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Rory Cullinan runs the world’s worst bank from a fifth-floor office overlooking Liverpool Street station in London. His 400-person outfit doesn’t lend money or trade securities. Instead, it sells blown-out mortgages, busted loans and entire companies amassed by Royal Bank of Scotland Group Plc before it collapsed in the global financial crash of 2008. On a Friday afternoon in February, Cullinan is savoring a new feeling in his life as a toxic-asset disposal specialist: hope that the worst is finally over.
After four years of marathon dealmaking, Cullinan’s Non- Core Division has whacked a 258 billion pound ($390 billion) financial junk pile down to 57 billion pounds and eased pressure on RBS’s balance sheet. That’s been Chief Executive Officer Stephen Hester’s No. 1 priority since the government saved RBS from insolvency beginning in late 2008 with a 45 billion pounds lifeline — the biggest bank bailout in history, Bloomberg Markets magazine will report in its May issue.
“RBS was obviously bankrupt, and there was a lot of tension, a lot of chaos, and I was living in here,” says Cullinan, 53, a silver-haired Scot who speaks with the speed of a dealmaker in a hurry. “Now, it’s a paragon of calm.”
While Cullinan’s so-called bad bank has made progress, Hester, 52, faces turmoil in almost every other part of RBS as he struggles to return the firm to profitability and pay back taxpayers. In the decade before the credit crisis, Edinburgh- based RBS epitomized the empire building that turned staid High Street lenders into systemic threats.
No British megabank drained its capital and piled on more debt to swallow rivals than did 286-year-old RBS. And no lender has saddled citizens with a heavier burden. The state, which holds an 82 percent ownership stake in RBS worth 24.6 billion pounds, was sitting on a 20.4 billion pound paper loss as of April 3.
By comparison, the U.S. government made a profit from its Troubled Asset Relief Program bailouts of Bank of America Corp. and Citigroup Inc. after giving each a $45 billion infusion.
Almost five years after RBS’s rescue, a growing chorus of investors, politicians and academics has concluded that the bank is too damaged to bounce back in its current form. From 2008 to 2012, RBS lost 37 billion pounds as it wrote down bad assets and revalued its debt.
“Taxpayers are still not getting a return on their investment,” says Ismail Erturk, a senior lecturer on banking at Manchester Business School. “RBS should be broken up and not left to current management.”
The RBS mess has pitted Chancellor of the Exchequer George Osborne, who continues to stand behind Hester’s turnaround plan, against Bank of England Governor Mervyn King, who says it is not working. King told the Parliamentary Commission on Banking Standards on March 6 that the government should fully nationalize RBS, then split it up and re-privatize the “good” pieces of the bank to recoup what it can of the bailout.
“We should simply accept the reality today that it is worth less than we thought and should find a way to get an RBS that can be useful to the U.K. economy,” said King, 65, who will retire from his post on June 30.
Hester has told investors and analysts that getting a grip on RBS has proven a far tougher task than he initially expected because the euro-zone sovereign-debt crisis and two recessions in the U.K. have undermined the bank’s bedrock lending business. Hester has also been hit with misdeeds that took root before he arrived at the bank in November 2008.
In February, RBS agreed to pay a $612 million penalty to regulators and law enforcement officials in the U.S. and the U.K. to settle allegations that 21 of its traders had manipulated the London interbank offered rate from 2006 to 2010. Barclays Plc (BARC) paid a $453 million penalty last July to settle its Libor case, and UBS AG was fined $1.5 billion in December.
And on April 3, a group of 12,000 RBS stockholders filed a lawsuit in London alleging the bank unlawfully inflated the strength of its capital position when it sold 12 billion pounds worth of new shares in the spring of 2008. The suit, which may seek as much as 4 billion pounds in claims, comes a week after a separate group of investors filed a lawsuit in London making similar allegations over the share offering. RBS spokesman David Gaffney declined to comment on either suit.
Hester has vowed that 2013 will be the final year of major red ink for RBS, thanks to Cullinan’s handiwork.
“We are coming much closer to the end of the restructuring phase of RBS than we have been,” Hester said on a conference call after the bank released its 2012 results — a 6 billion pounds loss on 26 billion pounds in revenue — on Feb. 28. “I do think the toughest work in recovering RBS is behind us.” He declined to be interviewed for this story.
Since Hester and Chairman Philip Hampton started restructuring RBS in 2009, the strategy has been to shift the focus of the universal bank toward the U.K. market. Hester, who was co-head of European investment banking at Credit Suisse Group AG (CSGN) before heading real estate investment trust British Land Co., aims to increase the proportion of the bank’s profit that comes from U.K. retail and corporate lending.
Gone are RBS’s ambitions to rise as a global investment- banking power. The firm fell to No. 16 in this year’s Bloomberg 20, Bloomberg Markets’ annual ranking of the world’s investment banks by the fees they garner, down from No. 11 in 2008.
In 2007, RBS drew about half of its operating profit from underwriting securities, trading, cash management and other investment-banking activities. As the crisis hit the following year, investment banking lost almost 11 billion pounds. Last year, Hester eliminated 3,500 investment banking jobs as he finally chucked major pieces of the division, including the cash equities desk and the M&A advisory business.
Bruce Van Saun, RBS’s group finance director, says he and Hester are nearing their goal for realigning the bank. They are striving to reduce investment banking’s portion of RBS’s operating profit to 20 percent, from 24 percent in 2012, and boost retail and corporate lending to 80 percent, from 67 percent last year. Later this year, Von Saun may leave his job to head RBS’s Citizens Financial Group Inc. unit in the U.S. as it prepares to sell 20 to 25 percent of the company in an initial public offering, according to a person with knowledge of the potential move.
Hester isn’t done firing people. Van Saun says the bank plans to announce a smaller round of job cuts in investment banking in July as it continues to reorganize the division to help corporate clients such as BP Plc and Glaxo-SmithKline Plc (GSK) raise capital and hedge currencies and interest rates.
In all, Hester has announced the elimination of 36,000 jobs across the bank — slicing the workforce by 39 percent from its peak in 2007. RBS, the No. 8 financial services firm worldwide with 1.3 trillion pounds in assets as of December 2012, is still a sprawling enterprise with 137,200 employees.
“You have to make some hard decisions about where you’re going to play,” says Van Saun, 55, a Virginia native who served as chief financial officer and vice chairman of Bank of New York Mellon Corp. from 2005 to 2008. “You still need to offer basic services that corporations need, but we don’t want to be in investment banking just for the fun of it.”
As a ward of the state, the bank should be lending more to British companies in a time of economic hardship, says Nigel Lawson, Margaret Thatcher’s chancellor of the Exchequer from 1983 to 1989. Even though RBS takes part in a Bank of England- administered program that provides cheap capital to banks for lending to nonfinancial companies and households, its loans to them fell by 2.3 billion pounds from June 30 to Dec. 31.
“Lending to small and medium-sized businesses is the most important contribution the RBS group can make,” says Lawson, a Conservative member of the House of Lords who sits on the banking standards commission. “That is not Hester’s background at all; he’s an investment banker.”
Van Saun says RBS isn’t being stingy. The bank says it accounts for more than a third of the loans made to U.K. companies with less than 25 million pounds in annual revenue. He says it’s hard to find borrowers with the collateral and sales growth to qualify for credit in an economy that contracted 0.3 percent in the fourth quarter and may be headed into its third recession since 2008.
“We want to make loans,” he says. “We would be making more money if there were more lending opportunities out there.”
U.K. Business Secretary Vince Cable says banks such as RBS aren’t trying hard enough to lend to small and medium-sized companies.
“I don’t take that argument seriously which I hear in the banking world that we can’t find good business customers,” Cable, a Liberal Democrat, said in a speech at Bloomberg LP’s London office on Feb. 6. “That’s just lazy and rather ridiculous, to be frank.”
Cable, King and Lawson say the prior Labour Party government made a mistake by not taking a stronger hand in managing RBS and directing it to boost lending. To allay investors’ concerns that RBS would be ruled by government fiat after the bailout, former Prime Minister Gordon Brown agreed not to direct Hampton and Hester in how to manage the bank.
After Conservative Party leader David Cameron became prime minister in 2010, he stayed the course. U.K. Financial Investments Ltd., the government entity that holds its stake in RBS, doesn’t even have a director on the bank’s 13-member board.
“The whole idea of a bank being 82 percent owned by the taxpayer and run at arm’s length from the government is nonsense,” King told the banking standards commission in making his case to break up RBS.
Osborne told the commission at a Feb. 25 hearing that Hester is right to keep RBS intact. The chancellor said British banks must maintain their heft and services to cater to global corporations or they will lose out to foreign rivals. Osborne said it was wiser to let Hester finish what he had started rather than have the government spend billions of pounds to buy out RBS’s minority shareholders and take total control of the bank.
“You have to weigh the upfront costs, the complexity of separating the bank,” Osborne said. “You would have to weigh that against current strategy, which is to take the Royal Bank of Scotland and greatly reduce its assets and its ambition from being a global universal bank.”
Even so, Osborne is searching for ways to shake loose what commission member Susan Kramer called his “albatross” at the Feb. 25 hearing. RBS’s stock closed at 271 pence on April 3, 46 percent below the average 502 pence the government paid when it bailed the bank out in 2008 and 2009.
This year through April 3, RBS shares fell 16 percent compared with a 9 percent surge by the FTSE All-Share Banks Index (FABANK), which tracks Barclays, HSBC Holdings Plc (HSBA), RBS and three other British lenders. And yesterday RBS’s shares were trading at a 0.44 price-to-book ratio, or less than half of what the bank says its assets are worth.
“The early hope of re-privatization now looks a distant dream, unless at an unacceptable loss,” Cable said in his Feb. 6 speech.
The business secretary has urged the government to consider a novel solution for getting RBS back into private hands. He wants to give away the state’s 9.1 billion shares to the U.K.’s 45 million taxpayers. Under the proposal, members of the public would register to receive RBS shares valued at a floor price established on the day of the grant.
To curb a wave of immediate selling, stockholders would be able to pocket gains only above that price. The difference would go to the Treasury. Osborne is considering the plan as a possible exit strategy, Treasury spokesman Robert Mackie says.
Proponents of the share giveaway say that it would limit the short selling that would normally accompany a conventional offering of this size. Such trading would amount to a windfall for investors at the expense of the Treasury, says Michael O’Connor, a partner at Portman Capital Partners LLP, a London- based advisory firm that developed the plan.
“The proposal would pass value to the taxpayers and not financial institutions,” he says.
Hester is still cleaning up the mess left behind by former RBS CEO Fred Goodwin. A serial dealmaker, Goodwin mounted the 73 billion euro ($94 billion) hostile takeover of Amsterdam’s ABN Amro Holding NV in October 2007 based on due diligence that largely comprised two binders and one CD of data, according to a 2011 report by the Financial Services Authority. The FSA faulted Goodwin and RBS’s board for doing the deal with such inadequate information.
Goodwin used 12.3 billion euros in debt that came due in less than a year to help finance the biggest acquisition in banking history. His move compounded RBS’s day-to-day reliance on short-term funding as liquidity in global credit markets was evaporating. And that drove the bank to the brink of insolvency in October 2008, the FSA said.
Last year, Queen Elizabeth II, on the recommendation of the Honours Forfeiture Committee, stripped Goodwin of his knighthood. Retired from finance, Goodwin, 54, collects a 342,500 pounds annual pension.
Hester has weaned RBS from short-term notes to protect the bank from another liquidity crunch and bolster confidence in its balance sheet among credit-rating firms. In December 2012, RBS’s short-term wholesale funding was 42 billion pounds, or 5 percent of its balance sheet, compared with 297 billion pounds, or 24 percent, in 2008.
And he boosted the bank’s Tier 1 capital ratio, which measures its financial strength, to 10.3 percent from 4 percent, excluding Cullinan’s Non-Core unit.
Hester has said his key move was selling off the mountain of money-losing and unwanted assets RBS had piled up in the decade before the crash. For that job, he turned to Cullinan, a buyout specialist who had been roaming Africa and Russia for deals as co-managing partner of Renaissance Capital, a Moscow- based investment bank.
In addition to disposing of mortgage-backed securities and loans, Cullinan had to unload a raft of companies: branch networks in Romania, luxury hotels in London and even a chain of 918 pubs throughout the U.K. As he hunkered down in a corner office, Cullinan cast a droll eye on the cone-shaped Gherkin and the City’s other towers that loomed outside his window. He had tacked a cartoon to his wall that captured the spirit of his new job. “As you can see,” a realtor says to a client admiring the same skyline, “this property has excellent views of the recession.”
Rather than hold a fire sale, Cullinan assembled a team of more than 600 bankers, traders and analysts and spent 2009 determining the intrinsic value of every mortgage security, loan and asset in his bulging portfolio.
He tapped two investment bankers from Barclays Capital, Chris Marks and Mark Bailie, as his top deputies. Their patience paid off with RBS Aviation Capital, a finance company that leased commercial aircraft. In 2009, Cullinan rejected offers for the company that discounted its book value by 15 percent. It took three years, but Cullinan finally got $7.3 billion for it — a 4 percent premium on that valuation — from Tokyo-based Sumitomo Mitsui Financial Group Inc.
“The great fear was that when they divested, they’d get the wrong prices because they were forced sellers,” says Paul Mumford, senior fund manager at London-based Cavendish Asset Management Ltd., which holds 500,000 RBS shares. “They’ve done a reasonably good job under the circumstances.”
Van Saun, the finance director, says RBS’s healthier balance sheet and its focus on domestic retail and corporate banking will propel the firm toward profitability.
Last year, operating profits in the bank’s retail and corporate arms slid 5.6 percent, to 4.2 billion pounds, from 2011. And Ulster Bank, RBS’s lender in Northern Ireland and the Republic of Ireland, recorded 1 billion pounds in losses, its fourth straight down year.
“There is light at the end of the tunnel, and we expect RBS to look like a normalized bank in 2014, with a good capital position and a clear dividend policy in place,” says Van Saun. “That should create fertile ground for the government to sell its shares whenever it decides the time is right.”
Investors aren’t as optimistic, as RBS continues to produce a stream of bad news. It’s even having trouble keeping its computer systems running. Millions of retail customers lost access to their accounts last June and again in March. And RBS isn’t done reckoning with the misconduct that preceded Hester’s arrival.
The bank has paid out or set aside more than 2.5 billion pounds to settle claims that it ripped off small businesses and individual borrowers with flawed interest-rate swaps and payment-protection insurance in the years leading up to the 2008 credit crunch. Lloyds Banking Group Plc, Barclays and HSBC have also allocated billions of pounds to pay out claims in similar cases.
“Hopefully, there are no other horrors looming in the woodwork,” Mumford says. “But nothing would surprise me.”
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