Shrinking feeling

RBS turnaround enters critical period

Royal Bank of Scotland's incredible shrinking act is entering its most acute phase. Shares in the 79 per cent state-owned British lender fell as much as four per cent on February 26 after it reported a full-year loss of £3.5 billion ($5.4 billion) and operating profit undershot estimates. That reflects the difficulty RBS will have sustaining last year's 20 per cent stock outperformance relative to European banks.

Chief Executive Ross McEwan still has the correct strategy. By 2019, the trading and advisory unit will have exited 25 countries and be run with a maximum of £40 billion of risk-weighted assets, half the previous target and almost a third of the current level. That's even smaller than UBS's investment bank, although UK requirements to "ring-fence" retail operations make it logical.

The investment bank cuts mean more short-term pain, though. Restructuring costs in the division last year were £295 million, and while McEwan was able to sell a large US loan portfolio to Mizuho at a minimal loss, RBS has said revenue will now decline far faster than costs will reduce. Even after excluding all its legal and reorganisational charges in 2014, RBS's investment bank only managed a 1.9 per cent return on equity, with group ROE negative.

Investors awaiting a resumption of their dividend face other problems. RBS still hasn't fully settled with US regulators investigating the market for residential mortgage-backed securities or provisioned against it, but could face a final fine of $3 billion (£2 billion) from the Federal Housing Finance Agency, Deutsche Bank analysis shows. More fines for foreign exchange are also expected: an additional provision of £320 million in the fourth quarter suggests these could come sooner.

The big unknown is the UK parliamentary election this May. Should the UK's Labour party gain power, competition reviews into retail and investment banking are more likely to see RBS lose domestic market share. Were the business-friendly Conservative party to be re-elected, RBS would still remain a state plaything, as demonstrated by a letter from Chancellor George Osborne to incoming Chairman Howard Davies requesting him and McEwan to limit RBS's activities to helping British businesses. A valuation of 0.8 times forward book value indicates investors fear future losses - even if McEwan's approach is the right one.