RBS retains structured products in restructure

Royal Bank of Scotland retains its investor products and equity derivatives businesses in its latest restructuring, but ditches cash equities, corporate broking, equity capital markets and mergers and acquisitions. Richard Jory reports

Structured products and equity derivatives will fit within the Markets business at Royal Bank of Scotland (RBS) following the restructuring announced on January 12. Markets and International Banking are the two components of the new wholesale banking division under the leadership of John Hourican. "We're keeping [structured products] within the Markets business because it is performing well and we consider it a core business," says an RBS spokesperson.

The bank says it will either sell or close cash equities, corporate broking, equity capital markets and M&A, "businesses [that] accounted for £220 million of income in [the first nine months of 2011], equivalent to 35% of equity income, 4% of [Global Banking & Markets] income and just 1% of group income," according to Citi research. "The ‘exit' businesses are currently unprofitable, so future earnings impact is negligible," adds the research.

In the statement released early on January 12, RBS declared its structured products intentions: "We remain firmly committed to our investor products (structured retail) and equity derivatives businesses... We will continue to have a significant international network to support our clients' needs globally."

One source close to the bank says "the restructuring doesn't change anything [for structured products], other than leading to closer integration between equity derivatives and Fig (the Financial Institutions Group)... and [our commitment to exchange-traded funds (ETFs) doesn't change."

Exchange-traded funds complement structured products well, according to another source. "Funding is always going to be a difficult game for everybody in this market now," he says. "If it is volatile and you are in delta 1, it's a natural hedge against those problems you can sometimes get when trying to sort out your funding. There is no change to equity derivatives and structured products."

The structured products business at RBS "does more than wash its face", says the source close to the bank. "It rains funding, makes money, and we are recognised for it. The bank is interested in the P&L, but is in a much better funding position now and is not so pressured on raising funding through issuing structured products. The change is that we're even more focused on businesses that we are already really good at."

The bank was the second most prolific issuer of structured products in the UK in November 2011, with roughly 22% of notional, according to data from Future Value Consultants. Investec was the top provider with 25% of notional in the same month, with Morgan Stanley a long way back in third with a share of 7.6%. "Our core retail and commercial businesses outside Ireland now operate with an attractive return on equity overall," says Stephen Hester, group chief executive. "Our investment bank has produced an average return on equity of 19% and delivered over £10 billion in profits since 2009. Our non-core assets have fallen below £100 billion, ahead of schedule. Profits from our core businesses have been essential to pay for the clean-up losses of RBS legacy."

According to the Citi research: "Long-term, this shift in strategy should help to appease RBS's largest shareholder, improve the group funding structure, and provide modest capital relief, while we think the current valuation (0.4x P/TB) remains attractive. However, near-term we expect this to add to existing uncertainty, given the high execution risk, and the possibility of further damaging staff morale within the remaining ‘Markets' business. We prefer Barclays, which we perceive to be a ‘winner' in the consolidating world of capital markets."

The former Global Banking & Markets funded balance sheet is targeted to fall from roughly £420 billion as of June 30, 2011 to around £300 billion over the three-year implementation period, says RBS in the January statement. "Associated usage of unsecured wholesale funding is targeted to decrease by £75 billion during the same period. RWAs and equivalents, post Basel III changes, at the end of the implementation period are expected to be less than £150 billion versus the c£225 billion previously indicated, of which the Markets business will aim for c£100 billion."

The bank is due to reveal more detail on its new global banking and markets strategy with the release of full-year results on February 23.

A divestment programme that had started with the announcement, in February 2009, that certain non-core assets were put up for sale, recorded some success on January 17, when the bank announced an agreement to sell RBS Aviation Capital to Sumitomo Mitsui Banking Corporation, acting on behalf of a consortium comprising its parent, Sumitomo Mitsui Financial Group, and Sumitomo Corp for $7.3 billion, subject to certain post closing adjustments.

RBS announced the first sale in the latest divestment programme on February 1, with an agreement to sell RBS Hoare Govett corporate broking operations and transfer certain other professionals to Jefferies International. The sale includes the transfer of certain other cash equities professionals to Jefferies. The sale is for nominal cash consideration and is expected to complete by the end of the first quarter of this year. The transaction is not subject to any regulatory or other conditions precedent.

"RBS will work closely with Jefferies and existing clients of the UK corporate broking business in seeking to transfer existing corporate broking roles to Jefferies to the satisfaction of its clients," says RBS in a statement released on February 1. "RBS remains in active discussions with other third parties interested in acquiring various parts of the businesses it has identified for exit. Further updates will be provided based on developments."

 

Box: Cash equities exit could hike hedging costs

Royal Bank of Scotland's decision to exit cash equities will make it more expensive for the bank to hedge its structured products book, rival dealers claim - and could also undermine its equity derivatives flow business.

The bank announced a restructuring of its global banking and markets business on January 12, involving the closure or sale of its cash equity business. RBS will continue to offer structured retail products and equity derivatives. But that means the exposures resulting from the structuring business - for example vega, which measures the change in an option's value caused by changes in volatility - will no longer be naturally offset by positions taken for clients in the cash market, dealers say.

"It's going to pinch in terms of vega-hedging. The supposed value of the integrated cash-plus-derivatives model is that you acquire risk in the structured note and corporate business, and then lay it off in the two-way flow business. In theory, you earn bid-offer on both sides and never pay it. But RBS will now be forced to hedge its vega via listed options or the interdealer market and pay the full bid-offer, as opposed to being able to recycle the risk via an active flow business," says the head of equity derivatives at one US bank.

Another equity derivatives head at a European bank in London says the impact will be inconvenient rather than life-threatening. "It's not fatal stuff. The magic in the structured products business is the distribution - if you have good access and relationships, and another dealer is priced 20 basis points better, it's not going to matter that much. The bigger risk is that people start questioning the commitment of RBS to equities. Is this the end-point or a step in the direction of the dissolution of equities?" he says.

Royal Bank of Scotland declined to comment. In the statement released by the bank in the middle of January announcing the closing of cash equities, corporate broking, equity capital markets, and mergers and acquisitions businesses, the bank revealed that these businesses, which had income of around £220 million in the first nine months of 2011, were not earning enough to be profitable.

But it might not be realistic to expect the flow part of the equity derivatives business to thrive without a cash franchise. "Equity derivatives flow businesses cannot be successful without cash equities. Hedge funds and long-only funds are very reluctant to trade with a bank that doesn't have a cash equities franchise, so without it the flow business will shrivel. That said, flow isn't that profitable a business - the margins are very thin," the US bank's equity derivatives head says.

Matt Cameron