DBRS Confirms The Royal Bank of Scotland Group plc; Senior at ‘A’, Trend Stable

DBRS, Inc. (DBRS) has today confirmed the ratings of The Royal Bank of Scotland Group plc (RBS or the Group) and its related entities, including the Group’s Senior Debt & Deposits rating of “A” and its Short-Term Notes rating of R-1 (middle), and The Royal Bank of Scotland plc’s A (high) Senior Debt & Deposits rating. The trend on all ratings is Stable.

The Group’s ratings reflect its designation as a Critically Important Banking organisation (CIB) in the U.K. As a CIB, RBS’s ratings are subject to the floor rating, which is A (high) for long-term debt and deposits and R-1 (middle) for short-term debt and deposits at the bank level. The level of the floor reflects DBRS’s expectation that the U.K. Government will provide support, if necessary, to prevent any CIB from weakening below this rating level to ensure that its financial system is fully functioning. The CIB designation provides a two notch uplift to the intrinsic assessments (IA), which are BBB (high) for the The Royal Bank of Scotland Group plc and A (low) for The Royal Bank of Scotland plc.

The intrinsic ratings recognise the notable strength of RBS’s Core businesses, which provides a sound foundation for the overall solid Core franchise. Moreover, as illustrated by recent results, the Core businesses continue to produce solid top-line revenues, improving pre-impairment income generation, and considerable operating profit. In confirming the intrinsic ratings, DBRS also considers the significant progress RBS has made over the last three years in improving the funding and liquidity profile, lowering the risk profile, and realigning and right sizing the business. Nonetheless, in DBRS’s view, the Group has more achievements to secure in the future. These include growing profitability, further reducing the quantum of short-term wholesale funding, and lowering elevated credit costs. While DBRS recognises the significant progress the Group has made, DBRS is nonetheless concerned that the continuation of solid execution of the restructuring plan may be delayed by the deteriorating economic conditions in the U.K., the potential contagion impacts of the ongoing disruption in the Euro zone, and global efforts by banks to reduce non-strategic assets.

The improving underlying performance of RBS’s Core businesses is factored in the confirmation of the intrinsic ratings. For 1Q12, the Core Bank recorded an operating profit of GBP 1.7 billion, a 46% quarter-on-quarter increase, which followed GBP 6.1 billion of operating profit for the full year 2011. DBRS notes that with the exception of Ulster Bank, all Core divisions reported an operating profit for 2011. Importantly, RBS has made good progress in shifting the revenue mix from the more volatile Markets business toward the more stable Retail & Commercial businesses. To this end, Retail & Commercial (pro-forma for the restructuring of GBM) accounted for 80% of total Core revenues in 2011 (excluding insurance) compared to 66% in 2007. The improvement in underlying earnings has led to the restoration of pre-impairment income (IBPT) to a level that is sufficient to absorb losses generated by the Core businesses. In addition to showing the strength of the Core businesses, DBRS considers the recent results as validating the Group’s strategic direction and management efforts towards restoring RBS’s underlying earnings ability. While DBRS looks at the performance of the Core Bank as a view into the future, DBRS is also looking for improved performance in the Non-Core segment. Indeed, the intrinsic ratings would benefit from a return to statutory profitability on a Group-wide the consolidated basis.

RBS continues to make impressive progress in removing risk from the balance sheet. To this end, RBS has made noteworthy strides reducing Non-Core assets, which, at 31 March 2012, declined to GBP 83 billion from GBP 258 billion at year end 2008. The benefits of these efforts is evident in the narrowing Non-Core operating loss for the quarter ending 31 March 2012 to GBP 483 million from a loss of GBP 1.3 billion in 4Q11. The quarter’s results benefited from a 35% decrease in loss provisions on favourable credit trends and lower operating expenses due to business disposals.

Credit performance has stabilised with risk elements in lending (REILs) totalling 8.6% of gross loans at the end of March 2012, unchanged from year-end 2011, and 60 basis points higher than in 1Q11. The year-on-year increase reflects higher REILs in Ulster Bank driven by the ongoing difficult operating environment in Ireland and a denominator effect given the deleveraging efforts of the Group. As a result, impairments for loan provisions totalled GBP 1.3 billion in 1Q12, 22% lower on a linked quarter basis and a 33% reduction from the comparable period a year ago. DBRS views the improving credit performance as evidencing the shift in RBS’s risk appetite and the overall improvement in the risk profile. Nonetheless, DBRS remains cautious as RBS’s European businesses, similar to peers, face significant headwinds. Overall, balance sheet credit exposures to the Euro zone are significant at GBP 200.4 billion at the end of March 2012. Of the total exposure, GBP 64.4 billion is to the more distressed Euro zone periphery countries, including Ireland. Although Ulster Bank accounts for only 10% of gross loans to customers, it generated 50% of total Group impairment charges in 1Q12. DBRS sees the potential for increased impairments for the Group especially if prospects for the Euro zone weaken further, or if recessions are deeper and more prolonged than anticipated. Furthermore, DBRS remains cautious regarding the trajectory of impairment charges in the Group’s U.K. Retail and Corporate lending books given the recent indications of a slowing of the U.K. economy.

RBS continues to strengthen and transform its funding and liquidity profile. Customer deposits, which underpin the diverse funding mix, were GBP 432.5 billion at the end of March 2012. Importantly, at the Core Bank, loans and advances are funded by deposits. While wholesale funding remains a notable part of the debt stack, it is being reduced in tandem with the runoff of Non-Core assets. Wholesale funding is now a manageable 35% of total funding, down from 52% in 2008. Moreover, the quantum of short-term wholesale funding has been reduced 73% since YE08 to GBP 80 billion, lowering the Group’s financial risk profile. Yet, DBRS expects further reduction in short-term funding over the medium-term. Reflecting RBS’s more conservative mandate, liquidity reserves have been bolstered. The liquidity pool totalled GBP 152.7 billion at quarter-end, exceeding short-term wholesale funding by nearly 2x.

Regarding capital, the Core Tier 1 capital ratio stood at 10.8% at 31 March 2012, increasing from its low point of 4% at the start of 2008. While RBS’s capitalisation has been enhanced by the capital support provided by the U.K. Government and the participation in HM Treasury’s Asset Protection Scheme, DBRS notes that the capital ratios have been largely stable since year-end 2009. DBRS views the Group’s ability to manage the run-down of the Non-Core asset portfolio while maintaining stable capital levels as demonstrating the solid underlying organic capital generation of the core franchise. Furthermore, capital ratios benefit from the reduction of risk-weighted assets, which totalled GBP 434.3 billion at 31 March 2012.

DBRS sees RBS’s ultimate challenge as positioning itself as a strong stand-alone entity, independent of Government support and ownership. In DBRS’s view, the support which was provided by the U.K. government, the comprehensive restructuring plan, the focused management team, along with the resilient Core-RBS franchise, will allow the Company to meet this challenge in due course.

Notes:
All figures are in GBP unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Steven Picarillo
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 27 October 2004
Most Recent Rating Update: 20 May 2011

For additional information on this rating, please refer to the linking document under Related Research.