Aug 14 (The following statement was released by the rating agency)
RBS's solid half-year earnings, based on an increasingly robust balance sheet, are likely to reduce the benefit of implementing a "bad bank" split, as currently being considered by the UK government, Fitch Ratings says. A bad bank split is unlikely as we believe the costs, obstacles and uncertainties involved in transferring some assets to a state-run bad bank would exceed the benefits, in particular to the UK government as majority shareholder in the bank and potential acquirer of assets from the bank.
In light of this and given the large unknown elements of what could be transferred and under what mechanisms even were some sort of split to occur, we have not taken any related rating action on RBS.
From a bondholder's perspective, there are a number of reasons why any split is likely to be neutral for the bank's Viability Rating, although this cannot be assured without full knowledge of what is being considered. At its simplest, it is difficult to imagine a restructuring being sanctioned that would increase risk for bondholders without also reducing value for shareholders, most obviously the UK government, one of whose very objectives is to create shareholder value for reprivatisation.
RBS has just proved, in its recent set of results and following the UK Prudential Regulatory Authority's recent adjusted capital requirement test, that it can continue to operate viably under its current plans. As such, we expect any restructuring would take place outside any existing statutory framework, presumably involving the sale by RBS of certain assets at no less than fair value in order to avoid a breach of EU state aid rules.
Indeed, the UK has pledged not to inject any more money into the bank. Any restructuring scheme that fell foul of EU state aid requirements would, under the revised rules effective 1 August 2013, require junior debt burden sharing and, presumably therefore, dilution of the government as shareholder in favour of junior bondholders.
For any such restructuring to go ahead, the UK government would likely need the approval of some of the minority shareholders in RBS, who would probably want to see a compelling valuation benefit to support a strategy that consumed significant management time. Uplift for shareholders could be difficult to achieve with the costs, legal complexities and valuation adjustments that accompany a good bank/bad bank scheme.
Another consideration is that the public sector debt will likely increase by the size of the assets selected to go into a state-owned bad bank. Public sector banking groups, such as RBS, are excluded from the primary measure of net public debt used by the government and the Office for Budget Responsibility. However, like the existing state run UK Asset Resolution, the bad bank will most likely be included on the exchequer's balance sheet, and thus be included in the public debt. The government may have limited appetite to see an increase in the debt level, so this would likely be a constraint for the size of a potential bad bank asset pool.
The assets that could be considered for transfer into public ownership would likely be in Ulster Bank, UK commercial real estate and some legacy portfolios. They would also likely be loans accounted for at above fair value, so any asset transfer at fair value would likely crystallise losses. The gap between the fair value of RBS's loans and the carrying value at which they were held in the accounts has fallen, but remains substantial at GBP17bn at end-H113. A large portion of the deficit is likely to relate to Irish and property loans, even though some will stem from low-risk assets written at uneconomic rates, such as housing association loans.
If a split were to happen, it might be negative for reported capital ratios. But we believe the impact would likely be moderate, considering the constraints on the potential size of the asset pool and some capital relief from the removal of impaired assets. There has also been media speculation that the government could recycle any compensation it received from RBS's exit of the dividend access share - a scheme put in place as part of RBS's bailout to make it impractical to pay dividends to ordinary shareholders - as a further equity investment. Even if capital ratios deteriorated moderately, asset quality would improve and tail risks would diminish after the asset transfers.
We believe the most likely outcome is for the group to continue to follow its planned capital actions - to deleverage further, partially float its US Citizens operations, and reduce and reshape its markets business. One of the greatest risks facing the RBS group is the litigation and conduct costs relating to legacy business. This risk remains unquantifiable but potentially significant and would be difficult to remove with a bad bank split.
A new chief executive with retail banking pedigree could lead to a strategy more focused on the UK and further reshaping of the markets operations, which would reduce risk-weighted assets, volatility in income and tail risk. But Ulster Bank will remain a drag on capital, as it is not expected to become fully profitable until the medium term.