “The trouble for Stephen was that his strategy didn’t work – and the buck stopped with him.” Nevertheless, some saw it as an activist campaign mounted by the bank’s biggest shareholder. “[It] smashes any lingering pretence that RBS is being run at an arm’s-length basis,” wrote one analyst. 

Ross McEwan took over as CEO with a mandate to refocus the bank on its core UK and Irish franchise, exiting a lot more businesses and activities. McEwan unveiled plans to downsize the investment bank, to sell off Citizens – a Rhode Island-based bank that RBS had originally bought in 1988 – and to tackle the cost base of what remained. 

One idea at the time had been to hive off more of RBS’s bad assets into a “bad bank” managed separately from the core business of the group and funded fully by the government. But a government analysis concluded that the creation of a taxpayer-funded external bad bank would do more harm than good, as it would not contribute to a capital improvement, would distract management and would involve significant implementation challenges. Instead, the group set up an internal capital resolution unit to wind down £47 billion of poorly-performing assets. The analysis also noted that spinning off bad assets wasn’t a panacea – returns in the core ongoing business were below both the group’s cost of equity and those generated by comparable banks. 

McEwan pressed ahead with his restructuring but it wasn’t a smooth process – shrinking can be an expensive business (as I discuss in the context of Credit Suisse in my Bloomberg column this week). The bank took £15 billion of restructuring charges as well as £2.4 billion in losses in an aborted attempt to craft a new bank around 300 or so branches as part of the deal with the European Commission to allow state aid. The group was also subject to a raft of conduct-related charges linked to LIBOR, foreign exchange manipulation and personal protection insurance, none of which helped its reputation as it looked to build back its franchise. 

Other than in 2010, RBS reported a loss every year from 2008 right through to 2016. Finally, in 2017, the process neared completion. By the end of that year, assets had shrunk to below $1 trillion, with almost all non-core assets sold and the losses taken. He stuck around to see dividend repayments started, but in early 2019, Ross McEwan announced his resignation. “With much of the restructuring done and the bank almost strong, stable and profitable footing, I have delivered the strategy I set out…and now feel it's the right time for me to step aside for a new CEO to lead the bank.”

NatWest Group Today

The new CEO was Alison Rose, who took up the role later in 2019. She changed the name of the group to NatWest to align with the brand under which the large majority of business was delivered, and doubled down on McEwan’s strategy to de-emphasise investment banking and focus on the domestic market. In investment banking, she launched another major downsizing programme with the goal of halving the size of the business (by risk-weighted assets) over the medium term. And in domestic banking, she retrenched further, taking the bank out of Ireland to focus principally on the UK market.

Her strategy was partly a response to rules that were introduced in the UK in the aftermath of the crisis but began to bite at the beginning of 2019. Unlike other countries, the UK introduced a regime requiring larger banks to “ring-fence” their retail banking services – deposits, overdrafts and the like – from investment banking and international banking activities in order to insulate them from any problems that may emerge. It was a complex process. NatWest put around £500 billion of assets into its ring-fenced bank and around £300 billion into its non-ring-fenced bank. Rose’s focus was the larger, ring-fenced bank.

The problem with ring-fencing is that it concentrates customer deposits in one side of the bank and when deposits mount up, excess liquidity can accrue. That’s exactly what has happened over the past few years. Since the pandemic, excess deposits in the UK have increased by around £300 billion, as banks have drawn down on central bank funding schemes and households have spent less and saved more.

Initially, excess liquidity found an outlet in mortgage markets, which attracted more competition. However, now that policy rates are rising, deposits are becoming much more valuable. Banks have such an abundance of deposits that there’s no compunction on them to pass rate rises through to customers. Even corporate deposits, which have traditionally been more flighty than retail deposits, don’t have to be remunerated as keenly in this rate tightening cycle. And few banks are as exposed as NatWest. The bank has passed on only around 20% of the hike in rates to retail depositors and around 10% to corporate depositors. 

Such a high level of interest rate sensitivity encouraged Rose to upgrade her guidance for the bank’s earnings recently: she raised her 2023 target for return on capital to 14-16% from above 10% previously. That’s a far cry from what the bank was doing during its long period of rehabilitation. And it even leaves some upside. The target was established on the basis of 2% base rates being reached at the end of 2022 and staying at that level thereafter; with the market currently pricing a higher peak in rates, NatWest has scope to deliver even higher returns.

There are a few risks, of course. The first is that any revenue benefits could be offset by rising loan losses as the economy slows. But based on the Bank of England’s 2019 stress test exercise, in an environment where unemployment rises to 9%, NatWest would suffer around £12 billion in loan losses, which is less than the benefit that may accrue from rising rates. 

Another risk is that the government spots the high level of profitability and slaps a tax on it. UK banks are still subject to a bank levy that was introduced in 2011 but the rate was dropped this year and given that Truss has ruled out windfall taxes for energy companies, it is unlikely she will impose them on banks.

Where the government can extract some value, though, is as a participant in any profits that NatWest makes. It began selling down its stake in 2015, but as at April 2022, still owns 48% of the group. It’s not clear the government will make all its money back. The ‘in’ price was around 500p a share, not taking into account funding costs. Currently, the shares trade at around 255p. But, in the hunt for funding to secure the cap on energy bills, the legacy of the last crisis can go some way to ease the next one.

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