DBRS Downgrades RBSG Rating to “A Low”, Trend Negative

DBRS Ratings Limited (DBRS) has today downgraded the long-term senior debt rating of the Royal Bank of Scotland Group (the Group or RBS) to “A low” from “A”, and the long-term senior debt and deposits rating of Royal Bank of Scotland plc to “A” from “A high”. The Trend on the long-term ratings is Negative. This rating action concludes the review initiated on July 15, 2013. The downgrade incorporates the impact of the removal of the rating floor in the UK for critically important banking organisations (CIBs). DBRS has not downgraded the ratings further as a result of RBS’ November 1 announcement of the creation of an Internal Bad Bank, and the Intrinsic Assessment of Royal Bank of Scotland plc remains “A low”. However the significant execution risk in the Group’s restructuring plans is the main driver of the Negative Trend on the ratings. A full list of affected ratings is at the end of the press release.

DBRS removed the UK’s A (high) rating floor on July 15 following an assessment of the applicability of the rating floor for CIBs in the UK. The senior debt and deposit ratings of RBS previously incorporated two notches of uplift from the Intrinsic Assessment (positioned at A (low) at the Royal Bank of Scotland plc, the main operating bank). Following the removal of the rating floor, DBRS continues to incorporate one notch of uplift into the ratings, in line with other systemically important banks in the UK, reflecting the challenges that the authorities would face in the resolution of the largest banks.

On November 1 2013 the UK Government concluded its review into the case for an RBS bad bank and expressed its support for RBS’ decision to create an “internal” rather than an “external” bad bank. DBRS considers that this outcome is better for bondholders and will enable the Bank to progress more quickly with the de-risking of the balance sheet, and consequently has not downgraded the Group’s ratings further.

However, the Group’s plans have significant execution risk and will result in a number of upfront losses. RBS has selected (net of provisions) GBP 17 billion higher risk assets from the Core Bank as well as GBP 29 billion assets from the Non-Core Bank for the internal bad bank (IBB) and is targeting an accelerated wind-down of these assets. Around 60% of these assets (gross of provisions) are from Ulster Bank and UK commercial real estate portfolios and half of them are already non-performing. By the end of 2013 RBSG expects these assets to total around GBP 38 billion (around 5% of total assets), although DBRS notes that the GBP 11 billion capital allocated to these assets is around 20% of Group capital due to their higher loss content. As a result of an accelerated wind-down of these assets, RBS expects GBP 4 – 4.5 billion of impairment provisions in Q4 2013. The impact of this on the fully-loaded Basel 3 core tier 1 ratio will be limited to a negative 10bp, as these assets currently incur capital deductions as well as high risk-weightings. But in addition, the Group expects a further GBP1 billion impairment on currently performing assets in the IBB over the 2014 – 2016 period, as well as GBP 1.5 – 2 billion disposal costs and GBP 1 billion annual running costs.

Other measures planned by the Group to strengthen capital and realign the focus of the Group on UK Retail and Corporate Banking are the accelerated disposal of its US subsidiary, Citizens (which is expected to increase Group capital ratios by around 200bp), starting with a partial IPO in 2014, as well as an overall review of the Group to be communicated in February 2014. In addition, the Group still has to sell 315 branches in line with EC requirements.

RBS is still struggling to return to full profitability. In Q3 2013 the Group reported a net loss (excluding fair value of own debt) of GBP 332 million (compared to a profit of GBP 15 million in Q2 2013). At an operating level before one-off and other items the Group reported a profit of GBP 438 million (GBP 931 million in Q2 2013). Impairment charges have remained stubbornly high (GBP 3.32 billion in 9m 2013, compared to GBP 3.83 billion in 9m 2012), and one-off items continue to impact the Group’s performance. In line with global and UK peers, the Group also continues to face a series of ongoing conduct charges and regulatory investigations, including the Federal Housing Finance Agency lawsuit regarding US mortgage-backed securities sold to Fannie Mae and Freddie Mac. However DBRS notes that due to its lower levels of profitability RBSG has less flexibility to absorb further provisions and settlements than many peers.

Nevertheless, RBS retains a strong and stable presence in its core UK Retail and Commercial Banking franchise. As the Group’s restructuring progresses, this franchise will represent an increasing proportion of the Bank’s revenues and net profits, and it is the strength of this business which is underpinning DBRS’ decision to maintain the Intrinsic Assessment at A (low).

DBRS considers it broadly positive for bondholders that RBSG is focused on ensuring the Group can meet the tougher regulatory requirements faced by UK banks, and it has set a target of 12% or higher fully-loaded Basel 3 core tier 1 ratio by 2016. However, RBSG faces significant challenges as it further downsizes the Group and tries to improve the profitability of its core operations. If DBRS considers that RBSG is losing relevance in its core franchise, this could lead to downward pressure on the ratings. On the other hand, if over time the franchise and profitability stabilise, the trend on the ratings could be changed to stable.

Separately DBRS has upgraded by one notch to BB the ratings of the preference shares issued by RBS Capital Funding Trust V/VI/VII. Payments on these instruments had been halted from 2011 in line with EC restrictions on RBS as a recipient of State Aid, but payments have been resumed from 30 June 2013. Following the resumption of coupon payments, DBRS now rates these instruments in line with our standard notching.

Notes:
All figures are in British Pounds (GBP) unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other applicable methodologies used include the DBRS Criteria – Intrinsic and Support Assessments; DBRS Criteria: Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments and DBRS Criteria – Rating Bank Preferred Shares & Equivalent Hybrids. These can be found at: http://www.dbrs.com/about/methodologies

[Amended on July 30, 2014, to reflect actual methodologies used.]

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.

For further information on DBRS historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.
Lead Analyst: Elisabeth Rudman
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 27 October 2004
Most Recent Rating Update: 15 July 2013

DBRS Ratings Limited
1 Minster Court, 10th Floor
Mincing Lane
London
EC3R 7AA
United Kingdom
Registered in England and Wales: No. 7139960

For additional information on this rating, please refer to the linking document located at: http://www.dbrs.com/research/236983/banks-and-banking-organisations-linking-document.pdf