DBRS Comments on RBS’s 1H12 Results; Senior Unaffected at “A”, Stable

DBRS, Inc. (DBRS) has today commented that the ratings for The Royal Bank of Scotland Group plc (RBS or the Group) and related entities, including its Senior Debt & Deposits rating of “A”, are unaffected by the Group’s announcement of 1H12 results. The ratings consider DBRS’s designation of RBS 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 trend for all ratings is Stable.

In the face of a slowing U.K. economy and weak capital markets activity, RBS posted solid underlying results that continued to evidence the Group’s progress with its efforts to reduce Non-Core assets, restructure the Markets business, and strengthen its balance sheet. However, statutory results were impacted by several one-time items, including a GBP 3.0 billion charge for movement in the fair value of own debt, cost of APS, an additional GBP 260 million PPI provision charge, and other items. For 1H12, the Group reported an attributable loss to shareholders of GBP 2.0 billion compared to a loss of GBP 1.4 billion in 1H11. Excluding the one-time items, RBS generated an operating profit of GBP 1.8 billion, compared to an operating profit of GBP 2.0 billion a year ago. DBRS notes that included in operating profit were two exceptional items: a GBP 50 million provision for interest swap mis-selling, and a GBP 125 million charge related to the Group’s technology incident that affected the Group’s systems in June 2012. While DBRS views these costs as manageable, DBRS is concerned that these items, as well as the ongoing LIBOR investigations, risk damaging the franchise at a time when restoration of the franchise from the 2008 crisis was progressing well.

Total income declined 15% year-on-year (YoY) to GBP 13.6 billion, reflecting the deleveraging of the balance sheet and challenging capital market conditions. Net interest income was 8% lower YoY, reflecting the competitive savings market for U.K. Retail, the reduced loan book in International Banking, and the continued run-down of Non-Core. Net interest margin was reduced 8 basis points from 1H11 to 1.92%, primarily due to the Group’s prudent decision to hold a sizeable liquidity buffer given uncertainties regarding the Eurozone crisis. DBRS notes that NIM increased quarter-on-quarter in 2Q12 by 6 basis points and expects further stabilisation in NIM, given the shift in funding mix, good pricing achieved on new lending, and the gradual reduction in the liquidity buffer. Non-interest income fell 19% YoY driven by a notable decline in Non-Core that reflected significant gains recognised in 1H11 and the lower Markets non-interest income on reduced client activity due to lower investor confidence.

In Core RBS, operating profits for 1H12 were GBP 3.2 billion, 19% lower than a year ago. Revenues were constrained by the weakening economic conditions in the U.K. and the ongoing restructuring of the Markets business. Weak revenue generation across a range of products reflecting subdued client activity as investor and issuer confidence remained weak resulted in Markets reporting an operating profit after own credit adjustments of GBP 1.1 billion, a 21% YoY reduction. Within Retail & Commercial (R&C), performance was resilient despite the challenging economic backdrop and low interest rates. For the half-year, R&C generated an operating profit of GBP 2.1 billion, 12% lower than in 1H11. This solid performance in R&C was achieved despite still elevated operating losses at Ulster Bank, which increased modestly YoY to a loss of GBP 555 million. This loss was driven by higher credit costs and weaker income generation due the challenging economic conditions in Ireland. U.K. Retail and U.K. Corporate each delivered another solid half-year despite the slowing U.K. economy. U.S. Retail and Commercial reported 40% YoY growth in operating profit, underpinned by lower impairment losses and modest growth in net interest income on commercial loan growth and lower funding costs. From DBRS’s perspective, the ability of the Core businesses to produce sustainable income is critical for the Group in rebuilding its intrinsic strength. Importantly, losses in Non-Core continued to narrow in 1H12 with an operating loss of GBP 1.4 billion, down from a loss of GBP 2.0 billion a year ago. The improved results reflect a 56% decline in impairment primarily driven by lower Ulster Bank charges, and a 20% reduction in operating expenses, which partially offset lower revenue generation. In DBRS’s view, the results demonstrate the resiliency and strength of RBS’s Core franchises, which still have considerable underlying earnings capacity that further validates the Group’s strategic direction.

RBS’s credit metrics continue to reflect positive trends. Importantly, leading credit indicators remain positive, indicating further near-term improvement in credit performance. During 1H12, Group risk elements in lending (REILs), excluding disposal groups, fell 3% to GBP 39.7 billion, or 9% of loans. For 1H12, impairment charges were 37% lower YoY at GBP 2.6 billion. Impairment losses were lower in Core and Non-Core, reflecting positive credit trends across the R&C businesses in the U.K. and U.S., and a noteworthy reduction in Non-Core primarily driven by lower charges in the Ulster Bank portfolio. Impairments in the Core Business declined 10% to GBP 1.6 billion. Ulster Bank reported impairment charges, across both Core and Non-Core, of GBP 1.2 billion in 1H12 driven by high unemployment, reduced household income, and weak economic activity, which have resulted in falling property values and rising mortgage arrears. However, while the impairment charge is still elevated, DBRS notes the significant improvement from GBP 2.5 billion in 1H11, which reflects the continuing run-down of the Non-Core portfolio.

Despite turbulent markets, RBS continues to make good progress on its five-year restructuring plan. Non-Core third party assets (excluding derivatives) declined 23% from the end of 2011 to GBP 72 billion. Importantly, at quarter-end, total Non-Core third party assets were 8% of Group total funded assets.

The Group’s financial risk profile continues to strengthen underpinned by further progress in improving the liquidity and funding profile. Group-wide customer deposits, including GBP 22.5 billion relating to disposal groups, totalled GBP 435.3 billion at the end of June, and now represent 67% of total funding. RBS’s loan-to-deposit ratio improved to 104% at the end of 1H12 from 114% a year ago. Within the Core Bank, this ratio was 92%, well-ahead of the targeted circa 100%. The continued deleveraging of the Non-Core book and Markets has allowed the Group to further reduce its wholesale funding requirements. During 1H12, short-term wholesale funding was reduced by GBP 40 billion to GBP 62 billion. As a result, wholesale funding (excluding derivative collateral) maturing in more than 1 year represented 66% of total wholesale funding (excluding derivative collateral). The Group continues to hold a prudent liquidity buffer, which totalled GBP 156 billion, or 2.5x short-term wholesale funding at 30 June 2012.

RBS continues to bolster its capital position. At 30 June 2012, RBS’s Core Tier I ratio stood at 11.1%, 50 bps higher than at year-end 2011. The improved capital ratio reflects the reduction in risk-weighted assets before the impact of the Asset Protection Scheme (APS), which were 4% lower than at year-end 2011, and lower capital deductions. Excluding the benefit of the APS, the Group’s Core Tier 1 ratio was over 10.0% at 30 June 2012.

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 commentary was disclosed to the issuer and no amendments were made following that disclosure.

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

Lead Analyst: Roger Lister
Approver: William Schwartz
Initial Rating Date: 27 October 2004
Most Recent Rating Update: 5 July 2012

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