Betting on RBS is a losing proposition. Former investors learned this the hard way in 2008 when the troubled bank posted a staggering loss of £24.1bn ($34.2bn) – the worst annual performance in UK corporate history. Incredibly, the share price has spiked in recent days, buoyed by hopeful projections that recent downsizing of its investment banking division will make the enterprise leaner and more efficient. This is mere fantasy.
It is important to remember that RBS had previously intended to hold on to – and even expand – its investment banking operations. The investment bank has served as the firm’s primary growth engine since 2009, “producing an average return on equity of 19% and delivering more than £10bn of profits.” (source: Financial Times)
The UK government – with its controlling 83% stake – had other ideas. Poor third-quarter results from the investment bank likely accelerated its demise. Year-over-year, third quarter performance was down across the board: a 73% decline in revenue for credit operations, a 59% decline in revenue for fixed-income and currencies, and a 42% drop in revenue for equities (source: Bloomberg). In the month following the release of these results, George Osborne, current Chancellor of the Exchequer, called upon RBS to “return to its roots as a UK-based lender” (source: Financial Times). Management’s investment banking aspirations effectively died with the following statement by Osborne:
It’s a necessary thing that the Royal Bank of Scotland, which built up this enormous investment bank around the world, shrinks their investment bank…You have to ask yourself why is it that a bank which is largely owned by the British taxpayer is taking all these risks in Asia and America and the like. (source: Bloomberg Businessweek)
In the wake of this mandate, RBS has cut its cash equities, corporate broking, equity capital markets, and M&A businesses. The investment bank will trim £120 from its balance sheet over the next three years. With its sale of Sempra Commodities to JP Morgan in November 2010, RBS must now rely heavily on its fixed-income division to avoid a disastrous drop in revenue and profitability. A net income comparison over the past several years between RBS and rival Barclays (BCS) shows the diverging fortunes of the two British banks:
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RBS is not leaving investment banking on its own terms. Rather, its hand has been forced by disgruntled shareholders – the UK taxpayers. Osborne’s decision to “pull the plug” on many investment banking operations is a harsh indictment of RBS’s management and raises questions as to the bank’s autonomy. As a quasi-government organization, RBS is locked in a devastating (and efficiency-killing) internal struggle between the firm’s executives and government officials.
So what is the fate of RBS? At best, it will become a respectable regional player in commercial and retail banking in the long run. In the short-term – as the bank struggles to find its identity and replace lost revenue from the investment bank – I expect share price to drop anywhere between 15% – 25% in 2012. According to Trefis – a valuation model developed by MIT engineers – sales & trading activities currently account for 14.3% of RBS’s stock price. Various regulatory hurdles, souring investor sentiment, and the inglorious demise of the investment bank should cause investors to consider initiating a short position on RBS in the following months.
One senior investment banker at RBS sums up the case for a short position:
What they’re (the UK government) going to realise is that without global banking and markets, RBS as a ‘utility bank’ isn’t a very good business. The emperor’s clothes will be stripped off.
They will indeed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.