WITH REVENUES DECLINGING AND THE REGULATORY COST of doing business rising sharply, investment banks around the world are scaling back and seeking to find the right size and scope for their operations. Few institutions are doing so in the face of as much political scrutiny — and interference — as Royal Bank of Scotland Group.
RBS is the U.K.’s poster child for banking excess. The bank’s breakneck expansion in the past decade — culminating in its ill-fated £48 billion ($76 billion) purchase of ABN Amro in 2007, just before the U.S. subprime mortgage market imploded — left it hopelessly overextended when the financial crisis erupted in full fury after the collapse of Lehman Brothers Holdings the following year. With losses mounting and wholesale funding markets shutting down, RBS needed a massive public capital injection of £45 billion, the largest bank bailout in the world. Not for nothing did CEO Stephen Hester last year describe RBS as “an emblem of the financial crisis.”
Today, Hester is struggling to restore the bank to health while managing the public pressures that come with being 82 percent government-owned. The former is proving easier than the latter.
Through asset sales and the disposal of noncore businesses, Hester and his team have slashed RBS’s bloated balance sheet by £712 billion, or 44 percent, from its 2008 peak and reduced its reliance on short-term wholesale funding by nearly two thirds, to £102 billion. “We have to defuse the biggest balance-sheet time bomb in history, and we’re making very good progress in doing that,” Hester said last month in announcing the group’s 2011 results.
Although the bank remains unprofitable — sovereign debt write-downs caused the net loss to widen by 78 percent last year, to £2 billion — RBS’s core retail and investment banking activities are in reasonable shape. Operating profits on those core businesses were £6.1 billion in 2011, down 18 percent from a year earlier. Global banking and markets, or GBM, as the investment banking division is known, has generated £10.7 billion of operating profits over the past three years — 44 percent of the group’s total.
Yet RBS and Hester remain convenient public whipping boys. The board’s decision in January to award Hester a bonus of £963,000 for 2011 provoked a public outcry that led the CEO to waive the payment. Ed Miliband, leader of the opposition Labour Party, railed against the proposed bonus and called a parliamentary debate on the issue, prompting Iain Duncan Smith, the government’s minister for Work and Pensions, to urge Hester to give up the award. The incident undermined the government’s contention that it can effectively manage its RBS stake at arm’s length through U.K. Financial Investments (UKFI), a Treasury agency created expressly for the task. The political uproar will also make it harder for RBS to recruit and retain the talented professionals needed to sustain the bank’s turnaround, especially in investment banking. Hester acknowledged the problem when he presented the bank’s 2011 results last month, saying that the “noise around RBS is damaging to the prospect of achieving the goals everyone needs of it.”
The recent controversy will almost surely delay any attempt by the government to sell off some or all of its stake, keeping RBS firmly in the political crosshairs. The bank’s shares were trading at 28 pence late last month, well below the government’s purchase price of 51 pence. Just over a year ago, when the share price was approaching 50 pence, UKFI started preparations for a possible privatization within 12 months, but regulatory and market pressures have put those plans on hold, and Treasury sources say a sale is unlikely before the next parliamentary election, which is due to be held by 2015. Hester told the BBC last month that the government would retain its stake for “quite a few years.”
Given this climate, the prospects for GBM, led by the division’s chief executive, John Hourican, have dimmed. It is not simply that fees are evaporating across the industry and that the new Basel III regulatory framework is forcing all banks to raise their capital and liquidity buffers at a time when investors have little appetite for bank equity or debt. The U.K. government is imposing an additional layer of restraints on its banks because of the costly bailouts of RBS and HBOS, which was later merged with Lloyds Banking Group. The changes, recommended by the Independent Commission on Banking, will require banks to ring fence their retail and commercial banking operations from their investment banking activities, a move that will substantially raise the costs of investment banking.
RBS’s sorry legacy means that Hourican and his colleagues have to look over their shoulders at British politicians. That fact was driven home in December when Chancellor of the Exchequer George Osborne called on RBS to curb its riskier activities and concentrate on the U.K.
As a result, RBS is now pressing ahead with a new round of cuts in GBM and effectively abandoning its experiment with full-service investment banking.
Under a plan announced in January, RBS is cutting 3,500 jobs at the division, reducing its head count to 13,500. The group sold Hoare Govett, its corporate brokerage subsidiary, to U.S. securities firm Jefferies & Co. for an undisclosed amount last month. RBS is preparing to sell its cash equities and M&A advisory businesses. The significance of the moves is as much symbolic as financial. The three businesses generated just £220 million of revenue, a mere 3.3 percent of GBM’s total, in the first nine months of 2011, and they were second-tier businesses at best. RBS ranked tenth by revenue in European equity trading in 2011 and was outside of the top 15 in the other categories, according to Coalition Development, a London-based financial research firm.
The bank is also reducing the capital allocated to GBM’s core fixed-income, currency and derivatives business. RBS plans to cut the unit’s balance sheet, already slashed by nearly 60 percent since 2008, by a further 25 percent, to £300 billion, over the next three years. Executives say that the bank is merely responding to market and regulatory realities like most of its rivals and that it won’t be eliminating any products or territories in its main debt and currency businesses.
“Most banks have been exiting noncore activities and prioritizing client facilitation,” says Suneel Kamlani, the Stamford, Connecticut–based president of GBM. “Our core proposition is that we are a top player in the fixed-income markets.”
Hester insists that he remains fully committed to the debt-focused heart of the investment bank, and for good reason: RBS is a top five player in global fixed-income trading and foreign exchange trading. “These are the cornerstone products and services for the global economy in any economic environment,” Hester said in an internal memo in January.
Yet some observers believe the scale of the cutbacks at RBS and the political scrutiny the bank faces threaten to cause a long-term decline at the investment bank and make it unlikely that it can achieve management’s target annual return on equity of 12 percent. Christopher Wheeler, banking analyst at Mediobanca in London, says RBS, like many other banks, is cutting back much more sharply than the big fixed-income powerhouses: Barclays Capital, Deutsche Bank and JPMorgan Chase & Co. “These banks are the global flow monsters, with the capital, with the global critical mass to make money at a difficult time in the markets,” he says. “RBS is certainly strong in certain areas, but it’s not in the same league as these three. The senior managements of these banks are also stronger.”
Other analysts believe further cutbacks are likely as RBS implements the sharper separation between retail and investment banking mandated by U.K. regulators. “I’d be very surprised if head count is as high as 13,500 in three years’ time,” says Vivek Raja, a banking analyst at Oriel Securities in London.
RETRENCHMENT IS THE ORDER OF THE DAY IN THE industry as investment banks adjust to the lower revenues and more-onerous regulatory requirements that currently prevail. According to Freeman & Co., a New York–based research firm, the total European investment banking fee pool fell 13 percent in the fourth quarter of 2011, to $4.2 billion, the lowest level since 2004. Globally, too, there is a sharp downturn. Goldman Sachs Group reported a 34 percent drop in revenue in its vaunted fixed-income, currencies and commodities (FICC) unit last year, and the bank’s return on equity fell to just 3.7 percent, the lowest level since 1999. Citigroup’s securities and banking division posted a loss of $163 million in the fourth quarter of 2011, compared with a profit of $212 million a year earlier, while Bank of America Corp.’s global banking and markets unit had a loss of $433 million in the quarter, compared with a profit of $724 million a year earlier. JPMorgan saw a 56 percent drop in investment banking revenue in the fourth quarter.
Although virtually every investment bank has announced significant job cuts in recent months, weaker players are doing much more than trimming at the margins. UBS, which received a big bailout of its own from the Swiss government following massive subprime losses, announced 1,800 job cuts at its investment bank last fall and is withdrawing from several business lines, including FICC macro trading and equity proprietary trading (see story, page 26). France’s Société Générale is cutting 1,600 investment banking jobs and has announced that it will focus on European clients and no longer seek to compete against global bulge-bracket players. Italy’s UniCredit pulled out of sales, trading and research in Western European equities in November, with a loss of 130 jobs.
For RBS the cutbacks are all the more painful because they represent a repudiation of the bank’s once-towering ambitions.
The bank was a latecomer to the investment banking party, gaining entrée with its daring acquisition in 2000 of much larger rival National Westminster Bank, which had a big presence in the U.S. bond market through its Greenwich Capital Markets subsidiary.
Then-CEO Fred Goodwin made GBM his main growth vehicle as he sought to compete globally with Barclays Capital and HSBC Holdings. That thinking motivated his pursuit of Dutch bank ABN Amro, which ranks as the largest banking acquisition ever.
The combination of corporate overreach and a global financial crisis proved disastrous. In 2008, RBS posted the largest loss in U.K. corporate history, an astounding £40.7 billion. Four fifths of that total reflected the write-down of intangible assets, mostly goodwill on the ABN Amro deal, but RBS also suffered £7.8 billion of credit losses, the bulk of it on U.S. residential-mortgage-backed securities held by the investment bank.
At the time, GBM contained 54 percent of RBS’s total assets of £1.6 trillion, and market concerns about potential losses in credit-trading activities undermined confidence in the bank, causing it to collapse into the arms of the state.
Goodwin resigned at the end of 2008, taking a retirement package valued at more than £8 million. Public anger at the lack of any legal or regulatory sanctions prompted the government to withdraw Goodwin’s knighthood this January, a rare rebuke. To replace him, the board recruited Hester, a onetime investment banker at Credit Suisse, from his post as CEO of real estate company British Land. Johnny Cameron, who had led GBM through its heady growth years, resigned in October 2008 and was replaced by Hourican.
Hester launched a strategic review of the bank, including GBM, and executives considered all options, including a possible sale or winding down of the investment bank. “There were no sacred cows,” says Hourican. “We clinically looked at everything.” Many in the market believed that the RBS brand had been irredeemably tainted by the bank’s implosion. The review identified £258 billion of bad assets and shifted them into a noncore division for eventual disposal. Fully 90 percent of those assets had been held by the investment banking arm.
“It was something of a surprise that GBM was retained in 2009,” says Simon Adamson, a senior analyst at CreditSights, a New York–based research firm.
But retain it RBS did, because Hester regarded the investment banking division as critical to the bank’s future. It didn’t hurt that the division was capable of generating substantial profits when capital markets thawed in 2009.
“If you look at what has been delivered since 2009, you have to be pleased with the retention strategy,” says Hourican. “It was a pretty good decision.” GBM produced operating profits of £3.4 billion in 2010, or 45 percent of the total for RBS’s core businesses. Those figures fell to £1.6 billion and 25 percent of core operating profits last year as GBM was hit by the global decline in investment banking revenue. The unit posted a £95 million loss in the fourth quarter, a dismal period for the industry that saw the investment banking arms of Bank of America, BNP Paribas, Citigroup, Crédit Agricole, Credit Suisse, Deutsche Bank, Morgan Stanley, SocGen and UBS all go into the red.
An Irish national who trained as an accountant with PricewaterhouseCoopers in Dublin, Hourican joined RBS as an associate director in leveraged finance in 1997, then worked his way up the ranks to become COO of GBM. He was a popular choice among colleagues when the board offered him the top job. “He had a combination of intelligence, technical capability and ready wit which, allied with the ability to get on well with people at all levels in the organization, marked him out as a likely highflier,” says Jeffrey Thornton, former head of project finance, who left RBS in 2007.
Hourican’s priority these days is to restructure and shrink his business instead of building and hiring. His careful language reflects corporate circumspection rather than any large-scale vision, and he has a limited profile outside the bank, giving few media interviews and only occasionally briefing analysts.
From 2009 to 2011, Hourican cut his staff by 7,000 jobs, to roughly 17,000, and reduced the investment bank’s assets by nearly 60 percent, to £362 billion. As part of the bank’s de-risking efforts, he abandoned leveraged and project finance in 2009.
Now GBM faces a fresh downsizing, which will include a withdrawal from cash equities, corporate brokerage and M&A, and reduce the payroll by 20 percent over the next three years. RBS is also restructuring the operation, creating a new markets division that consists mainly of the fixed-income, currencies and derivatives businesses, and moving the corporate lending activities of GBM into a new international banking division that Hourican will oversee.
The moves effectively bring an end to any pretensions of competing across the board with Barclays Capital. As Hourican puts it, “We’re not trying to be the world’s premier investment bank.”
The executive plays down the withdrawal from equities and M&A, saying those activities “have always taken second place at RBS.” The bank ranked a lowly 29th in European equity capital markets revenue last year and 15th in European M&A, according to data provider Dealogic. It fared somewhat better in equity trading, finishing the year in tenth place, according to Coalition.
Although RBS is dialing back, the bank has a strong position in the core fixed-income and currency businesses it’s retaining, even if it is seldom one of the top three players in any market. The bank came in sixth place as a book runner in European debt capital markets last year, trailing JPMorgan and Barclays Capital but finishing ahead of UBS and Citi, according to Dealogic; RBS worked on 494 deals worth a combined $92 billion. The bank ranked fifth in European syndicated loans. In the U.S., RBS ranked in the top ten in both categories; globally, it finished in tenth place by debt capital markets revenue. It finished as one of the top three players in European investment-grade debt and fourth in European securitization. In the latter market it has started 2012 strongly, lead-managing the $1.6 billion whole business securitization of U.K. holiday village operator Center Parcs.
“Despite all the obituaries at the beginning of 2009, our franchise has held up well, and we have the very realistic objective of being one of the top five financing houses globally,” says Richard Bartlett, head of debt capital markets and corporate risk solutions in Europe.
The bank arranged debt deals last year for such prominent companies as France Telecom, Johnson & Johnson, Verizon Communications and Volkswagen, and for the governments of France, Germany and the U.K. In September, RBS was the lead manager for a $5 billion offering of covered bonds by Toronto-Dominion Bank — the largest such issue ever in North America. “We’re winning prestigious new mandates all the time,” says William Fall, head of RBS’s financial institutions group.
The big challenge, of course, is whether the bank can continue to rack up mandates and compete effectively against bond giants Barclays Capital, Deutsche Bank and JPMorgan, even as it reduces the investment bank’s balance sheet and faces continuing political pressure. Seeking to fend off public complaints about banking compensation, British Prime Minister David Cameron and Chancellor of the Exchequer Osborne have insisted repeatedly that RBS should be a “back marker” on pay rather than a pacesetter. Hourican contends that “our pay for our key staff compares reasonably well to that of other banks.” But the pay controversy forced RBS’s chairman, Sir Philip Hampton, to bow to public criticism last month. “Pay has been too high for too long, particularly for banks, particularly in the investment banks,” he told the BBC. “Shareholders have done badly and employees have done pretty well in the last ten years.”
A key test for RBS will involve none other than Hourican himself. The executive could be entitled to a bonus of nearly £6 million in shares next month if he meets certain undisclosed performance targets. Hourican received a total of £6.2 million in compensation in 2010 and £7.7 million the year before. But many analysts doubt that the bank would maintain his pay at a similar level in today’s climate. In the wake of the row over Hester’s pay, RBS last month reduced the overall bonus pool in the investment bank to £390 million, down 58 percent from a year earlier, after hastily convened talks with UKFI. The bank has raised salaries over the past year, so total compensation for investment bankers fell only 26 percent.
Constructing attractive packages for investment bankers is challenging for a bank that is largely state-owned and was the first institution forced to adhere to the U.K.’s Remuneration Code. The code requires at least 50 percent of bonus payments to be made in the form of noncash instruments and at least 40 percent to be deferred over three to five years. The code also contains a provision to claw back pay in the event of a downturn in the bank’s performance.
Under the code, banks are required to disclose the number of staff who earn more than £500,000 a year. RBS has said that about 150 employees globally in the investment bank fell into that category in 2010 and that they were paid an average of £1 million. By comparison, Barclays Capital had 231 such staff and paid them an average of £2.4 million, while Deutsche Bank paid its equivalent group of 168 bankers an average of £3.4 million apiece.
Notwithstanding the constraints that RBS faces, the group has done surprisingly well so far in attracting and retaining investment banking talent. The bank has lost only “two key bankers” in sales and trading since the beginning of 2009, says Peter Nielsen, global head of markets. Steve Ashley, head of fixed-income rates trading, resigned in February 2010, and derivatives trader Gary Cottle, who was global head of corporate risk solutions sales, left in April 2011. “Those businesses are doing well despite those departures,” says Nielsen. Ashley’s position is now split between two co-heads, Michael Lyublinsky in the U.S. and Peter Rading in London, while Cottle’s job has been taken by Bartlett.
Other senior managers also insist that staffing has stabilized. Tim Carrington, global head of foreign exchange, says there has been so little turnover among his 400 employees that “I can count on the fingers of one hand those who have left of their own volition in the 18 months since I took the job.”
Outsiders say RBS has been aggressive in trying to keep its critical talent. “They do everything they can to hang on to their most valued senior people, offering them attractive packages — a number earn £1 million or more,” says Timothy Elborne, a London-based consultant at headhunting firm Webber Chase who recruits fixed-income traders.
RBS has occasionally ponied up large sums to lure star performers. In 2009 the bank recruited Antonio Polverino from Bank of America Merrill Lynch to become head of institutional FICC sales. The following year the bank lured Kamlani, former European COO of UBS’s investment bank, to be president of GBM. Last year RBS hired Tim Skeet, previously head of covered bond origination at Bank of America Merrill Lynch, as a debt capital markets managing director in London.
Another big challenge facing Hester and Hourican is the tough new U.K. regulatory regime. The government has committed itself to implementing the recommendation of the Independent Commission on Banking that big banks separate their investment banking activities from their retail and commercial banking operations. Although the exact details and timing of the change have yet to be determined — RBS says the consequences might not become clear for several years — bankers are bracing for a significant rise in the cost of doing business.
Assuming the ring fencing plan is enforced, most likely beginning around 2015, RBS’s investment banking division would have to fund itself through the wholesale finance markets and meet Basel III liquidity requirements without the help of its parent’s ratings and retail deposits. The position of the RBS group looked healthy at the end of 2011, with a core tier-1 capital ratio of 10.6 percent and a buffer of £155 billion worth of safe, liquid securities that could be sold in a crisis.
GBM carries riskier and more volatile assets than RBS’s retail and commercial divisions, so its credit rating would be lower and its funding spreads would be higher. The extra cost of those spreads or of getting sufficient additional equity capital to prevent a rating downgrade would be about £1.2 billion a year, according to the banking commission’s September report. The commission based its estimates on a median of the figures calculated by sell-side equity analysts and the bank itself. RBS estimates the cost at anywhere between £800 million and £1.5 billion a year.
Rivals will face a similar rise in operating costs. HSBC estimates that the separation of retail and investment banking will raise its costs by between £300 million and £900 million a year, while Barclays Capital pegs its tab at between £900 million and £1.4 billion. That’s hardly chump change, but both institutions are in a stronger position than RBS.
“Barclays Capital is bigger and more able to absorb the costs, and it can also afford to be a little less risk-averse and a little more creative in what it does with corporate deposits,” says Ian Gordon, a banking analyst at Investec Securities in London. “HSBC, meanwhile, is much less dependent on investment banking, and it has the option of redomiciling to avoid the regulation.” At a time when most banks face funding difficulties because of the euro zone’s sovereign debt crisis, raising money through the wholesale markets looks to be a forbidding prospect. As Hester told Parliament’s Treasury Committee in November, banks are seen as a “dumb” investment now.
Hourican and Kamlani decline to speculate on the costs of ring fencing but say the whole industry faces problems. “Given all the regulatory changes affecting the industry, and renewed macroeconomic pressures, return on equity within investment banking will be challenged for some time to come,” says Kamlani.
Some senior investment bankers privately say that the industry in Europe could struggle to achieve double-digit returns on equity over the next two years at least. GBM’s return slipped to 7.7 percent last year from 16.6 percent in 2010.
“The current difficult revenue environment does not allow RBS to generate anything like a decent return in its investment bank,” James Invine and Philip Richards, banking analysts at Société Générale, said in a recent note to clients. Most analysts, such as Keefe, Bruyette & Woods’s Mark Phin and Investec’s Gordon, forecast returns in single digits this year and next, before a rise to 10 percent in 2014.
If the revenue environment were all RBS had to deal with, it might have had a stronger outlook for its investment banking operations. Investment banks routinely expand and contract with the markets. But under attack as it is from regulators and politicians, and weighed down with a troubled recent history, RBS will have to shrink further and look back at 2009–’11 as its halcyon days, never to be repeated. • •
