RBOS still triumphant despite rising bad debts

Cost cuts arising from the National Westminster Bank takeover in 2000 have exceeded even the highest City expectations
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The Independent Online

Royal Bank of Scotland, the UK's second largest bank, yesterday revealed bad debt charges totalling almost £1bn for last year but delighted its shareholders by posting pre-tax profits up 27 per cent at some £4.3bn. As the banks' results season draws to a close, has the sector succeeded in convincing the City that it can ride out the economic slowdown?

RBOS, along with its rival Barclays, has been perceived as among the UK banks most vulnerable to the global slowdown. It has been pushing into the US, while in the UK it is the largest player in small business banking ­ a sector that quickly turns sour in a recession.

Fred Goodwin, the chief executive, said that a "bunch" of loans at the bottom end of the credit quality scale were behind RBOS's 54 per cent hike in provisions against bad debts in 2001, which stood at £991m. The culprits within the bad bunch were not named, but analysts have estimated that the collapse of Enron alone was responsible for £200m out of the £269m increase in provisions seen in the bank's corporate banking and financial markets division. RBOS was also hit by smaller provision recoveries than it enjoyed in 2000.

Mr Goodwin warned that a greater deterioration in the economy would further impact charges, although overall credit quality was firm. "We think that in 2002 we could see bad debts up a little," he said. "But not an amount that would cause alarm."

As has been the case with rival banks, the increase in provisions was larger than forecast and sent RBOS shares tumbling in early trading. But this time round it did not take long for investors to regain their composure and the shares closed down only 2p at 1,732p. Simon Maughan, banks analyst at Goldman Sachs, said: "Anyone who was spooked by the bad debts must have been on drugs. The market was looking for something around £1bn. Of course, the year-on-year rise looks dreadful. But how could you not have expected it?"

The bad debt problem may have already been a major headache at the start of the reporting season, but Lloyds TSB, Barclays and Abbey National nevertheless spooked investors with the scale of the hikes in their provisions for bad debts in 2001. The ability of RBOS shares to resist a mauling was put down to the rapid acceleration in revenue growth achieved by RBOS during the second half of last year, combined with fresh cost savings targets resulting from the acquisition of National Westminster Bank in 2000.

Group income growth was some 18 per cent last year, taking the total to about £14.6bn. Yet operating expenses were up only 3 per cent. That helped the keenly watched cost to income ratio fall from 53.5 per cent to 46.9 per cent.

The annual benefits from integrating NatWest were raised by £300m to £2bn come 2003, albeit at a one-off cost of £2.3bn rather than the £1.4bn originally proposed. At the time of the bid, RBOS was targeting annual savings and revenue synergies of just £1.32bn. Between the deal's completion and the end of next year, the group expects to have eked out benefits of some £5.5bn, mainly by the loss of about 18,000 jobs.

However, while the infrastructure integration continues apace, cultural integration is lagging. The proportion of NatWest customers who say they are very satisfied with service levels is only 44 per cent, compared with almost 60 per cent for customers who bank at Royal Bank of Scotland branches.

Mr Goodwin moved to temper the City's expectations for further aggressive organic growth in the UK. "We are probably past the explosive point," he warned.

Organic growth was now a greater priority at Citizens bank, its US subsidiary in Maryland, although the group was also readying itself to make further acquisitions in the region following the success of its $2.2bn (£1.5bn) purchase of Mellon Financial's retail banking arm.

Mr Goodwin declined to comment on speculation linking RBOS to Allied Irish Banks, or its subsidiary Allfirst Financial, which is still reeling from the £500m fraud in its treasury operations revealed last month. While prices of European banks were too high just now for a deal to work, Mr Goodwin had his eye open for "tactical" deals at cheap prices in the UK.

Neither was there any need, said the finance director, Fred Watt, for RBOS to follow rival HBOS, which this week shocked the Square Mile by issuing new shares to raise £1bn for funding organic growth through aggressive pricing strategies. "We would not be going back to ordinary shareholders. We are throwing off capital. The business we are adding is profitable," he said.

Jonathan Pierce, analyst at HSBC, said: "Bad debts may have been a shade higher than expected, but the differential between the momentum of income growth and cost growth was sufficient to offset that."

By contrast, results from other banks have shown them failing to achieve income growth without also jacking up costs. Cost control appears to be emerging as a theme likely to weigh as ­ if not more ­ heavily on investors' minds as bad debts have to date.

Simon Price, analyst at JP Morgan, said the sector had this year disappointed the high expectations of the City, which had been nudging bank shares higher relative to their continental peers amid hopes that domestic banks would make a better show on cost control. "Barclays really disappointed on costs, as did Lloyds's restructuring charges," he said.

Colin Hector, an analyst at Lehman Brothers, said: "I think bad debts were the issue, but what we're now surprised about is costs."

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